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![Overview on thin capitalization
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
Provides debt Outside India
India
Pays interest
Foreign AE
Indian Company or PE of
Foreign Company](https://image.slidesharecdn.com/190105thincapitalsiation-overview-190517103449/85/Thin-Capitalisation-4-320.jpg)
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Thin Capitalisation
Thin capitalization refers to a situation where a company is financed through high levels of debt compared to equity, resulting in a thin capital structure. Section 94B of the Indian Income Tax Act governs thin capitalization by restricting the deduction of interest expenses in cases where debt is from an associated enterprise or guaranteed by an associated enterprise. Excess interest, defined as interest exceeding 30% of EBITDA or total interest paid to associated enterprises, whichever is lower, is not deductible and can be carried forward for up to 8 years. The provisions apply to both debt from non-resident associated enterprises and debt from Indian lenders that is guaranteed by a non-resident associated enterprise.
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Thin Capitalisation
- 1. Overview on thincapitalization Overview on Thin Capitalisation
- 2. Overview on thincapitalization THIN CAPITALISATION – SECTION 94B 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 claimexcessive 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
- 3. Overview on thincapitalization The below is the brief gist of the applicability, disallowance and exclusions provided in Section 94B. •Indian Company or PE of a Foreign Company •Interest or similarconsideration paid in respectof any debt from AEs or debts guaranteed by AEs Applicability •Interest or similarconsideration for debt issueby a Non-resident AE exceeding INR 1 Crore, which is deductiblein computing business income - The excess interest will bedisallowed. What isdisallowed? •Foreign Company engaged in Bankingand insuranceis excludedExclusions •Amount of total interest paid or payablein excess of 30% of EBITDA, or •Interest paid/payableto AE; whichever is lower Meaningof excessinterest •By Associated Enterprise to the lender not associated •Implicitor explicitguaranteeor depositof corresponding/ matching amounts with lenders by AE Guarantee •For 8 assessmentyears Carry forwardof unamortised interest
- 4. Overview on thincapitalization 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 Provides debt Outside India India Pays interest Foreign AE Indian Company or PE of Foreign Company
- 5. Overview on thincapitalization 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 Provides guarantee Provides debt Pays interest Lender Indian Company AE of Indian Company
- 6. Overview on thincapitalization 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.
- 7. Overview on thincapitalization LOAN BORROWED IN INDIA – WHETHER SECTION 94BAPPLICABLE? 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. Provides guarantee Provides loan Interest payment ABC Inc. ABC India Indian BankAE of Indian Company 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.
- 8. Overview on thincapitalization 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. Provides guarantee Provides loan Interest payment ABC Inc. ABC India Branch of Foreign BankAE of Indian Company 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.
- 9. Overview on thincapitalization 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
- 10. Overview on thincapitalization About Taxpert Professionals Taxpert Professionals is a conglomeration of multi-diverged professionals known for providing concentrated services in relation to taxation and corporate laws in a seamless manner. Taxpert professionals believe in the creation of value through advising and assisting the business. At Taxpert the pool of professionals from different spectrum like tax, accountancy, legal, costing, management facilitate the conversion of knowledge into beneficial transaction. About CA. 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. Her articles are regularly published in the Journals of several institutes and at various other forums and has authored the following books: Practical aspects of FDI in India published by Institute of Company secretaries of India Due Diligence under Foreign Exchange Management Act, 1999 published by CCH. Comprehensive Guide to Foreign Exchange Management in two volumes published by CCH. Practical Guide to Foreign Exchange Management published by CCH, a Wolter Kluwer’s company. Handbook on FEMA, Publication of Institute of Chartered Accountants of India A scholar throughout her life she has been awarded many awards and recognitions including “Women Empowerment through CA Profession” by Northern India Regional Council (NIRC) of Institute of Chartered Accountants of India (ICAI). Backed by experience in International firms she has extensive experience of handling international transactions. She advises corporate as wellas government authorities in lot of intricate transactions. Rendering tax and regulatory advisory services, she has overseen and played a crucial role in the execution of complex international transactions involving issues revolving around tax, repatriation, minimization of tax exposure, Foreign Investment (Inbound and outbound) etc.