The revised discussion paper on Direct Tax Code (DTC) proposes to introduce General Anti Avoidance Rules (GAAR ) to curb tax avoidance by disregarding any arrangement called ( Impermissible Avoidance Arrangement (IAA) ) entered or carried on in a manner
a) Which is not normally employed for bona-fide business purposes or
b) Which is not at arm’s length prices or
c) Which Abuses the provisions of the DTC or
d) Which Lacks economic substance.
However in order to prevent arbitrary application of GAAR suitable threshold limits for invoking GAAR will be considered. One such measure may be the application of the concept ‘Thin Capitalisation’ rules to check tax avoidance by providing a benchmark Debt-Equity Ratio.(Safe harbor ratio)
Thin capitalisation means such a capital structure of a company where the amount of funding by debts is higher than equity-funding with an object to avoid tax because interest on debts is tax deductible while dividend is subject to some form of tax like Dividend Distribution Tax in India.
THIN CAPITALIZATION: – Thin capitalization means a firm or company where the higher proportion of funds is from loans and borrowings and not from equity and capital. There is no agreement on what constitutes thin capitalization. Two obvious measures are the debt/equity ratio and the ratio of interest to profits before tax. However the choice of going for debt funding is saddled with solvency risk and raising of equity depends on the economic conditions of the county and the condition of capital market. Therefore a judicious combination of debt, equity and reduction in tax liability is the need of the hour. An example may perhaps clarify the concept:
|Safe Harbor Ratio (Ideal D/E Ratio)||1||2||3||4||5||6|
|Total Funds deployed||2000||2000||2000||2000||2000||2000|
|Profit available for dividend||126||98||84||76||70||66|
|Less: Dividend tax||15%||19||15||13||11||11||10|
|Total tax collected||73||57||49||43||41||38|
|Return on equity Capital||11%||12%||14%||16%||18%||20%|
|Tax as % of EBIDT||24%||19%||16%||14%||14%||13%|
|Distribution of EBITD|
|*EBID= Earning before interest and tax|
From the above table it is clear that so long as the rate of return on funds employed is more than the rate of interest, the post tax return to the equity holder keeps on increasing while the rate of tax on EBITD goes on reducing. The GAAR proposes measures to fight illegal tax optimization and non-payment of taxes by a mixture of debts & equity as above explained. Even when equity is easy companies will still go in partly for debt because equity is more expensive to service. Tax laws allow interest as cost while the whole of the profit becomes taxable. As such, debt, by reducing the tax liability, enhances the return on equity. GAAR thus proposes measures like fixing an ideal Debt/Equity ratio so as to optimize the rate of tax revenue. Thin capitalization per se can not be said undesirable because it is, many a times positive for the global economy, since these loans increase investment and spending on business development projects around the world. However the impact of safe harbor rule is not likely to affect the Indian Industries as most of them are already hovering around D/E of 1, while in case of banking sectors, it is around 12. The transactions conducted in a manner to disguise the nature, location, source, ownership, or control, are most likely to be specifically covered under the net of arrangements lacking commercial substance.
The government may like to have a number of options to decide the nature of capitalisation of a company.
(1) The fixed ratio approach : Under this approach that part of interest paid on loans in excess of D/E ratio may either be disallowed as it is or the same may be treated as dividend liable to dividend distribution tax. It may be noted that the disallowance of interest may not reduce the interest income of the creditor and he may have to pay tax on it by including it in his taxable income as interest income.
(2) The subjective approach : Under this approach the prevailing circumstances are evaluated to determine the terms and nature of the contribution to decide whether debt has been disguised as equity. The test of substance over form may be applied in this case.
(3) The hidden profit distributions: Under this approach, the excess interest is treated as dividend and taxed accordingly. The general principles of transfer pricing rules may also play a role in this respect.
While it is desirable to fix a safe harbor ratio to control the concept of thin capitalisation, it is not that easy as it appears to be because many factors must be taken into account before deciding an Ideal Debt/Equity Ratio.
1) What should be the generally accepted debt-equity ratio. Is it 2: 1, 3:1 or any other ratio.?
2) What provisions should be made where there is a reverse thin capitalisation situation i.e. the D/E is less the fixed D/E. Should the equity be re-characterised as debt. ? Should that excess interest be tax free ?.
3) Whether the D/E should be fixed for the company as a whole as at the end of a tax-period or should it be restricted to transactions between the company and “related parties.” (The related party must also be suitably defined). Further, what should be done if the transactions between related party and the company are at “arm’s length price”.
4) In a developing country like India, fixing a fixed D/E ratio may not be practicable at all. It must consider the typical conditions for different type of industries in different stages of project cycle .
a.The D/E ratio of a highly capital intensive industry may have a high D/E ratio compared to a service industry which generally has a much lower D/E ratio. Well, in case of Infosys Technology the D/E is =0. How should these situations be monitored ? Should the reverse of thin capitalization be applicable here?.
b. Even within highly capital intensive industries, different D/E may have to be fixed. For example the D/E for the following industries may not be the same:
i. Textiles Industry, ii) Sugar Industry iii) Cement Industry iv) Steel Industry v) Automobile Industry, vi) Petroleum & Refinery Industry vii) Real Estate Industry etc..
5) In computing the debt-to-equity ratio, whether only the debt and equity from a related party should be considered or the D/E of the company as a whole should be considered.
6) Problems would also crop up if the D/E ratio of related party transactions carried out at arm’s length price , is lower than that of the cut off D/E while the company level D/E is more than the fixed ratio.
7) If the actual interest rate of the borrowing enterprise is higher than that of a related-party rate of interest , should the lender be subject to the D/E rule in this case also.?
8) What should be the basis of calculating D/E ratio ?. Whether on the average debts outstanding during the year or the debts due as of the date of balance sheet.?
9) What should be included in the definition of debts ? i) Only long term debts; ii) long term debts and current liabilities ; iii) Only interest bearing long term debts; iv) All the local debts or only foreign debts ; v) Debts provided by financial institutions etc.
10) What should be the basis of calculating debts. Is it at the gross level or net of debt due and loans given by the company. What if this adjustment turns out to be a reverse of thin capitalisation ?
11) What should become of the interest disallowed because of D/E ratio ?. Like MAT, should it be allowed to be carried forward for a certain period like business loss or indefinitely like depreciation.? Or should a certain per cent of the amount be reduced every year and balance carried forward.?
12) Should the classic system of corporate taxation be continued providing thereby deductions for inter-corporate dividend, Rebate in taxation of Long Term Capital Gain, Deductions allowed for setting up of new industrial undertaking etc.
13) What if the rate of interest under thin capitalisation system is determined as per the rating arrived at by an independent rating agency like (CRISIL)? The rating depends, inter alia, on the solvency risk of the enterprise.
14) Can it be one of the option which disallows ‘excess net interest expense,’ which may be defined as the excess of interest expenses over interest income if such excess exceeds a defined % of the earnings before (net) interest, tax, depreciation and amortisation (EBITDA).
15) Many Indian enterprises had devised a igneous method to avoid thin capitalisation system as also the rules provided for the ECB. A novel instrument called “Optionally Redeemable Preference Shares” was designed and used for disguising debts as equity.
16) In India, the Foreign Investment Promotion Board (FIPB) has defined the debt to equity ratio limit for the automatic investment route in various sectors. However, companies can always go for a higher debt to equity ratio after taking approval from FIPB. Moreover, FIPB norms are only for checking foreign investment and this does not apply to domestic investors.
The readers are requested to express their learned opinions on all the aspects of the system of thin capitalisation.
CA LALIT MUNOYAT
B.Com.(Hons.), CS, FCA, DISA