Clarity eluding the concept of thin capitalization?

V K Subramani
FCA

Entities engaged in economic activity continue to pursue the objective of wealth creation in
order to weather the storm, be it recession or out-dation of technology or displacement /
disturbance due to competition. Like human beings, corporates too have a sort of lurking
fear about the future and in the process try to consolidate their reserves and surplus to
continue their existence and activity in spite of ups and downs. One of the methods
prominent in domestic taxation is to borrow money and do business instead of testing its own
fortune. This may sound proper. However, with a view to have the benefit of claiming the
interest on borrowed funds and having the residue as income in the corporate sense as
accumulation of profit, entities have continued to transfer money between cross borders in
order to obtain maximum return by deploying the money in markets where there is attractive
return on investments.

In the process, a company in a different tax jurisdiction with huge idle funds or resources
may support or backup its associated enterprise who is having potential to earn profits but
not having enough monetary resources. Thus flow of money from low income jurisdiction to
income earning jurisdiction or attractive income earning jurisdiction is resorted to by MNEs.
The interest paid on such borrowing from the group entity goes to shield the tax outflow of
the borrowing entity and only after reducing such borrowing cost the income is subjected to
tax levy.

In India, section 94B was enacted by the Finance Act, 2017 in order to mitigate the impact of
interest expenditure claimed by business enterprises by prescribing a cap @30% of EBITDA.
This refresher takes note of the thin capitalization concept contained in the Income-tax Act
vis a vis the BEPS Action Plan 4.

Limitation of interest deduction in certain cases - Section 94B:

Section 94B starts with a non-obstante clause that notwithstanding anything contained in the
Act, the provisions contained therein will have a full flow. Where an Indian company or a PE
of a foreign company borrows money and incurs interest expenditure exceeding Rs.1 crore
the provisions of this section would apply.

The limit of deduction is applicable only where the interest is deductible while computing the
income chargeable under the head 'Profits and gains of business and profession' in respect of
debt issued by a non-resident, being an associated enterprise (AE) of the borrower. Interest
shall not be deductible to the extent it is in excess of 30% of EBITDA.

Where the debt is issued by a lender who is not an AE but the AE has either provided implicit
or explicit guarantee to such lender or has deposited a corresponding and matching amount
of funds with the lender then also such debt shall be deemed to have been issued by the AE.
The Finance Act, 2020 w.e.f 01.04.2021 inserted sub-section (1A) to section 94B whereby the
provisions of this section will not apply in respect of interest paid for a debt issued by a
lender which is a PE of a non-resident and where such non-resident being a person engaged
in the business of banking.

Similarly, section 94B(3) says that the interest limitation shall not apply to an Indian
company or a PE of a foreign company which is engaged in the business of banking or
insurance.

Where the interest expenditure incurred is more than the threshold limit of 30% of EBITDA
and the entire interest expenditure was thus not deductible against the income under the
head 'Profits and gains of business or profession', such amount of interest not so deducted
shall be carried forward to subsequent assessment year or years for set off against the
profits and gains, if any, of any business or profession carried on by the borrower-assessee
which is assessable for that assessment year. However, for that year also the deduction is
limited to 30% of EBITDA being the maximum allowable interest expenditure specified in
section 94B(2).

No interest expenditure so carried forward be eligible for set off beyond 8 assessment years
succeeding the assessment year for which such excess expenditure was first computed.
Thus, the amount of interest expenditure not allowed previously has to be identified and
carried forward for subsequent 8 assessment years. There is no concept of aggregating the
brought forward interest expenditure as current year expenditure even for the limited
purpose of section 94B.

Section 94B(5) says associated enterprise shall have the meaning assigned to it in section
92A(1) dealing with associated enterprise and section 92A(2) dealing with deemed
associated enterprise.

'Debt' means any loan, financial instrument, finance lease, financial derivative or any
arrangement that gives rise to interest, discount or other finance charges which are
deductible while computing the income chargeable under the head 'Profits and gains of
business or profession'. The term 'permanent establishment' includes a fixed place of
business through which the business of the enterprise is wholly or partly carried on. Thus,
even if there is no fixed place of business, the term PE is covered since the expression used
is 'includes' and would therefore span beyond what is given in the section.

