Some companies take large loans to take the benefit of tax deduction. It means if the loan amount is high, the companies need to pay higher amount of interest and all this interest will be tax free. Means companies may use it as a tax saving instrument. Like if the companies take the equity capital instead of loan, then the companies need to pay dividend which is almost like interest amount and the dividend is not tax free, one need to pay income tax first and then distribute dividend to the shareholders. But now government is planning to introduce ‘thin capitalization’ rule to check this type of tax evasion.
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.
New thinking of the income tax department: – income tax department seriously think of applying thin capitalization rules in India from which the tax authority will be able to classify some parts of the interest paid as dividend and deduct tax on it.
How to reclassify loan or equity: – Debt equity ratio will be the deciding factor to reclassify the amount is loan or the equity capital. There is wholly company decision to form capitalization portion of debt and equity and not impact of tax department. But tax authorities can watch the proportion and if found wrong, they can classify some parts of interest paid as dividend.
Other countries: – other countries such as USA, Netherlands, China, Poland, Russia and Germany have the limit to debt to equity. After which the interest paid on the loan amount is disqualified and companies need to pay taxes on it. India has no such rule but with this new thinking, soon India also has some sort of stoppage from free flow of tax evasion.
Impact on India: – if debt to equity system will introduce in India, there will no such great impact on the companies whereas tax evasion will be decreased to some extent.
Department is also serious about implementing debt to equity ratio in which interest on loan can be treated as dividend and companies need to pay taxes on it. So in the direct tax code proposal we can see a light on debt to equity ratio. After implementing this rule India will also a great tax structure and evasion of taxes will be hard in DIRECT TAX CODE.