INTRODUCTION
Multinational entities (MNEs) have actively contributed to the global value chain. These MNEs that have established affiliates or subsidiary companies transacting cross-borders and have always been a matter of discourse. Such related party transactions if ungoverned, tend to create a hassle for their respective jurisdictions in allocating taxing rights and could lead to an administrative tax tangle. To avoid payment of excessive tax, MNEs typically finance or capitalise their subsidiaries through debt and equity. ‘Where a company is financed through a relatively high level of debt compared to its equity’[1] it is known as Thin Capitalisation.
This is considered a tax friendly mechanism and is adopted by most of the MNEs because the taxpayers can claim excessive deduction on the interest payments made on these debts unlike the payment of dividend income on equity, where no claim can be made for a tax-deductible expense and an additional tax burden by way of dividend distribution tax is seen. These interest payments are either deducted against the profits that attract tax liability or are shifted to a comparably low tax jurisdiction or a jurisdiction attracting nil tax rate. Such interest expense deductibility may lead to double non-taxation in both their respective jurisdictions that the parent entity and subsidiaries belong to. To address this concern, over 125 jurisdictions have adopted the Base erosion and profit shifting (BEPS) initiative taken by the Organization for Economic Co-operation and Development (OECD) with the G20 countries to curb these tax abusive measures.
Action Plan -4
Action Plan 4 under BEPS addresses the ‘Limitation on Interest Deduction’ with an ‘aim to limit the base erosion by using interest expense to achieve excessive interest deductions or to finance the production of exempt or deferred income’.[2] This action plan was initiated to fluid the money and create a balance between the debt and equity of a controlled entity.
‘Certain methods adopted by different jurisdictions to curb thin capitalization are[3]:
1. Fixed ratios that limit the level of interest expense or debt in the entity with a fixed ratio of debt or equity, interest or earnings therein.
2. Arm’s length basis test that compares the interest rate of such debts of an entity with that of the company charging such interest to a third party.
3. Rules for specific percentage for interest payment that is disallowed irrespective of the nature of payment or the recipient.
4. Certain targeted anti-avoidance rules that disallow interest on specific transactions.
To meet the BEPS commitment, the Indian tax administrative department enacted certain measures to limit the practice of thin capitalization in India. In relevance to the limitations on interest deductibility, a new Section 94B has been incorporated in the Finance Act,2017 to regulate Indian laws as per the recommendations made by the OECD under Action Plan 4.
Section 94B of the Income Tax Act,1961-
It reads as ‘where an Indian company, or a PE of a foreign company in India, being the borrower incurs any expenditure by way of interest or of similar nature exceeding one crore rupees which is deductible in computing income chargeable under the head ‘Profits and gains of business or profession’ in respect of any debt issued by a non-resident being an associated enterprise of such borrower, the interest shall not be deductible in computation of income under the said head to the extent that it arises from excess interest.
Provided, that where the debt is issued by a lender which is not associated but an AE either provides an implicit or explicit guarantee to such lender or deposits a corresponding and matching amount of funds with the lender, such debt shall be deemed to have been issued by an AE’[4].
The allowance of interest paid given under this section was – total interest payable in excess of 30% EBITDA (earnings before interest, taxes, depreciation and amortization) of the borrower in the previous year or the interest paid to the AE for that previous year, whichever among these is lesser is taken into account. The interest deduction if not wholly deducted under the head, shall be carried forward to the following assessment year. Provided, no such interest expenditure shall be carried forward for more than eight assessment years succeeding the assessment year when the first interest computation was made.
Exception to this provision is that it shall not be applicable to any Indian co. or a PE of a foreign co. which is engaged in the business of banking and insurance.
