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Provisions-of-Income-Tax-Act

Section 94B: Thin Capitalisation

Section 94B: Thin Capitalisation

The concept of thin capitalisation aims to achieve a distinction between the tax treatments of debt and equity. The Government of India (GoI) has stated that it will always stay committed to the Base Erosion and Profit Shifting (BEPS) initiative implemented by The Organisation for Economic Co-operation and Development. Several reforms were introduced in the domestic tax legislation to plug loopholes, prevent double non-taxation and to strengthen data sharing between the contracting states. As a part of this initiative, the GoI introduced Section 94B in the Income Tax Act of 1961. The new section was inserted by the Finance Act of 2017 to curb thin capitalisation in the nation. The present article briefly discusses the provisions of Section 94B, and also the rules associated with the section.

Thin Capitalisation

  • Financing of projects is generally executed through equity or debt or a combination of the two. Equity is a lesser attractive option as it tends to be more expensive regarding cost and ownership. On the other hand, debt is not only affordable to service, but it also brings down tax liabilities and enhances the return on equity. Many companies are prompted to classify a large part of their capital as debt and then, later claim the interest as an expense for tax deductibility.
  • The initiative to segregate a major portion of the capital into debt a  is mainly executed in the light of cross-border transactions, where the profit is shifted to a lower tax jurisdiction, and the money is remitted in the form of a loan. The interests on the loans are then claimed as an expense and thereby, lowering the company’s tax burden. This mechanism to reduce the tax burden was found to be used in many countries and Multi-National Corporations in particularly. Therefore, the rules on Thin capitalisation were essential to prevent the solvency risks posed by highly leveraged entities.
  • Thin capitalisation rules were deemed necessary to prevent tax avoidance by leveraging in excess. Although, there is no specific benchmark rule for Thin Capitalisation. The subject was discussed at the G-20 summit where the Organization for Economic Co-operation and Development (OECD) in its Base Erosion and Profit Shifting Plan (BEPS) had taken up this issue of using excessive interest as a method to reduce taxable profits.
  • To bring an end to this, the Finance Minister of India had proposed that the Section 94B be included in the Income Tax Act of 1961 during the Budget 2017. The rule is to be applied and enforced in the Assessment year 2018-2019 onwards. This section corresponds to the BEPS Action 4 and is named Limiting Base Erosion Involving Interest Deductions and Other Financial Payments.

Requirements of Section 94B

  • Section 94B of the Income Tax Act of 1961 provides the provisions for the restriction of interest payments made by a company in India or a foreign company that is permanently set up in India to its Associated Enterprise that is established abroad.
  • Interest Payments should be restricted to a 30 per cent of the revenue before any interests, taxes, depreciation and amortisation or interests paid to an Associated Enterprise, whichever may be less. A period of 8 years is permitted to carry the disallowed potion forward. Moreover, the provisions offered by the Section would be applicable if an interest payment exceeds INR 1 Crore only.
  • The following example will help to understand this better. Suppose, the Earnings before interest, tax, depreciation and amortisation (EBITDA) of an Indian Company is INR 200 Crores. The total interest payment would be INR 65 Crores which would be split as INR 45 Crores to Non-Associate Enterprise and INR 20 Crores to Associate Enterprise.
  • The disallowance would be calculated as lower of 30% of the amount of tax sought to be evaded, or 20% of the sum totally payable to the associated enterprise. For example, out of Rs. 5 crores, INR 20 lakhs would be payable as a penalty to the Income Tax Department.

Preventing Thin Capitalisation

The following are the methods adopted by some jurisdictions to curb thin capitalisation.

  • Fixed Ratio: These are the rules that limit the level of interest expenses or debt in a company or an entity, concerning a fixed ratio of debt or equity, interest or earning, etc.
  • Specified Percentage: These are the rules that disallow a specified percentage of the interest expenses in a company or an entity, regardless of the nature of the payment or to whom the payment is made.
  • Arm’s Length Basis: These are the rules that compare the level of interest or debt in a company or an entity with the position, had the company been dealing entirely with third parties.
  • Anti-Avoidance Rules: These are targeted anti-avoidance rules that disallow interest on particular transactions.

Applicability

As per the provisions provided in Section 94B, this section would apply under the following conditions.

  1. If the borrower is either an Indian Company or a permanent establishment for a foreign company in India.
  2. If the lender is a company that is located abroad and is an Associate Enterprise within the aspects mentioned under Section 92A of the Income Tax Act.
  3. If the expense is deductible under the head Profits and Gains of Business or Profession.
  4. If the expense is like interest, discount or any other similar finance charges and includes the debt in the form of a loan, financial lease, financial instrument, financial derivative or other arrangements that give rise to the expenses mentioned above.

It should be noted that if the borrowing is not from an Associate Enterprise directly, the debt shall also be termed to from an associate enterprise for the section. This also included when the lender, in turn, has borrowed from an associated enterprise of the borrower entity and has in turn on-lent.

Exceptions

Banking and Insurance companies are not included under the rules of the This Capatolation Rules. Non-Banking Financial Companies have not been involved in the exemptions.

Impact on A Non-Banking Financial Company

The provisions of the Section has dramatically affected the A Non-Banking Financial Companies and the same has been summarised below for a quick reference.

  1. Section 94B applies to Non-Banking Financial Companies as the interest expenses of the respective company will be subject to disallowance from the income tax perspective if the threshold limits prescribed by the section are breached.
  2. One of the major cost components of a non-banking financial company happens to interest expense. These companies take money from investors and provide funds to the earn interest income. Therefore, there happens to be a greater outflow for tax if the company is funded by an Associate Enterprise and exceeds the threshold limit.
  3. If the parent of a non-banking financial company happens to be a FOCC, the provisions of this section would be applicable apart from the whole transfer pricing provisions and rules, which would add to the cost burden of the company.
  4. Furthermore, this section has a clause that states so much interest as by an Indian company which has been implicitly or explicitly guaranteed by the Associate Enterprise would be disallowed.
  5. Similarly, it would be difficult for core investment companies having funds from associated enterprises to survive.
  6. The purposes of leveraging are to increase the return on equity, reduce tax burdens and maintain the cost of funds facilitating the viability of a business. The disallowance of the interest expenses under this section would force companies to create a sort of balance between the debt and the equity, such that the disallowance may be negated, which would further have an impact on the cost of the funds as well.

Impacts on other sectors

After scrutinising the opinions received from various quarters, the Central Board of Direct Taxes (CBDT) has arrived at the conclusion that this section would have a significant effect on the following sectors, which are listed below:

Impact on Start-ups

Most start-ups are funded by foreign companies that hold significant stakes in the company they are supporting. According to the broad definition of Associated Enterprises in the Section, it may seem like start-ups would have to face hurdles. Furthermore, a start-up procures funding on a guarantee provided by the Associated Enterprise that holds stakes and a guarantee of being covered under the ambit of the provisions will also affect the operations of start-ups.

Impact on Infrastructure Companies

Given that substantial funding is required for an Infrastructure Company, it is primarily funded by an Associated Enterprise, and the provision under the Section is likely to impede operations of an Infrastructure Company. While the regulatory aspects of banks and non-banking financial companies may seem equal, non-financial banking companies are not involved in the exclusion list for the applicability of this section. This certainly has a negative impact on the funds costs and the ability to do business.

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