How Does Thin Capitalization Affect Taxation? 

INTRODUCTION

The Organization for Economic Cooperation and Development (OECD) and the (G20) countries have launched an initiative known as base erosion and profit shifting (BEPS), which consists mostly of tax avoidance methods. These techniques primarily aim to fill in and make accommodations for tax policy loopholes, which aid in leveraging such gaps in tax regulations to deceptively shift earnings to low or no-tax nations. A business is often funded (or capitalized) through a combination of debt and equity. Thin capitalization is a condition in which a corporation is financed with a relatively high degree of debt relative to equity. Thinly capitalized enterprises are also known as highly leveraged or highly geared. To avert such difficulties, over 125 nations and jurisdictions have agreed to collaborate and adopt BEPS measures. India is dedicated to reducing the problem of tax evasion and has taken initiatives such as updating tax treaties to close loopholes and strengthening information exchange to prevent duplicate non-taxation between contracting jurisdictions from time to time.

Multinational corporations typically organize their finances to maximize the benefits of thin capitalization. Corporations based in high-tax countries frequently borrow more money or at a higher rate of interest from companies situated in no-tax or low-tax countries to shift such earnings indirectly into such low-tax countries in order to get tax benefits. To address the issue of thin capitalization, tax administrations in various nations frequently implemented anti-avoidance procedures or laws in the form of Specific Anti-Avoidance Rule (SAAR) or General Anti-Avoidance Rule (GAAR), to establish a limit on the amount of interest that may be deducted when computing a company’s taxable income and to discourage cross-border profit shifting through excessive debt in order to protect a country’s tax base.

THIN CAPITALISATION

In most countries, interest paid or due can be deducted when calculating the tax measure of profit. The higher the company’s debt level, and hence the amount of interest it pays, the smaller its taxable profit. As a result, debt is frequently a more tax-efficient source of financing than equity. A company can get funding in two ways: stock and debt. Thin capitalization has resulted from the structure of these two forms of capital funding. A corporation is considered to be thinly capitalized when its debt exceeds its equity capital, i.e. when its gearing, or leverage, is very high. Multinational corporations are frequently able to tailor their finance arrangements to maximize these advantages. They can not only produce a tax-efficient combination of debt and equity in borrowing nations, but they may also impact the tax treatment of the lender who gets the interest.

According to the OECD’s Background Paper on Country Tax Administration, “a corporation is normally funded (or capitalized) by a combination of loan and equity.” Thin capitalization is a condition in which a corporation is financed with a relatively high degree of debt relative to equity. Thinly capitalized enterprises are sometimes known as ‘highly leveraged’ or ‘highly geared.’ It is critical to understand how a firm has funded its capital since the manner of capitalization impacts the amount of earnings reported for taxes, and interest paid or payable is deductible when calculating tax obligation. As a result, when a firm has a lot of debt, the amount of interest it needs to pay on that loan rises higher, but the amount of taxable profit goes down.

From the perspective of a multinational tax planner, it is preferable to select debt over equity to fund the capital structure since it is deemed more tax effective due to the business’ ability to pick between different foreign taxation standards and lower the company’s overall tax burden since the financing cost (dividends) paid on stock is not a tax-deductible expenditure, but the financing cost (interest) paid on debt is tax-deductible. As a result, if a firm decides to borrow from businesses in low-tax nations and lend to businesses in high-tax countries, it allows such firms to deduct interest payments from earnings or taxable income in high-tax countries, resulting in a decrease in overall tax payments.

METHODS ADOPTED BY CERTAIN JURISDICTIONS TO PREVENT THIN CAPITALIZATION.[1]

FIXED RATIO: Rules that restrict an entity’s interest expenditure or debt by reference to a fixed debt/equity, interest/earning, or other ratio.

ARM’S LENGTH BASIS: Rules that compare an entity’s amount of interest or debt to the situation if the firm had only dealt with third parties.

ANTI-AVOIDANCE RULE: Anti-avoidance measures that prohibit interest on specified transactions.

SPECIFIED PERCENTAGE: Rules that prohibit a certain proportion of interest expenditures in a company, regardless of the source of the payment or to whom it is made.

