Genesis of the thin capitalization rules
The genesis of the thin capitalization rules lies in the distinction between tax treatment of debt and equity. A company typically finances its projects either through equity and debt or mixture of both, equity being costly in terms of cost and ownership is less attractive than the debt financing where interest is a deductible expense. Debt is not only less expensive to service, it also reduces tax liabilities and enhances return on equity.
Tax deductibility of interest prompts many companies to classify large part of their capital as debt and then claim interest as expense. This is particularly done in the light of cross border transactions whereby profit is shifted to lower tax jurisdiction and the money is then remitted in the form of loan. The interest on the loans is then claimed as expense, thus lowering the tax burden on the company. The problem existed in many countries and MNCs in particular were found to use this mechanism to lower taxes. Thin capitalization rules were necessary in consideration of the solvency risks highly leveraged entities posed.
To prevent tax avoidance by excessive leveraging thin capitalization rules were deemed necessary. There is no benchmark rule for thin capitalization. In China debt to equity of 5:1 is acceptable, on the other hand,in the USA, debt to equity exceeding 1.5:1 is considered thinning of capital.
The matter was taken up at the G-20 summit and in a bid and ode to the G20 initiative, the Organization for Economic Co-operation and development (OECD) in its Base Erosion and Profit Shifting plan (BEPS) had taken up the issue of base erosion and profit shifting by comprehending on the problem of using excessive interest as a device to reduce taxable profits.
To this end, the Finance Minister had proposed the section 94B in the Income Tax Act, 1961 (“IT Act”) vide Budget 2017, applicable from the previous year 2017-18 i.e. Assessment year 2018-19 onwards. The new section corresponds to the BEPS Action 4 titled “Limiting Base Erosion Involving Interest Deductions and Other Financial Payments”. The provisions of the section and its effect on NBFCs has been discussed in this article.
Analysis of the Section 94B
Section in brief
The section provides for the restriction of interest payment made by the Indian company or a permanent establishment of the foreign company in India to its Associated Enterprise (“AE”) abroad. Interest payment shall be restricted to 30% of the earnings before interest, taxes, depreciation and amortization or interest paid to the AE, whichever is less. The disallowed potion will be allowed to be carried forward for the period of 8 years. Further, the provisions of the section would be applicable only if interest payment exceeds Rs. 1 crore.
We can understand this through a following example-
Suppose EBITDA of an Indian company is Rs 200 crores. The total interest payment is Rs 65 crores i.e. Rs.45 crores to Non AE and Rs.20 crores to AE. The disallowance shall be calculated as follows:
- 65 – 30% of 200 i.e. 60 which equals Rs 5, or
- Rs 20 payable to AE
Therefore the disallowed portion of Interest would be Rs 5 crores, which could be carried for 8 years.
Applicability of the Section
As per the provisions of the section 94B, the section would apply if:
- Borrower is either an Indian company or a permanent establishment of a foreign company in India.
- Lender is a company located abroad and is an AE within the meaning given to it under section 92A of the IT Act.
- The expense is deductible under the head PGBP.
- The expense is nature of interest, discount or other similar finance charges and includes debt in the form of loan, financial instrument, finance lease, financial derivative or any other arrangement giving rise to the above mentioned expense.
It is also pertinent to note that if the borrowing is not from an associated enterprise directly, but the lender in turn as borrowed from as associated enterprise of the borrower entity and has in turn on-lent, such debt shall also be deemed to be from an associated enterprise for the purpose of this section.
Meaning of Associated Enterprise
Section 92A of the Income Tax Act, 1961 provide for the meaning of an associated enterprise.
Section 92A (1) — The term associated enterprise in relation to another enterprise, means an enterprise –
- which participates, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise; or
- in respect of which one or more persons who participate, directly or indirectly, or through one or more intermediaries, in its management or control or capital, are the same persons who participate, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise.
