THIN CAPITALIZATION IN INDIA

THIN CAPITALIZATION IN INDIA

1.0         INTRODUCITON

A company is said to be thinly capitalized when a greater proportion of its ‘capital-structure’ is made up of ‘debt’ than of ‘equity’. The interest payments generated on ‘debt capital’ is treated as a finance charge, and is allowable as a deduction in the taxable corporate income, thereby reducing the corporate tax burden. On the contrary, the dividend distribution tax is payable by enterprises on their after-tax profits, and if there is no profit dividend is not payable.

Hence, higher proportion of debt results in tax avoidance. To prevent such abuse, separate rules had been introduced in many countries. These rules are known as ‘thin capitalization rules’.

2.0         THIN CAPITALIZATION IN WORLD

Tax-authorities in several countries treat ‘debts’ accepted beyond certain limits from controlling shareholders as ‘veiled-capital’ and term it as ‘thin capital’(also known as ‘hidden capital’) to distinguish it from normal loans. Interest paid on that part of the debt which is rechristened as ‘thin capital’ will be treated as ‘dividend’. Dividend, being expenditure disallowed, will be added back to the total income of the company and assessed to tax. This way, the tax avoided is restored by restructuring ‘debt’ into ‘thin cap’ and ‘debt’. This sort of capital-structure is recognized only for the purpose of Tax Legislation.

Many countries like Australia, Germany, France, Japan, China and USA have incorporated specific Thin Capitalization rules in their jurisdiction to deter erosion of the tax base through excessive interest payments.

But, since the concept stands in the way of free flow of investment, many other countries have not yet recognized it. India is one among them. Indian Tax Legislation does not have separate rules for ‘thin capital’-neither does it directly recognize the concept.

3.0       POSITION IN INDIA

It is pertinent to note that ‘foreign investors’ can take advantage of the same and invest in India. The deduction of tax at source on interest payment to foreign company is 5% under Section 194LC of the Income Tax Act, 1961 (“the Act”) otherwise at the “rates in force” under Section 195(1) of the Act while in Double Taxation Avoidance Agreement (“DTAA”), the withholding tax rate lies in the range of 10%-20% with the treaty countries.

On top of it, the dividend paid by an Indian Company are subject to Dividend Distribution Tax (“DDT”) under Section 115-O of the Act at an effective rate of 16.995%.  In this regard, it is worthwhile to refer to the second proviso to Section 195(1) of the Act. The relevant extract has been reproduced below:

“Provided further that no such deduction shall be made in respect of any dividends referred to in Section 115-O”

Further, reference may be had to Section 10(34) of the Act. The relevant extract has been reproduced below:

“In computing the total income of a previous year of any person, any income falling within any of the following clauses shall not be included—

(1).....

(2)....

(34) any income by way of dividends referred to in section 115-O;”

           

From the perusal of the above, it can be seen that the aforesaid remittance of dividend is not taxable after paying tax on distributed profits at an effective rate of 16.995% in terms of Section 115-O of the Act. To avoid double taxation (Corporate tax and DDT) of the Corporate Income, the Foreign Company can claim credit on the tax paid in India with reference to Underlying Tax Credit method while the credit would be available for DDT or not is not free from doubt.

Chapter X of the Income Tax Act, 1961 provides special provisions relating to Avoidance of Tax. But it does not recognize ‘thin cap’. Also the Act is silent on taxing deemed dividend in the place of interest paid to ‘thin capital’, even though it defines certain other dividends, under section 2(22), which are deemed as dividend. In other words the Act defines deemed dividend, but does not include interest on ‘thin cap’.

In this regard, reference can be made to Bombay High Court decision in the case of  Director of Income-tax, International Taxation-II, Mumbai v. Besix Kier Dabhol SA [ITA No. 776 of 2011] wherein the facts are as follows:

“Assessee, a non-resident company had borrowed money from its shareholders in same ratio as equity shareholding resulting in abnormal debt-equity ratio of 248:1. Revenue's contended that debt was to be re-characterised as equity and interest payment thereon disallowed. The High Court ruled in favour of assessee and held that since there are no thin capitalization rules in force, interest payment on debt capital to shareholders could not be disallowed”

4.0       Foreign Exchange Management Act, 1999 (FEMA) and Regulations

It would be pertinent to note that the RBI Master Circular No. 12/2013-14 on External Commercial Borrowings (ECB) and Trade Credits stipulates a debt equity ratio of 4 : 1 for borrowings by Indian Entity from ‘‘Recognized Lenders’’ in excess of US $ 5 Million from ‘‘Foreign Equity Holders’’. The Foreign Equity Holders should hold a minimum of 25% of the paid-up equity of the eligible borrower. Further the regulations clarify ‘‘i.e. borrowing the proposed ECB not exceeding four times the direct foreign equity holding’’. This adds a new dimension to the basic question of Debt Equity ratio. This circular will stand withdrawn on July 1, 2014 and be replaced by an updated Master Circular on the subject.

