Multinational entities (MNEs) often borrow funds both externally and internally. This could be in the form of external loans or leveraging internally on the funds available within the group to increase their investments and meet their business requirements. MNEs are generally seen at an advantage vis-à-vis local businesses, due to their access to global debt and equity markets, with varying interest rates and borrowing terms.
Debt and equity are two primary sources of finance for any company. A mix of debt and equity in the capital structure of any commercial organisation is dependent on various factors such as capital intensity of the industry they operate in, risk appetite, ability to raise funds through debt, and legal, commercial and tax considerations. In general, an entity financed through comparatively higher amount of debt as compared to equity is regarded as a thinly capitalised entity.
While the compensation for debt and equity is interest and dividend respectively, their tax implications are quite different. Dividends are not deductible as an expense for the taxpayers and are generally taxable in the hands of the recipient. On the other hand, in case of debt, interest payments are generally tax-deductible for the taxpayer and taxable in the hands of the recipient. In case a company has high debt, an issue may arise whether the capital structures are devised in a manner that could result in potential claim of higher deduction of interest payment on debts from taxable income.
Simply put, in a situation where a business is financed through relatively higher level of debt as compared to equity contribution from its owners, the taxpayer can claim excessive deduction of interest payment owing to such high debt. Such arrangements may be questioned during revenue audits and taxpayer could be required to substantiate the debt-equity combination, which otherwise may be treated as tax base erosion.
The Organisation for Economic Co-operation and Development (OECD) has expressed that multinationals may have certain thinly capitalised entities achieving favourable tax results, which is now a global concern. To counter this issue, called base erosion and profit shifting (BEPS), an initiative of the OECD and the G20 nations adopted the Action 4 Report titled ‘Limiting Base Erosion Involving Interest Deductions and Other Financial Payments’.
The Action 4 Report specifically addresses the BEPS risk arising from three different types of situations wherein MNE Groups:
i)place higher levels of third-party debt in high-tax countries,
ii) generate interest deductions in excess of the group’s actual third-party interest expense by using intra-group loans, and
iii) use third party or intra-group financing to fund the generation of tax-exempt income.
Accordingly, the OECD recommended that tax jurisdictions should implement a mechanical rule to limit interest deductions, which may have been undertaken as an instrument for excessive tax deductions. Three broad practices have been suggested to tackle the issue of thin capitalisation.
First, the fixed ratio rule, which limits the interest costs benchmarked as a percentage of earnings before interest, taxes, depreciation, and amortisation (Ebitda). This restricts an entity’s net interest deductions to a fixed percentage (say, between 10 to 30%) of its Ebitda calculated using tax principles.
Second, the group ratio rule, which allows an entity to deduct interest expense limited to the ratio of interest/Ebitda of its worldwide group.
Third, the targeted rules, to address specific risks not addressed by the fixed and group ratio rules.
Implementation of BEPS Action 4 Report in Indian legislation
The Government of India, through Finance Act, 2017, introduced anti-abuse provisions in the Indian tax laws that provides for limitation on interest deduction in certain cases, which is broadly in line with the recommendations as per BEPS Action 4 Report.
It is applicable to an Indian company, or a permanent establishment (PE) of a foreign company, which pays interest or incurs an expenditure of a similar nature, for payment to a non-resident associated enterprise in excess of `1 crore (approximately $0.13 million). It is also applicable where debts are issued by third-party lenders for which an associated enterprise provides an implicit or explicit guarantee or the associated enterprise deposits a corresponding and matching amount of funds with the lender. An exception from the applicability of provisions has been carved out for Indian companies or permanent establishments of a foreign company engaged in the business of banking or insurance.
The provisions limit the deductibility of the payment of interest by an entity to its non-resident associated enterprise to 30% of Ebitda. Interest amounts exceeding such threshold are allowed to be carried forward for a period of eight succeeding years, subject to maximum allowable interest expenditure of 30% of Ebitda for each such period.
Many countries have implemented interest limitations rules in various forms, including a) arm’s length rule, by establishing the arm’s length debt amount that an independent party is willing to lend and further the arm’s length interest rate that an independent party is willing to charge; b) general rules, which disallow certain percentage of interest expense or limit the level of interest expense or debt with reference to a fixed ratio like interest to earnings or debt to equity at an entity level or at a group level; and c) targeted rules, to address specific planning risks and limit interest deduction on specific transaction.
Different tax jurisdictions have implemented interest limitation rules by applying various parameters, which are aligned with their objective of implementing such rules. Brazil, Canada, China, Indonesia, Mexico, Russia, and Switzerland have prescribed threshold ratios of debt to equity, which ranges from 1.5:1 to 4:1. On the other hand, India, Germany, Luxembourg, Malaysia, the Netherlands, US and UK have prescribed an upper cap for interest expense deduction in the form of interest to Ebitda ratio, which ranges from 10% to 50%. France, Korea, and Japan have adopted a hybrid approach by implementing both parameters to test thresholds using debt to equity and interest to Ebitda approach.
In a growing number of countries, tax administrations deem it necessary to include such thin capitalisation rules in their tax legislations, to limit interest deductions to regulate the alleged profit shifting by MNEs. Subject to commercial considerations, this would necessitate MNEs to consider the deductibility of interest expense while obtaining an interest-bearing debt. The inclusion of third-party borrowings guaranteed by the non-resident associated enterprise under the ambit of thin capitalisation could have serious repercussions on the fundraising efforts of taxpayers, especially those operating in capital-intensive sectors or sectors having longer gestation periods. Further, it could impact certain start-ups who generally face a loss situation in their initial years and usually need support in the form of guarantees from their related parties to leverage their third-party borrowings, which could be deemed as related-party debt under these provisions.
The challenges faced by taxpayers under the thin capitalisation rules have further aggravated on account of the hardships faced during the covid-19 pandemic. Some entities would have incurred huge losses due to varied reasons. To ensure the survival of such entities and ensuring sufficient working capital requirements, MNE groups may extend support by lending funds. Such increased debts combined with losses (or insignificant profits) may adversely impact the interest deductibility for several taxpayers.
MNEs may navigate the complexities of interest deductibility by determining an optimal capital structure, especially during the initial or low profit phases of their operations, or exceptional circumstances faced during the pandemic.
This article was originally published in Mint.