Impact on The Indian MNEs-
The thin capitalization rules incorporated under Section 94B of the Income Tax Act,1961 are applicable to the Indian resident entities that pay interest to their non-resident AE’and if such Indian entities able to borrow guarantee either explicit or implied from the foreign AEs, then the provisions under this Act hold no good. ‘There would be severe repercussions for the Indian taxpayers or start-ups who need funding or capital investment in their initial years. The de minimis threshold for the non-deductibility of interest expense may affect the private equity funds and angel investments in India where the investors have to be re-assured to invest in Indian entities considering the disallowance of interest payments, criteria in carrying forward and setting off against future profits. Further the ambit of this provision does not include Indian partnership firms, LLPs, trusts etc. unless they are a PE of a foreign entity resulting in res-structuring of their business.’[5]
The Indian legislative is silent on providing any exceptions for the interest paid to the third-party lenders on such loans that are provided for any projects benefitting public and no specific thin capitalization guidelines on these might burden the industries at large. Each entity being subjected to the same threshold and the percentage of interest being levied would jeopardise the interests of real tax payers and low profit making MNEs while interfering in their trade and commerce.
WAY FORWARD
To regulate thin capitalization in the economy, tax administrators have introduced these rules in their jurisdiction. OECD has recommended four approaches in which India has adopted the ‘ratio approach’ in its legislation to govern and tackle tax evasion through thin capitalisation. It is duly seen that adopting anti- abuse provisions by linking interest deductions with EBITDA would be very unfavourable to the taxpayer as it differs from year-year irrespective of the interest paid being constant. Specially for start-ups the EBITDA in their initial years could be fair and satisfactory and it may be higher as the entity grows. By adopting this approach and limiting the amount of interest deducted, may adversely affect the economies distorting the functioning of these subsidiaries. Fixed ratio-based approach might not oversee the resultant market conditions and its effect on specific industries which may cause inconsistent treatment of MNEs lacking in proper implementation of the provisions, Eg; the downfall due to Covid-19 has affected the profit ratio of several entities and their debts which required larger MNEs to lend support by providing funds.
The way ahead could be by adopting the ‘Arm’s-length approach’. This approach would provide a closer proximity on the debt of that individual corporation and compare it with a similar independent entity to analyse the Arm’s length percentage of interest charged. Thin capitalisation rules can not be universally applicable, they have to be analysed on a case-to-case basis and by adopting this approach, determining the deductible debt interest is favourable. This shall also mitigate the concept of double taxation where the computation is entity specific, and their taxing rights are agreed in the respective tax treaties.
The only con of this approach is that it involves heavy compliance and requires resources to implement. This could be mitigated if the Indian thin capitalisation rules are regulated accordingly where the tax auditors are made aware of these third-party lending’s and the Government facilitates certain percentage of funding specially to the low profit-making companies and start-ups to reduce their tax compliance and documentation burden.
MNEs may navigate these complexities of interest deductibility by determining their optimal structure of capital allotment but it is the need of the hour to govern and regulate MNEs according to the structure of their entity, the prevailing market conditions, nature of debt etc. and there can not be a standard limitation on interest deductible.
BIBILOGRAPHY
1. Action Plan 4, OECD (2015)
https://www.oecd.org/tax/beps/beps-actions/action4/
2. Income Tax Act,1961. (Section 94B)
https://incometaxindia.gov.in//
3. 4 Samir Gandhi & Ian Clarke, Thin Capitalization Rules- A comparative study of regulations in major tax jurisdictions, International Taxation- A Compendium, (Chap 123, 2013).
4. S. R. Patnaik, Thin Capitalisation- The line is getting blurred, Cyril Amarchand Mangaldas (2017)
https://tax.cyrilamarchandblogs.com/2017/03/thin-capitalisation-line-getting-blurred/.
5. Thin Capitalization Legislation (Initial Draft 2012)
https://www.oecd.org/ctp/tax-global/5.%20thin_capitalization_background.pdf
6. Vikas Vasal, Thin Capitalisation rules- limitation on interest expenses, Grant Thorton (2021)
https://www.grantthornton.in/insights/blogs/thin-capitalisation-rules-limitation-on-interest-expenses/.
[1] S.R. Patnaik, Thin Capitalisation- The line is getting blurred,Cyril Amarchand Mangaldas (2017).
[2] Action Plan 4, Inclusive framework on BEPS, OECD (2015).
[3] Ibid (n1)
[4] Section 94B, Income Tax Act, 1961.
[5] Vikas Vasal, Thin Capitalisation rules- limitation on interest expenses, Grant Thorton (2021).
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