Section 94B- whether in violation of treaty provision on non-discrimination?

April 10,2018
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Rahul K Mitra (Chartered Accountant)

The Finance Act, 2017 had interalia legislated a provision for limitation on interest deductions through section 94B of the I T Act, in line with the recommendations of Action 4 of OECD/ G-20 BEPS Project. The provision aims to restrict interest deductions in the hands of Indian companies or permanent establishments of foreign companies in India, on borrowings obtained from their non-resident associated enterprises (AEs); or even from third parties, which are backed by – (a) either implicit or explicit guarantees; or (b) deposit of matching funds, provided by such AEs, to 30% of cash profits of the payer, namely earnings before interest, taxes, depreciation and amortization. The section carves out exceptions for companies engaged in banking and insurance businesses; and also provides for the carry forward of shortfall in the deduction of interest, if any, for a period of eight fiscal years.

There have been discussions at several quarters on whether the introduction of the aforesaid provisions in the domestic tax laws of India runs counter to the non-discrimination clause contained in international tax treaties signed by India with various countries. An attempt is made in this article to analyse the said debate.

Before proceeding with the analysis, it is important to appreciate that the aforesaid provision is not one of thin capitalization, which ideally aims at reclassifying a certain quantity of debt into equity, if found to be not adhering to an arm’s length debt-equity ratio, either through the application of mandatory safe harbour rules introduced by a country with reference to such debt-equity ratio; or normal manner of benchmarking, having regard to the industry norms prevalent in the country of the borrower; and also the credit worthiness of the borrower. Such thin capitalization rules would determine the amount of arm’s length debt in advance; and thereafter, post the application of arm’s length rate of interest thereon, the resultant interest would be tax deductible in the hands of the borrower, without having the necessity to pay heed to the level of profits, which the borrower would have otherwise earned.

On the other hand, the provisions of section 94B aim to restrict deduction with respect to interest payments even with respect to arm’s length amount of debt and rate of interest, in case of inadequacy of profits in the hands of the borrower, as discussed above, thus making it amply clear of not being one of thin capitalization, in the true or strict sense of the term.

For the ease of reference, let us take the example of an Indian subsidiary company of a foreign parent company, which resides in a country, say ABC, with which India has entered into a tax treaty, whose provisions relating to Article 9, namely dealing with transfer pricing; Article 11, namely dealing with taxation of interest income; and Article 24, namely dealing with non-discrimination, are in line, to the extent relevant for the current purpose, with corresponding Articles contained in the latest version of the OECD Model Convention (MC), which incidentally is the actual case with majority of the tax treaties signed by India, particularly with its major treaty partners.

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  • sanjeevgupta on Apr 18,2018

    Very Informative and insightful.

  • Rajendra Agiwal on Apr 10,2018

    Very interesting analysis

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