A company is generally financed through one of the two modes or a combination of the same; Debt and Equity.
Equity financing refers to the funds generated by the sale of stock. The main benefit of equity financing is that there is no obligation to repay the funds. However, it comes with a greater risk to the investor so the cost of equity is larger than the cost of debt.
A new concept called Thin Capitalisation rolled out in the previous years and is gaining a lot of attention.
Let’s dive into the pool of ‘Thin Capitalisation’?
What is Thin Capitalisation?
Thin capitalisation refers to the situation in which the portion of the debt is heavier than the equity. They are sometimes referred to as highly leveraged or highly geared companies.
Thin capitalisation simply means, Debt > Equity
What is the significance of Thin Capitalisation?
Now, we know that in thin capitalisation, the portion of the debt is more than the equity. Debt often comes with an interest component. Further, the interest element in the debt helps in the tax benefit. The quantum of profit that a company reports for the tax purposes often depends on the way it is financed.
Many Multinational Companies often make arrangements in such a way that the interest is received in a jurisdiction where there is a lower tax rate or no tax rate. This helps in structuring the financial arrangements to maximise the benefits.
The Antidote to the above arrangement:
To counter the above arrangement where Multinational companies were making arrangements to claim higher interest tax benefit, Finance Act 2017 introduced the Section 94B - Thin Capitalisation. This section is in the lines with the BEPS Action Plan 4. The main aim to introduce this section is to limit the allowability of interest paid or payable to the Associated Enterprise.
Thin capitalisation puts restriction on interest expense deduction.
Applicability of Section 94B:
The provision is applicable to an Indian Company, or a permanent establishment of a foreign company, being the borrower, who pays interest in respect of any form of debt issued by a non-resident who is an Associated Enterprise of the borrower.
Carry forward of disallowed interest expenditure:
The interest which is disallowed under the section 94B is allowed to be carried forward for 8 assessment years immediately succeeding the assessment year for which the disallowance is first made.
The section is brought into picture only to target large interest payments. It provides a threshold of interest expenditure of Rs. 1 crore in respect of any debt issued by a non-resident associated enterprise. However, the said provision is not applicable to banks and insurance companies.
Modes of financing:
As we have already discussed the modes of financing in the Introduction paragraph, let us understand the same by an example;
Company X is an Indian Resident and is a subsidiary of Company Y located in the United Kingdom. It is in requirement of Rs. 500 crores. The modes of financing available are Equity and Debt but the company is in dilemma about the mode it should go.
In the case of a Debt financing, interest paid is an allowable expenditure and helps in savings of tax @ 30% on the interest expense claimed. Further, it is taxable at a very nominal rate under the tax laws.
In the case of Equity financing, the dividend is not allowable from the profits of the payer.
Limitation of Interest allowed:
Interest is not to be deducted while computing the income under the head Profits and Gains from Business or Profession to the extent that it arises from the excess interest.
Section 94B disallows the excess interest thereby limiting the deduction.
Excess interest can be calculated as follows:
- Calculate the total interest paid on debt.
- Calculate the 30% of EBIDTA of the borrower.
- The difference between the above two.
- Calculate the interest paid on debt borrowed from the Associated Enterprises.
- Excess interest is Lower of 3) and 4).
Approaches adopted to prevent thin capitalisation:
- Fixed Ratio: This approach restricts the level of interest expense or debt with reference to a fixed ratio of debt/equity, etc.
- Arm’s length basis: This approach compares the level of interest or debt in the company with that of the same with the third parties.
- Specified Percentage: This approach disallows a specified percentage of the interest expense.
- Anti-avoidance: This approach disallows interest on specific transactions only.
Expressions in this section:
- “Associated enterprise” shall have the meaning assigned to it in sub-section (1) and sub-section (2) of section 92A.
- "Debt" means any loan, financial instrument, finance lease, financial derivative, or any arrangement that gives rise to interest, discounts or other finance charges that are deductible in the computation of income chargeable under the head "Profits and gains of business or profession".
- "Permanent Establishment" includes a fixed place of business through which the business of the enterprise is wholly or partly carried on.
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