Meaning
Legislated boundaries restrict the amount of specific business costs a firm can subtract from its gross income for tax purposes. When applying expense deductibility caps, tax authorities typically target items prone to personal use or those used for profit shifting. These limits ensure that the taxable profit of a company remains within a range deemed reasonable by the government.
Common examples include limits on interest payments, advertising costs, royalty payments and entertainment expenses.
Interest Limitation
Thin capitalization rules prevent companies from reducing their tax burden through excessive internal debt. Expense deductibility caps often limit the interest a subsidiary can pay to a parent company based on a ratio of debt to equity. If the interest exceeds this threshold, the surplus is treated as a non-deductible distribution of profit.
This mechanism protects the tax base of the country where the production occurs.
Service Fee
Management charges between related entities undergo scrutiny to prevent the artificial lowering of local tax liabilities. The application of expense deductibility caps to intercompany service fees requires the firm to prove that the services were actually rendered and priced at market rates. Documentation must show that the local entity benefited from the head office support.
Without such evidence, the tax bureau may disqualify the entire expense.
Timing Difference
Disallowed expenses often create a temporary difference between the book profit and the taxable profit.