THIN CAPITALIZATION REGIMES IN DIFFERENT JURISDICTION

Various nations have established various sorts of thin capitalization regulations based on the principles, which are explored further below.[2]

THIN CAPITALIZATION RULES IN INDIA

In order to meet its commitment to BEPS, the Indian government enacted steps to limit thin capitalization in India under the Finance Act of 2017. Among other tax reforms, the budget includes new limitations on interest deductibility (thin capitalization regulations) in accordance with the OECD’s base erosion and profit shifting (BEPS) study. In light of the BEPS effort and the report on Action Plan 4, the Government incorporated a new Section 94B into the Finance Act 2017 to bring Indian laws in line with the recommendations of the OECD BEPS Action Plan 4. The clause applies to borrowers that are an Indian corporation or a Permanent Establishment (PE) of a foreign corporation and pay interest on any type of debt provided to a non-resident or a PE of a non-resident who is a ‘Associated Enterprise’ of the borrower.

Furthermore, whenever an Associated Enterprise gives an implicit or explicit guarantee to the lender or deposits a comparable and equal quantity of cash with the lender, the debt is assumed to be issued by an Associated Enterprise. The requirements limit an entity’s payment of interest to its Associated Company to 30% of its earnings before interest, taxes, depreciation, and amortization (EBITDA) or interest paid or due to the associated enterprise, whichever is smaller. To target just significant interest payments, it is planned to set an interest expenditure threshold of INR one crore, over which the provision would operate. The provisions also allow for the carry-forward of disallowed interest expense to the eight assessment years immediately following the assessment year in which the disallowance was first made, as well as a deduction from income computed under the heading “Profits and gains of business or profession to the extent of maximum allowable interest expenditure.” Because of the unique nature of these enterprises, banks and insurance companies are exempt from the scope of these regulations.

IMPACT OF THIN CAPITALIZATION RULES.

As a result of the non-deductibility of interest expense above the de minimis threshold, private equity funds / investors investing in Indian businesses through debt may have to recalculate their return on investment and factor in the present value of the interest that can be disallowed, carried forward, and set off against future profits. Furthermore, because Indian partnership firms, trusts, and LLPs are not currently covered by the thin capital restrictions (unless they are a PE of a foreign business), the preferable organizational structure may change in the future.

Furthermore, because the Indian thin-capitalisation requirements do not provide an exception for interest paid to third-party lenders on loans used to support public-benefit projects, its application may raise the tax burden on industries such as infrastructure, etc. In this regard, the OECD granted countries the option to exclude, subject to specific circumstances, interest paid to third-party lenders on loans used to support public-benefit projects, since the BEPS risk is decreased owing to the nature of these projects and the strong relation to the public sector. Furthermore, start-ups (whose EBITDA is often modest in the early years) may be negatively impacted by this anti-abuse measure.

CONCLUSION

The most effective strategy for tax authorities across the world to protect against thin capitalization concerns is to enact thin capitalization laws. By incorporating thin capitalization requirements into the country’s tax laws and restricting the maximum amount of interest deductible, it is possible to avoid base erosion and profit shifting. A stringent application of the thin capitalization rules, on the other hand, may jeopardise the interests of real taxpayers while also interfering with the taxpayer’s trade and commerce. As a result, such regulations should not be understood in an overly technical manner, and the concept of substance over form should be followed. Each case should be evaluated on the facts and circumstances of the specific case, attempting to lift the corporate veil of the parties involved and showing the underlying reason of such debts. It is also envisaged that the implementation of these regulations will not result in significant litigation and that tax consideration will not become the exclusive criterion for defining the capital structure of the organization.

 ENDNOTES

[1] https://taxguru.in/income-tax/thin-capitalization-section-94b.html ACCESED ON 12-06-2021

[2] Patnaik, S. R. (2017, March 1). Thin Capitalisation – The Line Is Getting Blurred! Retrieved June 12, 2021, from https://tax.cyrilamarchandblogs.com/2017/03/thin-capitalisation-line-getting-blurred/.

[3] Section 18 (4)- 18(8) of Canada’s Income Tax Act