“When there is an income tax, the just man will pay more and the unjust less on the same amount of income.” – Plato
The taxation regime in India seems to be undergoing crucial changes to negate the above quote from one of the greatest philosophers of all times. On this backdrop, the principles of thin capitalisation as prescribed in the Organization for Economic Cooperation and Development (‘OECD’) Base Erosion and Profit Shifting (‘BEPS) Action Plan 4 have prompted Indian lawmakers to adopt the same vide Finance Act, 2017.
Thin capitalisation refers to a situation in which a company is financed through relatively high level of debt as compared to equity. Generally, such a practice is followed for jurisdictions with high tax rates to avert the dividend distribution tax and, alternatively, upstream cash vide interest payments on debts availed. Due to such high debt, companies may claim excessive deduction of interest payment from taxable income.
The introduction of thin capitalisation provisions would have a bearing on the current debt funding structures adopted by various companies, considering that the debt funding structures attracted a beneficial tax rate of 5% on the interest payments under sections 194LB, 194LC and 194LD (as the case may be) of the Income-tax Act, 1961 (‘ITA’), including structures involving foreign lenders. The entire interest payments made by companies to their associated entities were earlier tax deductible subject to arm’s length pricing.
The provisions for thin capitalisation have been prescribed under section 94B of the ITA. The provisions under this section are applicable when any Indian company or permanent establishment (‘PE’) of a foreign company in India has availed debt from a non-resident, being an associated enterprise (‘AE’) of such a borrower, and the deductible interest payment exceeds ₹1 crore. However, these provisions are not applicable if the Indian companies are involved in banking or insurance business.
Herein, the term “AE” shall be construed the same as has been defined under section 92A of the ITA. Thereby, parties covered as deemed AEs should also be considered for the purposes of thin capitalisation provisions. For example, where a third party provides a loan that constitutes 51% or more of the book value of the total assets of a company or provides a guarantee that exceeds 10% of the borrowings of the company, the third party would be considered an AE. Accordingly, any interest paid to such third party would also be subject to thin capitalisation provisions.
The thin capitalisation provisions state that excess interest (interest amount that exceeds 30% of earnings before interest, tax, depreciation and amortization [‘EBITDA’] or the total interest amount payable to AEs, whichever is less) shall not be available for deduction. However, such disallowed interest expenditure can be carried forward for eight assessment years, but deduction of the same cannot exceed the excess interest.
Further, the thin capitalisation provisions also apply to transactions with the associated entity, wherein it provides implicit or explicit guarantee for a loan provided by any third party or similar deposits or corresponding amount with such a lender.
Usage of the term “implicit guarantee” may have wide-ranging implications, as the same may include a letter of comfort, surety, assurance letters, reciprocal agreements or similar instruments. While it may be prudent to await due clarifications from revenue authorities, companies having a similar arrangement should be wary of the applicability of thin capitalisation provisions.
It should also be noted that the definition of “debt” as provided in the aforementioned section has wide connotations and includes 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 nature. Thereby, it covers an array of debt instruments, namely Rupee Bonds, Compulsorily Convertible Debentures, and Non-Convertible Debentures, which are typically utilized in debt funding.
Further, the thin cap provisions as provided in the ITA compute the disallowance of excess interest based on the EBIDTA of the respective companies. Further, the computation mechanism may not be ideal for certain industries that are capital intensive in nature, such as companies in infrastructure, power, manufacturing, etc.
Thereby, capital-intensive industries that typically have high debt in their books and have negative or minimal EBIDTA may face a situation whereby the interest expenses incurred may be disallowed to a large extent and cause undue financial hardship. While the provisions still allow the carry forward of such disallowed interest up to eight years, the companies will have an impact on their tax cash flows.
Considering that thin capitalisation provisions have been enacted as non-obstante clause, the same would be applicable in conjunction with the transfer pricing provisions of the ITA, which mandate that interest payments to AEs should be at an arm’s length.
While the thin capitalisation provisions are still in their nascent stage, it would be prudent to expect that the revenue authorities would provide necessary clarifications and guidance on their applicability to address various issues as enumerated above.
It is pertinent to note that although the Government is keenly looking to open the door to foreign debt to provide a fillip to infrastructure sectors (such as road, power, Engineering Procurement and Construction, real estate, etc.), such provisions are making fundraising expensive.
(Views expressed are personal to the author. Article includes inputs from Janardhan Rao Belpu – Director – M&A Tax, PwC India, Komal Jain – Assistant Manager – M&A Tax, PwC India and Sambit Das – Assistant Manager – M&A Tax, PwC India.)