Thin capitalisation: An issue that should not be looked at thinly

Amanda Pletz, Emmanuel Llinares and Rob Patton, NERA, London and Paris

Emmanuel Llinares is a Director, Amanda Pletz and Rob Patton are Senior Consultants  

An issue that should not be looked at thinly

Thin capitalisation is an often overlooked issue in transfer pricing. A company is said to be thinly capitalised when it has a high level of debt relative to equity. In a transfer pricing context, thin capitalisation can become an issue if tax authorities believe that an affiliate's related-party debt appears to exceed what that entity would be able to borrow from the market on a stand-alone basis. This can lead to “excessive” interest deductions.

In many countries, legislation imposes restrictive conditions on intra-group debt. Such conditions can restrict debt levels to well below the levels for free-standing companies' borrowing on the market. Moreover, in many countries, rules of thumb are still relied upon to establish limits on what may be treated as debt for tax purposes. In such jurisdictions, affiliates' interest charges may be deductible only for debt up to a certain debt-to-equity threshold: for example, some countries use 3:1, while others impose a limit as low as 1.5:1. These thresholds are applied regardless of the business, strategic situation, industry, or economic environment. Such arbitrary limits obviate the need for in-depth economic analysis.

As illustrated during the recent financial crisis, debt-to-equity ratios of companies may evolve substantially due to market conditions. This can lead to a high degree of leverage being quite common in certain sectors. In many cases, the leverage observed for stand-alone companies is well in excess of the regulatory thresholds for affiliates, thereby rendering these limits inconsistent with market practice. At the end of 2012, for example, 18 percent of the constituent companies of the EURO STOXX 50 index had debt-to-equity ratios in excess of 3:1.

Given the limitations of thin capitalisation requirements and the increasing importance of intra-company financing, many tax authorities have recently revised (or at least acknowledged the desirability of revising) existing policies and thresholds. The objective of this article, however, is not to review various countries' tax legislation relating to thin capitalisation. Rather, as economists dealing with intra-group pricing issues, we believe that there are economically sound approaches that can be used to determine whether an observed debt-to-equity ratio is consistent with independent (or arm's length) ratios in the industry of the company being evaluated. In this article, we describe such an approach.

The approach we describe below may not be applicable in all circumstances. In particular, in countries that have adopted prescriptive (i.e., rule-of-thumb based) legislation, the approach would not apply. However, the framework we set out can be applied in those jurisdictions where thin-capitalisation legislation is sufficiently flexible as to accommodate a more analytical approach.

l. Context

Multinational enterprises determine their capital structure to enhance corporate value and minimise the cost of financing on a global basis -- including tax costs. Continuing financial market innovations have resulted in an increased use of innovative sources of hybrid financing. Furthermore, hybrid financing is in many instances more attractive to companies as hybrid financing instruments receive more favourable treatment from rating agencies and thus can protect companies from rating downgrades following substantial debt issuance.1 Chart 1 shows the issuance of hybrid financing instruments (convertible securities and preferred equity) from 2008 to the first quarter of 2013. The rise of hybrid financing instruments has made the determination of what should be treated as “equity” and what should be treated as “debt” more complex, especially when comparing ratios across firms

Chart 1, TMIJ  


In this context, how does one assess, from an “arm's-length” perspective, the debt-to-equity ratio of a company that is part of an affiliated group?

The first stage of such an analysis should concentrate on understanding the background and context of the related intra-group debt. Similar to typical transfer pricing analyses, a functions, assets, and risks analysis of the affiliate being evaluated is essential. A similar analysis should be completed for other affiliates of the group. Such an analysis may not be sufficient, however. Recent cases such as the highly publicised GE Capital Canada case demonstrate the importance of considering the relationship between parties when evaluating intra-group transactions, particularly in the context of financial transaction arrangements. Reviewing the capital structure of an affiliated entity also requires an assessment of those relationships in order to form a reliable understanding of the relevant risks and resources available to the affiliated entity.

When it comes to thin capitalisation, these dimensions are often overlooked. Many functional analyses are limited to setting out which entity is lending and under which conditions and to describing the main characteristics of the borrower. These analyses often fail to consider the relationship between the borrower, the lenders, and other stakeholders in the group such as the borrower's primary trading partners.

In practice, the availability and organisation of funding in a group are important aspects that affect corporate value. Furthermore, capital structure decisions are subject to a number of factors including size, profitability, fixed assets, bankruptcy probability, dividend policy, sectoral risks, and other risk exposures including foreign exchange risk, political risk, and local capital market risk.2,3 This article does not aim to provide an exhaustive list of the factors to be considered as part of this analysis.

