Thin Capitalization – Part II

In part I of this article, we tried to analyzed and understood provision of sub-section (1) of section 94B. In this part, we try to analyze and understand remaining portion of section 94B as below,

Proviso to sub-section (1)

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.

Proviso provides that where lender is not associated enterprises, but associated enterprise has provided implicit or explicit guarantee to such lender or deposited back to back fund with lender, then such debt by third party lender deemed to be issued by associated enterprise and provision of Sec 94B will apply.
One may have a situation as below while going through above proviso,

Debt issued by Non – AE	Guaranteed by AE	Debt is deemed to be issued by AE	Remarks
Non-resident	Non-resident	Yes	As deeming proviso will apply.
Non-resident	Resident	No	As sub-section (1) deal with debt issued by non-resident only, proviso cannot travel beyond main section/ sub-section to which it append. Hence, on strict interpretation, deeming proviso will not apply.
Resident	Non-resident	Yes	On strict interpretation, deeming proviso will apply.
Resident	Resident	No	As in this case, there is no base erosion and profit shifting as All are resident. Hence, ideally deeming proviso will not apply.

Further, what is Implicit or explicit guarantee is not specified anywhere in Income-tax Act, 1961. AS per OECD’s draft on financial transaction guideline,

“142. By providing an explicit guarantee the guarantor is exposed to additional risk as it is legally committed to pay if the borrower defaults. Anything less than a legally binding commitment, such as a “letter of comfort” or other lesser form of credit support, involves no explicit assumption of risk. Each case will be dependent on its own facts and circumstances but generally, in the absence of an explicit guarantee, any expectation by any of the parties that other members of the MNE group will provide support to a related party in respect of its borrowings will be derived from the borrower’s status as a member of the group. The benefit of any such support attributable to the borrower’s group member status would arise from passive association and not from the provision of a service for which a fee would be payable. See paragraph 7.13 on passive association and Section C.1.3 Effect of group membership.”

Further, proviso seem to be discriminatory in respect of disallowance of interest paid to resident lender as there is no base erosion or profit shifting. One may argue that borrowing from third party lender on the basis of guarantee from associated enterprise are in nature of quasi equity and hence, same is consider as lending by associated enterprise and provision of this section may apply. However, again purpose for which provision introduce may fail as there is no base erosion or profit shifting in case of interest paid in respect of lending by resident.
Further, by covering implicit guarantee, it may also cover situation where there is element of guarantee on any kind of loan taken by entity being part of MNE, though no actual guarantee is provided. Further, how revenue will assess the existence of implicit guarantee from associated enterprise in case of third party lending-borrowing transaction.
Further, the term “deposits a corresponding and matching amount of funds with the lender,” need to clarify. Whether 100% fund arrangement could be consider as deposits a corresponding and matching amount of fund with the lender or even 51% fund arrangement could also be consider.
Recently, Finance Act, 2020 has inserted sub-section (1A) in section 94B w.e.f AY 2021-22,

“(1A) Nothing contained in sub-section (1) shall apply to interest paid in respect of a debt issued by a lender which is a permanent establishment in India of a non-resident, being a person engaged in the business of banking.”

Sec 92A deems two enterprises to be associated enterprise, if during the previous year, loan advanced by one enterprise to the other enterprise is 50% or more of the book value of the total assets of the other enterprise. Thus, interest payment in respect of loan advanced from branch of foreign bank provision of this section may trigger. To carve out such situation, above sub section inserted. Hence, interest payment in respect of borrowing from PE of non-resident being person engaged in business of banking.

For Thin Capitalization… Part – I you may refer below link,

https://taxguru.in/income-tax/thin-capitalization-part-i.html

Tags: Transfer Pricing