15.1 Foreign investors can normally remit profits out of India when the Indian company declares dividend. There is an additional tax on dividend. The dividend is not deductible as expenditure. Thus there is double tax – on profits of the Indian company, and again on dividend.
One of ways in which a foreign investor can remit profits out of India without tax or lower tax is to charge expenses to its Indian subsidiary. The expense in the Indian subsidiary reduces the profits. The corresponding income may be taxed in India or may not be taxed – depending on the kind of expenses. However there is only one tax.
15.2 One of the expenses which the foreign investor charges to the Indian company is interest. This is done by providing a loan by the foreign investor to the Indian subsidiary - apart from equity capital. (FEMA has its own restrictions on foreign loans. However that is a different subject. Under FEMA, it is possible for a foreign shareholder to provide loan to an Indian subsidiary.)
Higher the debt, more is the interest which can be claimed. High debt means less equity (thin equity). This is known as “Thin capitalisation”. Hence under Thin Capitalisation rules, usually there is a limit on debt-equity ratio. If the loan is in excess of permitted debt-equity ratio, then the interest corresponding to excess loan is considered as dividend for income-tax purpose and taxed accordingly. Thus the benefit of debt is not available.
15.3 The finance bill provides a limit on the interest which can be allowed under ITA. Instead of providing a limit on debt-equity ratio, it has provided a limit on interest expenditure which can be claimed as a deduction. This is in BEPS action reports (No. 4) which G20 and OECD have agreed. The details are discussed below.
15.4 The amount of interest paid on loan borrowed from a non-resident Associated Enterprise (related party) is restricted to 30% of the Earnings before Interest, Tax, Depreciation and Amortisation or the actual amount of interest paid to the Associated Enterprise, whichever is lower. (Amortisation is spreading of expenses over more than one years). Popularly such earnings are known as “EBITDA”. This restriction also applies to a Permanent Establishment of a non-resident in India which pays interest to the Head Office or a group company.
There is no specific limit on interest paid to independent third parties except as mentioned in para 15.5 below.
15.5 Avoidance of Anti-Avoidance Provision:
15.5.1 S.94B is an Anti-Avoidance Provision. It restricts allowability of interest paid/ payable to a NR associated enterprise (AE).
To avoid such a restriction, parties can arrange the loan differently. The loan may be given to the Indian assessee based on or relying on:
(i) a guarantee given by the NR; or
(ii) funds provided by the AE to the lender.
Hence S.94B provides that even in such cases – where interest is not paid to NR AE, it will still be disallowed.
This is Anti-Anti-Anti Avoidance provision.
15.5.2 If say, the foreign parent company provides a guarantee to the foreign bank which lends funds to the Indian subsidiary, such a transaction will also be considered to a transaction with related party. Restriction on deduction of interest will apply.
Similarly if the foreign company keeps a deposit with a foreign bank which then provides the loan, similar restriction is there.
This restriction on allowability of interest expenditure is applicable only when all the following circumstances are applicable:
(i) Interest is payable by an Indian company; or by a permanent establishment of a foreign company. (Non-Corporate assessees should not bother.)
(ii) Interest payable is in excess of Rupees One Crore (presumably for the assessment year).
(iii) Interest is payable to a Non-Resident.
(iv) Interest is claimed as deductible expenditure against Indian income taxable under the head “Profits from Business or Profession”.
(v) If Indian assessee is a banking or Insurance company, S.94B won’t apply to it.
This is a protection from difficulties to small assessees. This provision is to prevent erosion of India’s tax base. If there is no “Base Erosion”; this restriction need not be applied.
15.5.3 A healthy approach may be observed:
Normally, for allowing tax relief, there are several conditions. Under the new provisions; restrictions, will be applied only if several conditions will be fulfilled. Further, the expenditure disallowed in one year is allowed to be carried forward.
The restriction applies to all kinds of financial arrangements – loans, financial leases, financial derivatives, etc. – which give rise to interest, discount or financial charges.
15.6 In case - interest in excess of 30% of EBITDA is disallowed, the excess can be carried forward to subsequent years and be set off against profits of those years. The total deduction (for past years’ interest and current year’s interest) in any case will not exceed the limit of 30%.
The excess interest can be carried forward for a maximum of 8 Assessment Years.
15.7 A concern is raised that many times a parent
company provides a guarantee only to enable the
subsidiary to avail of the loan. The parent company
provides a guarantee to all group companies. Other
than this facility, the subsidiary has to borrow at
competitive rates. Interest expenditure is paid to a
foreign bank which is a 3rd party. There
is no inter- company transfer of income. The parent
abroad does not derive any benefit/ income which
gets deducted as expenditure in India. There is no
base erosion due to Transfer Pricing. Even though
this may be the case, all such arrangements are
covered for the purpose of restriction.
(see para 15.10)
15.8 What should be considered for EBITDA? Does it refer to earnings as per accounting standards or earnings as per ITA? The law does not provide for the same. The BEPS reports state that EBITDA can be as per tax law or accounting standards as the country may provide. Further it also states that incomes which are exempt from tax (like dividend) should not be considered to compute EBITDA. This is logical. If the income is exempt, the expenses pertaining to such income also cannot be allowed. By not considering such incomes for EBITDA, automatically the interest to be allowed is restricted.
No such provision is made in the Finance Bill proposal. It will be better to have clarity in the Indian rules on EBITDA.
15.9 Does it mean that restricting the deduction of interest is the only adjustment for excess interest? Consider the following:
i) The MNC holding company provides that the rate of interest will be 20% instead of the market rate of 5%. Even after charging 20% interest, the total interest is within 30% of EBITDA. Will the excess interest due to extra 15% rate of interest be disallowed? Prima facie under the Transfer Pricing rules, the excess interest can be disallowed.
ii) If the MNC holding company provides funds in the ratio of low equity and high debt, can any adjustment be made? While Transfer Pricing rules do not provide a specific adjustment, the GAAR rules provide that high debt-equity ratio can be considered to determine whether GAAR rules should apply. (The difference between Transfer Pricing rules and GAAR is that in case of Transfer Pricing rules, the tax payer is required to suo-moto adjust the income to reflect the market price. Whereas GAAR needs to be invoked by the tax department if it considers that the arrangement is to avoid income-tax.)
iii) The DTAs provide that if interest paid is in excess of that which is normally payable between unrelated parties, then the lower rate of tax will not apply. Can this rule continue to apply? Legally, yes.
15.10 Disallowance of interest above 30% is a “Specific Anti-Avoidance Rule(SAAR)”. Having applied the specific rule, can other avoidance rules also apply? The circular by tax department (No. 7 dated 27.1.2017) states that GAAR can apply even if there is a specific anti-avoidance rule. By this logic, other rules can also apply.
15.11 The BEPS report discusses several ways (or combination of ways) in which excess interest can be disallowed. More countries are adopting a fixed ratio rule as adopted by India in this Finance Bill. BEPS has recommended that countries may fix a ratio between 10 and 30% above which the interest will be disallowed. India has adopted a ratio of 30% - perhaps considering the higher interest rates in India compared to developed countries where the rates are much lower. The thought behind applying a fixed ratio is that it is objective and simple. It avoids other difficulties of finding the market rate of interest, debt-equity ratio etc.
15.12 Wherever S.94B applies, Income-tax assessment proceedings can be lengthy and time consuming. It will be better for the assessee to collect all necessary evidence & information at the time of filing of the return – and in any case, even before the AO serves a scrutiny assessment notice.