Thin Capitalisation & Interest Deduction Advisory — HK

HK does not have a formal debt:equity ratio or thin capitalisation rule in its legislation. However, interest deductions are subject to the conditions in s.16(2) IRO — particularly that interest must be incurred on money borrowed for the purpose of producing assessable profits, and the lender must be a financial institution or the interest must be otherwise taxable in HK. These conditions effectively limit interest deductions on certain intercompany structures.

Interest on borrowings from a non-financial institution such as a group company is deductible only if: (a) the interest is subject to HK profits tax in the lender's hands under s.16(2)(c), (b) the lender is resident in a DTA country and interest is subject to tax there under s.16(2)(f), or (c) IRD is satisfied the arrangement is genuine and at arm's length. If none of these conditions are met, the interest is non-deductible regardless of the debt level.

Under HK's transfer pricing rules in s.50AAF IRO, intercompany transactions must be at arm's length. If the interest rate exceeds the arm's length rate, IRD will disallow the excess deduction. If the arrangement has the sole or dominant purpose of reducing tax, s.61A anti-avoidance may also apply. We benchmark the rate using commercial databases and document the methodology to defend any challenge.

Section 16(2)(f) allows a deduction for interest paid to a non-HK lender if: (1) the interest would be subject to tax in the lender's jurisdiction, (2) a DTA applies between HK and that jurisdiction, and (3) the lender is not controlled by the HK borrower. This exception is commonly used to allow interest deductions for loans from parent companies resident in DTA countries such as UK, Japan, Germany, and Singapore.

BEPS Action 4 recommends a 10-30% of EBITDA cap on net interest deductions. HK has not formally enacted Action 4. However, IRD refers to BEPS guidance when analysing aggressive structures, and groups planning significant interest deductions should consider how their structure would look under a hypothetical 30% EBITDA cap analysis — particularly for Pillar Two purposes.

Essential documentation includes: a written loan agreement with clear principal amount, interest rate, repayment schedule, and security provisions; board resolutions authorising both the loan and the borrowing; evidence the funds were actually transferred; contemporaneous TP benchmarking of the interest rate; and annual accrual records consistent with the loan terms. IRD auditors routinely request all of this in field audits.