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Over the years, tax considerations have become increasingly important in financing decisions. Most jurisdictions offer tax deductibility for interest expense on debt, while dividend on equity usually comes with a tax cost for the paying company or for the receiver. The ease with which finance can be raised cross border, enables multinational groups to use cross border debt as an effective tool for managing overall group tax costs and to facilitate periodic repatriation.
BEPS Action Plan 4- Limiting Base Erosion Involving Interest Deductions and Other Financial Payments ('BEPS 4') sought to address this tax induced bias towards debt financing. BEPS 4primarily advocates use of ratios linked to EBITDA to restrict quantum of tax deductible interest. While countries like Germany and France had similar rules for interest restriction even before introduction of BEPS 4, countries like UK, US have taken a cue from BEPS 4 and have proposed to introduce/introduced similar rules in their respective domestic tax laws. India is not far behind in this endeavour and has adapted the principles advocated in BEPS 4, albeit with a local flavour. In this connection, Finance Act 2017 ("Act") has inserted new section 94B which advocates a formula to determine quantum of tax deduction available to interest paid on related party debt.
This article attempts to decode the provisions of section 94B and highlight potential issues that could arise in its application.
A sneak peek into section 94B
Debt deemed to have been issued by an AE of the borrower, in case the AE provides implicit or explicit guarantee to a lender or deposits a corresponding and matching amount of funds with the lender.
[Excess interest means Total Interest paid / payable less 30% of Earnings before interest taxes depreciation and amortisation
Further, carry forward interest shall be allowed as a deduction in subsequent
assessment years against profits and gains, if any, of any business or
profession carried on by the Company to the extent of interest restriction
Local borrowing in India
Sub-section (1) inter-alia provides that interest expense on account of debt raised from a non-resident AE would be subject to the rigors of section 94B. Proviso to sub-section (1) provides that the section will also apply to debt raised from any lender where such debt is guaranteed by an AE of the borrower.
On a literal reading, the proviso seems to clearly suggest that the section would apply where debt is raised locally [from an Indian resident] and guaranteed by an AE. However, the main provision i.e. sub-section (1) restricts the scope of section 94B to debt raised from a non-resident AE. In this context, one could argue that a proviso cannot travel beyond the domain of the main provision and that the proviso to section 94B(1) may be interpreted to include only debt raised from a non-resident, that is guaranteed by an AE.
Nevertheless, based on judicial precedents1, an alternative view could emerge that a proviso can go beyond its purpose and may matters extraneous to that section which may have to be interpreted as a substantive provision, dealing independently with the matter specified therein. However, considering that there is no base erosion in a loan transaction between a borrower and resident lender, and the intention of section 94B is to prevent base erosion, it may be reasonable to conclude that section 94B does not apply to such borrowing.
Guarantee in the context of section 94B includes implicit and explicit guarantee. In an explicit guarantee arrangement, a guarantor explicitly (mostly, in a black and white in agreement) provides assurance to the lender that in case of default by the borrower, all the claims would be settled by the guarantor. Implicit guarantee is an arrangement, where being part of a multi-national group, a Company is able to secure a loan or secure a loan with more favourable terms. In implicit guarantee arrangements, the lender perceives that the parent entity of the group would intervene in the case of any default.
In this context, it would be relevant to note that BEPS Action Plan 8 – Aligning TP outcomes withvalue creation advocates that an implicit guarantee arrangement does not warrant arms' lengthevaluation. Identification and substantiating the provision of implicit guarantee is a subjective exercise and in the absence of explicit guarantee, the Indian Company could be required to substantiate before the tax officer(s) that its third party borrowings are not implicitly guaranteed by its AE. Thus, litigation on this account cannot be ruled out.
Protection to interest paid on third party debt
BEPS 4 provides for limiting the net interest expense, regardless of the relationship between borrower and lender. The objective is to restrict the ability of multinational groups to selectively place higher levels of third party debt in high tax countries. On the contrary, the intent of section 94B is to restrict interest deductibility on related party debt. Thus, deductibility of interest on third party debt should not be impacted. However, the definition of excess interest creates ambiguity as to whether a borrower might be subject to disallowance in respect interest on of third party debt.
It is illustrated in the table below that the formulae for computing disallowance is conceived in a way to safeguard interest pay-outs to third party lenders (even in cases where EBITDA in negative or NIL).
