Infrastructure & Economic Growth: Thin Capitalization Norms Need To Be Aligned
The present form of the thin capitalization rules could hamper the debt availability and may even increase the cost thereof for certain players, which will be counterproductive considering India’s growth plans.
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The Road Transport and Highways Minister’s recent reiteration of his priorities in terms of resolving stalled projects and increasing the targeted pace of coverage has underscored government’s intent to develop the country’s infrastructure. In addition, there was discussion around the innovative funding for the infrastructure projects and policies centered on job creation in the MSME segment.
At the same time, the government has realised that public private partnership, more specifically, the participation by private players, is a prerequisite for success in any infrastructure project. And to increase participation by private players, Government has been easing norms of doing business in India including introducing measures that could help in improving availability of funds including debt at reasonable rates. While every business tries to aim for a healthy debt-to-equity leverage, debt is also preferred when compared to equity given the associated costs. Revisiting the thin capitalization provisions as spelt out in Section 94B of the Indian tax laws could be a step in this direction in that context.
Thin capitalization, an arrangement in which the capital structure of an entity is skewed in favour of debt, to avail tax deduction on interest payouts, has been viewed as a device to shift profits and reduce the tax burden. To curb the tax avoidance menace, several countries including India introduced provisions relating to thin capitalization. Effective from FY 2017-18, Section 94B aims at limiting deduction of interest or similar consideration paid, exceeding Rs. 1 crore by an Indian company or a permanent establishment (PE) of a foreign company in India, in respect of funds borrowed from a non-resident Associated Enterprise (AE). The said provision also applies where funds are borrowed from third-party lenders but guaranteed by the AE or where AE has deposited a matching amount of funds with the lender.
The rigours of this provision do not apply to Banking and Insurance companies. However, this exemption has not been extended to the Non-Banking Financial Companies (NBFC) in spite of them being an important part of the financing value chain. Considered as shadow banks, debt is a raw material for the NBFCs also and to support them, they too should be excluded from the purview of Section 94B.
Infrastructure projects typically have long gestation periods during which time cash flows are adversely impacted. With finance cost being one of the major costs, disallowing interest under Section 94B increases the burden. Also, some projects, with even longer gestation periods, may lose the tax deduction benefit in entirety for the initial years. Hence, the Government should consider exempting the infrastructure projects from the provisions of Section 94B. Alternatively, enhancing the deduction threshold from the present 30 percent of EBITDA or increasing the time period for carrying forward the unclaimed finance cost from the current 8 years could be looked at.
Apart from industry-specific challenges, the provisions of Section 94B have certain nuances which need to be addressed in the upcoming Union Budget in order to give the legislation its intended effect. For instance, the present language of the section seems to suggest that the interest payment made to an Indian resident lender by an Indian borrower (guaranteed by non-resident AE) could be covered by Section 94B. Since there is no possibility of profit shifting in this case, unless one of the units is loss-making disallowance of interest would clearly be against the legislature’s intent and the same needs to be corrected. A plea against this has also been taken by one of the Multinationals in a writ petition before the Madras High Court.
Another point which needs to be addressed is the ambiguity around the terms like ‘EBITDA’ and ‘interest or of similar nature’ which are not defined and may result in different interpretations and ultimately litigation. Further, the provision should exclude the reference to implicit guarantee considering the possibility of a mere association with a multinational group company being viewed as implicit support. Also, as it is not possible to prove the existence or otherwise of an implicit guarantee, use of this term will only increase unwarranted litigation.
The present form of the thin capitalization rules could hamper the debt availability and may even increase the cost thereof for certain players, which will be counterproductive considering India’s growth plans. We hope that the Finance Minister, while presenting her first budget on 5 July, balances out the expectations of the industry and the need to increase tax revenues.
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