Intra-group Financing and thin Capitalization Rules

1)   Introduction

Intra-group financing, a way of financing associated entities through debt and “thin capitalization”, refers to the financing of a company through a relatively high-level debt. As this impacts the profits and the taxability of a company, “thin capitalization rules” are often introduced to limit the deductibility of interest paid on corporate debts.

2)   BEPS Action Plan 4

                        i.     Objective

• Prevent excessive interest deduction.
• Introduction of interest deduction limitation rules. 

                      ii.     Interest deduction Rule

a.    Fixed Ratio

• Fixed % of Earning before interest, tax, depreciation and amortization (EBITDA)

b.    Group Ratio

• Deduction of more interest expense depending on the relative net interest/ EBITDA ratio of the worldwide group.

3)   Thin Capitalization in GCC Countries

a.    KSA

• Interest payment to affiliates - Allowable, if at ALP and interest deductibility formula is met. 

b.    UAE

• Net Interest Expenditure ≤ 30% of EBITDA
• Interest on loan obtained from a Related party (“RP”) to be at ALP. 

c.    Oman

• Debt-to-equity - 2:1
• Interest on excess debt disallowed. 

d.    Kuwait

• Executive Rule No. 38 governs tax treatment of interest with DIT discretion for case-specific tax determinations.

e.    Bahrain

• No specific legislation regarding thin capitalization. 

f.     Qatar

• Loan = Arm’s Length
• Interest ≤ 3 times of Equity

4)   Safe Harbour Insights

                            i.        Intra-Group Financing

• Establish acceptable interest rates and terms.
• Reducing the risk of transfer pricing disputes.
• Reduced documentation requirements.

                          ii.        Thin capitalization

• Specifies acceptable debt-to-equity ratios.
• MNEs can minimize the potential for disputes with tax authorities over the deductibility of interest expenses.

5)   Key Takeaways

• Strengthens the ALP by matching interest rates with unrelated entities, fostering fairness and transparent financial dealings
  
  
• BEPS Action 4: Limits on interest deductions counter tax erosion, favoring genuine economic activities.
  
  
• Prudent Simplification: Safe harbor provisions simplify compliance, yet careful application is crucial to avoid oversimplification risks.