What is Thin Capitalization

   Thin Capitalization Taxation

Limitation Of Interest Deduction in certain cases U/S 94B of income Tax Act 1961 (OECD BEPS Action Plan 4)

For the purposes of this section let first understand the

expressions—

(i ) “Associated Enterprise" shall have the meaning assigned to it in sub-section (1) and sub-section (2) of section 92A;

      ---92A (1) "asso­ciated enterprise", in relation to another enterprise, means an enterprise—

      (a) which participates, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise; or

      (b) In respect of which one or more persons who partici­pate, directly or indirectly, or through one or more intermedi­aries, in its management or control or capital, are the same persons who participate, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise.

     ---92A (2) For the purposes of subsection (1), two enterprises shall be deemed to be associated enterprises if, at any time during the previous year,

(a) one enterprise holds, directly or indirectly, shares carrying not less    than 26% of the voting power in the other enterprise; or

(b) any person or enterprise holds, directly or indirectly, shares carrying not less than 26% of the voting power in each of such enterprises; or

(c) a loan advanced by one enterprise to the other enter­prise constitutes not less than 50% of the book value of the total assets of the other enterprise; or

(d) one enterprise guarantees not less than 10% of the total borrowings of the other enterprise; or

(e) more than half of the board of directors or members of the governing board, or one or more executive directors or execu­tive members of the governing board of one enterprise, are ap­pointed by the other enterprise; or

 (f) more than half of the directors or members of the governing board, or one or more of the executive directors or members of the governing board, of each of the two enterprises are appointed by the same person or persons; or

(g) the manufacture or processing of goods or articles or business carried out by one enterprise is wholly dependent on the use of know-how, patents, copyrights, trade-marks, licenses, franchises or any other business or commercial rights of similar nature, or any data, documentation, drawing or specification relating to any patent, invention, model, design, secret formula or process, of which the other enterprise is the owner or in respect of which the other enterprise has exclusive rights; or

(h) 90% or more of the raw materials and con­sumables required for the manufacture or processing of goods or articles carried out by one enterprise, are supplied by the other enterprise, or by persons specified by the other enterprise, and the prices and other conditions relating to the supply is influ­enced by such other enterprise; or

(i)  the goods or articles manufactured or processed by one enterprise, are sold to the other enterprise or to persons speci­fied by the other enterprise, and the prices and other conditions relating thereto are influenced by such other enterprise; or       

(j) where one enterprise is controlled by an individual, the other enterprise is also controlled by such individual or his relative or jointly by such individual and relative of such individual; or

(k)  where one enterprise is controlled by a Hindu undivided family, the other enterprise is controlled by a member of such Hindu undivided family or by a relative of a member of such Hindu undivided family or jointly by such member and his rela­tive; or

(l )  where one enterprise is a firm, association of persons or body of individuals, the other enterprise holds not less than 10% interest in such a firm, an association of persons or body of individuals; or

(m) there exists between the two enterprises, any relation­ship of mutual interest, as may be prescribed

(ii) “Debt" means any loan, a 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";

(iii) “Permanent Establishment" includes a fixed place of business through which the business of the enterprise is wholly or partly carried on.

  👉Thin Capitalization

1. Debt financing of the cross-border transaction is often favorable than equity financing for the taxpayer.
2.  How the company is capitalized has a major impact on the amount of taxable profit.
3.  Deduction in respect of Interest is allowed while arriving taxable profit. However, the dividend paid on equity is not deductible.

Due to this reason, debt financing is considered a more tax-efficient method. So the  Multinational groups are often able to structure their financing arrangements to maximize tax benefits.

Hence given above the recommendations of OECD BEPS Action plan 4, section 94B has been inserted in the Income Tax Act 1961. Therefore to provide a cap on the interest expense that can be claimed by an entity to its Associated Enterprise.

👉Limitation of Interest Deduction in Certain cases [section 94B]

1. Excess Interest shall mean an amount of,

              (I) Total Interest – 30% of EBITDA

              (II) Interest paid to Associated Enterprise

              Whichever is Lower

The provision applies to

         - Indian Company, or

         - a permanent Establishment of Foreign Company in India

                                   and

where expenditure by way of interest or of similar nature exceeds Rs. One Crore, in respect of any form of debt, issued by non-resident being an Associated Enterprise of such borrower.

If you enjoyed this post, I’d be very grateful if you’d help it spread by emailing it to a friend, or sharing it on Twitter or Facebook. Ask your queries at askankita474@gmail.com Thank you!