Thin capitalisation refers to a scenario where an entity is highly geared, that is, has high proportion of debt as compared to equity.  Interest payments generated on ‘debt capital’ is treated as a finance charge, and are tax deductible while computing the taxable income, thereby aid in reducing the overall group tax cost.  On the contrary, the dividend distribution tax is payable by the company on their after-tax profits, and if there is no profit dividend tax is not payable.  

There was no specific law in India with regard to thin capitalisation. Transfer pricing provisions would be solely applicable in case of interest payment to associated enterprises so as to allow arm's length interest pay-outs.

The Organisation for Economic Co-operation and Development (‘OECD’) under the Base Erosion and Profit Shifting project (‘BEPS’), Action Plan 4, recommended alternate approaches/ parameters for countries to limit tax base erosion through interest deduction and other financial payments.  Henceforth, Finance Act 2017, introduced Section 94B (applicable w.e.f. AY 2018-19) in the India income tax laws, to overcome loss of revenue by way of thin capitalization. Taxpayers engaged in banking or insurance business are specifically excluded from the ambit of Section 94B.

Swift Recap

Section 94B shall apply to an Indian company, or a permanent establishment of an overseas company being the borrower who pays the interest or similar expenses (including those paid on existing debt) to (i) overseas associated enterprises or (ii) third-party lenders for whom the underlying debt is backed by an implicit or explicit guarantee or equivalent deposit from overseas associated enterprises.

Any interest paid for the year under consideration in excess of 30% of the earnings before interest, taxes, depreciation, and amortisation (EBITDA) of the taxpayer will be treated as excess interest and shall be disallowed in the said year.

Excess interest disallowed in a year will be eligible for carry forward up to eight consecutive years, subject to the above limits. The provision will, however, not apply to interest paid or payable up to INR 10 million. 

Comparative analysis of key provisions of BEPS Action Plan 4 vis-à-vis Section 94B:-

Key points to ponder – Practical implications

(i) Borrowings from tax resident of country with which India has favourable non-discrimination article

When it is possible to borrow funds from lenders resident in various countries, prefer borrowings from a lender, which is a tax resident of a country, the tax treaty signed by which with India contains favourable non-discrimination article.  In such a scenario, it is possible for the borrower to claim benefit of non-discrimination article and argue that interest could not be disallowed u/s 94B. Applicability of GAAR provisions need to be examined separately.

(ii) Loss making entities and the entities having high gestation periods

In case of loss making entities including infrastructure undertakings having initial gestation periods, it would have detrimental effect and interest pay-outs by such entities may become sunk cost for tax purposes. BEPS Action 4 report takes into cognizance a case of loss making company and illustrates an example of applicability of thin capitalization rule to such company.

(iii) Interplay between GAAR and section 94B

Section 94B begins with a non-obstante clause which means that it could override other provisions of the Income-tax Act, 1961(the Act). It is interesting to note that section 95 (GAAR provision) also begins with a non-obstante clause. Hence, the question which arises is, which non-obstante clause will prevail? Section 94B qualifies to be in the nature of specific anti-avoidance rule (SAAR). Can GAAR apply to a situation where SAAR is applicable? CBDT has clarified2 that GAAR and SAAR can co-exist and may be applicable. Consequently, on application of GAAR, the entire interest could be disallowed in appropriate cases vis-à-vis limiting interest deduction under section 94B.

(iv) Book EBITDA or Tax EBITDA

Limit of interest deduction is linked to EBITDA. The term EBITDA is not defined under the Act. This term is generally used in published accounts and is one of several indicators to measure the performance of a company. It emerges from the financial accounts of the company. BEPS Action 4 recommends that EBITDA should be based on tax rules. In absence of any guidance, there is no clarity as to which EBITDA can be adopted by the borrower to compute the dis-allowance.

(v) Restricted to income chargeable under the head “profits and gains of business or profession”

The applicability of section 94B is restricted to income chargeable under the head “profits and gains of business or profession”. Thus, if interest is claimed as a deduction against income chargeable to tax under the other heads of income (such as income from other sources under section 57(iii), house property), the same is not restricted to disallowance under proposed section 94B. 

(vi) Guarantee arrangements

Implications of guarantee arrangements by holding/ group companies would be closely watched and revenue may attempt to impute interest to such arrangements. The use of conjunctive "or" instead of "and" is negative, since apparently, only where cash outflow occasions such provision of guarantee, should there be considered a form of financial accommodation, warranting such imputation of interest in hands of the lender.

Conclusion

Interest limitation provisions will surely impact the debt servicing ability of the Indian companies  (i.e. infrastructure companies and start ups) which have availed debt from its overseas AEs.  Consequently, Companies shall be required to contemplate plausible options for debt servicing and may undertake necessary restructuring exercise.  However, while doing so, one is also required to consider GAAR, transfer pricing regulations, etc.