Thin Capitalisation: The Multinational Tax Avoidance Strategy

CA Ashish Chadha has explained the law on “Thin Capitalisation” in the context of section 94B of the Income-tax Act and the judgements on the point. He has also identified the issues which lack clarity and which can be potential sources of dispute. He has called upon the authorities to clarify the contentious issues so as to enable seamless implementation of the law

1. Introduction

Debt and equity are the elementary sources of raising funds for any business organisation. Although, it is of supreme importance for every business entity to adopt the right financing mix of debt and equity, certain entities tend to become highly leveraged by having a thin capital structure.

A company is said to be thinly capitalised when the level of its debt is much greater than its equity capital. The way a company is capitalized often has a significant impact on the amount of profit it reports for taxation purposes as the tax legislations of many countries allow deduction for the interest paid while arriving at the profit for taxation purposes, while the dividend paid on the equity capital is not deductible from the said profit. Therefore, higher the level of debt in a company, higher will be the amount of interest it pays, which will ultimately lower its taxable profits.

The multinational organisations usually structure their financial structure in a way to maximise the above benefits. Meaning thereby, the multinational organisations tend to adopt a high leveraged financial structure, as a result of which their Indian limb is able to claim high interest expenditure in the initial years of operation, and thereafter, when the entity earns profit, the losses carried forward from previous years could be adjusted against the profits.

This issue of base erosion and profit shifting by way of excess interest deductions by multinational enterprises was taken up by the OECD (Organization for Economic Co-operation and Development) in its Action Plan 4 of the BEPS (Base Erosion and Profit Shifting) project. The OECD had proposed several measures to address this issue.

2. Judicial Background

The Income Tax Department in the past, considering the thin capitalisation rules issued by the OECD, has in some cases formed a view that considering the abnormal debt-equity capital structuring ratio, the interest payments made by the non-resident companies was to be disallowed. However, in the absence of thin capitalisation rules being adopted and introduced in the Income Tax Act, the Courts have held that such interest payments on debt capital could not be disallowed. In this regard, reference is drawn to the judgment of High Court of Bombay in the case of Director of Income Tax, International Taxation, Mumbai v. Besix Kier Dabhol SA [2012] 26 taxmann.com 169, whereby it has been held that interest on debt capital borrowed from shareholders resulting in abnormally high debt-equity ratio, cannot be disallowed in the absence of any thin capitalisation rule. Similar view has also been adopted by the ITAT Mumbai in the case of Topsgrup Electronic Systems Ltd. v. Income-tax Officer [2016] 67 taxmann.com 310.

3. Induction in Income Tax Act

The introduction of concepts like equalisation levy and country-by-country reporting in the Income Tax Act, India has shown its inclination and biasness towards the BEPS project of the OECD, which aims at taxation of profits to be at the place where the economic activity takes place.

In line with the proposal of the OECD, a new Section 94B has been inserted in the Income Tax Act by virtue of Finance Act, 2018, which provides for limitation on the interest deduction in certain cases. The provisions of the said Section are applicable in India with effect from 01.04.2018, i.e. in relation to A.Y. 2018-19 and subsequent years.

As per the provisions of this sub-section (1) of Section 94B, if an Indian company or the PE (Permanent Establishment) of a foreign company in India incurs any expenditure by way of interest or of similar nature in excess of Rs.1 crore rupees, the interest being in respect of a debt issued by a non-resident AE (Associated Enterprise), such interest shall not be deductible in the computation of income to the extent it is in excess of the limit under sub-section (2). The Proviso to sub-section (1) further provides a deeming provision, whereby the debt issued by a lender which is not an AE will also be deemed to have been issued by an AE, if the AE either provides an implicit or explicit guarantee to such other lender, or deposits a corresponding amount with such other lender.

Sub-section (2) further prescribes the meaning of excess interest. The excess interest means that amount of interest paid or payable which is in excess of 30% of the EBITDA (Earnings before Interest, Taxes, Depreciation and Amortisation) of the entity for the previous year.
Sub-section (3), however, prescribes that the provisions of this Section will not apply to the entity which is engaged in the business of banking or insurance.

Sub-section (4) of Section 94B gives the benefit of carry forward of the disallowed interest expenditure to the entity. As per the provisions of this sub-section, the interest expenditure which has not been wholly deducted from the income of an year in lieu of the provisions of sub-section (1) and (2) of the Act, shall be allowed to be carried forward and allowed as a deduction against the income of a subsequent assessment year. It has been further elucidated that the maximum allowance of interest expenditure in that subsequent year has to be in accordance with the provisions of sub-section (2). It has been further made clear that the interest expenditure is allowed to be carried forward uptill 8 assessment years immediately succeeding assessment year for which the excess interest was first computed. No excess interest expenditure will be allowed to be carried forward beyond the period of 8 years.

Sub-section (5) of Section 94B gives the definitions of certain terms for the purposes of this Section, which are as under:

(i) ‘associated enterprise’ has the same meaning as assigned to it in sub-section (1) and (2) of Section 92A of the Act

(ii) ‘debt’ means any loan, financial instrument, finance lease, financial derivative, or any arrangement that gives rise to interest, discounts or other finance charges that are deductible in the computation of income chargeable under the head PGBP

(iii) ‘permanent establishment’ includes a fixed place of business through which the business is wholly or partially carried on

To put this in a nutshell, as per the provisions of Section 94B, the interest expenses claimed by an entity to its AE shall be restricted to a maximum of 30% of its EBITDA.
However, in order to target multinational organisations which make large interest payments, the Section provides a threshold limit of interest expenditure of Rs.1 crore rupees, exceeding which the provisions of this Section would be applicable. Further, the provisions of this Section allow for carry forward of the disallowed interest expense to 8 assessment years, subject to a capping of the maximum allowable interest expenditure of 30% of the EBITDA.

4. Undetermined Areas for Litigation

Though the introduction of the concept of thin capitalisation to limit the interest deduction to prevent base erosion on account of excessive deduction from taxable profits has been received with open arms, there are some uncertainties and open ends in the provisions, which should be clarified to ensure its seamless implementation. Some of such uncertainties are as under:

• Sub-section (1) specifies that the provisions are applicable for any expenditure by way of interest or of similar nature. The meaning of the term ‘similar nature’ has not been specified in the said Section, which may cause confusion as to what other payments could or could not be covered under the provisions of this Section.

• The Proviso to sub-section (1) states that in case of implicit or explicit guarantee given by the AE to the lender would also be deemed to be debt issued by the AE. In this case also, the definition of the term ‘implicit guarantee’ has not been provided, which could cause interpretational issues.

• The maximum limit prescribed under sub-section (2) for the interest payment is 30% of the EBITDA, however, it has not been defined as to what all specifically would be included and excluded in the computation of EBITDA, as there may be difference of opinions on this aspect as well.

• Sub-section (3) provides that the provisions of this Section would not apply in case of entities engaged in the business of banking or insurance. However, it is not clarified as to whether NBFCs, for whom also debt is a raw material would get the benefit of this exemption or not.

5. Conclusion

The induction of the concept of thin capitalisation in the Income Tax Act as a method to restrict the interest deductions is an action that increases the possibility of success in preventing base erosion on account of excessive deduction out of taxable profits. One hopes that the implementation of this provision does not become a cause of substantial litigation and also does not result in tax reasons becoming the sole criteria to determine the capital structuring of an entity.