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By Siri Bulusu
India’s tax administration will limit foreign companies’ interest deductions to plug a loophole that reduces tax liability on business income and dividend distribution in what one tax practitioner described as “not an investor-friendly” move.
Provision 94(B) of the Income Tax Act, 1961, introduced in the Finance Bill 2017 with effect from April 1, 2017, sets a cap on how much a foreign company may deduct in respect to interest paid out to related enterprises, a measure in line with Action 4 of the OECD’s initiative to combat tax base erosion and profit shifting.
Tax practitioners said the new “thin cap” rule will restrict foreign companies from structuring investments to have excessive debt to reduce tax liability in India, and ultimately strip away revenue earnings.
The tax policy change, while aimed at multinationals that shift profits across jurisdictions by funding companies with more debt to get a tax advantage, also will hurt manufacturers, infrastructure companies, and start-ups—all of which rely heavily on debt financing, Maulik Doshi, a tax partner at SKP Business Consulting LLP, told Bloomberg BNA in a June 5 email.
An Indian company has “a huge tax liability” if it structures its investments as equity investments. “So what happens is the company will change the character of the investment from equity to debt to save on tax,” Bhavin Shah, partner and financial services tax leader at PwC India, told Bloomberg BNA June 5.
If a Singapore-based company invests in an Indian company, the Indian company will first pay a 34.61 percent corporate tax rate on income earned in India and then a dividend distribution tax at the rate of 20.36 percent when it remits profits to its associated enterprise in Singapore, Shah said.
On the other hand, up to March 31, 2017, if the Singapore-based company invests $100 dollars in an Indian company, and 99 dollars were structured as debt, then the Indian company could claim tax deductions on the interest paid on the 99 dollars of debt—drastically reducing the tax liability both on corporate tax as well as distribution tax, according to Shah.
“Interest should be deductible when it’s a related party, the loan should be arms length otherwise the interest deduction was used, or misused, around the world,” Shah said.
The two ways this issue is addressed internationally is by limiting the debt to equity ratio, or by capping the maximum deduction to a certain percentage, and India adopted the latter by capping interest deduction at 30 percent of earnings before interest, tax, depreciation and amortization (EBITDA).
After April 1, 2017, using the same Singapore-India example, Shah said even where 99 percent of a $100 investment is structured as debt, the Indian company can only deduct a maximum of 30 percent of its EBITDA profits as interest paid to a related non-resident entity. The excess interest above 30 percent EBIDTA is disallowed, which will increase the corporate tax burden for the Indian company.
The new provision will affect industries that use thin capitalization investment structures like real estate and infrastructure and only applies to non-resident companies investing in India.
“This is definitely not an investor-friendly provision because they’ll pay more tax in India, but it is in line with the BEPS initiative and it has nothing to do with India becoming overly aggressive or adverse to transfer pricing,” Shah said.
BEPS Action 4 seeks to curb base erosion involving interest deductions and other financial payments.
Most developed countries have adopted such measures, but some practitioners say India’s new provision goes against the current administration’s promise to foster manufacturing growth.
“The new provisions would also go against the government’s focus on ‘Make in India’ and ‘Start Up India’ since it would badly hit the manufacturing companies and infrastructure companies—which are capital intensive and hence high-debt funding and long gestation period,” Maulik Doshi, tax partner at SKP Business Consulting LLP, told Bloomberg BNA.
Doshi said the provision is aimed at multinationals that use financing and funding structures to shift profits across jurisdictions by funding companies with more debt, to gain a tax advantage, but that it will affect genuine companies with similar investment structures.
The new provisions would definitely impact low-profit or loss-making companies, he noted, such as start-ups, which would have obtained debt funding from non-resident associated enterprises.
Potential impact of the provision could extend to multinational corporation groups where lending from foreign banks is guaranteed by parent companies.
Doshi said the provision also covers interest payments on debt obtained from non-associated enterprises like foreign banks, where an associated enterprise has guaranteed the loan or has deposited a corresponding amount with the lender.
Tax practitioners said the new rule allows companies to carry forward the disallowed interest for eight years, so the maximum amount of interest is maxed out at 30 percent in the concerned year.
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