A company is typically financed (or capitalized) through a mixture of debt and equity. Thin capitalization refers to the situation in which a company is financed through a relatively high level of debt compared to equity. Thinly capitalized companies are sometimes referred to as ‘highly leveraged’ or ’highly geared’.
As a result of having a higher proportion of debt, the taxpayer can claim a substantial deduction of interest payment on such debt from their taxable income. This approach is more tax friendly than having to declare dividend to equity shareholders.
Thin capitalization rules are an anti-tax avoidance measure to curb abusive use of artificial loan financing in cross border transactions.
BEPS Action Plan 4 – Limiting Base Erosion Involving Interest Deductions and Other Financial Payments discusses the rules which have been adopted by various countries to counter thin capitalization (Existing rules were clubbed in the following six categories in the BEPS Final Report):
- Arm’s length tests, which compare the level of interest or debt in an entity with the position that would have existed had the entity been dealing entirely with third parties.
- Withholding tax on interest payments, which are used to allocate taxing rights to a source jurisdiction.
- Rules which disallow a specified percentage of the interest expense of an entity, irrespective of the nature of the payment or to whom it is made.
- Rules which limit the level of interest expense or debt in an entity with reference to a fixed ratio, such as debt/equity, interest/earnings or interest/total assets.
- Rules which limit the level of interest expense or debt in an entity with reference to the group’s overall position.
- Targeted anti-avoidance rules which disallow interest expense on specific transactions.
The BEPS report suggests that the best practice approach could be based on a combination of some or all of the rules in groups 4 to 6 above.
In light of the BEPS initiative and recommendations of Action Plan 4, a new Section 94B was introduced by Finance Act 2017 to formally introduce Thin Capitalization Rules in the Indian tax regulations.
The Indian Thin Capitalization rules operate in the following manner:
Applicable to: Indian company or Permanent Establishment (PE) of a foreign company
When will it apply: When the borrower pays interest in excess of INR 1 crore in respect of debt to a nonresident or to a PE of a non-resident and who is an ‘Associated Enterprise’ of the borrower.
Implication: Restrict the interest expense allowability to the lesser of 30% of earnings before interest, taxes, depreciation and amortization (EBITDA) or interest paid or payable to AE. The disallowed interest expense can be carried-forward to eight assessment years immediately succeeding the assessment year.
Reporting Requirements
Clause 30B of the Tax Audit Report requires the disclosure of the following items:
- Amount (in Rs.) of expenditure by way of interest or of similar nature incurred
- Earnings before interest, tax, depreciation and amortization (EBITDA) during the previous year (in Rs.):
- Amount (in Rs.) of expenditure by way interest or of similar nature as per (i) above which exceeds 30% of EBITDA as per (ii) above:
- Details of interest expenditure brought forward as per sub-section (4) of section 94B
- Details of interest expenditure carried forward as per sub-section (4) of section 94B
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