Introduction of Thin Capitalization Rule in India
By Stella Joseph and Ranjeet Mahtani
By the proposals in the Union Budget of 2017, India has sought to adopt and introduce in its Income tax law provisions, what is popularly known as the Thin Capitalization Rule. The proposal is aligned to the Action Plan 4 of the Base Erosion of Profit Share (BEPS) project of the Organisation for Economic Co-operation and Development (“OECD”), under the initiative of G-20 countries (which includes India). The Final Report on Action Plan 4 was released in October 2015 and additional guidelines thereto have been released in December 2016. The Thin Capitalization Rule has been explicitly adopted by a number of economies including the United States, Russia, Indonesia, Canada, Australia and various European nations. The form which is proposed to be adopted by India (also known as the ‘earnings-stripping approach’) is comparable to that adopted by Germany and Italy.
What is earnings stripping approach?
According to Investopedia, ‘Earnings stripping is a commonly used tactic by multinational companies to escape high domestic taxation by using interest deductions to their foreign headquarters in a friendly tax regime to lower their corporate taxes. It is commonly used during corporate inversions’.
Presently, a company having debt is eligible to claim a tax deduction on the amount of interest paid on such debt. This is some incentive for taxpayers to have or increase their debt ratio and take loans from associated enterprises located in tax friendly jurisdictions and claim higher tax deductions. This structure provided some undue benefits and lower tax outgo for multinational groups.
To curb this practice, a new Section 94B has been proposed to be inserted in the Income-tax Act, 1961 (“the IT Act”). The provision seeks to restrict the interest amount on which tax deductions can be claimed by an Indian company (or a permanent establishment of a foreign company in India) as regards a debt given by an “associated enterprises” located outside India to 30% of earnings before interest, taxes, depreciation and amortization (EBITDA) or interest paid or payable to associated enterprise, whichever is less.
This restriction would only apply if the interest expense exceeds Rs.1 crore (approximately $ 149,421) in the previous year.
For better understanding a simple example [as provided in Thin capitalization legislation: A Background Paper for Country Tax Administrations issued by the OECD in August 2012] of how the ‘earnings-stripping approach’ will operate is given below:
- Company X, a corporation resident in Country A, establishes group affiliate Company Y in Country Y with an investment of 10 in equity capital and a loan of 90 from Company X, which carries a 10% interest rate. Company Y thus pays interest of 9 (90x10%).
- Company Y generates EBITDA of 15 and taxable profit of 6 (15- 9). (The example assumes there is no depreciation and amortisation charge in the year).
- Country A has legislation in place that restricts the deduction of interest to 30% EBITDA.
- In this case, deductible interest is restricted to 4.5 (30% x 15) and the remaining interest of 4.5 will be disallowed in the computation of taxable profit. The resultant taxable profit of Company Y thus becomes 10.5 (15- 4.5).
A new connotation to the term ‘Debt’
“Debt” has been defined to mean any loan, financial instrument, financial lease, financial derivative or any arrangement that gives rise to interest, discount or other financial charges that are deductible in the computation of income chargeable under the head “Profit and gains of business or profession”.
Multinational enterprises and group affiliates may be able to structure their financing arrangements through third parties such as banks, in order to avoid the applicability of this provision. To curb this, the debt shall be deemed to be treated as issued/ provided by an associated enterprise, where it provides an implicit or explicit guarantee to the lender or deposits a corresponding and matching amount of funds with the lender. Therefore, financing/ funding through banks and Financial Institutions will also be impacted by the proposal.
This provision is proposed to be made inapplicable to banks and insurance businesses, considering the special nature of such businesses (they hold financial assets and liabilities as an integral part of their main business activities).
The amendment will take effect from 1st April 2018 and will accordingly apply in relation to the assessment year 2018-19 (financial year 2017-18) and subsequent years. A silver lining provided to the Indian companies is that a company would be eligible to carry forward the disallowed interest expense for a period up to eight consecutive years.
The proposed amendment will impact companies with a high debt-equity ratio, especially in the capital-intensive sectors and dis-incentivise debt as the means for funding.