Thin capitalization is a term which refers to those resident corporations financed by non-resident investors primarily through debt as opposed to equity solely for tax reasons. Viewed by countries as a form of tax avoidance, three alternative approaches exist to deter such practices. First, the flexible/arm's length approach determines an acceptable level of debt financing relative to equity based on the facts and circumstances of each particular corporation. Second, the fixed ratio approach specifies a fixed ratio of what is an acceptable level of debt to equity applicable to all corporations. Third, a combination of the above two approaches exists, whereby a fixed debt to equity ratio is specified but may be exceeded if a corporation can prove a more suitable debt to equity ratio is appropriate in the circumstances. From a global perspective, however, little consensus exists as to which method is most appropriate given each approach has been endorsed by national taxation authorities throughout the world. It is the objective of this paper to critically analyse these approaches, and to illustrate their operation by reference to the thin capitalization provisions of a selection of countries throughout the world, namely Australia, Japan, the United Kingdom and the United States.
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