Thin Capitalization in Egypt: Tax Deduction Boundaries

Thin capitalization is a tax term that refers to a situation in which a company has a high level of debt and relatively low equity. The concept aims to portray a company with a financial structure heavily skewed towards debt financing instead of equity financing.
A high gearing ratio can create problems for:

• creditors, which bear the solvency risk of the company.
• Tax Authorities, which are concerned about excessive interest claims.

Tax issues

Even where countries’ corporate laws permit companies to be thinly capitalized, revenue authorities in those countries will often limit the amount that a company can claim as a tax deduction on interest, particularly when it receives loans at non-commercial rates (e.g. from connected parties).
For That tax authorities limit the applicability of thin capitalization rules to corporate groups to avoid  BEPS “Base Erosion and Profit Shifting” to other jurisdictions.

Thin Capitalization in Egyptian Tax Law

The Egyptian thin capitalization rule provided by the Egyptian Income Tax Law #91 Y 2005 and updates #30 Y 2023, As Interest expenses are deductible for Net income tax calculation purposes after offsetting any tax-exempt interest income, using the rate of debt-to-equity 4:1 and this rate will gradually change to reach 2:1 as follows:

• 4:1 for FY 2023.
• 3:1 for FY 2024 to 2027.
• 2:1 for FY 2028 onwards.

Interest expense deductions are only allowed if the following conditions are fully met

• The interest rate does not exceed twice the discount rate as determined by the Central Bank of Egypt at the beginning of the calendar year in which the tax year ends.
• The interest expense is in return for loans complying with the local thin capitalization rule debt-to-equity ratio.
• This provision shall not apply to banks and insurance companies or companies exercising the financing activities to be determined by a ministerial decree.
• The Egyptian transfer pricing rules (i.e. arm’s-length principle) are being followed (Transfer pricing section for more information). In case of a tax audit, if the interest rate isn’t proven to be at arm’s length, the tax authority has the right to adjust this price to arrive at the ‘arm’s-length price’ and re-calculate the taxes due accordingly.
• The loan is business-related.

Conclusion

As per Egyptian tax legislation, the deduction of interest payments by Egyptian companies on loans and advances is prohibited if the total amount of such loans and advances exceeds four times the average equity, as determined from financial statements prepared in accordance with Egyptian accounting standards. Put simply, any interest payments exceeding this threshold cannot be claimed as deductions.

The scope of “debt” encompasses loans, advances, bonds, and any other form of debt financing, regardless of whether they involve fixed or variable interest rates. Debit interest refers to all payments made by a taxpayer in exchange for obtaining loans, advances, bonds, or bills.

Collaborating with a reputable tax partner, such as Andersen Egypt, which boasts a team of tax experts, is crucial for avoiding erroneous or poorly planned practices that could adversely affect overall business performance.

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