Preference of debt over equity as a measure to finance businesses:
Debt and equity are the instruments through which a company is generally financed or capitalized. The manner in which a company is capitalized has a major impact on the amount of taxable profit as the tax laws of countries generally provide for a deduction in respect of interest paid or payable while arriving at the taxable profit. However, the dividend paid on equity contribution is not deductible. Therefore, the higher the level of debt in a company, and thus, the amount of interest it pays, the lower will be its taxable income. Due to this reason, debt is considered a more tax efficient method of finance than equity. Multinational groups are often able to structure their financing arrangements to maximize tax benefits.
Tax Rules to prevent shifting of profits through excessive interest payments:
In order to address this issue, tax rules are in place in each country to fix a ceiling limit on the amount of interest deductible in computing a company’s profit for tax purposes. Such rules are designed to counter cross-border shifting of profit through excessive interest payments, with the objective of protecting a country’s tax base.
Relevant Action Plan of BEPS:
Under the initiative of the G-20 countries, the Organization for Economic Co-operation and Development (OECD) in its Base Erosion and Profit Shifting (BEPS) project had taken up the issue of base erosion and profit shifting by way of excess interest deductions by the MNEs in Action Plan 4 and recommended certain measures in its final report.
Insertion of provision in the Income-tax Act, 1961 in line with BEPS Action Plan 4:
Section 94B has, accordingly, been inserted in the Income-tax Act, 1961, in line with the recommendations of OECD BEPS Action Plan 4, to provide that interest expenses claimed by an entity to its associated enterprises shall not be deductible in computation of income under the “Profits and gains of business or profession” to the extent that it arises from excess interest.
Excess interest shall mean an amount of
whichever is less.
*Total interest paid or payable may be interpreted as interest paid or payable to non- resident associated enterprise as per the intent expressed in section 94B(1) and also the Explanatory Memorandum to the Finance Bill, 2017.
The provision shall be applicable to an Indian company, or a permanent establishment of a foreign company in India, being the borrower who incurs expenditure by way of interest or similar nature in respect of any form of debt issued by a non-resident who is an ‘associated enterprise’ of the borrower.
However, the provision of this section would be applicable only where the expenditure by way of interest or of similar nature exceeds 1 crore in respect of any form of debt issued by a non-resident, being an ‘associated enterprise’ of such borrower.
Meaning of debt:
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”.
Provision of guarantee and deposit of matching amount deemed to be debt issued:
Where the debt is issued by a lender which is not associated but an associated enterprise either
Carry forward of excess interest:
The disallowed interest expense can be carried forward up to eight assessment years immediately succeeding the assessment year for which the disallowance was first made and claimed as deduction against the income computed under the head “Profits and gains of business or profession” to the extent of maximum allowable interest expenditure.
Businesses excluded from applicability of the provisions of section 94B:
Taking into consideration the special nature of business of Banks and Insurance business, an Indian company or permanent establishment of a foreign company which is engaged in these businesses have been excluded from the applicability of the provisions of this section.
Limitation of interest deduction (Section 94B): A Summary