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Understanding ‘Thin Capitalization’ norms in India – A double whammy to abusive tax structures

June 23, 2017[2017] 82 taxmann.com 401 (Article)
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Introduction

1. Amidst the fear of GAAR looming large over multinational enterprises (MNEs) operating in India, the Central Government has introduced thin capitalization norms by insertion of Section 94B1 in the Income-tax Act, 1961 (Act) vide the Finance Act, 2017.

These norms are broadly based on the recommendations of the Action Point 4 - Limiting Base Erosion involving Interest Deductions an Other Payments of the Final Report of the base erosion and profit shifting (BEPS) Project.

Salient features of the Indian thin capitalisation norms, along with illustrations to demonstrate the impact of such norms on corporations working in India with a highly leveraged capital structure, have been shown below.

Let us first understand what is meant by thin capitalisation and why is there a need to bring in norms to control it.

What is Thin Capitalisation and why it needs to be regulated?

2. When the capital structure of a company comprises of debt as compared to equity, i.e., the ratio of debt to equity is high, it is called highly leveraged or thinly capitalized. The reason why companies may opt to operate with a highly-leveraged capital structure is simple. In case of investment by way of equity in an Indian company by a foreign parent, the foreign parent repatriates the return on its investment by way of dividends. Dividends are subject to a dividend distribution tax (DDT) in the hands of the Indian company at an effective rate of 20.36%. On the other hand, in case the Indian company is capitalised by way of a loan or any other form of debt from its foreign parent, the foreign parent receives interest on such debt. Such interest payment will be subject to a withholding tax in India, generally ranging from 5% to 20% on the gross amount, depending upon the nature of debt (subject to beneficial rate as per applicable tax treaty) which is deductible from the total income for computing income-tax, thus giving an arbitrage to foreign parents to thinly capitalise their Indian subsidiaries in order to save tax costs in the absence of any rules or norms to govern such thinly capitalized companies in India.

The presence of thinly capitalised companies causes erosion of tax base and shifting of profits to foreign jurisdictions, typically with a lower tax rate. This helps MNEs to reduce their overall tax costs at the group level.

3. Salient Features of this capitalization norms in India:-

Applicability

3.1 Section 94B of the Act will be applicable to a borrower being (a) an Indian company; or (b) a permanent establishment2 (PE) of a foreign company in India in respect of interest expenditure or any other payment of similar nature incurred in respect of any debt3 issued by a non-resident, being an associated enterprise4 (AE) of such borrower.

Further, the proviso to Section 94B(1) of the Act creates a deeming fiction to recognise a debt to be issued by an AE of the borrower where the lender is not an AE of the borrower but an AE of the borrower either explicitly or implicitly provides a guaranty to the lender in respect of such debt or deposits a corresponding or matching amount of funds with the lender.

It is interesting to note here that the proviso does not qualify the term AE by the words 'non- resident'. Thus, on a strict reading of the provision, cases where a guaranty is provided by a resident AE may also be caught within the rigours of Section 94B of the Act.

However, an exception has been made in respect of an Indian borrower engaged in the business of banking or insurance having regard to the special nature of such businesses.

De Minimis Threshold-

3.2 Section 94B of the Act is triggered only when the interest payments made to the foreign AE are in excess of INR 1 Crore.

It provides for disallowance of any interest expenditure or payment of similar nature, claimed as tax deductible to the extent such expenditure arises from excess interest payments.

Excess Interest

3.3 Section 94B(2) of the Act provides that the excess interest shall mean either (a) amount of total interest paid/payable in excess of 30 per cent of earnings before interest, taxes, depreciation and amortisation (EBITDA) of the borrower in a particular year; or (b) interest paid/payable to the AE for such year, whichever is less.

