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CA. Sudha G. Bhushan


OVERVIEW ON THIN CAPITALISATION

Introduction:

Thin capitalisation refers to a situation in which a company is financed through relatively high level of debt as compared to equity resulting into a thin capital structure. Generally, such a practice is followed for jurisdictions with high tax rates to avert the dividend distribution tax and, alternatively, upstream cash vide interest payments on debts availed. Due to such high debt, companies may claim excessive deduction of interest payment from taxable income.

The taxation regime in India seems to be undergoing crucial changes. The principles of thin capitalisation as prescribed in the Organization for Economic Cooperation and Development (‘OECD’) Base Erosion and Profit Shifting (‘BEPS) Action Plan 4 have been introduced in the Indian Income Tax Act, 1961 vide Finance Act, 2017.

Section 94B of the Income Tax Act, 1961 governs the provision of Thin Capitalisation in India. Under this section, deduction for interest expense is restricted in following cases:

1. Interest expense is incurred by a company on debt from an AE; and / or

2. Interest expenses on debt from an unrelated party which is based on guarantee or funds provided by an AE

The below is the brief gist of the applicability, disallowance and exclusions provided in Section 94B.

Limitation of interest deduction

The thin capitalisation provisions state that excess interest (i.e. interest amount that exceeds 30% of earnings before interest, tax, depreciation and amortization [‘EBITDA’] or the total interest amount payable to Associated Enterprise, whichever is less) shall not be available for deduction. However, such disallowed interest expenditure can be carried forward for eight assessment years, but deduction of the same cannot exceed the excess interest.

The same is explained by way of few examples:

Example 1:

1. Foreign AE provides debt to an Indian Co. or Permanent Establishment of a Foreign Co.

2. Indian Co. or PE of Foreign Co. pays interest exceeding INR 1 Crore in respect of such debt

Example 2:

1. Lender provides debt to an Indian Co.

2. AE of Indian Co. provides guarantee or deposits sum of equivalent amount with lender

3. Indian Company pays interest exceeding INR 1 Crore in respect of such debt or guarantee

The thin capitalisation provisions applies to transactions where the debt is issued by a non-resident, being an associated enterprise. Further, it also extends to debt from lender which is not an associated enterprise but an associated enterprise either provides an implicit or explicit guarantee to such lender or deposits a corresponding and matching amount of funds with the lender.

Therefore, in both the above examples, interest paid above 30% of EBITDA not to be allowed as tax deduction. Excess interest paid to be allowed to be carried forward for 8 years.

Loan Borrowed in India – Whether Section 94B Applicable?

The provisions of the Act are drafted in such a way that the implications of the Section may also arise to loans which are borrowed in India. The same is explained in few examples below:

Example 1

ABC Inc is Associated Enterprise of ABC India. ABC India borrows from an Indian Bank against which ABC Inc. provides guarantee.

The Section applies to obtaining debt from non-resident lender. Here, in this case, since the lender is resident in India, the provisions of 94B will not be applicable. Therefore, there won’t be any limit for disallowance of any interest in this Section.

Example 2

ABC Inc is Associated Enterprise of ABC India. ABC India borrows from a branch of Foreign Bank in India against which ABC Inc. provides guarantee.

Sub-section (1) of Section 94B specifically requires the lending to be from a non-resident AE for the section to be triggered. However, branches or permanent establishments of foreign banks are also “non-residents” for the purposes of the Income-tax Act.

Therefore, since the lender is non-resident, the provisions of Section 94B will be applicable.

94B – Issues for Consideration

There are few businesses which operates mainly on the debt raised. Therefore, these Companies have huge expense with respect to interest, disallowance of which may impose hardship on such business. Keeping in mind the law as well as the practical perspective, below can be the issues which may arise:

1. Thresholds of 30% is applied regardless of the business, strategic situation, industry, or economic environment

2. High degree of debt / equity ratio is quite common in sectors like Steel, Petroleum, Automobile, Power, Infrastructure, etc. Therefore, for such sectors disallowance of interest may hamper their business

3. Infrastructure companies having large gestation periods and losses in initial years. Therefore, there would be unnecessary limitation on interest deduction in initial years

4. Start-ups could have losses / low profitability in initial years, resulting in higher sunk cost and thereby, limiting the investment potential, despite the inherent business strength

5. Section 40(a)(i) and Section 94B – the order of applicability is not clear

About the author. Sudha G. Bhushan

Sudha is qualified Chartered Accountant and a Company Secretary with more than a decade of experience in the Foreign Exchange Management Act, RBI, Transfer pricing and International taxation matters. She is a noted speaker and author.

 

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Disclaimer: Above expressed are the personal views of the author, and the publisher or the author disclaim all, and any liability and responsibility, to any person on any action taken on reliance of it.

                                                                                     

 


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