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Thin capitalization refers to intentionally increasing borrowing as opposed to investing funds in financing to reduce the tax burden. The Thin Cap is a system which does not recognize the interest on borrowing as a deductible expense.
Concept
A corporation tends to borrow funds from shareholders rather than invest funds since the interest on a loan is a deductible expense, while a dividend on investment cannot be calculated as a deductible expense. Thin cap is a system to prevent tax avoidance by not recognizing the interest on a loan exceeding a certain amount as a deductible expense.
Application
In cases where a domestic corporation has borrowed funds from a foreign controlling shareholder or from a third party under a payment guarantee by a foreign controlling shareholder, and such borrowings exceed twice the amount (six times for a financial business) invested by the foreign controlling shareholder, the interest and discount fees paid in relation to the excess amount are not included among the deductible expenses of the domestic corporation.