Applicability to Limited liability Partnership ('LLP')
Section 94B of the Act is applicable to Indian company or a permanent establishment of a foreign company in India and not to LLPs. The reason behind this could be the fact that LLP as an entity structure is currently prohibited under the exchange control regulations from raising external commercial borrowings. However the section may still apply to an LLP in the following scenario:
Deductible interest expenditure is NIL
The provision shall be applicable to expenditure by way of interest or similar nature in excess of INR 10 million that is deductible while computing business income. In a scenario, where the entire interest expense on debt raised from an AE, is not deductible due to non-compliance with section 195 a view could be taken that for the purpose of section 94B, interest deductible would be NIL and the provisions of section 94B may not apply.
Interplay with section 40(a)(i)
Sub-section (1) limits the applicability of Section 94B to deductible expenditure by way of Interest or of similar nature vis-à-vis sub-section (2) that uses the phrase 'interest paid or payable' for the previous year. Literal reading of sub-section (2), indicates all interest paid or payable [whether or not the same is deductible], needs to be considered for computing disallowance under section 94B.
However, this interpretation could lead to double disallowance or a situation where disallowance under section 94B being in excess of interest deductible. Considering that the scope and spirit of the section is to scrutinise interest that is otherwise deductible in the first place in computing business income and to avoid any double or excess disallowance, an alternative approach may be to consider 'interest deductible' in lieu of 'interest paid or payable' while applying the formula.
The possible result of the difference between the above interpretations is illustrated below:
[Lower of (A) or (E)]
[Lower of (C) or (E)]
Thus, if the disallowance under section 94B is computed with reference to interest paid or payable, then there could be a double disallowance as illustrated above. Further such disallowance exceeds interest that is deductible in the first place. In the alternate approach of computing 94B disallowance with reference to interest deductible, there may not be any double disallowance and disallowance under sections 40(a)(i) and 94B will not overlap.
The above interpretation could also extend to any disallowance that is made under section 92 on account of arms' length determination.
Needless to say, controversies on account of practising the alternate approach cannot be ruled out.
Scope of debt issued by AE
The term debt has been widely defined to include loan, financial instrument, finance lease, finance derivative or any arrangement that give rise to interest. In case of finance lease, the tax treatment is in variation from the treatment in the books of account owing to the Apex Court ruling in the case of ICDS Ltd 350 ITR 527. This could give rise to various issues with regard to identifying the applicability and determining the quantum of disallowance under section 94B, which includes the questions such as
Interplay with tax holiday
Where a company owns an undertaking that is eligible for deduction under section 10AA, it needs to be analysed whether such deduction can be claimed on any disallowance made under section 94B. In this connection, jurisprudence provides 'Profits of Business' for the purpose of ascertaining 10AA deduction would mean profits computed in accordance with provisions of sections 28 to 44D. Based on the above, companies used to claim enhanced deduction for disallowances made.
Given the fact that the disallowance of interest is contemplated under section 94B and not sections 28 to 44D, it may not be possible to claim 10AA deduction on such disallowance.
Interplay with the concept of Place of Effective Management ('POEM')
Section 94B applies where debt is raised from a non-resident AE. The applicability of the section needs to be analysed in a scenario where the said non-resident AE is determined to be a resident in India by virtue of POEM guidelines issued by the Central Board of Direct Taxes.
Interplay with General Anti Avoidance Rules ("GAAR")
The provisions of Chapter X-A of the Act relating to GAAR will come into force from April 1, 2017. CBDT circular no 7/2017 clarifying the implementation of GAAR provisions indicates that the GAAR and Specific Anti-Avoidance Rules ['SAAR'] may coexist and are applicable, as may be necessary in facts and circumstances of the case. A good example of this would be application of GAAR provisions and section 94B which is a SAAR to a transaction.
It is to be noted that section 94B does not presuppose the existence of tax avoidance motive on the part of the assessee. In other words, section 94B would apply, regardless of the rationale behind raising debt. On the other hand, GAAR provisions would apply where the main purpose of an arrangement is tax benefit. Thus, the tax authorities could recharacterise debt as equity using GAAR provisions, notwithstanding that interest paid on debt raised from AE has been subject to disallowance under section 94B.
Anti-avoidance provisions introduced in the recent past contained grandfathering clause(s) to protect existing structures/arrangements. However, section 94B does not grandfather debt raised before its introduction. This could impact the business plans made in the past, adversely affecting cash flows and tax costs companies.
Additionally, unlike BEPS 4, which advocates exclusion of loans to fund public benefit projects, section 94B does not take cognizance of sectors [especially infrastructure] that are conventionally geared. This provision could impact the cost of infrastructure projects and affect competitiveness of multinational groups interested to support the Make in India initiative in various projects – smart cities, metro projects, port development, etc.
Apex Court in S. Sundaram Pillai v. V. R. Pattabiraman 1985 AIR 582.