Thin Capitalization Rule and Earnings Stripping Rule

The two rules are similar and are both trying to restrict interest expenses paid to its parent/affiliate companies. But they are a little bit different in their target. Here are the rules:

Thin Capitalization Rule

The interest paid to its affiliated company overseas that owns more than 50% of its shares is allowed to be deductible only up to the amount corresponding to its loan triple of its equity. For example, if its capital is 10M Japanese Yen and retained earnings are 3M. The interest expenses are only allowed only for its loan up to 39M(13M * 3) yen. If the total loan is 50 million yen, the interest on the remaining 11 million yen loan (50M – 39M) will not be deductible.

Earnings Stripping Rule

You can deduct interest expenses paid to overseas affiliated company from taxable income only at maximum 50% of its taxable income. The exception is that the rule is not application if the total interest is less than 10 million yen.

Japanese Thin Capitalization Rule and Earning Stripping Rule (過小資本税制と過大資本利子税制)

Thin capitalization rule

You may think that putting in capital in form of loan is better (more tax efficient) than in form of equity because you will probably be able to pay yourself back in form of interest to reduce your taxable income. Interest must be deductible, right?

That is not always the case.
The thin capital rule restricts interest expenses paid to its shareholder up to to a limit. The interest is restricted to the amount paid for loans up to triple of its own equity. For an example, if the equity is 100 and your loan is 370, the interest expense paid to the 70 will not be allowed deductible. Interest expense is allowed to be expensed only up to 300, which is three times of its own equity (100).

The rule is applicable to interests paid to an overseas entity who owns more than 50% of the interest payer company in form of direct or indirect ownership.

Japanese Earning Stripping Rule

There is also a rule to restrict the total amount of interest to be deductible from corporate taxable income in Japan. If the interest is more than 50% of taxable income (before the interest to its controlling party), the portion exceeding the 50% line will not be allowed to be deducted from its income. The rule is not applicable if the interest in total is less than 10 million Japanese yen.