Thin capitalisation- compatible with EC law?

Abstract: Thin capitalization means an abnormally high debt-to-equity ratio of a corporation, in a situation where the debt finance comes from a foreign affiliated contributor of capital. The contributor of debt capital is often simultaneously a direct shareholder. Tax revenue from debt is generally realized primarily by the state of residence of the investor whereas the tax revenue from direct investment, equity in particular, is realized by the state of residence of the financed corporation. The use of debt instead of equity distributes tax revenue from the source state to the state of residence of the return on an investment. Therefore, in order to avoid taxation in the source state, a corporation may be financed excessively with debt. The tax advantage gained by debt instead of the use of equity has resulted in various complicated constructions by international companies in order to avoid or at least decrease their taxation. Within the European Union, the member states have chosen different approaches to measure whether a company is thinly capitalized for tax purposes. Some member states have general tax rules, using a subjective approach or the ''arm's length'' approach where the company has to prove that the same loan could be obtained from a third party under the same circumstances and conditions. If the arm's length principle is not fulfilled the granting of the loan by the shareholder is only motivated by the subsidiary shareholder relationship. Other member states have enacted particular rules on thin capitalization by specifying an accepted relation between debt and equity, a so-called debt/ equity ratio. If the debtor's debt exceeds a certain proportion of its equity, an adjustment will be made under the country's thin capitalization rule.