When performing the analysis, it can be helpful to refer to the OECD Transfer Pricing Guidelines' comparability factors. These are a useful starting point in identifying the core factors that influence the level of debt that a firm might carry on an arm's length basis. They include:

• The characteristics of the entity and the transactions that have given rise to the intra-group debt;

• The functional profile of the entity that receives the debt and the related parties involved in intra-group transactions with the tested party;

• Contractual terms of the transaction defining how the responsibilities, risks, and benefits are divided between parties. The risks considered include both entity-specific risk factors and debt-related, transaction-specific risk factors. The latter should generally be reviewed in light of the contractual allocation of risks;

• The economic circumstances of the transactions that have given rise to the intra-group debt. This should include reviewing the industry in which the entity and the group operate. Our experience and data suggest that arm's length debt-to-equity ratios vary substantially across industries as well as within industries and over time; and

• The underlying business strategies should also be evaluated when considering the arm's length debt-to-equity ratio. When considering differing levels of debt-to-equity, the firm's individual circumstances and the business strategy it relies upon to create value can lead to appreciably different ratios even within an industry.


In addition to the comparability factors cited above, the operational links (the relationship) between the affiliate that has the debt, on the one hand, and the lender and the group as a whole, on the other hand, should be reviewed carefully.

In principle, the arm's length criterion aims to establish whether third parties, given their operational circumstances, functional, risk and asset profile and their contribution to value creation, would have been able and willing to rely upon a level of debt-to-equity similar to that of the tested party. Reviewing these factors is an essential part of comparability analysis. In short, the objective of the qualitative part of the analysis is to set out the substance of the transactions and relationships that explain the capital structure of an affiliate operating within a multinational group.

ll. An approach for assessing market levels of debt-to-equity ratios

Having set the stage in terms of the context of the transactions and relationships that affect the debt-to-equity ratio of an affiliate, we now turn to the economic and financial part of the analysis. In this section, we describe a two-step analysis to evaluate whether an affiliated entity's debt-to-equity ratio is consistent with what one would expect to result from strictly arm's-length transactions.

Step 1: Leverage of comparable independent companies

The purpose of this step is to determine the debt-to-equity ratios for independent market participants. In broad terms, it involves conducting a search for independent but otherwise comparable companies operating in the same market as the tested entity. The comparables' leverage ratios are then calculated and compared to that of the affiliate being evaluated.

The search strategy and criteria used to identify comparable companies should be based on the OECD Guidelines comparability criteria set-out above, with the additional requirement that the comparables be independent, as their debt-to-equity structure must reflect market conditions.

The analysis of comparable companies reveals the extent of leverage in the tested entity's industry. If the tested entity's leverage is within the interquartile range it is broadly consistent with market practice.

This first step does not necessarily imply, however, that the tested entity is capable of assuming the debt it has given its business model or product life cycle. In addition, in cases where income is underpinned by long-term agreements, higher levels of leverage may potentially be justified and sustained.4 Instead, this first step needs to be complemented with a second analysis, the objective of which is to assess whether the tested entity's actual return on equity is in line with the return on equity of independent companies with comparable leverage.

Step 2: Analysis of return, given leverage

Step 2 involves a review of expected returns on equity achieved by independent firms with leverage similar to that of the entity being evaluated. This step assesses whether the debt-to-equity ratio of the entity being evaluated is consistent with what is observed for other firms by considering the expected return on equity.

An increase in financial leverage increases the “levered beta”. The levered beta, which is also the beta for an equity investment in a firm, reflects systematic risk and is determined by both the riskiness of the business and the leverage taken. Higher leverage increases the variance in net income and makes equity investment in the firm riskier. This increased risk requires a correspondingly higher expected return on equity.5

Thus, the objective of this step is to determine an arm's-length range of return on equity for the evaluated affiliate based on the return on equity of companies that are comparable in terms of debt-to-equity ratio. This involves benchmarking the return on equity of the affiliate being evaluated, in order to determine whether it is consistent with the expected return on equity of similarly capitalised companies. In performing the analysis, we rely upon the Capital Asset Pricing Model (CAPM).

The CAPM is widely used for the calculation of the cost of equity and describes the relationship between a firm's expected rate of return and its beta (the previously described parameter reflecting firm-specific, non-diversifiable risk). The CAPM measures the rate of return that an equity investor would expect from an investment given the investment's non-diversifiable risk.6 In this context, using the CAPM enables one to test whether the expected return on equity for the entity being evaluated, given its leverage, is consistent with market returns on equity for similarly leveraged equity investments.

The CAPM is well established in academic finance literature and widely used within the finance community. It estimates the cost of equity as the sum of (1) the risk-free rate and (2) the excess return of the market portfolio over the risk-free rate (the equity or market risk premium), adjusted for non-diversifiable risk (“beta”):

Chart 2, TMIJ  

The risk-free rate is the expected return on an asset that does not bear any credit or liquidity risk. These rates are typically taken from government bonds which are both liquid and (with notable exceptions) practically default-free, as they are backed by their issuing government.

