Section 94B has been inserted in Income Tax Act, 1961 via Finance Bill,2017 to curb the practice of shifting of profits to tax havens through excessive interest payments by primarilyconsidering the recommendations by the OECD under Action Plan 4 of the Base Erosion and Profit Shifting ("BEPS") project.

Action Plan 4 of BEPS states that use of interest is one of the simplest profit shifting techniques as the companies can use debt to achieve excessive interest deductions. In the case of multinationals, the companies may take excessive deductions on intra group loans to shelter local profits from tax which may lead to base erosion and profit shifting.

Action 4 Report set out a common approach to address BEPS involving interest and similar payments. This included a 'fixed ratio rule' which limits an entity's net interest deductions to a set percentage (10%-30%) of EBITDA and a 'group ratio rule' to allow an entity to claim higher net interest deductions, based on a relevant financial ratio of its worldwide group.

Based on the recommendations under Action Plan 4, Section 94B has been inserted which limits the interest deduction as per the fixed ratio rule.

Section 94B is attracted in the cases where any Indian company or the Permanent Establishment of a foreign company pays interest exceeding One crore rupees to its Nonresident AE during the year beginning from Financial year 2017-18.

As per Section 94B (2) the excess interest, which is lower of the below, shall be disallowable:

- an amount of total interest paid or payable in excess of thirty per cent of earnings before interest, taxes, depreciation and amortization[EBIDT] of the borrower in the previous year, or

- interest paid or payable to associated enterprises for that previous year

Further, As per the proviso to Section 94B(1), where the loan has been provided by the third party lender, but the AE provides explicit or implicit guarantee to such lender or deposits the corresponding or matching amount of funds with the lender, the loan shall be deemed to have been provided by AE.

The approach adopted by India to tackle base erosion through excess payment of interest is liberal from recommendation of BEPS AP 4 to the extent India has prescribed to disallow excess interest only when paid to nonresident being AE though BEPS has prescribed to disallow excess interest paid to resident as well as nonresident lender. The purpose is to prevent base erosion that take place when excessive interest is paid to nonresident (particularly AE) and is taxable in India at lower or nil rate.

However, proviso to section states that interest on loan from any lender, whether resident or nonresident will be disallowed if loan has been implicitly or explicitly guaranteed by AE or back to back funded by AE. In this context, we have analyzed the proviso hereunder to understand the possible purpose and reasonability of the proviso to tackle BEPS:

Text of proviso is reproduced for quick reference

"Provided that where the debt is issued by a lender which is not associated 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, such debt shall be deemed to have been issued by an associated enterprise."

Analysis

- Where loan is granted by non associated person and associated entity deposits a corresponding and matching amount of funds with the lender

Proviso provides that where loan has been granted by a person other than AE whether resident or non resident and AE deposits equivalent amount of fund with lender, loan shall be considered as given by AE and accordingly provisions of section will apply and excess interest shall be disallowed.

This insertion is to curb the structuring of transaction as also recommended by Action Plan 4 in its targeted rules. The insertion is valid and will check the base erosion possibility through routing the lending of money by way of non associated enterprise.

- Where loan is granted by a non associated person and associated entity provides an explicit guarantee to lender in respect of loan

When AE has given guarantee to lender, base erosion will be to the extent of guarantee fees paid by borrower in India to AE and that is well taken care by section by including "any expenditure by way of interest or of similar nature" under the section 94B(1).

However proviso states that loan that is guaranteed by AE will be treated as loan by the AE and accordingly excess interest will be disallowed. In the said circumstances, if loan is taken from resident lender, there is no base erosion except when there is structuring of transaction (By arranging loan from loss making entity to borrower). In our view, proviso is discriminatory to the extent prescribes for disallowance even when interest is paid to resident as there is no base erosion in such scenario,and requires amendment in section to cover only non-resident lenders. Also, If the purpose is to check on arranged transactions, then there should be adequate provision on case to case basis and also with the introduction of GAAR also, such type of structuring will make the arrangement impossible and thus disallowing of interest in all cases of explicit guarantee is discriminatory and unreasonable to the extent there is no base erosion.