5.0       DIRECT TAX CODE, 2010

Of late, the Government of India is seriously considering steps to prevent ‘all arrangements’ to avoid tax. The change proposed in General Anti Avoidance Rules (GAAR) is a step in that direction. The Direct Taxes Code (DTC) intends to widen the scope of the said GAAR so as to include in its purview all arrangements which aim to avoid tax without violating the express provisions of the Code. ‘Thin Capitalization’ is considered as one such arrangement to avoid tax and hence may come under the purview of GAAR. It is in this context that the awareness of the concept gains importance.

The possible consequences for an impermissible avoidance arrangement can be that the arrangement could be disregarded in part or in full or, combined or re‑characterized in part or in whole. One of the types of re-characterization contemplated under Clause 123(1)(f) of DTC is re-characterization of debt as equity, and vice versa. Interestingly, for the purposes of anti-abuse provisions, interest has been defined to include dividends.

6.0         GENERAL ANTI – AVOIDANCE RULES (GAAR)

The GAAR provisions will come into effect only if the assessee enters into an impermissible avoidance arrangement as defined in Section 96(1) of the Act.

On 17^th July 2012, the Prime Minister had constituted an Expert Committee under the chairmanship of Dr Parthasarathi Shome to engage in extensive consultation process and finalize the GAAR guidelines.

On 30^th September 2012, the Expert Committee submitted its Final Report on GAAR provisions. It provides guidance on Thin Capitalization through key illustration as follows; an Indian Company raising funds from a foreign company incorporated in a low tax jurisdiction outside India through borrowings, when it could have issued equity is not covered by GAAR. In such case, there is no specific provision dealing with thin-capitalization in the Act. An evaluation of whether a business should have raised funds through equity instead of debt should generally be left to commercial judgment of a taxpayer. The onus will be on the Revenue to identify the scheme and its dominant purpose.

However, GAAR would apply to a case where the interest rate is linked to actual profits and it appears that an actual equity investment is disguised as debt to obtain a tax benefit.

Similarly, GAAR would apply to a case where a loan is assigned to a resident of a country which has favourable treaty with the view of avoiding withholding tax in India on interest.

After due consideration of the Final Report of the Expert Committee headed by Dr. Parthasarathi Shome and the Recommendations made therein, the Government of India has made GAAR applicable from the FY 2015-16 and the monetary threshold of Rs. 3 crores of tax benefit in the arrangement has been accepted for invoking GAAR. GAAR not to apply retrospectively and hence to apply only to income arising to the taxpayer on or after GAAR provisions come into force. It is to be noted that the statement made by the Finance Minister does not contain any recommendation on funding through debt or equity.

7.0         BENCHMARKING OF TRANSACTION

As per Finance Minister’s speech in 2013, the assessee shall have an opportunity to prove that the arrangement is not an impermissible avoidance arrangement. A connected person, who had invested in the “debt capital” of the taxpaying company, may enable the company to take shelter under ‘ALP-safe harbor’ if and when he does the following:

(i)       Ascertain how much the company would have been able to borrow from an independent lender; and

(ii)     Compare this with the amounts actually borrowed from group companies or with the backing of group companies.

(iii)   Consider whether the rate of interest is one which would have been obtained at arm’s length rate while comparing from an independent lender as a standalone entity.

A comparison can then be made between the interest payable on the actual debt and that which would be payable on the amount which could have been borrowed at arm’s length. Sometimes the difference may be nil; in which case it can be established that the debt falls under ‘ALP shelter’.

8.0       BASE EROSION AND PROFIT SHIFTING (BEPS)

The term "base erosion and profit shifting" means, tax planning strategies that exploit gaps and mismatches in tax rules to make profits 'disappear' for tax purposes or to shift profits to locations where there is little or no real activity but the taxes are low resulting in little or no overall corporate tax being paid. India being a non-OECD member is a member of BEPS as it is a member of G-20 countries.

