Curb on debt funding - Limiting the deduction of Interest paid

February 02,2017
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Maulik Doshi (Partner, International Tax and Transfer Pricing, SKP Group)

Background

OECD BEPS Action Plan 4 dealt with “Limiting Base Erosion Involving Interest Deductions and Other Financial Payments”.

The primary objective of OECD BEPS Action Plan 4, was to design rules to prevent base erosion / profit extraction by the multinationals through the use of abusive financing structures which could be through

  • higher levels of debt in high tax countries;
  • intra-group loans to generate interest deductions in excess of the group’s actual third party interest expense;
  • third party or intra-group financing to fund the generation of tax exempt income.

Therefore, profits were being extracted by means of charging interest on such excessive debt financing which would be tax deductible.

Proposed changes

In view of the above and taking recommendation from OECD BEPS Action Plan 4, the Government in the Union Budget 2017 proposed to insert a new section 94B, to restrict interest expenses claimed by an Indian company on interest paid to its associated enterprises (AEs) to 30% of its earnings before interest, taxes, depreciation and amortization (EBITDA). The above provision would get triggered only in cases of interest expenditure exceeding INR 10 Million and would not apply to banking and insurance companies. The excess interest that is not tax deductible would be allowed to be carry forward and adjusted in subsequent years, upto a maximum of 8 years.

The restriction on interest cost is not confined to only loan provided by an non-resident associated enterprise/ related party but will be extended to loans from third parties wherein implicit/explicit guarantee is given by AEs or loans are indirectly funded by AEs.

Analysis and implications

Let’s understand the above by way of an example.

A large German MNC – G Co has set up a manufacturing facility in India in form of Indian Subsidiary I Co. G doesn’t wish to have substantial equity infusion in S and thus is looking at the following 3 options to fund the Indian operations:

  1. Provide a loan in form of External Commercial Borrowings;
  2. I Co borrows locally from the Indian branch of the Bankers of German parent based on SBLC / parent company guarantee from G;
  3. I Co borrows locally in India from Indian banking company without any guarantee of the parent company G.

In all the scenarios, S pays interest on the loan amounting to INR 50 million and the EBIDTA of S is INR 100 million for that relevant year.

The implications of the proposed changes on the above scenarios would be as follows:

In scenario 1, the interest deduction would be restricted to 30% of EBIDTA i.e. only INR 30 Million and the balance interest of INR 20 million would be allowed to be carried forward for adjustment in subsequent years.

In scenario 2, even though the interest payment is to non-related party yet the interest deduction would be restricted since the loan from Indian branch of German Bank is based on guarantee from parent company G.

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