Also, as section 94B is based on the recommendations of BEPS Action Plan 4, it also does not recommend consideration of guarantee as a loan from AE.

One more possible intention can be to cover the cases where the guarantee provided by AE is in the nature of quasi equity and thus loan given by non AE based on such guarantee is to be considered as loan by AE. Even under such circumstances, there is no base erosion as interest is payable to residents only. It will be reasonable had it been specified that proviso is applicable on non resident lender only.

However, in many circumstances, there are genuine business reasons where AEs are required to grant guarantee to enable newly set up subsidiaries to avail loan. Under such circumstances, it will create business difficulty for MNEs to operate in India. India has even adopted Action plan 4 in narrower sense giving advantage to domestic groups or standalone Indian corporate over MNE entitities in respect of interest expense. This may lead to trigger of Non discrimination clause as well under DTAAs.

- Where loan is granted by a non associated person and associated entity provides an implicit guarantee to lender in respect of loan

The impugned proviso also covers the cases where the where the lender is a non related party however an implicit guarantee has been provided by the AE. In our view, proviso is arbitrary and does not clarify the meaning of "Implicit guarantee". As per OECD's draft on Financial Transactions guidelines

"142. By providing an explicit guarantee the guarantor is exposed to additional risk as it is legally committed to pay if the borrower defaults. Anything less than a legally binding commitment, such as a "letter of comfort" or other lesser form of credit support, involves no explicit assumption of risk. Each case will be dependent on its own facts and circumstances but generally, in the absence of an explicit guarantee, any expectation by any of the parties that other members of the MNE group will provide support to a related party in respect of its borrowings will be derived from the borrower's status as a member of the group. The benefit of any such support attributable to the borrower's group member status would arise from passive association and not from the provision of a service for which a fee would be payable."

Passive association and implicit support may be viewed as any benefit derived by an entity solely from its affiliation with parent or broader group. As there is an element of guarantee on any loan taken by a company which is a part of a group, this can come under the ambit of implicit guarantee irrespective of the fact that no guarantee has been actually provided by the AE. This will bring all entities, being part of multinational group who have taken loans under the net of Section 94B and interest paid by them in excess of 30% of EBITDA will be disallowed. The ambiguity and obscurity in the proviso will open the gates for huge litigation and harassment of taxpayers and requires clarity in regard to definition. This leads to differential benefit to domestic companies over the multinational companies setting up in India, and thus can discourage the foreign companies to Invest in India if they require hefty investment in the form of debt.

Writ petition

A writ petition has also been by filed by Seimens Gamesa Renewable Power Pvt. Ltd challenging the constitutional validity of Section 94B which has been admitted by Chennai High Court.

The writ petition filed to challenge the proviso to Section 94B(1) which seeks to disallow the interest also in the cases where the loan has been provided by the Non AE, whether resident or nonresident , but guarantee has been provided by the AE for the same. Thus constitutional validity of Section 94B is under challenge based on similar arguments as discussed above.

Conclusion

As Discussed above, section 94B was inserted to curb thin capitalization and shifting of tax base and the proviso to section 94B(1) was introduced to discourage the structuring of the transaction by routing the loans through a third party by way of providing the guarantee or depositing of the funds with the lender by the AE. However, the proviso to section 94B(1) is arbitrary and has many loopholes which creates unreasonable hardship for the companies which are part of the international group.

The loopholes in the impugned section leads to differential benefit to domestic companies over the multinational companies setting up in India, and thus can discourage the foreign companies to Invest in India if they require hefty investment in the form of debt. Therefore, in the light of current economic requirements that India has to still compete to attract FDI, it is arguable whether India is economically ready for this regime and may require postponing the applicability of it.