The Action plan 2 of BEPS is “Neutralise the effects of hybrid mismatch arrangements” which develops model treaty provisions and recommendations regarding the design of domestic rules to neutralise the effect (e.g. double non-taxation, double deduction, long-term deferral) of hybrid instruments and entities. This work will be co-ordinated with the work on interest expense deduction limitations, the work on Controlled Foreign Company (CFC) rules, and the work on treaty shopping.

On 19^th March, 2014 the OECD publishes the Discussion Draft on Action Plan 2. The timeline for completion of the Action plan is expected to be September 2014, although it may take longer for the impact of these changes to be fully applied in practice.

9.0       WAY FORWARD

The coverage of “connected person” in GAAR definition is wide as defined in Section 102 of the Act which may potentially even include strategic investors and lenders who otherwise may not have had an intention of becoming an affiliated entity. While the anti-avoidance and thin capitalization principle introduced in the Direct Taxes Code and GAAR report is a welcome step, the Government needs to simultaneously take the next step and provide the required guidance upfront to multinational enterprises as to how the capital structures (debt-equity) should be formed or maintained and the principles to be adopted while evaluating them for arm’s length, commercial substance and bona fide nature. Announcing a Safe Harbor on debt-equity ratios for different types of industries in different stages of project cycle could be one of the options that the Revenue authorities could consider to alleviate the concerns of various commercial concerns. If no specific rules or safe harbors are announced, it would leave the capital structure and debt-equity ratio of multinational enterprises to be benchmarked against prevailing industry practices and norms, though traditional methodologies for arm’s length benchmarking would be found inadequate for this purpose. We have seen the confusion created by the RBI Master circular while stipulating the debt-equity ratio with respect to ECB from foreign equity holders.

           

Moreover, if the arrangement is for more than Rs. 3 Crores, then only it will fall under the ambit of GAAR provisions and there is no separate indication when to re-characterize equity into debt. The GAAR also gives room to double taxation as applying arm’s length concept for determining the correct debt equity ratio in India while trying to qualify within the statutory debt equity ratio in the other country, would be a very delicate matter.

So, still there is no clarity in application of Thin Capitalization in India and foreign companies can invest in India keeping in mind the application of GAAR provisions from the FY 2015-16 onwards. The effect of thin capitalization must be closely studied by each corporate, since it may have consequences for the business structures currently employed by companies.

Author :

Kushal Agarwala

B.Com, CA (Final) and CS (Final)

agarwalakushal25@gmail.com

ICAI expresses its concern on the proposed definition of “Accountant” in DTC, 2013 - (17-04-2014)

Announcement by ICAI in relation to proposed change in definition to the term 'Accountant' in proposed DTC

As the members are aware, the Direct Taxes Code, 2013 has proposed to widen the scope of the definition “Accountant” to include other professionals as well. It is a fact that various provisions in the Income-tax Act, 1961 under which chartered accountants have been given the responsibilities to undertake audit and certification of accounts of various entities have the emphasis on “audit” of the relevant accounts which is the exclusive domain of Chartered Accountants.

The Council of ICAI is aware that the proposed change is a cause of major concern to the entire profession. In this regard, ICAI has through a representation to Ministry of Finance, placed on record its concern not only for the profession, but for the country as a whole since issuance of audit certificates by persons having limited knowledge of audit of accounts will not only be professionally incorrect and but will raise many concerns including causing huge revenue leakages.

A meeting in this regard was held with Mr. Rajiv Takru, Revenue Secretary and Mr. R.K.Tewari, Chairman, CBDT on 16.4.2014, wherein CA. K. Raghu, President, ICAI and CA. Manoj Fadnis, Vice President, ICAI emphasized on the fact that there is a very significant difference in the area of expertise of other professionals vis-a-vis Chartered Accountants.

Members be assured that the Council of ICAI is equally concerned and will not leave any stone unturned to save the profession and the nation.

Secretary, Direct Taxes Committee

Wealth Tax Basic you should know

We also bring to you latest news from Tax in India. Below is the article published in one of the News Tabloid in India.

Wealth tax is a direct tax levied on individuals, HUFs and companies annually. It is charged at the rate of 1% of net wealth (the value of specified assets on the valuation date in excess of the value of the debt that the taxpayer owes on the said assets) of a person if it exceeds Rs 30 lakh. Wealth tax is applicable on an asset held by a taxpayer as on March 31. Hence, the assets sold during the year are not subject to wealth tax.