Carry-forward & Set-off

3.4 Where in a particular year interest is not wholly deductible as discussed above, such interest or part of interest may be carried-forward and set-off to the extent of the maximum allowable interest expenditure in any subsequent year for a maximum period of 8 subsequent years from the year in which such interest expense was first computed

Application/Impact Analysis

4. In view of the above provisions till AY 2017-18, the entire interest expense paid by a borrower to its lender outside India will be tax deductible in computing its total income under the Act. However, due to the introduction of Section 94B of the Act, from AY 2018-19 onwards, only the maximum allowable interest shall be tax deductible. Set out below is an impact analysis of thin capitalisation norms in case a highly leveraged borrower through the following illustrations:

4.1 Illustration 1

Particulars Amount (INR)
EBITDA of Indian borrower 100
30% of EBITDA 30
Interest incurred for AEs 5
Interest incurred for non-AEs 35
Total Interest Expense 40
Total Interest Expenses in excess of 30% of EBITDA (A) 10
Interest paid/payable to AEs (B) 5
Lower of A & B 5
Interest Expenses to be disallowed u/s 94B of the Act 5

4.2 Illustration 2: Where interest expense is only incurred for AEs

Particulars Amount (INR)
EBITDA of Indian borrower 100
30% of EBITDA 30
Interest incurred for AEs 40
Interest incurred for non-AEs NIL
Total Interest Expense 40
Total Interest Expenses in excess of 30% of EBITDA (A) 10
Interest paid/payable to AEs (B) 30
Lower of A & B 10
Interest Expenses to be disallowed u/s 94B of the Act 10

4.3 Illustration 3: Where interest expenses is incurred for both AEs and non-AEs

Particulars Amount (INR)
EBITDA of Indian borrower 100
30% of EBITDA 30
Interest incurred for AEs 20
Interest incurred for non-AEs 20
Total Interest Expense 40
Total Interest Expenses in excess of 30% of EBITDA (A) 10
Interest paid/payable to AEs (B) 20
Lower of A & B 10
Interest Expenses to be disallowed u/s 94B of the Act 10

An interesting take away is that even in case where interest paid to AEs is less than 30 per cent of EBITDA, there is a disallowance of INR 10 due to the fact that Section 94B of the Act considers 30 per cent of the total interest expense incurred by the Indian borrower in computing whether any interest expense is to be disallowed under these provisions.

General Anti-Avoidance Rules (GAAR)

5. It is noteworthy that effective from April 1, 2017, GAAR has come into effect. Pursuant to such rules, tax authorities may broadly re-characterize any transaction which was entered into to obtain a tax benefit and lacks commercial substance. These rules may apply in addition to, or in lieu of any other basis for determination of tax liability.

Further, vide Circular no. 7 of 2017 dated January 27, 2017, the central board of direct taxes has clarified that that GAAR and specific anti-avoidance rule (SAAR) can coexist and may be applied simultaneously, depending on the facts and circumstances of each case.

In view of the above, while the thin capitalization norms have been introduced as part of the Indian TP regulations which is a SAAR, and provides the Income-tax authorities to re-characterize debt into equity to eliminate base erosion and profit shifting, the possibility of income-tax authorities initiating separate proceedings under GAAR cannot be ruled out.

Furthermore, another open question that needs further clarification is the application of transfer pricing adjustment along with Section 94B disallowance. In case interest payments are made in excess of ALP as determined by the transfer pricing officer (TPO) attracting disallowance of excess interest, the question that remains is whether Section 94B will also be attracted causing a double whammy to the taxpayer?

Conclusion

6. The Government has certainly shown its commitment to adhere to the BEPS project by introduction of thin capitalization norms in India, but questions such a double whammy TP adjustment along with Section 94B disallowance or simultaneous application of GAAR along with Section 94B remain open till further clarification from the CBDT. It would do good to clarify such fears that may discourage MNEs from investing in India.

■■


1. Section 94B of the Act shall take effect from April 1, 2018, i.e., AY 2018-19 onwards

2. "permanent establishment" includes a fixed place of business through which the business of the enterprise is wholly or partly carried on.

3. "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"

4. "associated enterprise" shall have the meaning assigned to it in sub-section (1) and sub-section (2) of section 92A

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