Thin Capitalization in India

1.0 Introduction

A company is said to be thinly capitalized when a greater proportion of its 'capital-structure' is made up of 'debt' than of 'equity'. The interest payments generated on 'debt capital' is treated as a finance charge, and is allowable as a deduction in the taxable corporate income, thereby reducing the corporate tax burden. On the contrary, the dividend distribution tax is payable by enterprises on their after-tax profits, and if there is no profit dividend is not payable.

Hence, higher proportion of debt results in tax avoidance. To prevent such abuse, separate rules had been introduced in many countries. These rules are known as thin capitalization rules'.

2.0 Thin Capitalization in the World

Tax-authorities in several countries treat 'debts' accepted beyond certain limits from controlling shareholders as 'veiled-capital' and term it as 'thin capital'(also known as 'hidden capital') to distinguish it from normal loans. Interest paid on that part of the debt which is rechristened as 'thin capital' will be treated as 'dividend'. Dividend, being expenditure disallowed, will be added back to the total income of the company and assessed to tax. This way, the tax avoided is restored by restructuring 'debt' into 'thin cap' and 'debt'. This sort of capital-structure is recognized only for the purpose of Tax Legislation.

Many countries like Australia, Germany, France, Japan, China and USA have incorporated specific Thin Capitalization rules in their jurisdiction to deter erosion of the tax base through excessive interest payments.

But, since the concept stands in the way of free flow of investment, many other countries have not yet recognized it. India is one among them. Indian Tax Legislation does not have separate rules for 'thin capital'-neither does it directly recognize the concept.

3.0 Position in India

It is pertinent to note that 'foreign investors' can take advantage of the same and invest in India. The deduction of tax at source on interest payment to foreign company is 5% under Section 194LC of the Income Tax Act, 1961 ("the Act") otherwise at the "rates in force" under Section 195(1) of the Act while in Double Taxation Avoidance Agreement ("DTAA"), the withholding tax rate lies in the range of 10%-20% with the treaty countries.

On top of it, the dividend paid by an Indian Company are subject to Dividend Distribution Tax ("DDT") under Section 115-O of the Act at an effective rate of 16.995%.  In this regard, it is worthwhile to refer to the second proviso to Section 195(1) of the Act. The relevant extract has been reproduced below:

"Provided further that no such deduction shall be made in respect of any dividends referred to in Section 115-O"

Further, reference may be had to Section 10(34) of the Act. The relevant extract has been reproduced below:

"In computing the total income of a previous year of any person, any income falling within any of the following clauses shall not be included—

(1).....

(2)....

(34) any income by way of dividends referred to in section 115-O;"

From the perusal of the above, it can be seen that the aforesaid remittance of dividend is not taxable after paying tax on distributed profits at an effective rate of 16.995% in terms of Section 115-O of the Act. To avoid double taxation (Corporate tax and DDT) of the Corporate Income, the Foreign Company can claim credit on the tax paid in India with reference to Underlying Tax Credit method while the credit would be available for DDT or not is not free from doubt.

Chapter X of the Income Tax Act, 1961 provides special provisions relating to Avoidance of Tax. But it does not recognize 'thin cap'. Also the Act is silent on taxing deemed dividend in the place of interest paid to 'thin capital', even though it defines certain other dividends, under section 2(22), which are deemed as dividend. In other words the Act defines deemed dividend, but does not include interest on 'thin cap'.

In this regard, reference can be made to Bombay High Court decision in the case of  Director of Income-tax, International Taxation-II, Mumbai v. Besix Kier Dabhol SA [ITA No. 776 of 2011] wherein the facts are as follows:

"Assessee, a non-resident company had borrowed money from its shareholders in same ratio as equity shareholding resulting in abnormal debt-equity ratio of 248:1. Revenue's contended that debt was to be re-characterised as equity and interest payment thereon disallowed. The High Court ruled in favour of assessee and held that since there are no thin capitalization rules in force, interest payment on debt capital to shareholders could not be disallowed"

4.0 Foreign Exchange Management Act, 1999 (FEMA) and Regulations

It would be pertinent to note that the RBI Master Circular No. 12/2013-14 on External Commercial Borrowings (ECB) and Trade Credits stipulates a debt equity ratio of 4 : 1 for borrowings by Indian Entity from "Recognized Lenders" in excess of US $ 5 Million from "Foreign Equity Holders". The Foreign Equity Holders should hold a minimum of 25% of the paid-up equity of the eligible borrower. Further the regulations clarify "i.e. borrowing the proposed ECB not exceeding four times the direct foreign equity holding". This adds a new dimension to the basic question of Debt Equity ratio. This circular will stand withdrawn on July 1, 2014 and be replaced by an updated Master Circular on the subject.

5.0 Direct Tax Code, 2010

Of late, the Government of India is seriously considering steps to prevent 'all arrangements' to avoid tax. The change proposed in General Anti Avoidance Rules (GAAR) is a step in that direction. The Direct Taxes Code (DTC) intends to widen the scope of the said GAAR so as to include in its purview all arrangements which aim to avoid tax without violating the express provisions of the Code. 'Thin Capitalization' is considered as one such arrangement to avoid tax and hence may come under the purview of GAAR. It is in this context that the awareness of the concept gains importance.

