The Organisation for Economic Cooperation and Development [OECD] and G20 group has formulated 15 point Action Plan under the Base Erosion and Profit Shifting [BEPS] project to address the issue of shifting profits from high tax jurisdiction to low tax jurisdictions.
India is one of the member of the G20 group and has been very keen and active in adopting the recommendations in BEPS Action Plan. There have been a lot of developments in the international tax regime in India in the recent years to implement the BEPS Action Plan in India. The Government of India has already introduced country-by-country reporting, masterfile reporting requirements, equalization levy in line with the BEPS Action Plan.
In the Finance Bill, 2017, it has been proposed to limit the deduction of interest by implementing the recommendations listed in OECD's BEPS Action 4 on 'Limiting Base Erosion Involving Interest Deductions and Other Financial Payments'.
BEPS Action 4 states that the use of third party and related party interest is perhaps one of the most simple of the profit-shifting techniques available in international tax planning. Multinational groups may achieve favourable tax results by adjusting the amount of debt in a group entity. Groups place high level of debt in high tax countries, thereby claiming deduction of interest expenditure which results in low profits. Further, such interest payment is taxed at a comparatively lower rate in the hands of the lender. In order to curb such practice, the OECD proposed restriction of interest deduction under BEPS Action 4. Action 4 is based on a 'fixed ratio rule' [FRR] which limits an entity's deductions for interest and payments economically equivalent to interest as a percentage of its earnings before interest, taxes, depreciation and amortization [EBITDA]. The restriction on interest is proposed to be within the range of 10% to 30% of EBITDA. Some groups are highly leveraged with debt for non-tax reasons. In such cases, Action 4 gives an option to supplement the FRR by 'group ratio rule' to allow an entity to claim higher net interest deductions, based on a relevant financial ratio of its worldwide group. Further, as per Action 4, a country can also lay down specific rules such as threshold on interest payment, carry forward of disallowed interest, etc.
The memorandum to the Finance Bill, 2017 explains that such practice of claiming high interest deduction is widely followed in India. A company having higher debt will incur high interest expenditure, thereby resulting in lower profits. In order to exploit this tax benefit, multinational companies structure their financing arrangements in a way to increase the debt component. In view of the above practice and the OECD recommendation (Action 4), the Government of India has proposed to introduce section 94B in the Income-tax Act, 1961 [the Act] for limiting interest deductions with effect from 1 April 2018 (i.e. assessment year 2018-19 onwards).
Proposed provisions under the Act
The salient features of these provisions are as under:
The proposed provisions shall be applicable to interest or similar consideration in excess of INR 10 million payable by an Indian company or a permanent establishment of a foreign company in India in respect of the following:
• any debt issued by a non-resident associated enterprise; or
• any debt where an associated enterprise
- provides an implicit or explicit guarantee to the lender; or
- deposits a corresponding and matching amount of funds with the lender.
These provisions shall not be applicable to an Indian company or a permanent establishment of a foreign company which is engaged in the business of banking or insurance.
Restriction on deduction of interest expenditure
The interest or similar consideration which is deductible in computing income chargeable under profits and gains of business or profession shall not be deductible to the extent that it arises from excess interest.
Excess interest shall be the lower of:
• Total interest paid or payable in excess of 30% of the earnings before interest, taxes, depreciation and amortization [EBITDA] in the previous year; or
• Interest paid or payable to associated enterprise for that previous year.
Carry forward of interest disallowed
The interest disallowed can be carried forward upto eight assessment years immediately succeeding the assessment year in which disallowance was first made.
The interest carried forward will be allowed as a deduction against income from business of that assessment year to the extent of interest restriction specified above.
Associated enterprise shall have the same meaning as assigned to it in the transfer pricing provisions under the Act.
Debt means any loan, financial instrument, finance lease, financial derivative, or any arrangement that gives rise to interest, discounts or other finance charges that are deductible in the computation of income chargeable under the head profits and gains of business or profession.
Permanent establishment includes a fixed place of business through which the business of the enterprise is wholly or partly carried on.
Certain issues to be addressed
The amendment proposes to restrict the deduction for interest or similar consideration.
The OECD in its BEPS Action 4 also covers payments which are economically equivalent to interest but have a different legal form or incurred in connection with the raising of finance. However, it specifically states that in general, the rules set out in Action 4 should not limit deductions for items which are not interest, economically equivalent to interest or incurred in connection with the raising of finance, such as:
• Foreign exchange gains and losses on monetary items which are not connected with the raising of finance;
• amounts under derivative instruments or hedging arrangements which are not related to borrowings, for example commodity derivatives;
• discounts on provisions not related to borrowings;
• operating lease payments;
• accrued interest with respect to a defined benefit pension plan.
There is no such exclusion provided in the proposed amendment neither the term 'similar consideration' is defined in the proposed provisions. Therefore, such a term can have wide implications and should be aptly defined to avoid litigation with the Indian tax authorities.
The rate of 30% of EBITDA is a blanket rate and not sector specific. Application of such fixed percentage across all sectors could adversely impact sectors which need heavy funding like infrastructure, township and real estate development. Reduction of borrowed funds could impact infrastructure development which is the need of the hour. Considering that development of townships and infrastructure require heavy investment and longer gestation period due to which such companies may not be able to claim the full benefit of carry forward of interest disallowed. Accordingly, Government may consider increasing the duration of carry forward for some specific sectors.
The foreign associated enterprise, may also be filing its tax return in India offering the interest income to tax in India. Similarly, it may also be offering the interest income to tax in its country of residence. In such case, if the Indian company or permanent establishment is not able to claim the deduction of such interest expense, then it would also tantamount to multiple taxation on the same transaction. This would increase the tax cost significantly and may adversely impact even the genuine tax payers.
Again, increase in tax cost due to limiting the deduction of interest expenditure could reduce the foreign funding through debts into India thereby reducing the inflow of foreign currency. It may also lead to a negative sentiment for the foreign investors making India less attractive investment destination.
The above issues need to be addressed for smooth and hassle free implementation of the proposed provisions restricting the interest deduction.
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