Overview And Theoretical Explanation Of Section 94B Of The Income Tax Act
For any business organization, having the right mix of financing in debt and equity is of extreme importance. Certain entities tend to become highly leveraged by having a thin capital structure, i.e., more debt over equity.
In line with the BEPS (Base Erosion And Profit Shifting) Action Plan, 4, Thin Capitalization provisions were introduced through Section 94B of the Income Tax Act, 2017 in India, to disallow interest paid to foreign associated enterprises (AEs) in excess of 30% of Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) or interest paid or payable, whichever is lower.
Further, the proviso to section 94B provides that debt shall be deemed to be provided by AEs where such AE provides an implicit or explicit guarantee to the lender or deposits a corresponding and matching amount of funds with the lender.
Practical Example To Explain Section 94B
To explain it better practically and further dive into what it essentially entailed, let’s look at the example of what used to happen earlier in the case of multinational companies (MNCs) with wholly-owned subsidiaries (WoS) in India.
Previously, the way the MNCs used to take a return on their capital was by placing higher loans in the Indian companies, leading to high interest expense which ultimately resulted into lower taxable profits in India.
Here, the foreign company may be in a low tax jurisdiction viz-a-viz India which is a high tax jurisdiction, that results into a tax break of 30% on the interest expense in the hands of the Indian company, and the foreign company is taxed at the applicable beneficial treaty rate of 5%, 10%, or 15%, as applicable.
For example, let’s say there is a French company (referred to as the foreign company) which has a wholly owned subsidiary in India (referred to as the Indian company). Assuming the Indian company has taken a loan from a bank in India, which is counter-guaranteed (by way of either an standby letter of credit (SBLC), or pledging a sum, or collateral) by the foreign company, the essential purpose of bringing in Section 94B was to curb the practice of paying interest to the foreign company and get a 30% tax break in the hands of the Indian company.
Imagine another situation with 2 companies, where one is a company established in India (Company 1) while the other is a wholly owned subsidiary of a foreign company (Company 2). Let’s say that Company 1 takes a loan from an Indian bank based on certain collateral (which is not a security provided by a foreign company) and Company 2 takes a loan from a given Indian bank based on certain collateral (which is a security provided by a foreign company).
In such a case as the one mentioned above, these two companies are being treated in a discriminatory manner.
As there is an interest limitation in the hands of Company 2 (up to 30% of EBITDA or interest paid or payable whichever is lower), the question which needs an answer is that when the interest payment is being made to the resident lender, where is the question of base erosion or profit shifting.
Further, the proviso to the main section, which is a deeming provision, can only carve an exception out of the main provision and not enlarge the purview of the main section.
Possible Solutions To The Problems Posed
The Union Budget 2020 had brought an amendment to Section 94B but not to a major effect. The amendment introduced only seeks to eliminate from its purview the payment of interest to any branch of a foreign bank from Section 94B.
Here, if we replace the Indian bank with the branch of a foreign bank, the latter has been removed from the purview of Section 94B.
It would only apply to Indian banks, which in principle has been deemed incorrect; because ultimately, you’re not paying an interest to a foreign company, you’re not paying interest outside India, and the interest which you’re paying is the income of the other tax resident which is paying proper taxes on its income in their given tax jurisdiction.
This debate has caused quite a lot of conundrum with regards to Section 94B, where the section seeks to cover even the bona fide cases where loans are being taken from Indian banks itself. To make amendments in the Section, it’d be ideal to exclude the Indian banks from the purview of the Section as well, as there is no offshore payment involved in such a case.
Further, where any interest is disallowed in the hands of the borrower under Section 94B, the same would lead to double taxation whereby the borrower and lender are paying taxes on effectively the same income.
Whenever foreign companies set up their WOS for doing business in India, they don’t have a security to get a loan from the bank.
The WOSs face the major problem of financing anyway when they’re operating in India, and the 2nd issue is having a proper exit strategy for the company funding the WOS in India. Therefore, equity share capital is one of the most preferred methods, but even that isn’t freely repatriable. So, if a foreign company puts in certain equity capital, the only way it can take it out is via dividend or upon the dissolution of the Indian company.
Other way of finance is to opt for loan or debt security, where loan is the simplest option. The loan comes with the added pain point of Section 94B, where it disincentivizes the WOSs from taking loans from their foreign parent companies and if they take a loan from an Indian bank, their foreign parent company would be require to counter-guarantee that loan via certain collateral.
The whole capital is being put in by the foreign company, the complete management control has been put in place by the foreign company, and ultimately, the banks require certain collateral from the foreign companies themselves in case anything goes south.
So, in any case, we come down to a point where the WOS has to see the resistance from the foreign company or we come to the point of falling into the purview of Section 94B.
Hence, even these types of bona fide cases/activities are being covered under Section 94B. The only type of businesses which are outside the purview of Section 94B are banking groups (not including NBFCs).
Our Thoughts On The Matter, And Looking At The Way Forward
In my opinion, one of the ways to avoid discrimination between the types of companies (Indian or WOS of foreign companies) is to make sure that all types of bona fide cases of loan from banks are removed from the ambit of Section 94B. This Section was ideally intended to be an anti-abuse measure, so it shouldn’t affect bona fide cases.
For any company looking to avail a loan at the justified arm’s length, interest rate shouldn’t be covered under this section and only those incidents where the interest rate is higher than the arm’s length rate should be put under the scrutiny of this measure.
Lastly, it must be highlighted that when a WOS is availing a loan from its foreign parent company and the said WOS pays an interest on the same loan, the foreign company in that case is paying taxes in India for that loan (and the interest is being subjected to the “30% of EBITDA” condition stated earlier). If the WOS in this case is a loss-making company, the complete interest paid or payable is disallowed. Here, in this case, there arises the scenario of double taxation.
In this scenario, the foreign company is paying the tax on that particular income and the WOS itself is also paying taxes for that particular income as it is not getting any allowance in its P&L account. This is another angle which must be considered. Like I said, it is only the interest higher than the arm’s length rate which should be under the purview of Section 94B to ensure that there is a fair treatment of companies in doing business in India.
Written By
Ayush Mittal
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Ayush currently leads the Tax and Regulatory Services at Coinmen as a Manager.
