Union Budget 2017– Thin Capitalisation Rules- Anomaly between Finance Bill & Memorandum

The Union Budget 2017 has taken another step in line with the recommendations of OECD BEPS Action Plan, specifically “BEPS Action Plan 4 – Limiting Base Erosion involving interest Deductions and other Financial Payments”.

It has been proposed under Section 94B (“Thin Capitalisation Rules”) to disallow the excess interest expenses or similar consideration, claimed by an Indian company or a Permanent Establishment (“PE”) of a foreign company in India, in respect of any debt issued by a non-resident, being an Associate Enterprise (“AE”) of the borrower. The mechanism to calculate such excess interest has been provided and shall be lower of following amount:

> Total interest paid or payable in excess of 30 percent of Earnings before Interest, Taxes, Depreciation and Amortisation (“EBITDA”) or

> Interest paid or payable to AE

Anomaly between the provision of Finance Bill and Memorandum explaining the Finance Bill

Interestingly the phraseology used in “Memorandum explaining the provisions of The Finance Bill 2017” (“Memorandum”) and “The Finance Bill 2017” to calculate the excess interest is ambiguous and results in different outcome. The language of in the Memorandum and provision of Finance Bill has been reproduced below:

The language in the Memorandum reads as follows:

“Interest expenses claimed by an entity to its associated enterprises shall be restricted to:

(i) 30 percent of its earnings before interest, taxes, depreciation and amortization (EBITDA); or

(ii) interest paid or payable to associated enterprise, whichever is less.”

For example, in a given situation where, an Indian Company’s:

• EBIDTA – Rs 100
• Total interest expense- 35
• Interest paid to AE – 15
• Interest paid to non-AE – 20

The amount of interest expense, which shall be allowed as per the language of Memorandum shall be as follows:

Whereas, the language as provided in the Finance Bill, 2017, is as follows:

“(1)……Indian company, or a permanent establishment of a foreign company in India, being the borrower, pays interest or similar consideration…….in respect of any debt issued by a non-resident, being an associated enterprise of such borrower, the interest shall not be deductible in computation of income under the said head to the extent that it arises from excess interest, as specified in sub-section (2):

(2) For the purposes of sub-section (1), the excess interest shall mean

(i) An amount of total interest paid or payable in excess of thirty per cent. of earnings before interest, taxes, depreciation and amortisation of the borrower in the previous year or

(ii) interest paid or payable to associated enterprises for that previous year, whichever is less.”

If we apply the provision of Finance Bill to the above mentioned example, the amount of interest expense, which shall be disallowed, shall be as follows:

Analysis: The Memorandum restrict the interest deduction to the extent of lower of 30 percent of EBITDA or amount paid to AE, however the provision of Finance Bill disallow the excess interest being lower of interest in excess of 30 percent of EBITDA or amount paid to AE. At a first look, the calculation for interest deduction under Memorandum and Finance Bill appears to be similar; however this is not the real case.

It would be right to say, that interest deduction shall be restricted to 30 percent of EBITDA (to the extent of total interest expense), which is provided under Finance Bill. However, applying the language of Memorandum and concluding that interest deduction shall be restricted to lower of 30 percent of EBITDA or amount paid to AE; would result into disallowance of interest paid to Non-AE, which is not the intention of law.

To understand the above matter cautiously, here is an example:

• EBIDTA – Rs 100
• Total interest expense- 25
• Interest paid to AE – 10
• Interest paid to Non-AE – 15

The amount of interest expense, which shall be allowed as per Memorandum and as per the provision of the Finance Bill, 2017 is summarised in the table below:

One could see that, the provision under Finance bill is restricting the interest deduction to the extent of 30 percent of EBITDA, which should be the right position. However the interest deduction in accordance with the Memorandum is disallowing the interest paid to Non-AE (i.e. Rs. 15).

While it is very rare occurrence, when the language in the Finance Bill and the intention of the law provided under the Memorandum gives diverse interpretation, unless the Government comes out with any clarification, there will be ambiguity with regard to the calculation of interest deduction under the provisions of Section 94B.

Other key points of the proposal include:

• This section shall be applicable only if the interest expense or similar consideration exceeds one crore rupees and deductible in computing the borrower’s income chargeable under the head “Profits and gains of business or profession” (“PGBP”).
• This section shall apply to interest costs or similar consideration in respect of debts issued by a non-resident, being an associate enterprise of the borrower
• The definition of AE as provided under sub-section (1) and sub-section (2) of section 92A shall apply for the purposes of this section also.
• An exception has been carved out for Indian companies / PE of foreign companies engaged in the banking or insurance business.
• The disallowed portion of interest expense shall be allowed to be carried forward for eight assessment years immediately succeeding the assessment year for which the excess interest expenditure was first computed.
• The definition of ‘debt’ is wide and covers any loan, financial instruments, financial lease, financial derivative or any other arrangement giving rise to interest, discount or other financial This could potentially cover debt instruments like masala bonds, NCDs, CCDs, ECBs etc.