THIN capitalisation refers to hidden equity capitalisation by borrowing higher level of debt as compared to equity and leveraging capital structure, which leads to reducing taxable profits to the extent of interest paid on debt borrowings. Multinational groups strategize their financing arrangements to create tax-efficient mixture of debt and equity in borrowing jurisdiction wherein interest expense can be claimed as deduction in computation of tax profits and lending jurisdictions that either exempts interest income from tax or interest taxed at lower rates.
Further, enterprises in developed countries borrow funds at lower interest rates and lend the same to their associated enterprises in other tax jurisdiction at higher interest rates to take advantage of interest arbitrage opportunities. Since India is a developing country, the rates of tax are higher than the developed countries. Thereby, there is motive for multinational groups to infuse funds in form of debt instead of equity. The period of repayment of debt is often extended by the MNCs after seeking requisite approvals from RBI. Such elongation of repayment period does, in substance, convert debt into funds available for long term benefit, equity under the mask of debt. Therefore, capital structure plays major role in reporting profits and tax payments by companies across the world.
Keeping up with the trend and in line with Organisation for Economic Cooperation and Development (OECD) recommendation in its Base Erosion and Profit Shifting (BEPS) project- Action Plan 4 Interest Deductions And Other Financial Payments, India has also announced Thin Capitalisation Rules by way of limiting interest deduction, also known as 'Earnings Stripping Approach'. It is proposed to introduce new section 94B to restrict interest deduction claimed by Indian company or permanent establishment of foreign company in India in respect of debt issued by non-resident associated enterprise exceeding 30% of earnings before interest, taxes, depreciation and amortisation (EBITDA) of borrower enterprise. The provisions are not applicable in case where interest expenses are less than or equal to Rs. 1 crore in respect of debt issued by non-resident associated enterprise in a financial year. Further, it is proposed to expand the scope of the section to include interest on debt issued by unrelated lender having underlying implicit or explicit guarantee by an associated enterprise to such lender or having corresponding or matching amount of funds deposited with such lender. The interest expense which is not wholly deducted against income shall be allowed to be carried forward and allowed as deduction against profits and gains of any business or profession carried on up to eight assessment years to the extent of maximum allowable interest expenditure as computed by the aforesaid provisions.
India is trying to recover from demonetisation and the government is encouraging fresh inflow of funds from abroad in order to sustain the growth, however, this proposal may adversely affect the investment avenues given by the government to encourage inflow of funds.
Certain issues which may arise while applying above provisions:-
1. The proviso to the section states that debt issued by unrelated lender with an underlying explicit or implicit guarantee by associated enterprise to such lender or in case of deposits with such lender shall be deemed to be issued by associated enterprise. There is no clarity whether such lender is non-resident or resident in India. Though the harmonious reading of section 94B(1) read with proviso indicates that the lender should be non-resident which also goes with the intention to eradicate cross border profit shifting,tax authorities may take stand that even where lender is resident in India still, the entire arrangement is structured to disguise loan and that also would be subject to these provisions.
2. For newly incorporated companies/Start-ups wherein break even period is higher compared to already established companies, there may be losses or reduced profits in initial years which may not absorb current period interest and set off brought forward interest of earlier years. Some methodologies provided by BEPS Action in this respect are as below:-
- Group wide interest allocation rule, which enables an entity to deduct interest expense up to an interest cap, equal to an allocation of the group's net third party interest expense based on a measure of earnings.
- Revenue authorities may also consider extension of period for which disallowed interest is allowed to be carried forward reduced by certain percentage every year.
3. As per provisions of the Income tax Act, interest includes interest payable in any manner in respect of moneys borrowed or debt incurred (including deposit, claim or other similar right or obligation) and includes any service fee or other charge in respect of moneys borrowed or debt incurred or in respect of any credit facility which has not been utilised.
So, for instance, if an Indian company pays guarantee commission to its non-resident holding company on guarantee issued by the latter in respect of loan borrowed from bank resident in India, whether provisions for limiting interest deduction will apply to guarantee commission paid by Indian company to its holding company?
Also, it remains to be seen that how the provisions of limiting interest deduction be construed by tax authorities in case of accounting treatment with respect to dividend of preference shares recharacterised as 'interest' under Ind AS 109 Financial Instruments.
4. As per the Memorandum to the Finance Bill, 2017, it is mentioned that the newly proposed section is in line with the recommendations of OECD BEPS Action Plan 4. The proposal does not provide computation methodology for 'Earnings before interest, taxes, depreciation and amortisation' (EBITDA). However, it is worthwhile to note that certain countries wherein tax system does not closely follow the accounting treatment use EBITDA computed as per tax provisions as mentioned in BEPS Action Plan 4. Considering the same, a question would arise that whether EBITDA as required under section 94B needs to be arrived as per books of accounts or as per provisions of the Income tax.
5. Further, where the provisions of the treaty are beneficial, they would override the provisions of the Act to the extent they are beneficial to the assessee. Tax treaties usually contain provisions that limit the benefits they accord where excessive interest is paid. For instance, Article 12(9)of India UK DTAA states that the restriction by way of any provision in laws of either contracting state on interest payment to non-resident company shall not operate(not applicable in holding subsidiary relationship). In such situations, it needs to be analysed whether benefit to such clauses, if any in DTAA, can be resorted to in place of anti-abuse provisions in form of limiting interest deduction.
In view of the above anomalies in the provision, the government is expected to come out with appropriate clarifications such that provisions can be applied with purpose of plugging anti abuse of capital leveraging and minimizing potential tax litigation.
(Mr. Yogesh Shah is Partner; Ms. Aparna Parelkar is Senior Manager; and Ms. Jolly Bajaj is Assistant Manager with Deloitte Haskins & Sells LLP. The views expressed are strictly personal.)