(2) For the purposes of sub-section (1), two enterprises shall be deemed to be associated enterprises if, at any time during the previous year,—
(a) one enterprise holds, directly or indirectly, shares carrying not less than twenty-six per cent of the voting power in the other enterprise; or
(b) any person or enterprise holds, directly or indirectly, shares carrying not less than twenty-six per cent of the voting power in each of such enterprises; or
(c) a loan advanced by one enterprise to the other enterprise constitutes not less than fifty-one per cent of the book value of the total assets of the other enterprise; or
(d) one enterprise guarantees not less than ten per cent of the total borrowings of the other enterprise; or
(e) more than half of the board of directors or members of the governing board, or one or more executive directors or executive members of the governing board of one enterprise, are appointed by the other enterprise; or
(f) more than half of the directors or members of the governing board, or one or more of the executive directors or members of the governing board, of each of the two enterprises are appointed by the same person or persons; or
(g) the manufacture or processing of goods or articles or business carried out by one enterprise is wholly dependent on the use of know-how, patents, copyrights, trade-marks, licences, franchises or any other business or commercial rights of similar nature, or any data, documentation, drawing or specification relating to any patent, invention, model, design, secret formula or process, of which the other enterprise is the owner or in respect of which the other enterprise has exclusive rights; or
(h) ninety per cent or more of the raw materials and consumables required for the manufacture or processing of goods or articles carried out by one enterprise, are supplied by the other enterprise, or by persons specified by the other enterprise, and the prices and other conditions relating to the supply are influenced by such other enterprise; or
(i) the goods or articles manufactured or processed by one enterprise, are sold to the other enterprise or to persons specified by the other enterprise, and the prices and other conditions relating thereto are influenced by such other enterprise; or
(j) where one enterprise is controlled by an individual, the other enterprise is also controlled by such individual or his relative or jointly by such individual and relative of such individual; or
(k) where one enterprise is controlled by a Hindu undivided family, the other enterprise is controlled by a member of such Hindu undivided family or by a relative of a member of such Hindu undivided family or jointly by such member and his relative; or
(l) where one enterprise is a firm, association of persons or body of individuals, the other enterprise holds not less than ten per cent interest in such firm, association of persons or body of individuals; or
(m) there exists between the two enterprises, any relationship of mutual interest, as may be prescribed.
The definition of associated enterprise is not limited to holding and subsidiary relationship. The meaning of associated enterprise, in essence, considers all such scenarios where an enterprise in substance is a) controlled, b) managed, c) policy making and decisions are influenced either by way of voting power, control over business, financial influence or control by another enterprise directly or indirectly.
Exceptions to the section
The thin capitalization rules in this section do not apply to banking and insurance companies. NBFCs however have not been added to the exclusion list.
Impact on NBFCs
It appears that the NBFCs would be greatly affected by the provisions of the section and the same has been summarized below:
- The section applies to NBFCs. This means that the interest expenses of the NBFCs will be subject to disallowance from income tax perspective if the threshold limits prescribed in the section are breached.
- Interest expense happens to be one of the major cost component of NBFCs as they simply take money from the investors and provide funds to the earn interest income. Therefore there will be a greater tax outflow in case the NBFC is funded by an AE and exceeds the threshold limit.
- Specifically so, in case the parent happens to be FOCC, then apart from the whole transfer pricing provisions and rules i.e. transaction at arm’s length price etc, the provisions of this section will apply, which will add to the cost burden of the NBFCs. Usually equity investment is limited to the regulatory requirements and the funding is by way of debt. Also the definition of associated enterprise is so expansive that there is likelihood that apart from holding companies other group entities may also get included in the definition of associated enterprise.
- Further, the section also has a proviso which states that so much interest as paid by the Indian company which had been implicitly or explicitly guaranteed by the AE would also be disallowed.
- Likewise for core investment companies having funds from associated enterprises will find it difficult to survive.
- The purpose of leveraging is to reduce tax burden, increase the return on equity and maintain cost of funds facilitating viability of business. The disallowance of the interest expenses pursuant to this section shall force companies to create a sort of balance between debt and equity such that the disallowance can be negated, which in turn will have an impact on the cost of funds as well.
In a way forward, it seems that it will have a huge impact on the following three sectors:
- Start-ups– Start-ups are funded by the foreign companies who have stake in the companies and looking at the definition of AE which is very wide, it seems that the start-ups will face huge problems. Further, the star-ups procure funding on the guarantee given by the AE having stakes and the guarantee being covered under the ambit of the provisions will also affect the operations of the start-ups.
- Infrastructure companies– Given the large funding requirement of the Infrastructure companies, these are largely funded by the AE and the provision is likely to impede operations of the Infrastructure companies.
- NBFCs– Many of the big NBFCs have funding in form of debt from the AE and the provisions of the section will definitely affect the operations of the NBFCs. This now poses questions on cost of funds, spreads earned and viability of entities and also forces NBFCs to look at alternate funding options.
While there is parity intended between banks and NBFCs on the regulatory aspects, NBFCs missing from the exclusion list for applicability of the section, certainly has negative impact on the fund costs and ability to do business.
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