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M&A Vocabulary – Understanding Experts: “Thin Capitalization” in Germany and Russia


In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner present an important term from the specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give or refresh a basic understanding of a term and provide some useful tips from our consultancy practice.

A company's need for capital can be generally covered by either equity or debt capital. The latter can be provided by a third party or a shareholder (the so-called shareholder debt financing).
A high level of shareholder debt financing often has tax implications: as a rule, the paid interest represents tax-deductible expenses on the part of the borrower, but on the lender's part it constitutes interest income subject to tax. Double taxation treaties generally provide that no tax is charged on interest in the source state, whereas the state of the lender has the right to tax the interest. If, on the other hand, the required capital is supplied as equity, the company can distribute profits only in the form of dividends. However, dividends are often a less advantageous option than the taxable interest because they are disbursed after tax”, i.e. they do not reduce the income tax base. Additionally, dividend distri­butions are often subject to withholding tax. If the lender and the borrower are resident in different countries, they can also use a high level of shareholder debt financing to profit from tax treatment differences between those countries.
To prevent such tax arrangements, international tax law includes a set of thin capitalization” rules. Depending on how the transaction is structured, those rules prohibit or restrict the tax-deductibility of interest expenses under certain circumstances or allow interest to be reclassified into dividends and treated as such for tax purposes.
The thin capitalization rules under tax law are meant to, among other things, prevent undercapitalization resulting from excessive capital gearing, but they must be clearly distin­guished from the company laws governing under­capitalization understood as an insufficient level of capital. The latter case occurs, for example, if equity is consumed by losses and falls below the amount of the registered capital. In Russia, corporate actions are required in such cases. Otherwise the company may be even liquidated under certain circumstances.
In terms of structure, the Russian thin capitalization rules are comparable to the shareholder debt financing rules which applied in Germany before the introduction of the interest capping rule [Zinsschrankenregelung]. While the debt-to-equity ratio allowed in Germany until 2017 was 1.5:1, the ratio permitted under Russian tax law is basically 3:1. In certain cases, e.g. in the case of leasing companies, the law permits even a ratio of 12.5:1. But as soon as this ratio is exceeded, the loan interest is reclassified into dividends. The debt-to-equity ratio must be checked based on accounting figures as of the last day of each calendar quarter. If the loan interest is reclassified, its excess portion is excluded from tax-deductible expenses and its payment triggers the obligation to pay a withholding tax on dividends of generally 15 per cent. However, if certain conditions stipulated in a relevant double taxation treaty (DTT) are met, the taxpayer may also apply the parent-subsidiary affiliation exemption available under the DTT on such reclassified interest and pay only e.g. a 5 per cent WHT (depending on the applicable DTT).  While the tax consequences in terms of the amount of the tax payable on the interest reclassified into dividends are rather insignificant in the case of smaller operating loans to the tune of only a few hundred thousand euros, the Russian thin capitalization rules should be borne in mind when taking out larger loans as their tax effects may be very serious.
A practice frequently applied until several years ago to avoid the Russian thin capitalization rules was to provide finance through a sister company. This gap” has been filled in the meantime, though. The Russian thin capitalization rules might also cover debt financing from banks if the borrower's associated company stands surety for the bank loan.
Besides the thin capitalization rules there are also other aspects of debt financing that should be taken into account. This includes the requirement according to which the agreed interest rate must be at arm's length. At the same time, Russian tax laws include a relatively generous safe harbour regulation in this respect (EURIBOR + 7 per cent).
Further, it should be noted that Russian tax authorities have recently also practiced reclassifying loans into investments (equity) in some cases, as a result of which interest is no longer tax-deductible. Such risk exists in particular when for certain reasons it is not possible to predict whether the Russian company will be able to repay the received loan.


While the thin capitalization rules have often rather minor tax consequences in the case of small loans, they should be borne in mind when taking out larger loans. It is also important to take into account other tax aspects of financing of subsi­diaries. These include e.g. the interest rate re­quirements and the risk of a loan being reclassified into equity.

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