The possible consequences for an impermissible avoidance arrangement can be that the arrangement could be disregarded in part or in full or, combined or re-characterized in part or in whole. One of the types of re-characterization contemplated under Clause 123(1)(f) of DTC is re-characterization of debt as equity, and vice versa. Interestingly, for the purposes of anti-abuse provisions, interest has been defined to include dividends.

6.0 General Anti-Avoidance Rules (GAAR)

The GAAR provisions will come into effect only if the assessee enters into an impermissible avoidance arrangement as defined in Section 96(1) of the Act.

On 17^th July 2012, the Prime Minister had constituted an Expert Committee under the chairmanship of Dr Parthasarathi Shome to engage in extensive consultation process and finalize the GAAR guidelines.

On 30^th September 2012, the Expert Committee submitted its Final Report on GAAR provisions. It provides guidance on Thin Capitalization through key illustration as follows; an Indian Company raising funds from a foreign company incorporated in a low tax jurisdiction outside India through borrowings, when it could have issued equity is not covered by GAAR. In such case, there is no specific provision dealing with thin-capitalization in the Act. An evaluation of whether a business should have raised funds through equity instead of debt should generally be left to commercial judgment of a taxpayer. The onus will be on the Revenue to identify the scheme and its dominant purpose.

However, GAAR would apply to a case where the interest rate is linked to actual profits and it appears that an actual equity investment is disguised as debt to obtain a tax benefit.

Similarly, GAAR would apply to a case where a loan is assigned to a resident of a country which has favourable treaty with the view of avoiding withholding tax in India on interest.

After due consideration of the Final Report of the Expert Committee headed by Dr. Parthasarathi Shome and the Recommendations made therein, the Government of India has made GAAR applicable from the FY 2015-16 and the monetary threshold of Rs. 3 crores of tax benefit in the arrangement has been accepted for invoking GAAR. GAAR not to apply retrospectively and hence to apply only to income arising to the taxpayer on or after GAAR provisions come into force. It is to be noted that the statement made by the Finance Minister does not contain any recommendation on funding through debt or equity.

7.0 Benchmarking of Transaction

As per Finance Minister's speech in 2013, the assessee shall have an opportunity to prove that the arrangement is not an impermissible avoidance arrangement. A connected person, who had invested in the "debt capital" of the taxpaying company, may enable the company to take shelter under 'ALP-safe harbor' if and when he does the following:

(i)       Ascertain how much the company would have been able to borrow from an independent lender; and

(ii)     Compare this with the amounts actually borrowed from group companies or with the backing of group companies.

(iii)   Consider whether the rate of interest is one which would have been obtained at arm's length rate while comparing from an independent lender as a standalone entity.

A comparison can then be made between the interest payable on the actual debt and that which would be payable on the amount which could have been borrowed at arm's length. Sometimes the difference may be nil; in which case it can be established that the debt falls under 'ALP shelter'.

8.0 Base Erosion and Profit Shifting (BEPS)

The term "base erosion and profit shifting" means, tax planning strategies that exploit gaps and mismatches in tax rules to make profits 'disappear' for tax purposes or to shift profits to locations where there is little or no real activity but the taxes are low resulting in little or no overall corporate tax being paid. India being a non-OECD member is a member of BEPS as it is a member of G-20 countries.

The Action plan 2 of BEPS is "Neutralise the effects of hybrid mismatch arrangements" which develops model treaty provisions and recommendations regarding the design of domestic rules to neutralise the effect (e.g. double non-taxation, double deduction, long-term deferral) of hybrid instruments and entities. This work will be co-ordinated with the work on interest expense deduction limitations, the work on Controlled Foreign Company (CFC) rules, and the work on treaty shopping.

On 19^th March, 2014 the OECD publishes the Discussion Draft on Action Plan 2. The timeline for completion of the Action plan is expected to be September 2014, although it may take longer for the impact of these changes to be fully applied in practice.

9.0 Way Forward

The coverage of "connected person" in GAAR definition is wide as defined in Section 102 of the Act which may potentially even include strategic investors and lenders who otherwise may not have had an intention of becoming an affiliated entity. While the anti-avoidance and thin capitalization principle introduced in the Direct Taxes Code and GAAR report is a welcome step, the Government needs to simultaneously take the next step and provide the required guidance upfront to multinational enterprises as to how the capital structures (debt-equity) should be formed or maintained and the principles to be adopted while evaluating them for arm's length, commercial substance and bona fide nature. Announcing a Safe Harbor on debt-equity ratios for different types of industries in different stages of project cycle could be one of the options that the Revenue authorities could consider to alleviate the concerns of various commercial concerns. If no specific rules or safe harbors are announced, it would leave the capital structure and debt-equity ratio of multinational enterprises to be benchmarked against prevailing industry practices and norms, though traditional methodologies for arm's length benchmarking would be found inadequate for this purpose. We have seen the confusion created by the RBI Master circular while stipulating the debt-equity ratio with respect to ECB from foreign equity holders.

Moreover, if the arrangement is for more than Rs. 3 Crores, then only it will fall under the ambit of GAAR provisions and there is no separate indication when to re-characterize equity into debt. The GAAR also gives room to double taxation as applying arm's length concept for determining the correct debt equity ratio in India while trying to qualify within the statutory debt equity ratio in the other country, would be a very delicate matter.

So, still there is no clarity in application of Thin Capitalization in India and foreign companies can invest in India keeping in mind the application of GAAR provisions from the FY 2015-16 onwards. The effect of thin capitalization must be closely studied by each corporate, since it may have consequences for the business structures currently employed by companies.