Interest deductions and other financial payments - BEPS Action Plan 4

BEPS Action Plan 4 is intended to address the interest deduction claimed by multinational
corporations by advancing money by way of loan to AEs in different tax jurisdictions and
deriving interest income which is a charge on profits of the paying entity who end up paying
income-tax on the balance residue income. Instead of participating in the form of equity, the
multinationals resort to lending on interest in which case the AE unit located in source
jurisdiction pay income-tax after charging interest. In the same scenario if the funds were
taken as equity, there would not be base erosion of income of the source entity and tax outgo
in the source jurisdiction would have been much larger.

The BEPS Action Plan in 2015 report gave guidance on the design and operation of the
group ratio rule and approaches to deal with risks posed by banking and insurance sectors.

There are three methods in which the interest deduction could be moderated they are as
under:

(i)   Fixed ratio rule: Where the interest expenditure on EBITDA is computed on a fixed
 ratio or limit such as section 94B presently implemented in India.
(ii)   Group ratio rule: Where the interest expenditure is allowed in the source
jurisdiction based on the overall group ratio of the entity's interest expenditure on
its worldwide income. This approach too, is not followed in India. The consolidated
EBITDA of the group vis a vis the consolidated interest expenditure of the group is
applied for deciding the proportion of interest expenditure allowable in a source
jurisdiction.
(iii)   Targeted rules: Which is to address specific risks by targeting transactions
between related parties and back-to-back arrangements which may be made to
inflate the interest expenditure without a corresponding economic cost.
Certain issues:

Reference to section 94B vis a vis the BEPS Action Plan 4 discussed above would lead us to
following issues:

(i)   Overall interest claim or interest to AE: Whether the interest expenditure of the
entity as such is to be considered for the purpose of section 94B or only the interest
expenditure attributable to the borrowings from associated enterprise to be
considered for limiting the deduction remains debatable. Section 94B(1) uses the
words 'incurs any expenditure by way of interest or of similar nature exceeding one
crore rupees which is deductible in computing income chargeable under the head
"Profits and gains of business or profession" in respect of any debt issued by non-
resident, being an associated enterprise of such borrower'. Thus one can interpret
the quantum of interest to be considered for the purpose of section 94B in either
way and thus there exists ambiguity.
(ii)   Interest to banks in India based on AEs guarantee: The proviso to section
94B(1) says that where the debt is issued by a lender which is not AE, but AE has
provided implicit or explicit guarantee or deposited matching funds for the lender to
advance loan to the borrowing entity in India, it would be deemed that the debt was
issued by the AE. Again, if an associated enterprise gives guarantee to a bank
outside India and by virtue of such guarantee a bank in India gives loan to the entity
and interest is paid to the bank in India, such interest expenditure cannot be
deemed as interest paid to AE (since the term AE means a non-resident entity). For
example, if an associated enterprise deposits money and a guarantee is issued to
SBI for giving a loan to an entity in India, the interest paid by the entity in India to
SBI cannot be treated as interest paid to foreign AE. However, clarity in this regard
is missing in the legal provisions.
(iii)   ALP determination and interest disallowance: Section 94B applies
notwithstanding the applicability of transfer pricing provisions. However, where the
interest expenditure is adjusted in determination of ALP and it is less than Rs.100
lakhs then the provisions of section 94B would not apply. On the other hand, if the
interest expenditure is subjected to ALP adjustment exceeding Rs.100 lakhs then
section 94B would apply in spite of the ALP adjustment carried out by the assessee.
For example, if EBITDA is Rs.900 lakhs and interest paid to AE is Rs.500 lakhs and
the ALP of interest is Rs.410 lakhs, no secondary adjustment is required since the
ALP primary adjustment is only Rs.90 lakhs. However, disallowance under section
94B would be applicable viz; Rs.410 lakhs less Rs.270 lakhs (30% of Rs.900 lakhs)
being Rs.140 lakhs. Similarly, if EBITDA is Rs.1200 lakhs and interest paid to AE is
Rs.650 lakhs with ALP of interest being Rs.530 lakhs would attract secondary
adjustment of Rs.120 lakhs under section 92CE and disallowance of interest under
section 94B of Rs.170 lakhs (Rs.530 lakhs minus 30% of Rs.1200 lakhs).
Conclusion:
Section 94B was inserted by the Finance Act, 2017 w.e.f. 01.04.2018 in consonance with
OECD BEPS Action Plan 4. The intent and coverage of section 94B is laudable but the
drafting of section 94B(1) and the proviso requires clarity. More so when banks in India not
being foreign entities lend money based on the guarantee of non-resident AE, applicability of
section 94B to such interest expenditure may not be an appreciable feature in our legal
framework.

■■