Thin Capitalization

Thin capitalization is a tax term that refers to a situation in which a company has a high level of debt and relatively low equity. This makes such companies highly leveraged and reliant on external sources of capital rather than internal capital. As a result, some companies may have a debt-to-equity ratio as high as 3:1, which indicates a high-risk position.

The concept aims to portray a company with a financial structure heavily skewed towards debt financing instead of equity financing.

The essence of thin capitalization is to limit the interest expense a company can claim as a deduction for tax purposes. This limitation typically takes the form of a debt-to-equity ratio, which sets a maximum threshold for the level of debt financing that a company can have relative to its equity. If a company exceeds this threshold, its interest expense will be disallowed or subject to certain restrictions, resulting in a higher tax liability.

How To Calculate?

To determine if a company is thinly capitalized, the financial leverage position of the business entity needs to be evaluated. If the debt-to-equity ratio is more than 1.5:1, the company is considered thinly capitalized. The debt-to-equity ratio of a company can be calculated using the following formula:

Debt-to-Equity Ratio = Total Liabilities / Total Shareholders' Equity