Section 94B Limitation of interest benefit provisions introduced – certain concerns to be addressed
(I) The Finance Act, 2017 introduced limitation of interest benefit (deduction) provisions in where an Indian company, or a permanent establishment of a foreign company in India, being the borrower, pays interest exceeding rupees one crore in respect of any debt issued/guaranteed (implicitly or explicitly) by a non-resident AE. The interest shall not be deductible in computing income chargeable under the head ‘Profits and gains of business or profession’ to the extent, it qualifies as excess interest.
Excess interest shall mean total interest paid/payable by the taxpayer in excess of thirty per cent of cash profits or earnings before interest, taxes, depreciation and amortisation (EBITDA) or interest paid or payable to AEs for that previous year, whichever is less.
There will be restriction on the deductibility of the interest in the hands of the taxpayer in a particular financial year to the extent it is excess as explained above. However, the same shall be allowed to be carried forward for a period of eight years and allowed as deduction in subsequent years. The above restrictions shall not be applicable to the taxpayer engaged in the business of banking or insurance. These provisions will be applicable for FY 2017-18 and subsequent years.
(i) India is a developing country with a need for foreign investment to fund various initiatives, in particular, the development of India’s infrastructure. The Government has given its support at a policy level, inter-alia, consistently reducing tax withholding rates on ECBs by Indian entities from non-residents, which indicates encouragement by the Government towards debt obtained by Indian entities by overseas parties. However, the restrictions imposed under the proposed Section 94B above in respect of interest of overseas loans is giving mixed signals to foreign as well as Indian parties at a policy level on overseas borrowings. This inconsistency may lead to further policy level uncertainty in the minds of the business community in India and may undermine the attempts at enhancing the “ease of doing business” by the Government. Under existing ECB guidelines, there is already a mechanism in place to limit the Borrower’s Debt/Equity ratio, which effectively safeguards India’s interests with regard to excessive debt. As such, there is no need for any additional measure to protect India’s interests in this regard.
(II) Without prejudice to the aforesaid, if at all it is considered necessary to have provisions to limit the deductibility of interest, the exclusions granted to banking and insurance companies may be extended to other sectors such as Infrastructure and Non-Banking Finance Companies. Large capital intensive companies with long gestation periods, Non-Banking Finance Companies, companies in the real estate sector and companies in the infrastructure sector (requiring significant foreign capital which may not always come in the form of equity) are typically highly leveraged on account of the business requirements (either by way of external or related party debt) and might be negatively impacted by the interest restriction.
(III) The proviso to sub-section (1) provides that where debt is issued by a non-associated lender but an AE either provides implicit or explicit guarantee to such lender, such debt shall be deemed to have been issued by an AE.
In respect of explicit guarantees, the transaction relating to associated enterprises is only towards a guarantee commission (in case charged by the overseas guarantor). The interest towards the borrowing is paid in this case only to a third party wherein the rate and terms are decided purely through negotiation. Hence, restriction of benefit in relation to guarantees ought to be only to the extent of the guarantee commission (if any) claimed as a deduction by the Indian entity and not interest paid to the third party lender.
Further, including implicit guarantees under the above restrictions would lead to significant hardship for the taxpayers and may result in protracted litigation in the coming years. It is pertinent to note that there is no clear definition of implicit guarantee and it would be an onerous task for the taxpayers and tax authorities to determine existence of an implicit guarantee. E.g. when a letter of comfort or simply an undertaking is provided by one AE to a lender or a bank, the tax authorities may contest that guarantee exists, without going into details whether the same has benefited the borrower and whether the AE has actually rendered any service or assumed any liability.
(IV) Based on the definition of the term ‘debt’ as provided in clause (ii) of sub-section (5) of proposed section 94B, interest may include many other payments made on various kinds of financial arrangements and instruments. There may be an issue as to what payments made by the taxpayer needs to be included in the term interest e.g. which payments on account of finance lease and financial derivatives should be included in the term ‘interest or similar consideration’ etc. which may again lead to litigation.
(V) There is lack of clarity on the mechanism to calculate EBITDA i.e. say, on the basis of book profits calculated on the basis of accounting standards, Ind-AS or otherwise. This may result in unnecessary litigation.
(VI) The BEPS Action Plan 4 provides for a Group Ratio Rule wherein the Group’s overall third party interest as a proportion of the Group’s EBITDA is computed and that ratio is applied to the individual company’s EBITDA to determine the interest restriction. This would take into account the actual third party debt and leverage at global level vis-à-vis third parties. This also addresses the issue relating to inherently highly leveraged industries since the global leverage ratio would take into account the significant debt and would be commensurate to the leverage ratio required at individual country level. Given this, a relatively fair leverage requirement at India level would emerge.
(VII) Sub-section (1) of Section 94B specifically requires the lending to be from a non-resident AE for the section to trigger. However, branches or permanent establishments of foreign banks are also “non-residents” for the purposes of the Income-tax Act. Whilst branches or permanent establishments of foreign banks operate essentially as Indian companies and compete directly with Indian banks, debt by related Indian branches of banks or guarantees given by AEs towards borrowings by Indian companies from branches or permanent establishments of foreign banks would qualify for disallowance under the above provision. This places the Indian branches of foreign banks at a disadvantageous position vis-à-vis competing Indian banks
(VIII) Section 94B(4) provides that where for any assessment year, the interest expenditure is not wholly deducted against income under the head “Profits and gains of business or profession“, so much of the interest expenditure as has not been so deducted, shall be carried forward to the following assessment year or assessment years, and it shall be allowed as a deduction against the profits and gains, if any, of any business or profession carried on by it and assessable for that assessment year to the extent of maximum allowable interest expenditure in accordance with sub-section (2): Provided that no interest expenditure shall be carried forward under this sub-section for more than eight assessment years immediately succeeding the assessment year for which the excess interest expenditure was first computed.
