International Transactions in Korea (Part 2): Understanding the Thin Capitalization Rule

1) Why the Thin Capitalization Rule (TCR) Exists

Related groups might fund a Korean subsidiary with debt instead of equity so the subsidiary can deduct large interest payments and reduce Korean corporate tax. The TCR prevents excessive interest deductions on loans from overseas controlling shareholders (or loans guaranteed by them).

Big idea: Normal funding mix is fine. Excessive related-party debt triggers add-backs (non-deductible interest) to protect the tax base.

2) The Core Mechanism — 2:1 Debt-to-Equity Limit

Standard limit: If borrowing from an overseas controlling shareholder (or a third-party loan **guaranteed** by that shareholder) exceeds 2× the shareholder’s equity investment, the interest on the excess portion is non-deductible.
Financial companies: Higher limit of 6× equity.
Disallowed interest (including discounts and certain financing costs) is computed by formula and added back to taxable income.

Practical tip: Track both equity basis (paid-in capital etc.) and all related-party/guaranteed debt by lender and date to monitor the ratio daily, not just year-end.

3) Who Is an “Overseas Controlling Shareholder”?

Typically a foreign person/entity that directly or indirectly owns ≥50% of voting shares or otherwise exercises control.
Also relevant for a foreign company’s Korean branch borrowing from (or guaranteed by) its overseas head office or related shareholders.
Loans from independent banks with a parent guarantee/collateral are treated as if funded by the parent → TCR applies.

4) The 30% Net Interest Limitation

Separate from the TCR, Korea also limits net interest deductions on cross-border related-party debt.

Rule: Net interest to overseas special related persons that exceeds 30% of adjusted income is non-deductible.
Works as a general backstop: even if you pass the 2:1 test, excessive net interest can still be disallowed under this 30% cap.

5) No Double Penalties (Duplication Rule)

If both the TCR and the 30% net interest cap apply to the same amount, tax authorities will disallow only the larger amount—so you aren’t penalized twice for the same borrowing.

6) Quick Examples — With Numbers & Tax Effect

Example 1: 2:1 ratio breach (standard company)

Facts: Parent equity in KR Sub = KRW 50B. Related/guaranteed debt = KRW 130B. Annual interest on that debt = KRW 7.8B (6%).

Test: 2× equity = 100B. Excess debt = 130B − 100B = 30B. Disallowed interest = 30B × 6% = KRW 1.8B.

Tax effect (illustrative): If marginal corporate tax rate ~19%, extra tax ≈ 1.8B × 19% = KRW 342M added to the bill.

Example 2: 30% net interest cap bites

Facts: Adjusted income (before interest cap) = KRW 10B. Net interest to overseas related parties = KRW 3.8B (38%).

Limit: 30% × 10B = 3.0B. Excess = 3.8B − 3.0B = KRW 0.8B non-deductible.

Tax effect (19% rate): 0.8B × 19% = KRW 152M additional corporate tax.

Example 3: Both rules apply — choose the higher disallowance

TCR disallows KRW 1.2B of interest; 30% cap would disallow KRW 0.9B. Result: Disallow KRW 1.2B (higher amount). No double disallowance.

Rates/definitions can change. Use current law and your actual marginal tax rate when modeling impacts.

7) In Summary

TCR limits related-party/guaranteed debt to 2× equity (financials: 6×). Interest on excess is non-deductible.
A separate 30% net interest cap can also disallow deductions.
If both hit, the larger disallowance applies (no double penalties).
Monitor ratios continually, document guarantees, and model tax effects before funding.

Next (Part 9): Reporting Overseas Financial Accounts—who must file, thresholds, penalties, and practical tips.

8) Disclaimer

This post is for general information only and not legal or tax advice. Rules evolve; outcomes depend on your facts. Consult a qualified professional.

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Thin Capitalization Korea Debt-to-Equity 2:1 30% Interest Limitation Overseas Controlling Shareholder Related-Party Financing Korean Taxation Series

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