Heading Towards Global Best Practices – Section 94b

On the auspicious day of Vasant Panchami, when Finance Minister Arun Jaitley rose to give the Budget speech for 2017-18, he reaffirmed the government’s intent to make India stand out as a bright spot in the world economic landscape and to ensure that India aligns with best global tax practices.
 
Among several tax amendments, he addressed the issue of thin capitalisation, thereby introducing section 94B to the Income-tax Act, 1961 (‘the Act’). The intent to introduce this section on thin capitalisation is discussed in the forthcoming paragraphs along with the key issues surrounding this amendment.
 
Limiting deduction of interest paid to Associated Enterprises
Interest expenditure in books of Indian taxpayers is a deductible expenditure u/s. 36(1)(iii) of the Act. Thus, claiming interest expenditure makes debt a more preferable option for taxpayers over equity, by helping them reduce their taxable profits. However, in the past few years, several cases have been identified where cash rich companies have borrowed funds, often from their overseas counterparts, with an intent to shift profits to a low/ no tax jurisdiction.
 
India had no thin-capitalisation rules in place prior to the introduction of Section 94B. Thus, there have been judgements, such as that in case of DIT vs. Besix Kier Dabhol SA {[2012] 26 taxmann.com 169 (Bom)}, wherein the Honourable Bombay High Court has allowed interest expenses to the taxpayer, on the ground that there are no thin capitalisation rules in place under the law. It is pertinent to note here, that in the case at hand, the debt to equity ratio was as typically and astronomically high as 248:1.
 
Further, in line with the recommendations of OECD BEPS Action Plan 4, it has been provided that when any Indian company, or the Permanent Establishment (PE) of a foreign company in India, being the borrower, incurs any expenditure in form of interest (or of similar nature) of INR One crore or more to its Associated Enterprises (AEs), the same shall be restricted to 30% of its earnings before interest, taxes, depreciation and amortisation (EBITDA) or the interest paid or payable to AE, whichever is less.
 
Further, the debt shall be deemed to be treated as issued by an AE, where the related party provides an implicit or explicit guarantee to the lender or deposits a corresponding and matching amount of funds with the lender.
 
In other words, the restriction is applicable where interest or similar consideration incurred to a non-resident AE lender, exceeds INR 1 crore. The excess interest is defined to mean:
 
–    Total interest paid or payable in excess of 30% of EBITDA; or
–    Interest paid or payable to an AE, whichever is less.
 
Such disallowed interest expenditure shall be carried forward up to eight assessment years immediately succeeding the assessment year for which the disallowance is first made. The deduction in the subsequent assessment year is allowed from ‘business income, subject to same restrictions as stated above. Further, this provision is not applicable to entities engaged in the business of banking and insurance. It is also interesting to note here, that the newly inserted section does not harmoniously limit the withholding tax liability or taxability of the AE on such interest income earned.
 
While break-downing section 94B, following inferences can be drawn:

Global Best Practices
Section 94B is yet another attempt by India to assert its strong support to being an active participant in the OECD Action Plans for combating Base Erosion and Profit Shifting (BEPS). BEPS Action Plan 4 speaks about limiting base erosion via interest deductions and other financial payments and is primarily designed to limit the deductibility of interest and other economically equivalent payments made to related parties as well as third parties.
 
Some pertinent similarities and deviations between Action Plan 4 and section 94B are tabulated below:
 

 
Key Issues/Queries Surrounding Section 94B
 
1.    EBITDA as per tax or as per financial statements?
    EBITDA is neither defined in the Companies Act, 2013, nor in the Income-tax Act, 1961. There is also no clarification in the section whether such item be adopted at the time of disallowance of any interest and whether EBITDA can be used as the base number or based on tax computation.
 
    Action Plan 4 recommends basis of EBITDA as per Tax rules. The idea is that by linking interest deductions to taxable earnings would mean that it is more difficult for a group to increase the limit on net interest deductions without also increasing the level of taxable income in a country. However, the Income-tax Act does not recognise any term as EBITDA or gross total income, causing ambiguity. In such a scenario and in absence of clarity, it would be a better approach to rely on EBITDA as per books of accounts.
 
