How owners finance a company has tax implications. Interest on loans is deductible for tax purposes, but dividends are not deductible. Loans are also easier to raise than equity. So, business owners often finance their businesses with a mix of equity and debt.
Thin capitalization refers to the proportion of debt financing. According to Ghana Tax laws, when the debt to equity ratio is 3:1 or more, the company has thin capitalization.
Tax authorities see thin capitalization as a tax avoidance scheme to reduce the tax base, so they have passed laws to reduce the erosion of profits when the majority owners are non-resident. Such companies may not deduct the full interest incurred when computing taxes.
Although the Companies Act of 2019 does not require a minimum amount of capital, the tax authorities, by implication, require you to fund the business with a reasonable amount of equity.
The Thin Capitalization Rules
Section 33(1) of the Income Tax Act, 2015 (Act 896) defines thin capitalization as:
“Where a resident entity which is fifty percent or more of the underlying ownership or control is held by an exempt person either alone or together with an associate, has a debt-to-equity ratio over three-to-one during a basis period”.
The above means that where a company has a debt to equity ratio of 3:1, and a foreign company and its associates hold majority interest, GRA will disallow part of interest and foreign exchange losses for tax. The portion disallowed is that part which exceeds the 3:1 debt-equity ratio.
Entities it Affects
The thin capitalization rule affects subsidiaries of international firms. These companies use a mix of equity, short-term credits and long-term debt. Tax authorities scrutinize transactions between international companies and their subsidiaries.
Why the Scrutiny
The parent company has control or influence over the decisions of its subsidiaries. Transactions between the two may not be at market prices. It is for this reason that the tax authorities scrutinize financing arrangements between such entities.
How Does the Thin Capitalization Rule Apply?
To explain, we use the example of A Limited, a subsidiary of a non – resident company.
A Limited’s total capital requirement is GHC 150,000.00. A non-resident company invests GHC 30,000.00 and the company borrows GHC 120,000.00 from the related party at an interest rate of 30%. Profit before interest for the year is GHS 50,000. The debt to equity ratio is 4:1.
Table 1: Tax before applying the thin – capitalization rule
| GHC | |
| Profit before Interest and Tax (PBIT) | 50,000 |
| Interest (30% of 120,000) | 36,000 |
| Profit before Tax | 14,000 |
| Tax at 25% | 3,500 |
The Commissioner-General has the power under Section 33 of Act 896 to disallow GHC 9,000 which is ¼ of the loan interest. He will add this back and tax it.
Table 2: Tax after applying the thin capitalization rule
| GHC | |
| Profit before Interest and Tax (PBIT) | 50,000 |
| Interest 75% of (30% of 120,000) | 27,000 |
| Profit before Tax | 23,000 |
| Tax at 25% | 5,750 |
From the examples above, by applying the thin capitalization rule, A Limited has a tax liability of GHC 5,750 which is more than GHC 3,500, its initial tax liability.
Takeaway
Financing arrangements between international firms and their subsidiaries in Ghana are subject to the thin capitalization rules, and companies should ensure they comply by these rules in calculating their tax liability.
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