Thin Capitalization – Section 94B

India has time and again shown its commitment to BEPS initiative of the OECD and introduced several reforms in domestic tax legislation to plug loopholes, strengthen information sharing between the contracting states and prevent double non-taxation. In line with its commitment, vide Finance Act 2017; the government has introduced measures to curb thin capitalization in India. The budget introduces new restrictions on interest deductibility (thin capitalization rules) in line with the OECD base erosion and profit shifting (BEPS) project, among other tax measures.

The debt and equity have been the fundamental sources of raising funds in any business. Although it is ideal for any business entity to find the right financing mix between debt and equity, but due to certain circumstances, a company may end up being highly leveraged and with a thin capital structure. This situation in which an entity is financed through a relatively high level of debt compared to equity is referred as ‘thin capitalisation’. It refers to a situation where an entity has a high proportion of debt as compared to equity. As a result of such high debt, the taxpayer can claim excessive deduction of interest payment on such debt from their taxable income. This is more tax friendly compared to paying a dividend on the equity, which cannot be claimed as a tax deductible expense and would also result in an additional tax liability by way of a dividend distribution tax (DDT). For this reason, debt is often considered to be a more tax efficient method of financing vis-a-vis equity, and often leads to thin capitalization.

Globally there are several approaches to curtail thin capitalization, which have also been discussed in the OECD paper, “Limiting Base Erosion Involving Interest Deductions and Other Financial Payments” (BEPS Action Plan 4). Some of the methods adopted by certain jurisdictions to prevent thin capitalization are listed below:

Methods adopted by certain jurisdictions to prevent thin capitalization

• Fixed Ratio: Rules that limit the level of interest expense or debt in an entity, with reference to a fixed ratio of debt/equity, interest/earning, etc.

• Arm’s length basis: Rules that compare the level of interest or debt in an entity with the position had the company been dealing entirely with third parties.

• Specified percentage: Rules that disallow a specified percentage of interest expenses in an entity irrespective of the nature of the payment or to whom it is made.

• Anti-avoidance Rules: Targeted anti-avoidance rules that disallow interest on specific transactions.

In view of BEPS initiative and report on Action Plan 4, the Government vide Finance Act 2017 inserted a new Section 94B in the Act to bring Indian legislation in line with the recommendations of OECD BEPS Action Plan 4 which is summarised below.

• Applicable to borrowers, being an Indian company or Permanent Establishment (PE) of a foreign company, who pay interest in respect of any form of debt issued to a non-resident or to a PE of a non-resident and who is an ‘Associated Enterprise’ of the borrower. Further, the debt shall also be deemed to be treated as issued by an Associated Enterprise where it provides an implicit or explicit guarantee to the lender or deposits a corresponding and matching amount of funds with the lender.

• The provisions restrict the payment of interest by an entity to its Associated Enterprise to the extent of 30% of its earnings before interest, taxes, depreciation and amortization (EBITDA) or interest paid or payable to associated enterprise, whichever is less.

• In order to target only large interest payments, it is proposed to provide for a threshold of interest expenditure of INR one crore, exceeding which the provision would be applicable.

• The provisions also allow for carry-forward of disallowed interest expense to eight assessment years immediately succeeding the assessment year for which the disallowance was first made and deduction against the income computed under the head “Profits and gains of business or profession to the extent of maximum allowable interest expenditure.

• Excludes Banks and Insurance business from the ambit of these provisions keeping in view the special nature of these businesses.

• This amendment will take effect from 1st April, 2018 and will, accordingly, apply in relation to AY 2018-19 and subsequent years.

Impact of thin-capitalisation rules:

As an immediate consequence, in view of the non-deductibility of the interest expense beyond the de minimis threshold (supra), private equity funds / investors investing in Indian businesses in the form of debt may have to re-compute their return on investments and factor in the present value of the interest which can be disallowed and carried forward and set off against future profits.

Further, given that at present Indian partnership firms, trusts and LLPs are not covered by the thin capital provisions (unless they are a PE of a foreign company), going forward, the preferred organisation structure may also undergo a shift. Further, given the fact that the Indian thin-capitalisation rules do not contain an exclusion for interest paid to third party lenders on loans used to fund public-benefit projects, the applicability of the thin-capitalisation rules may increase the tax burden on sectors such as infrastructure etc – in this regard, the OECD gave an option to jurisdictions to exclude, subject to certain conditions, interest paid to third party lenders on loans used to fund public-benefit projects as due to the nature of these projects and the close link to the public sector, the BEPS risk is reduced. Moreover, start-ups (for whom EBITDA is generally low in the initial years) may also be impacted adversely by this anti-abuse provision.