2.    Double taxation on the interest income element:
    BEPS Action Plan 4 suggests implementation of such thin capitalisation norms in cases where net interest exceeds a prescribed percentage of EBITDA. As against that, Section 94B mentions interest payments (gross payments). While provisions of Section 94B are simpler to implement (since it does not warrant detailed analysis of interest income that can be set off against relevant interest payment), to such extent, it implies enforcing double taxation at the group level. For example, in case an interest payment of India to the UK AE is partially disallowed u/s. 94B in India, to the extent of such partial disallowance, UK would still bear the tax on such interest income.
 
    Unless a specific provision is introduced in tax treaties/the Multilateral instruments signed by various countries, this shall remain an open issue. In absence of requisite clarifications, taxpayers may have to resort to dispute resolution mechanisms to eliminate double taxation.
 
3.    Deemed debt scenarios:
    The first proviso to section 94B(1) speaks of deeming fiction being triggered even in case of an implicit guarantee by an AE. However, the term implicit guarantee has not been defined anywhere in the Act. Also, no such reference is provided in BEPS Action Plan 4. It is therefore a matter of concern as to how the Revenue may evaluate the presence or otherwise of an implicit guarantee from an AE, with an underlying third party debt, especially in cases  when the AE is the parent of the Indian taxpayer.
 
    Assuming a scenario where the tax authorities may allege that an implicit guarantee exists only because a certain Indian company is subsidiary of an MNC, seems too farfetched. In such cases, the onus should be on the tax authorities to justify, with adequate supporting, that an implicit guarantee exists, based on actual arrangement/conduct of the parties involved.
 
4.    Corresponding and matching amount of funds:
    Proviso to Section 94B(1) suggests that debt shall be deemed to have been issued by an AE even where debt is issued by a third party lender but an AE deposits a corresponding and matching amount of funds with the lender. What is not well defined here is where the amount deposited by the AE ought to be equivalent to the amount of debt or a percentage thereof. For example, in a case where the base debt is INR 1 crore, but the amount deposited is INR 80 lakh, will proviso to section 94B(1) be triggered in such a case? Alternatively, would the answer be any different if the deposit was merely INR 5 lakh?
 
    The intent of the law here does not seem to be to cover only those cases where the guarantee is exactly corresponding to the debt involved.  In fact, imposing the criteria of matching funds would leave taxpayers with immense opportunity to immorally avoid any implication of section 94B on their transaction. Hence, keeping the intent of law in mind, it may be understood that corresponding and matching funds is not a mandate in such a case.
 
5.    Will only funds trigger the applicability of the proviso?
    Proviso to section 94B(1) suggests that debt shall be deemed to have been issued by an AE even where debt is issued by a third party lender, but an AE deposits a corresponding and matching amount with the lender. While reading the section, there appears no clarity in a case where the AE offers a collateral to the third party lender in any form other than funds. For example, in case the AE offers an asset as collateral which is not in the form of money/ funds, will proviso to section 94B(1) apply in such a case?
 
    Similar to the point above, the purpose of the law shall be defeated if restricted to only those cases where funds are maintained as collateral. The intent of the law may be read as any form of guarantee extended by an AE, for the applicability of this section to be imposed.
 
6.    Impact of Ind AS on reading of section 94B
    Ind As places focus on substance and contractual arrangement of financial instruments over its mere legal form. Accordingly, redeemable preference shares which were treated as shareholder capital under IGAAP shall be treated as debt under Ind AS since it encompasses all features of debt (i.e. fixed and determined payout; specified maturity date etc.). Also, dividend paid on redeemable preference shares shall be treated as interest in the books of accounts as per Ind AS, as against being treated as dividend as per IGAAP.
 
    One pertinent thing to note here is, whether change in characterisation of dividend as interest under Ind AS would have any direct impact on the interest as per section 94B. While there is no direct clarity on the topic at this stage, it is important to read the same in light of Circular 24 of 2017 (dated 25th July 2017), which clarifies that such dividend on redeemable preference shares, while may be considered as interest as per Ind AS, shall continue to be treated as interest for the purposes of MAT computation. Taxpayers may draw an analogy here that similar impact is to be given when it comes to computation of tax as per normal provisions.
 
In all the above cases, it would be helpful to receive clarification or objective guidelines from the CBDT, to avoid multiple cases of controversy and litigation, and to bring peace and clarity in the minds of taxpayers. _