Tax axe on firms with foreign debt

Interest payments in excess of 30% of Ebitda to foreign associates will lose tax exemption

To address the issue of thin capitalisation, the Budget has increased the tax burden on Indian companies which have low equity but have taken high debt from foreign associates. 

The move will impact infrastructure, real estate, pharmaceuticals, information technology (IT) and IT-enabled services sector firms that had raised debt from a foreign parent or associate companies, even as equity capital remained low. 

“It is proposed to provide that the interest paid by an Indian company or permanent establishment of a foreign company, in excess of 30 per cent of earnings before interest, taxes, depreciation and amortisation (Ebitda), or interest paid to its associated enterprise, whichever is less, shall not be allowed as deduction in computing its taxable profit. It is also proposed to allow carry forward and set off of the interest so disallowed for eight assessment years,” Union Finance Minister Arun Jaitley said in his Budget speech.

Experts said Section 94 B in the Finance Bill is applicable to an Indian firm or MNC operating via permanent establishment in India, which has debt from a non-resident associated enterprise and pays interest or similar consideration of over Rs 1 crore to the associated enterprise.  

With this measure, several companies with high debt and low Ebitda could see their tax outgo increase, and their profitability under pressure. “For overleveraged, stressed borrowers of the banking system, this will hit their interest servicing capacity and, thus, is a negative for banks, too,” said an analyst with Ambit Capital. 

“By introducing the thin capitalisation rule in India, the Budget will worsen the problems of the high-debt companies, which have low Ebitda. The rule says if a company’s interest cost is in excess of its Ebitda, then the excess of over 30 per cent will not be tax deductible. As a result, several companies, with high debt and low Ebitda, that did not pay tax in the current financial year (because their profit before tax was negative), will now end up paying,” the analyst added.

Tax experts said foreign firms with subsidies and branches in India will get impacted and any form of debenture or foreign group company loans will come under the law. New companies setting up branches or subsidiaries will also need to factor in the thin capitalisation limitations while determining their funding structure.

Explaining the loophole, an expert said the Indian unit would pay high interest to the foreign associated firm, which was tax deductible. Besides, the interest paid by the local company to the foreign associate was taxable at a lower rate when the foreign company was registered in a tax treaty country. Many companies preferred the debt route as tax on equity investment was higher by way of dividend distribution tax. 

“Introduction of thin capitalisation rules is in line with international practice. While debt funding in India was always subject to limitations of the ECB (external commercial borrowings) framework, disallowance of interest beyond 30 per cent of Ebitda will require MNCs to rethink their funding plans for Indian subsidiaries,” said Hiten Kotak, partner and leader, M&A Tax, PwC India.

Other experts said this would fundamentally change the manner in which MNCs determine the funding structure for their Indian operations. “It may also require those foreign parents, which have largely used debt instruments to leverage their Indian operations, to revisit their existing funding structures,” said Ravi Mehta, partner, Grant Thornton India. 

Punit Shah, partner, Dhruva Advisors said: “This provision could have an adverse impact on capital intensive and highly leveraged companies. Also, it has retrospective impact as it will impact all current debt financing arrangements.” 

The eight-year window to carry forward the interest component will work only if there is very high profit growth, which gives cushion for claiming the unabsorbed interest component. “In any case, the net present value of the tax deduction will keep reducing because of the pushing of deduction to later years,” Deepa Dalal, partner, transaction tax, EY India.