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Thin Capitalization – India tightens the screws!

April 22, 2017[2017] 80 taxmann.com 92 (Article)

In the era of globalisation, India cannot remain aloof from developments across the globe. Globalisation has led to faster integration of global markets and economies, impacting countries' income tax regimes. In the same light, international tax laws have become key pillars in supporting the growth of global economy, as well as in protecting local economy.

Recently, India introduced provisions pertaining to Thin Capitalisation, keeping in line with the global practice incorporated by many countries, such as Australia, France, Germany, etc. Given that this concept obstructs free flow of investments, India had not recognised it till now. However, being a member of G-20 countries, India is now taking all possible efforts to support Base Erosion and Profit Shifting (BEPS) project of Organisation of Economic Co-Operation and Development (OECD). The intent of the extant legislation is to align tax laws with global tax legislations, to deter erosion of tax base by introducing stringent norms.

In the globally integrated economy, multinational corporations have resorted to high tax deductions by relocating debt to high tax countries, which in turn distorts the trade-off between debt and equity financing.

A company is thinly capitalized when a greater proportion of its 'capital-structure' is made up of 'debt' than 'equity'. Interest payments on 'debt capital' is a finance charge, and is generally tax deductible, thereby reducing the tax burden. On the contrary, dividend distribution tax (DDT) is payable by enterprises on post-tax profits, while in case of losses, no dividend can be distributed. Many multinational companies therefore structure this arrangement to avail maximum benefits under the tax laws.

Tax authorities in several countries have been treating 'debt' beyond certain limits from controlling shareholders, as 'veiled-capital' and have termed it as 'thin capital' or 'hidden capital', to distinguish it from normal loans. It would be pertinent to note that as Indian Income Tax Act, 1961 (ITA) till now did not have provisions related to thin capitalisation, 'foreign investors' were tempted to take advantage of the same and invest in India. Further, deduction of tax at source on interest payment to foreign company, is also currently at a discounted 5% under ITA. Whereas, withholding tax rate on interest as per the tax treaties would typically fall between 10- 20%. In cases of repatriation of money through dividend, the effective tax rate goes up by approximately 20% on account of DDT. Moreover, it is also doubtful whether such DDT would be available as credit in the home country. To curb this practice of reducing tax liability through excessive interest payments, new provisions in section 94B of the ITA have been introduced i.e. 1 April 2017, that would restrict the amount of interest allowable as tax deductible expenditure, paid to associated enterprise (AEs) outside India.

The ambit of these provisions extend not only to interest payment made to AEs, but would be also applicable on payment made to unrelated lenders, if the AE has provided an implicit or explicit guarantee or paid the equivalent deposit for the debt.

To avoid hardship for smaller companies, it has been provided that these provisions shall trigger only when interest payment exceeds INR 1 crore. As per the provisions, the interest amount to be disallowed as deduction in computation of income, would be lower of the following:

  The total interest amount in excess of 30% of earnings before interest, taxes, depreciation and amortization (EBITDA)
  Interest paid or payable to AEs.

For Example:

Particulars Amount
EBITDA 500
30% EBITDA A 150
Interest Paid    
AEs B 100
Non- AEs 200
Total Interest C 300

 

Particulars Amount
Interest Amount to be disallowed under section 94B is lower of following  
- Total Interest amount in excess of 30% of EBITDA (C-A) 150
- Interest paid or Payable 100
Therefore the amount of interest paid to AE to be disallowed 100

The excess interest so disallowed would be allowed to be carried forward for eight assessment years and be set off against the profits of subsequent years, subject to the maximum allowable interest expenditure in any particular year.

Owing to these provisions, the return on investment may reduce for Private Equity funds / investors investing in Indian businesses through debt. Further, the interest disallowance, although allowed to be carried forward and set off against future profits, present value of the same needs to be factored in.

The increase in borrowing cost due to disallowance and without any corresponding changes in withholding tax obligations or change in taxation of non-resident AE, could lead to diversion in sources of raising money and change in investors' preference.

Further, the ITA provides for deduction on payment of interest on capital of partners of firm and Limited Liability Partnerships. However, thin capital provisions at present covers only Indian companies under its ambit. Therefore, it remains to be seen if Government may want to apply the thin capital limitations on interest payment to partners as well, in future.

Also, one would have to consider the disallowance under section 14A (read with Rule 8D) if such interest is used for earning any exempt income.

Though the changes are welcome and are in line with global practices, some potential issues arising out of the changes are mentioned below:

  There could be cases where a company has incurred huge operating losses. This could result in negative cash flow for the company. Entities incurring losses would also be required to carry out adjustments. This may result in additional tax burden for such companies.
  If the company has borrowed for funding capital expenditure and the interest is capitalised, whether the 30% should be computed in proportion to depreciation claimed and not the cash outflow from the company to non-resident.
  The computation mechanism for the "excess interest" indicates total interest paid or payable in excess of 30% would not be deductible. Whether all interest expense (including that paid to non-AEs) should be included? The memorandum to the Finance Bill 2017 suggests that computation applies only to interest charges paid/payable to AE, however, the provisions only talks about total interest without distinguishing.
  Whether the disallowance of interest by the TP officer would overrule the interest deduction of even 30%? Whether interest in excess of 30% would be allowed to be set-off and carried forward to next year in case of disallowances by TP officer?

With implementation of General Anti Avoidance Rules, Place of Effective Management provisions and now the thin capitalisation provisions, the focus seem to be clearly shifting to a 'Substance Over form' approach and increased transparency. It is probable that, like the other regulations, the Government will issue clarifications/guidelines to bring clarity to taxpayers.

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*Assisted by

Sneha Shah – Deputy Manager with Deloitte Haskins and Sells LLP

Deepesh Ramchandani – Assistant Manager with Deloitte Haskins and Sells LLP

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