Thin Capitalization Rules and Impact on Cash Pooling

Cash pooling transactions are often carried out for liquidity optimization purposes but also impact a company’s equity capital base. An important aspect to keep in mind when implementing a cash pool is the regulation for safeguarding a company’s equity. These regulations are designed to prevent erosion of a company’s equity base through certain transactions. While these regulations are not directly tailored to physical cash pooling they nevertheless govern cash pooling and failure to observe them can cause problems.

General Regulation of Thin Capitalization Legislation

Thin capitalization regulations, also referred to as under-capitalization regulations or debt-to-equity rules, have to be observed, particularly on an international level. These regulations normally contain general principles determining the maximum extent to which a corporation may cover its capital requirements with external capital. They are, however, applicable only if inter-company loans are extended by a parent company to its subsidiaries. They do not apply to third-party loans, for example normal bank loans. Such regulations are primarily based on the assumption that sound business sense tells us that funding a company with external capital is only justifiable up to a certain point. Instead, an injection of new equity capital should be made as even a third party like a bank would no longer provide a company with any capital. A loan in the other direction given from the subsidiary to the parent company does not fall under the thin capitalization rules, but this could be a forbidden refund of contributions as the opposite of the shareholders’ loans.

Figure 1: Inter-company Loans

In concrete terms this means that, if a cash pool functions as a loan, only a certain maximum ratio of inflowing external capital to existing equity capital is permitted. However, this ratio only refers to loans extended to subsidiaries. Any other indebtedness to banks that may exist will not be counted in that ratio. Loans up to that maximum ratio, which are extended by a company having a 100 per cent interest in the borrower, are referred to as a safe haven.

Key Position: Debt-to-equity Ratio

Not even the EU, however, provides uniform regulations for this ratio. Instead, each country with a tax code containing thin capitalization rules fixes different ratios. Some countries have no fixed ratio at all, but only basic principles according to which an excessive share of external capital is considered inadmissible under fiscal law. This ratio will be determined by the respective tax authorities or tax courts if required. Since liberalization of the economic system in Eastern Europe only began a few years ago, some of these countries have not yet codified any corresponding regulations. Nevertheless, it should be ensured that in practice no permanent thin capitalization occurs. In the final analysis, this is a basic tax principle, which is applicable to many legal systems so that in extreme cases the local courts may, on the basis of general legal standards, also arrive at decisions, which conform to the legal position in Western Europe.

An inflow of capital caused by the parent company and exceeding the permitted maximum ratio is not expressly prohibited but will be considered as a capital injection and not as a loan. This presupposes, however, that such payments are effected by the shareholders and not through bank loans in some countries. For example, in Germany the thin capitalization regulations will not apply if the paid interest does not exceed a total amount of €250,000 or if the group can prove to the tax authorities that the chosen capital structure stands up to an arm’s length comparison. The problem here is that in the scope of ‘safe haven’ there is a presumption in favour of the participating companies, whereas the burden to prove that the arrangement is in line with the arm’s length principle lies with the affiliated companies if the statutory maximum ratio is exceeded.

Negative Consequences When Rules are Violated

The consequence of these thin capitalization regulations is that interest payable on inflowing funds may no longer be deducted from taxes as a business expense for the payer. Instead, the tax authorities regard the deposits as undisclosed equity so that interest payments are considered a hidden profit distribution. Such profit distribution in turn is subject to regular corporate tax for the interest receiving party. This arrangement aims to preclude deduction of profit from tax within the group by distributing interest payments in such a way that they are concealed.

It must be noted, however, that some tax administrations (e.g. in Germany or Austria) will not consider any capital commitment up to a term not exceeding six months as external financing and that the loans must therefore not be placed to account when determining the debt-to-equity ratio. But current account loans are seen as long-term external equity; and cash pool transactions are consequently such loans under German or Austrian law. However, the tax authorities in other countries take a less restrictive view of that situation, but this should be ascertained on the spot if necessary. Without having a legal framework or explicit statements from the tax authorities companies carrying out cash pooling transactions, care should be exercised not to violate fixed debt-to-equity ratios.

No Unified Rules in a United Europe

Although most of the Eastern European countries are now members or candidates of the European Community, in fact there are no common rules in sight regarding thin capitalization. Nevertheless the local regulations should carefully be observed, because of the negative consequences of violation as described above. In countries with a fixed ratio, the group treasurer or the CFO should consider this. There is a constant danger of violation, especially in Germany and France with a 1:1.5 ratio, but also in countries with a ratio of 1:3 or 1:4. A ratio of 1:1.5 means that it is only legally permitted to use 60 per cent external capital (from the parent company or other credit grantors) and that there has to be another 40 per cent equity capital. But in fact, German stock companies normally have no more equity exceeding something around 20 per cent; so nearly all bigger companies or those listed on the Frankfurt stock exchange are not allowed to use significant funds from a cash pool out of their parent company without violating the relevant thin capitalization rules. Nevertheless, when implementing an international cash pool, this German ratio is only valid for the German subsidiary when funds are transferred to a parent situated either abroad or in Germany.

The situation is not so strict in countries without a fixed ratio like the UK or Austria. However, not having fixed ratios doesn’t make things easier because the tax authorities and the tax courts have stated special rules, as to how these inter-company loans should be carried out and when equity will become inadequate. One important point in this context is to have agreements on an arm’s length principle, although this is a topic of transfer pricing, but there is also an effect on the thin capitalization rules. Only if the inter-company loan agreement is acceptable in terms of all other aspects of tax and company law will there be no problem with thin capitalization rules.

The last group of countries like Russia and Croatia has in fact no thin capitalization rules at all, either in writing or otherwise, so companies do not need to observe any restrictions. However, there are other significant restrictions on cash pooling in these countries which must be observed.

When implementing a pan-European cash pool, the company has to consider the thin capitalization rules in every country involved as described above. What counts is to have a clear pooling structure with one master account holder. Starting from this account, the responsible persons must consider the thin capitalization rules in every country in which a single company maintains a pooling account involved in the cash pool with funds transfer to the master account. Funds transfer within one company or between branches are not problematical. Thus the whole cash pool must be documented accurately regarding thin capitalization regulations, so any violations of local laws can be traced in time. There have to be possibilities to stop the cash pool or to re-transfer funds manually, because the tax authorities assess the tax situation at the end of the period (quarterly or annual), when the company publishes its regular financial statements.