(IX) Carry forward of unused interest capacity: Section 94B(2) provides that the excess interest shall mean an amount of total interest paid or payable in excess of thirty per cent of earnings before interest, taxes, depreciation and amortisation of the borrower in the previous year or interest paid or payable to associated enterprises for that previous year, whichever is less.
Business may not earn consistent profit year on year. However, the interest expenditure may be consistent. Given that EBITDA may vary on account of economic considerations, it may be that the cap of 30% may not be exhausted in a particular year (say year 1).
(X) Section 94B deals with limitation on interest deduction in certain cases. The relevant extract of the same is reproduced below:
“94B. (1) Notwithstanding anything contained in this Act, where an Indian company, or a permanent establishment 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, as specified in sub-section (2):
Provided that where the debt is issued by a lender which is not associated but an associated enterprise 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 associated enterprise.
(2) For the purposes of subsection (1), the excess interest shall mean an amount of total
interest paid or payable in excess of thirty per cent of earnings before interest, taxes, depreciation and amortisation of the borrower in the previous year or interest paid or payable to associated enterprises for that previous year, whichever is less.”(emphasis supplied).
Whether for purpose of determining amount of excess interest under section 94B(2), interest paid to third party lenders (i.e. other than associated enterprises) should be included in ‘total interest paid or payable’ or it should only include interest paid or payable to associated enterprises?
- Sub-section (2) to section 94B refers to “an amount of total interest paid or payable”. The literal reading of the section does not create any limitation on inclusion of interest paid or payable to associated enterprises only. The words referred to are ‘total interest paid or payable’.
- The legislature in its wisdom has separately referred to “an amount of total interest paid or payable” and “interest paid or payable to associated enterprises” within the same sub-section itself.
Thus, basis the literal reading of the section, interest paid to third party lenders shall be included in ‘total interest paid or payable’ for the purposes of computing the excess interest under section 94B(2).
Having said the above, it may be possible to contend that interest paid to third party lenders may not be included in ‘total interest paid or payable’ for the purposes of computing the excess interest basis the intention of the legislature as per the Memorandum explaining the provisions of Finance Bill
Basis the intention of the legislature as per the Memorandum explaining the provisions of Finance Bill, it may be possible to contend that interest paid to third party lenders may not be included in ‘total interest paid or payable’ for the purposes of computing the excess interest.
Reference could also be made Commentary on Finance Act, 2017 published in Taxmann’s Master Guide to Income Tax Act [at page 1.91 para 1.7-8a]
(I) In view of the above policy level issues, it is suggested that the restrictions imposed on the interest benefits on overseas borrowings may be done away with entirely or at least deferred for 5-10 years to give India a chance to achieve high growth and achieve significant infrastructural development and maturity.
(II) It is recommended to carve out exceptions for inherently highly leveraged industries from the aforesaid restrictions. The exclusions granted to banking and insurance companies may be extended to other sectors such as Infrastructure, Non-Banking Finance Companies and loss making companies.
Also, the provisions should not be made applicable to new companies/start-ups (i.e. companies formed after 1 April 2016) for initial period of 3 years. This would help them to Jbuild good track record and be able to independently obtain debt without support of AE.
Alternatively, the provisions may not be applicable, subject to certain conditions in line with BEPS Action Plan 4.
(III) The said section should be amended to specify limitation of benefits in guarantee cases only to the extent of the guarantee commission (if any) paid by the Indian entity to the overseas guarantor (being its AE) and not the interest. Further, the word implicit guarantee may be dropped from the provisions. The term ‘explicit guarantee’ may also be appropriately defined to
obviate future litigation on this front.
(IV) It is recommended that:
- Appropriate guidelines may be issued to clarify what the term ‘interest or similar consideration’ should include or exclude as the definition provided in the existing Section 2(28A) of the Act may not be adequate for the purposes of thin-capitalisation rules based on the definition of the term ‘debt’.
- the provisions of this section should be made applicable to new debts taken on or after 1 April
- Interest disallowed under other provisions (sections 40(a)(i) or 43B) should be specifically excluded from definition of “total interest”
(V) It is suggested that the mechanism to calculate EBITDA be clearly laid down.
(VI) It is suggested in place of a fixed 30 per cent EBITDA restriction, a Group Ratio could be considered in order to apply the interest deduction restriction under the above provision.
(VII) It is suggested that borrowings by Indian companies from Indian branches or permanent establishments of foreign banks may be wholly excluded from the purview of the aforesaid Sec 94B (either by way of direct borrowing from or by way of guarantee by AE to such branches or permanent establishments of foreign banks).
- The CBDT may consider allowing carry forward of excess interest without any restriction on the number of years similar to provisions adopted in case of depreciation. However, in case the same is not feasible carry forward of excess credit should be allowed for a longer period, say 15 years, instead of the prescribed 8 years to cushion the long gestation periods forsuch industries.
- It may further be clarified that set off will be available even if the section is not triggered in the subsequent year due to interest expense being less than INR 1 Crore.
- It is suggested that there should be a credit mechanism to offset the unutilized limit in subsequent years.
- The period of set-off may be restricted to 3-5 years.
(X) Thus with a view to resolve the issue discussed, it is suggested that for the purpose of computing ‘excess interest’ under section 94B(2), the term ‘total interest paid or payable’ should only include interest paid to the associated enterprise.