A Belgian company opened a project office (permanent establishment or PE) in India for the purpose of construction of fuel jetty. The firm did not have any other business activity except the Indian project office. The total paid-up capital of the company was Rs 38 lakh. The PE, however, had borrowed Rs 94 crore directly from the shareholders of the Belgian firm. Effectively, the debt to equity stood at 248:1.
In this backdrop, the PE claimed deduction of interest on such borrowings against its income in India for the assessment year 2002-03. The assessing officer disallowed the interest on the grounds that they were ‘from self to self.’ He also referred to the OECD Model Convention Commentary, which called for a ban on deductions for internal debts and receivables.
In this case of Besix Kier Dabhol, SA versus DDIT [131 ITD 299], the Income Tax Appellate Tribunal (ITAT) allowed the deduction of interest and held that ‘thin capitalisation rules’ have not yet been introduced in India and that it is not open to tax authorities to re-characterise debt capital as equity capital and make the interest non-deductible. Considering the recent developments, it is clear that the assessing officer was ahead of his times.
Equity and debt are the two ways through which a company can source its funding. ‘Thin capitalisation’ refers to a situation where a company is financed through a substantially higher amount of debt than equity. The capital structure of a company has consequential effects on the amount of profit it reports for tax purposes – the Income Tax Act allows a deduction on interest paid or payable for arriving at taxable profit while dividend paid on equity is not deductible. Therefore, a higher level of debt entails lower levels of taxable profit, thereby providing an incentive to finance operations with debt rather than equity.
Companies (multinational ones, especially) structure their mix of finance in such a way that they maximise the benefit of claims of deduction of interest.
The Organisation for Economic Co-operation and Development in its Base Erosion and Profit Shifting project had taken up the issue of base erosion and profit shifting by way of excess interest deductions by the Multi-National Enterprises (MNEs).
‘Base erosion’ refers to reducing (eroding) taxable income (tax base) by claiming deductible expenses, tax treaty benefits, etc.
Debt levels of multinationals are particularly sensitive to jurisdictional tax rates — MNEs reduce their worldwide tax liability by concentrating debt in countries with relatively high tax rates. Then, since money is mobile, they use intra-group loans to transfer the finance. This creates problems for shareholders and creditors who have to bear solvency risks and revenue authorities who have to deal with abuses of tax laws. To counter this base erosion, many countries have introduced thin capitalisation norms to restrict deductibility of interest from business income.
Continuing in the same vein, the Union Budget 2017-18 proposed to restrict interest expenses claimed by an Indian company or a permanent establishment of a foreign company on payments to its non-resident associated enterprises (or a permanent establishment thereof) to 30 per cent of earnings before interest, taxes, depreciation and amortisation
With a view to targeting only large interest payments, this provision would be applicable only in cases where the interest expense exceeds Rs 1 crore. Banks and insurances companies have been exempted from these provisions.
— Rishika Pardikar is a chartered accountant