Thin Capitalization Tax Shelter Loans
How Entrepreneurs Save Money in High-tax Jurisdictions
Dec 10, 2008
An American or Canadian entrepreneur who wishes to start a company overseas is often faced with severe corporate tax rates on his or her business capital investment.
High tax jurisdictions comprise some of the most promising developing markets for international trade ventures. As specified in the article Highest Taxed Countries, China imposes an effective business tax rate of 46.9% while the comparable tax percentage is 38.8% in Brazil.
These corporate income tax and capital gains business tax rates represent direct taxation that cuts into the company’s bottom-line profits. In addition, the company has to pay indirect taxation in the form of excise taxes and customs duties.
An entrepreneur who decides to work in a foreign country but maintains his or her original citizenship is subject to double taxation for personal income taxes – another form of direct taxation.
Thin Capitalization Tax Saving Secret
Thin capitalization is a legal tax shelter for the business revenues generated by a foreign operation in a high-tax jurisdiction.
In a nutshell, thin capitalization treats business profits and capital gains as a deductible interest expense under a loan rather than taxable income.
Setting up a Tax Shelter Through Thin Capitalization
Consider an American investor who wishes to:
- Start a water purification company overseas in China
- Circumvent Chinese taxation rates of 46.9% on corporate revenues and profits.
The U.S. entrepreneur starts out with US$1 million to invest, and partners with a local Chinese company in the targeted foreign market to form a new corporation.
From the allotted $1 million in investment funds, the American then:
- Gives the new corporation a relatively small amount of capital to establish business operations, for example $100,000.
- Writes up a $900,000 loan to the new corporation using the remainder of the $1 million investment.
How Thin Capitalization Saves Taxes
After the $900,000 loan is set up, the corporation operates its water purification business generating revenue in China. Given the demand for clean water and China’s vast population of 1.3 billion, first-year revenues are $1 million and climbing fast.
Without the $900,000 loan, Chinese authorities would otherwise capture $469,000 in taxes.
Under the thin capitalization loan, the water purification corporation makes large interest payments to its American investor. For taxation purposes, those interest payments effectively wipe out all the new company’s potential profit.
Further, because company revenues have gone to paying off the loan, no money is left to pay corporate shareholder dividends. No dividends further insulates the new company from paying dividends in China.
In fact, an effective Thin Capitalization loan leaves nothing to be taxed in a high tax jurisdiction. Corporate revenues, profits and dividends have been re-characterized as interest – a deductible interest expense.
Lower Taxation Encourages International Trade
Some business analysts argue that Thin Capitalization presents an unfair advantage to multinational companies backed by foreign tax cheats, since domestic firms are burdened by the location taxation rates.
Still, jurisdictions with high taxation rates are imposing barriers to global trade that Thin Capitalization helps to overcome. Thin Capitalization is positive for the global economy, since these loans increase investment and spending on business development projects around the world.
Reference:
David M. Neiport, A Tour of International Trade (Prentice Hall 2000).
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