This tax is levied on the non-productive assets of a taxpayer. The intent of this law is to tax assets that do not generate any income. Broadly, house property, motor cars, jewellery, cash in hand subject to limits, urban land, yachts, boats and aircraft qualify as assets that are liable to wealth tax in India. The said assets, when used for commercial purposes, are excluded from the ambit of wealth tax. The tax is also not imposed on residential properties rented for at least 300 days in a year.

Chargeability to wealth tax depends on the nationality and the residential status (as defined under the Income-Tax Act, 1961) of a taxpayer. While Indian nationals qualifying as ‘resident and ordinarily resident’ are liable to pay wealth tax on their global net wealth, a ‘non-resident’ or ‘resident but not-ordinarily resident’ is liable to pay this tax only on assets located in India. In contrast, foreign nationals, irrespective of their residential status, are liable to wealth tax only on Indian assets.
The value of taxable assets for the purpose of wealth tax would be the value as on the valuation date (i.e., March 31 of a financial year). Further, such value of assets (except cash) would have to be determined in accordance with the valuation norms prescribed under the Wealth Tax Act, 1957.

The due date for filing the wealth tax return is the same as the due date for filing the I-T return. For individuals and HUFs, the due date is July 31 following the financial year for which this return is to be filed and, for companies, it is September 30 or November 30 (as the case may be). The return has to be filed manually in the prescribed form (Form BA).

The provisions of regular assessment that apply to income tax also apply to wealth tax. Simple interest at the rate of 1% per month is applicable for failure to pay wealth tax and/or furnishing the return on or before the due date.

There are penalty provisions in case of non-payment of taxes, concealment of wealth and failure to produce evidence in support of return, when required by the wealth tax authorities.
Practically, while the provisions under I-T laws are strictly enforced by the revenue authorities and penal proceedings are initiated for non-compliance, the same is not true of wealth tax enforcement. Wealth tax enforcement has not gained much importance by the revenue authorities. Consequently, its compliance has not got the desired attention of taxpayers.

Considering rising inflation, the Direct Taxes Code (DTC) proposes to increase the threshold limit for levy of wealth tax from Rs30 lakh to Rs 50 crore. Further, wealth tax rate is proposed to be slashed from 1% to 0.25%.

Though the DTC proposes to increase the ceiling limit for wealth tax, it also proposes to expand the ambit of wealth tax. The assets proposed to be covered would include both physical and financial assets and not limited to the current category of assets. While we all remain vigilant about our income tax liability, it is imperative that the same diligence is adopted for wealth tax compliance.
Divya Baweja
The writer is senior director, Deloitte in India. With inputs from Shailly Jain, manager, and Ajay Arora, assistant manager, Deloitte Haskins & Sells
The above article was published in The Hindu

DTC woes continues

We also bring to you latest news from Tax in India. Below is the article published in one of the News Tabloid in India.

The Direct Taxes Code (DTC) is, by now, a well-known concept to India Inc and the tax professional fraternity as it has been a matter of discussion and debate for almost six years now. The finance ministry released the revised draft—the Direct Taxes Code, 2013—for public discussion and comments in the first week of this month. DTC 2013, set to replace the half-a-century-old Income-Tax Act, has been in the news since 2009; but the latest draft came weeks before the ongoing general election, raising the prospect of the document being junked when a new finance minister takes charge next month.

In the revised draft, focus is on raising more revenue from high-net-worth residents, while leaving the slab rates unchanged for others. DTC 2013 proposes an additional levy of 10% tax on the recipient of dividend if the dividend income exceeds Rs 1 crore. Such dividend would fall under the income category of ‘special source’ and no deduction of expenditure would be allowed to be set-off against such income. This means, while non-residents are proposed to be kept out of this net so as not to further dampen the FDI environment, residents are covered.

At present, any domestic company after paying 30% corporate tax on its business profits is required to pay 15% dividend distribution tax (DDT) if it wants to distribute dividends to its shareholders. Further, once DDT is paid by the domestic company, such dividend remains tax exempt in the hands of the shareholders. However, the proposed additional tax will be paid by the resident shareholders and will be over and above the 15% paid by the distributing company. Here, if the recipient of such dividend is a company, then whether 10% rate would apply or would it be subject to MAT at the rate of 20% is also not clarified in DTC 2013.

