In the world of private equity (PE), where every basis point of return is fought for through financial engineering and tax efficiency, two financial tax concepts —thin capitalization and transfer pricing— are inherent part of the backbone of every deal. These rules shape leverage strategies, dictate interest deductibility, and increasingly determine whether a portfolio company triggers global minimum tax top-ups. This article breaks down their mechanics, their unique interplay in PE, and actionable strategies to navigate Mexico’s evolving regime.
Thin capitalization describes a capital structure tilted heavily toward debt, enabling sponsors to deduct interest expenses and lower taxable income. In leveraged buyouts (LBOs), this is foundational: debt acts as “patient capital”—senior in the waterfall, tax-advantaged, and return-amplifying—provided it is not recharacterized as equity by tax authorities.
1. Debt-to-equity ratio (3:1): Applies to related-party debt. Excess interest is non-deductible and treated as a dividend subject to withholding tax.
2. 30% of tax EBITDA cap: Net interest expense (related + third-party) cannot exceed 30% of adjusted fiscal profit (roughly EBITDA for tax purposes). This rule, aligned with OECD BEPS Action 4 and fully effective since 2020, allows indefinite carryforward of disallowed interest—critical for LBO modeling, as post-acquisition EBITDA growth unlocks deferred deductions.
Recharacterization risk in PE context: Tax authorities may treat intragroup debt as equity if it lacks commercial substance (e.g., no fixed maturity, subordinated to trade creditors, or guaranteed by the parent without arm’s-length terms). Once reclassified, interest loses deductibility entirely, and “repayments” may trigger deemed dividends
2025 Pillar Two overlay: Mexico’s adoption of the 15% global minimum tax (GloBE rules) means disallowed interest directly inflates jurisdictional effective tax rates (ETR). A portfolio company below 15% ETR triggers top-up tax—paid either locally or by the ultimate parent—eroding sponsor returns.
Mexico this limits under Article 28, Section XXVIII of the Income Tax Law (LISR)
Intragroup Financing Challenges in Private Equity LBOs
PE structures rely on intragroup loans to push debt into operating companies. These loans must satisfy both thin capitalization thresholds and transfer pricing arm’s-length standards (Article 76, LISR). A rate above market triggers a transfer pricing adjustment (constructive dividend); a rate within market but exceeding thin cap limits is still non-deductible. The result: dual disallowance risk on the same interest payment.
Key challenges in Mexico
- SAT enforcement trends: Audits increasingly target LBO debt pushdowns, covenant-lite terms, and parent guarantees.
- Pillar Two readiness: PE funds must now model GloBE ETR outcomes pre-closing, as interest blockers can push Mexican subs into top-up tax territory.
- Carryforward mechanics: The 30% EBITDA excess is not lost—but requires disciplined tracking and forecasting to utilize in future years.
Good takeaways:
1. Pre-deal modeling
Stress-test post-LBO interest deductibility under both 3:1 and 30% EBITDA caps. Simulate EBITDA growth scenarios to quantify carryforward utilization and Pillar Two exposure.
2. Debt instrument design
Fixed maturity, market-rate coupons, and senior ranking reduce recharacterization risk.
Consider third-party back-leverage (e.g., bank debt) to stay within related-party 3:1 while maximizing total leverage.
3. Transfer pricing compliance
Annual benchmarking (CUP method preferred for loans) and local file documentation. Include safe harbor rate updates per SAT’s published interbank equilibrium rates.
4. Governance & transparency
Board-approved loan agreements, independent credit analyses, and ESG-aligned tax policies strengthen defensibility and LP confidence.
Balancing risk and return in Mexico and beyond
Thin capitalization and transfer pricing are not constraints—they are optimization parameters. In Mexico, the 3:1 ratio sets the leverage ceiling, the 30% EBITDA cap governs annual deductibility, and carryforwards reward growth. Master these, and you don’t just comply—you engineer tax-alpha into the exit multiple. Ignore them, and a single SAT adjustment can wipe out years of value creation.
