Debt and interest: how a loan within the group turns profit into a tax deduction

Interest paid on a loan is, in almost every tax system, deductible against profit. That single rule creates a powerful move: if you can load a high-tax subsidiary with debt and have it pay interest to a low-tax company inside the same group, you have turned taxable profit into a deductible payment. The profit leaves the high-tax country dressed as an interest cheque. The technical name is earnings stripping, and the condition that makes it possible is thin capitalisation.

The mechanism, step by step

Take a worked example with round numbers:

• A group's parent sits in a zero-tax holding structure.
• A UK subsidiary earns £100 million of operating profit a year.
• The parent lends the UK subsidiary £500 million at 10% interest.
• The UK subsidiary pays £50 million a year in interest to the parent. That £50 million is deductible against UK corporation tax.
• UK taxable profit falls from £100 million to £50 million. The UK tax bill is roughly halved.
• The parent receives £50 million of interest income at zero tax.

A company is "thinly capitalised" when it carries more debt than it could have borrowed on its own two feet, only possible because the rest of the group is standing behind it. That is the tell tax authorities look for: debt that no independent lender would have advanced, at a rate no independent borrower would have agreed.

The rule that caps it

The OECD's answer (BEPS Action 4, final report October 2015) is a fixed-ratio rule: cap the net interest a company can deduct at a set percentage of its earnings before interest, tax, depreciation and amortisation, known as EBITDA. The OECD recommended a corridor of 10 to 30% of EBITDA, and most countries landed on 30%. There is usually a higher allowance for groups that are genuinely heavily borrowed from outside lenders, so the rule does not punish a real business that simply runs on debt.

How the six countries put it into law

• UK Corporate Interest Restriction: 30% of tax-EBITDA, with the rules biting only above £2 million of net interest a year, from April 2017.
• EU (Anti-Tax Avoidance Directive): 30% of EBITDA, EUR 3 million threshold, mandatory for all member states from 2019.
• Germany (the Zinsschranke, or interest barrier): 30% of EBITDA, EUR 3 million threshold, in place since 2008, before BEPS.
• United States (Section 163(j), reshaped in 2017): 30% of adjusted taxable income. This ran on an EBITDA-style basis to 2022, switched to a tighter EBIT basis for 2022 to 2024, and the EBITDA basis was restored from 2025 under the 2025 reform package.
• Australia (thin capitalisation, overhauled in 2023): 30% of EBITDA, replacing the old debt-to-assets test, for income years starting on or after 1 July 2023.

Where it overlaps with transfer pricing

Debt stripping rarely travels alone. The amount of the debt is policed by the thin-capitalisation rules; the interest rate on that debt is policed by transfer pricing, because an arm's-length rate is what an independent lender would have charged. A tax authority can attack both at once: too much debt, and too high a rate. The 2022 OECD Guidelines added a dedicated chapter on pricing financial transactions, including intra-group loans, precisely because the two mechanisms work together.

Who it is out of reach for

The mechanism needs a low-tax or zero-tax group company to be the lender, and a high-tax subsidiary to be the borrower. A standalone business borrows from a bank at a real market rate and deducts real interest, which is ordinary and legitimate. It has no captive group lender to route interest to, so there is no profit-shifting benefit on offer. As with the rest of the toolkit, the door is open only to those with companies on both sides of the loan.