India has time and again shown its commitment to curbing base erosion and profit shifting (BEPS), an initiative of the Organisation of Economic Co-operation and Development (OECD) and the G20 nations. The Finance Act 2016 is testimony to this fact as it enabled the introduction of an equalisation levy, country-by-country reporting and the Indian patent box regime. The Government has been continuously revising various tax treaties to plug loopholes, strengthen information sharing between the contracting states and prevent double non-taxation under the garb of avoidance of double taxation.
In continuation of the Government’s support of the BEPS project, the Finance Bill 2017 proposes to introduce measures to curb thin capitalisation in India.
What is thin capitalisation?
As per the Background Paper for country tax administration released by the OECD, “A company is typically financed (or capitalised) through a mixture of debt and equity. Thin capitalisation refers to the situation in which a company is financed through a relatively high level of debt compared to equity. Thinly capitalised companies are sometimes referred to as ‘highly leveraged’ or ’highly geared’.”
Thus, thin capitalisation 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. This leads to thin capitalisation.
Thin Capitalisation regimes in different jurisdictions
Globally there are several approaches to curtail thin capitalisation, which have also been discussed in the OECD paper, “Limiting Base Erosion Involving Interest Deductions and Other Financial Payments” (Action Plan 4). Some of the methods adopted by certain jurisdictions to prevent thin capitalisation are enumerated below:
- 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.
- Arms length basis – Test that compares 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.
On the basis of the above methods, various countries have adopted different types of thin capitalisation rules, which are discussed below:
|Country||Thin Capitalisation Rules||Carry forward of disallowed interest|
|United States||Rules known as “Earning Stripping Rules”, which are invoked following examination on a case-by-case basis. Interest deduction is restricted in case of debts owed to or guaranteed by non-US-related parties. In April 2016, the US treasury department proposed draft thin capitalization (thin cap) rules, but they are subject to finalisation.||Excess interest is allowed to be carried forward to future years. However, set off is subject to limitation of 50% of taxable EBDITA.|
|Germany||Germany moved from traditional thin capitalisation rules, based on a maximum debt-equity ratio, to earnings-stripping style rules in 2008. Thin cap rules are not in place; however, interest in excess of 30% of EBDITA is non-deductible. The threshold limit for the restriction is euro 3 million.||Carry forward of excess interest is allowed for future years. Not allowed in a case where there is a change in the shareholding.|
|France||Thin cap rules apply to interest payments made to associated enterprises (AE) and also loans guaranteed by related parties. Interest deduction is limited to maximum of prescribed limits. However, there is an exemption in cases where the debt equity ratio of the group is higher than that of the French company.||Carry forward allowed to future years (reduced by 5% each year from the second year).|
No specific thin cap rules are prescribed. It is considered as part of the transfer pricing rules.
Proposed Amendment to the Income Tax Act, 1961
In line with the recommendations of OECD BEPS Action Plan 4, the Finance Bill, 2017 has proposed to provide that interest expenses claimed by an entity in relation to payments made to its associated enterprises shall be restricted to 30% of EBITDA or interest paid or payable to its non-resident associated enterprise (AE), whichever is less.
The provisions shall be applicable to an Indian company, or a permanent establishment (PE) of a foreign company (being the borrower) who pays interest in respect of any form of debt issued by a non-resident or to a PE of a non-resident who is a non-resident AE of the borrower. Further, the debt shall be deemed to be treated as issued by an AE where it provides an implicit or explicit guarantee to the lender or deposits a corresponding and matching amount of funds with the lender.
The Finance Bill proposes to carry forward disallowed interest expenses for a period of eight assessment years to be allowed as a deduction against future profits of the taxpayer to the extent of maximum allowable interest expenditure. Further, it is proposed that the threshold limit for such interest payments will be pegged at INR 10 million. Banks and insurance businesses have been excluded from the application of these provisions keeping in view the special nature of these businesses.
As mentioned above, Thin Capitalisation Rules are applicable in respect of interest payable by Indian entities to their non-resident AEs. If the Indian entity is able to borrow on account of an explicit / implicit guarantee or any other support from its AE, then these provisions can also be invoked. This could have very serious repercussions on the fundraising efforts of Indian taxpayers, especially those operating in capital intensive sectors or in the infrastructure sector, which has a long gestation period.
It may be pertinent to note that the definition of an AE under the Income tax Act, 1961 is wide enough to cover even third party lenders, which may have financed 51% or more of the book value of the total assets of the borrower. Further, linking interest deduction with the EBITDA could lead to unanticipated results as the taxpayer may have high EBIDTA in some years and lower in some other years, even though the interest payout may have remained the same!