The equity risk premium is the additional return that investors require over and above the risk-free rate to accept the risks associated with owning equity.

Unlike Step 1, Step 2 requires identification of comparable companies that are publicly traded since it relies on a market value of the equity of the comparable companies. Hence, a search for comparable publicly traded companies is the starting point. The beta coefficients are obtained by regressing the stock market return of each comparable company on the return of a representative market index.

To benchmark the return on equity, considering leverage, an adjustment is applied to the betas. This adjustment consists of “un-levering” the beta for each comparable company, thereby eliminating any influence of debt on the coefficient. The un-levered betas are then “re-levered”, using the market value debt-to-equity ratio of the entity being evaluated. The adjusted betas are then used in the CAPM equation to estimate the expected return on equity for a firm with leverage equal to that of the entity being evaluated.

The expected return on equity results based on the CAPM is then compared to the expected return on equity of the tested affiliate. This can be estimated considering business plan over a suitable period of debt financing.

The re-levered betas for the comparables are used as inputs to the CAPM in order to obtain estimates for the required rate of return on equity for each such company. This rate represents the required return on equity investment in the firm when its debt-to-equity ratio is identical to the ratio of the entity being evaluated.

An additional factor that may need to be taken into account is liquidity. In some industries, such as real estate, transactions occur less frequently, with fewer readily available buyers and sellers and higher transaction costs involved. In such cases, an illiquidity adjustment may be required in order to capture the additional risk associated with holding an illiquid portfolio.

Once the adjusted rate of return on equity is calculated, it can then be compared to the rate of return on equity of the affiliate being evaluated. If the return on equity of the affiliate being evaluated falls within the range of adjusted rate of return on equity, one should be in a position to conclude, in combination with the results of Step 1, that the debt-to-equity ratio of the company is at arm's length.

lll. Conclusion

We have described a two-step approach to determine whether an affiliate's capital structure is consistent with what would be expected had the affiliate accessed capital in arm's length transactions. Step 1 aims to identify debt-to-equity ratios of comparable, independent companies operating in the same sector. This analysis provides general market evidence on the appropriate range of debt-to-equity ratios for an affiliate. This step alone is not sufficient, however, to enable a comprehensive benchmarking of the debt-to-equity ratio.

As companies increase their leverage, equity investors bear an increasing amount of market risk in the firm. The return that an entity earns should therefore take into account this risk. In order to do so, the CAPM can be used to assess whether the return on equity of the entity being evaluated is arm's length (i.e. consistent with market expectations). In Step 2 the increase in risk and the increase in leverage are reflected in the levered beta of the firm, a key input of the CAPM. This approach, arguably, can be viewed as analogous to a conventional transactional net margin method approach involving the testing of an affiliate's profitability to that of comparable market participants.

The approach that we have described may apply only in countries where thin capitalisation rules allow for a market-based approach. Nevertheless, we believe that this approach is sufficiently robust, if correctly applied, to assist in applying the arm's length standard to thin capitalisation issues. As economists, we believe that market pricing is the correct foundation for intra-company transactions, a principle agreed upon that tax authorities and taxpayers worldwide. From a policy standpoint, we believe that only regulation based on arm's-length pricing is consistent with that principle.

Amanda Pletz is a Senior Consultant in NERA's Global Transfer Pricing Practice, based in the firm's London office. Dr. Emmanuel Llinares is a Director at NERA and Head of Global Transfer Pricing, based in the Paris, Geneva and London offices. Robert Patton is a Senior Consultant in NERA's Securities & Finance practice, based in the firm's London office.

The authors would like to thank Harlow Higinbotham, a Senior Vice President in NERA's Chicago office; Pim Fris, an Affiliated Consultant in the firm's Paris office; and David Tabak and Marcia Kramer Mayer, Senior Vice Presidents in New York City office, for their contributions. This article expresses the views of the authors and does not necessarily represent those of NERA.

The authors may be contacted at:




1 A.M. Best Methodology, Equity Credit for Hybrid Securities, June 22, 2011.  


2 See for example, Aggarwal R, 2004, Internal Capital Markets and Capital Structure Choices of US Multinationals' Affiliates, p 1-4;  


3 See also Damodaran A, 2001, Corporate Finance Theory and Practice, Second Edition, Chapter 17 and 18.  


4 De Francesco, A.J, 2007; Gearing and the Australian real estate investment market, Journal of Property and Investment& Finance, p579-601.  


5 See for example, Damodaran, A; Second Edition, Corporate Finance Theory and Practice, p204  


6 The CAPM method thus assumes that the investor is fully diversified.