Thin capitalisation 110409


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Thin capitalisation 110409

  1. 1. Certificate Course on International Taxation by WIRC of ICAI Thin Capitalisation – A Concept Presented by: Mr. Paresh P. Shah Chartered Accountant P. P. Shah & Associates Email:
  2. 2. Overview Meaning and Nature of transaction Anti avoidance rule Taxation and Thin Capitalisation A part of domestic tax laws Thin Capitalisation & DTAA Survey of major tax system
  3. 3. Meaning & Concept Thin Capitalisation refers to an overweight of debt compared to the equity of a taxpayer It is measured in terms of the amounts of debt and equity in the balance sheet and the ratio which one bears to the other Due to special relationship between lender and borrower, usually debt is higher than what would normally be expected. However thin capitalisation rules may be applicable even in absence of such relationship Thin capitalisation refers to excess of debt The excess of interest on debt refers to non arm’s length interest rate between related parties. An issue may be of transfer pricing
  4. 4. Nature of Transaction Understanding legal & Economic implications of the transaction Optimal capital structure Value chain & Capital structure Modern Economic theory on cost of capital
  5. 5. Anti Avoidance Rules – An Overview A Hybrid Capital structure – A Rationale An Anti Avoidance (AA) Rule Thin capitalisation rules Alternative AA Approach Interest allowance barrier Thin Capitalisation Rules Transfer Pricing Regulation Criterians / basis to determine applicable approach
  6. 6. A Hybrid Capital Structure – A Rationale Hybrid Capital structure: The funding arrangement can be termed as hybrid if it has both debt-like and equity-like features or if it has neither debt-like nor equity-like features, whether for the purposes of tax law or corporate law or for accounting or regulatory purposes Hybrid instrument is a financial instrument that has economic characteristics that are inconsistent, in whole or in part, with the classification implied by its legal form A case to case approach gives rise to alternative anti avoidance approach
  7. 7. Thin capitalisation-Anti Avoidance Rule Thin capitalisation rules provide for Criteria for application of thin capitalisation Identification of capital as debts or capital Adjustment of debts & capital with respect to accounting standards IAS 12 on deferred tax asset IAS 36Impairment of assets IAS 38 on Intangibles IAS 39 on fair value Excess debt treated as capital under substance over form rule or interest on such excess debt is disallowed Application to local lenders and foreign lenders and its consequences under the tax treaty Prudential application of facts & circumstances and guidance from the court’s decision & revenue directives Taxation & nature of capital for charge of capital gains
  8. 8. Anti Avoidance – Alternative approach Thin Capitalisation – Not a complete solution Tendency to allow higher interest rate within ratio – anomaly Treatment of excess interest rate on the debt capital within the overall thin capitalisation ratio may not be resolved either in absence of special relationship or otherwise Conflict between rules & the tax treaty due to MC at divergent as compared to rules Paragraph 4 – Article 9(1) Paragraph 6 to 10 – Article 9(2) Paragraph 15(d) – Article 10(2) Paragraph 19 – Article 11(2) Paragraph 25 to 30 – Article 10(3) Paragraph 32 to 35 – Article 11(6) Paragraph 55,56 – Article 24(4)
  9. 9. Taxation Equity capital and taxation associated with income from equity capital Debt capital and taxation associated with debt capital Cost of capital and its alternatives Emergence of Hybrid capital & instruments
  10. 10. Thin Capitalisation - DTAA Excess interest paid by borrower Provisions OECD Model Convention – Article 9 So long as thin capitalisation rules or domestic transfer pricing regulation gives rise to a result/income in the hands of the borrower, not exceeding the arm’s length amount, there is no conflict between DTC and the domestic law Article does not bar the re-characterisation of debt into equity In case domestic anti avoidance provisions are inconsistent, then article on mutual agreement procedure will apply
  11. 11. Thin Capitalisation – DTAA Conflict in meaning of capital Article 10 & Article 11 Paragraph 18 & 19 of Article 11(3) Paragraph 25 of Article 10(3), clarifies the meaning of dividend in case of conflict Article 11 clarifies that no amount can be considered as interest once it is treated as dividend under article 10 (Reference to articles and paragraphs are of OECD MC)
  12. 12. Thin Capitalisation & DTAA Treatment of excess interest in case of special relationship Such excess interest cannot form part of income under Article 11(6) Article 9 may be applicable State may apply different article Mutual Agreement Procedure apply [Article 11(6), OECD MC, Paragraph 36]
  13. 13. Thin Capitalisation & DTAA Re-characterisation of interest to dividend (other case) Capital in such case is also re-characterised as equity capital [Article 10(2), OECD MC, Paragraph 15(d)] Application of Thin Capitalisation to Foreigner: OECD MC, Article 24(4) does not permit disallowance of interest to foreigner under thin capitalisation rules if these rules are not applicable to resident taxpayers in cases other than the circumstances stated under Article 9(1), 11(6) & 12(4)
  14. 14. Thin Capitalisation & DTAA Mutual Agreement Procedure apply in following cases In case of excess amount of interest paid by the borrower under special relationship and treatment is unresolved under article 9 or article 11(6) [Paragraph 8, Article 25] Debtor treats interest as dividend under article 9 resulting into double taxation [Economic double taxation, Paragraph 10, Article 25] Adjustment under Article 9 when sub-clause (2) is absent [Paragraph 10, Article 25(2)] Treatment of interest as dividend by the borrower – Relief from double taxation in the creditor’s state [Article 24, Paragraph 34] Issues concerning double taxation not arising out of the convention in certain cases
  15. 15. Survey of International Jurisdictions India Germany U.K. Sweden
  16. 16. Thank You