When you receive a loan from a financial institution or similar lender, you pay interest along with the principal each month. Naturally, you record the interest as an expense, right?

However, there are cases in which interest on borrowings does not count as an expense (a deductible expense).

That is the thin capitalization rule... If you do not know about it, you could suddenly be hit with a large tax bill.

What Are the Thin Capitalization Rules?

They are rules intended to prevent a company in Japan from using excessive borrowing when raising funds from overseas to record substantial interest expense, reduce its profits, and keep its corporate tax low (tax avoidance).

Background to the Thin Capitalization Rules

When a company in Japan raises funds from overseas, it may do so through equity investment or borrowing. In the case of equity investment, the overseas investor receives dividends, but those dividends cannot be recorded as expenses (deductible expenses). On the other hand, when borrowing from overseas, the company can record interest and treat it as an expense (a deductible expense). Thus, borrowing makes it possible to reduce profits in Japan by recording interest and shift profits overseas.

Specific Standards and Calculation Method for the Thin Capitalization Rules

To prevent conduct intended to keep corporate tax low (tax avoidance), if the following two conditions are met, part of the interest expense on borrowings from overseas is disallowed (is non-deductible).

  • The average balance of total interest-bearing debt (the total amount of debt that bears interest) exceeds three times equity capital (however, if the combined total of retained earnings carried forward and current-year net income is negative, the comparison is made with three times the amount of capital, etc., rather than equity capital)
  • The average balance of borrowings from overseas exceeds three times the amount of equity investment from overseas

In principle, the interest that does not count as an expense (non-deductible interest) is the following amount.

Interest on borrowings from overseas × (1 − amount of equity investment from overseas × 3 ÷ average balance of borrowings from overseas)

What did you think?

As globalization advances and investment from overseas increases, choosing borrowing rather than equity investment is by no means a bad option. However, I recommend considering the form of financing on the premise that interest may not count as an expense once it exceeds a certain amount.