At present, the credit of DDT is not available to the shareholder except in a case wherein the company receiving dividend from its subsidiary (in which it holds more than 50% equity shares) declares dividend to its ultimate shareholders. Here, it is to be kept in mind that DDT was introduced as a measure for easier collection of tax. So, it is clear that DDT at the rate of 15% is nothing but the taxes paid by the company for its shareholders. Thus, rather than over-taxing a select set of investors with such additional tax and discouraging them from investing, the idea should be to expand the tax base by bringing the tax evaders in the tax net and collect more revenues.

The income tax department, justifying the levy of additional tax, has stated in a note released with the draft DTC 2013 that “under the Income-Tax Act as well as in the DTC Bill, 2010, the DDT is to be levied at the rate of 15%. This favours high-net-worth taxpayers who pay only a fraction of their earnings as tax on their investments in the capital market.”

Exempting long-term capital gains arising from the sale of listed securities and dividend in the hands of the shareholders was clearly a boost to the Indian stock market. The idea behind such exemption is to create an investor-friendly environment in the market where investors invest the excess funds for the long-term, giving a much-required impetus to the markets. The current proposal of an additional 10% tax may lead to an aggravation of negative sentiments as the investors would view this tax as a penalty for investing excess funds in companies. This means that capital-deprived companies will resort to raising funds by way of debt, which will increase their finance costs and lead to lower profitability and, thereby, lower tax collections for the government.

Keeping in mind the capital-starved state of our country and the negative investment sentiment prevalent among the foreign investors due to the GAAR provisions and ambiguity around taxability on indirect transfer of assets, the government should avoid introducing provisions that will make the resident investors also turn their back towards making investments, while the need of the hour is to create a sound capital base.

Hiren Bhatt, director, KPMG in India, contributed to this article
The author is co-head of tax, KPMG in India. Views are personal
The above article was published in The Hindu

DTC may undergo a makeover under new govt

We also bring to you latest news from Tax in India. Below is the article published in one of the News Tabloid in India.

 Finance Minister P Chidambaram showed his commitment to the Direct Taxes Code (DTC) by releasing a revised draft of the Bill ahead of the elections, but its fate is in limbo as a non-UPA government might review it afresh or make significant changes to the current draft.

Experts said technically, Chidambaram has completed most of the major steps towards replacing the archaic Income Tax Act of 1961 and if the new government is on the same page, it would, at most, be required to refer the Bill to a select committee after tabling it in Parliament. However, the possibility of a new government junking this version of DTC or incorporating a Parliament standing committee recommendations on exemptions is not ruled out. “The timing (of inviting comments on the draft) is entirely misplaced. What do they hope to achieve? My advice to the bureaucracy is to wait for political guidance,” said senior Bharatiya Janata Party (BJP) leader Yashwant Sinha. The Standing Committee on Finance Chairman, however, added the BJP was in favour of a new direct tax law, as the current legislation had become complex after amendments over the years.

Some finance ministry officials and tax experts, however, said DTC in its current form does not serve any purpose as most of the things it proposed initially, such as General Anti-Avoidance Rules, Advance Pricing Agreements, have been incorporated in the Income Tax Act over the last couple of years.

“No policy is cast in stone. The future of DTC will depend on new economic realities and polices of the next government,” said a finance ministry official, adding the law could be simplified by amending the I-T Act.

Inviting comments on the revised draft of the DTC Bill on Tuesday, the finance ministry had proposed a 35 per cent tax on those earning more than Rs 10 crore, while turning down a Parliamentary Standing Committee recommendation on widening of tax slabs.

While it said widening the slabs was not possible as it would lead to a revenue loss of Rs 60,000 crore, Sinha said deciding the exemption limit should be the prerogative of the next government.

Another major proposal in the revised draft was to make a company liable to tax in cases of indirect transfers like Vodafone, if 20 per cent of its global assets are in India.

“Simplicity is certainly not one of the major features of any of the versions of DTC. The next government at the Centre should be allowed a say in the re-packaging of DTC as the extant DTC Bill lapsed at the end of last session of Parliament,” said Sunil Jain, Partner, J Sagar Associates.

He said the next government should decide the design and construct of a new I-T law and provide more clarity on how indirect transfers would be taxed in India.

Even if the new government accepts the current version and gets it cleared in Parliament in 2014-15, the earliest the legislation can be introduced is April 2016, as one year is needed for framing the rules.