Thin Capitalization A Detailed Study C.A. Divakar Vijayasarathy This paper is a copyright of Divakar Vijayasarathy & Associates. The author and the firm expressly disown their liability on any consequence or action taken on the basis of the content of this publication. The research report is only an interpretation of the statute/ legislation with related clarifications and shall not be construed as a professional opinion for any purpose. Divakar Vijayasarathy & Associates Chartered Accountants P h : 0 4 4-4 3 5 8 7 0 2 7 / 2 8 F a x : 0 4 4-4 2 0 4 6 3 0 4 2 8 / 0 3 / 2 0 0 9
Contents Particulars Page No 1 Concept of Thin capitalization 3 2 Steps to Check Thin capitalization 4 3 Evasive Forms of Thin capitalization 8 4 Administrative Issues in Thin capitalization 8 5 Thin capitalization Indian Perspective 9 6 Thin capitalization and Treaty Interpretation 10 Divakar Vijayasarathy & Associates 2
1- Concept of Thin Capitalization Thin capitalization refers to a situation where equity is camouflaged as debt for various favorable reasons. For example- X Plc of UK may be holding 100% stake in X Ltd India. The total paid up capital of X Ltd is Rs 100 lacs while its debt from X Plc is Rs 400 lacs. This is a classic case of thin capitalization. The most popular reasons for thin capitalization include: - Tax arbitrage through leverage financing- especially where the borrower is from a tax haven - Easier repatriation of debt over equity - Ensure priority over other creditors in the event of winding up - Debt has a tenure unlike equity which is outstanding to perpetuity - Ensure return on investment is independent of profits earned - Simpler statutory requirements (for example if debt financing has simpler procedures vis a vis equity investment) Illustration Tax Arbitrage through thin capitalization Particulars Entirely Equity Debt to Equity 3:1 Rs in Crores Equity 500 100 Debt @ 10% p.a 0 400 Total Investment 500 500 Corporate tax rate 30% 30% Profit before interest and tax 100 100 Less Interest 0 40 Profit before tax 100 60 Less Tax @ 30% 30 18 Profit after tax 70 42 Less Dividend distribution tax @ 15% 9.1 5.5 Net amount distributed to equity holders 60.9 36.5 Return on equity 12% 37% Total tax paid 39.1 23.5 Effective tax rate on PBIT 39% 23% Divakar Vijayasarathy & Associates 3
2. Steps to check the effect of Thin capitalization: Thin capitalization A detailed study Economies across the globe have evolved anti avoidance practices to combat thin capitalization. Few of such initiatives are illustrated below: - 2.1 Restriction on Debt to Equity ratio: This is one of the most popular methods for curbing thin capitalization. Countries have generally pegged a maximum debt to equity ratio beyond which: Excess interest paid may be disallowed or Penalty may be imposed or Interest may be reclassified as debt. The limit of permissible debt to equity ratio is popularly referred to as Safe harbor limit. Factual Update Given below is the list of debt to equity ratios together with the countries who have adopted the same: D/E ratio Countries 3:1 Australia, Japan, South Africa, Korea, New Zealand, Turkey, Poland, Romania, Russia and Netherlands 2:1 Canada, Portugal 1.5:1 France 4:1 India FEMA : Master Circular No 07/2008-09, dated 01.07.2008 where the ECB exceeds USD 5MM Minimum India FEMA : Master Circular No 07/2008-09, dated 01.07.2008 equity holding where the ECB does not exceed USD 5MM of 25% - 2.2 Arm's length principle: This is a concept popularly associated with transfer pricing regulations. The rationale extended to thin capitalization is on similar lines. Under this principle we are supposed to answer just one question Would the borrower be eligible to avail similar credit lines from an unrelated lender on identical terms and conditions?. If the answer to the above question is no- the transaction does not fulfill the arm's length principle. Divakar Vijayasarathy & Associates 4
Tax authorities across countries have used this principle to ascertain the reasonableness of the transaction and have: Reclassified the debt into equity Rechristened interest payout as dividend Disallowed excess interest payments Illustration: British airways UK has a subsidiary in China with a paid up capital of $100,000. The company also advanced a sum of $ 500,000 as term loan repayable over a period 5 years @ libor + 5%. Given the financial strength and vintage of the subsidiary an independent unrelated lender would have advanced a maximum sum of 300,000 @ Libor+3%. China has the policy of: Arm's length principle 2:1 Debt to equity rule Any loan beyond the permissible limits shall be considered as equity and the payouts shall also be treated as dividends. Discuss the tax implications assuming Libor rate has been 4% throughout the previous year. Tax Implications - Arm's length principle USD '000 Total loan amount 500 Maximum loan possible from unrelated lender 300 Amount to be considered as Deemed equity 200 Rate of Interest charged (Lib + 5%) 9% Payout on Deemed equity (Deemed as Dividend) 18 Rate of Interest charged (Lib + 5%) 9% Rate of Interest charged by unrelated lenders (Lib + 3%) 7% Excess Interest paid (%) 2% Excess Interest paid considered as dividend 6 (Excess interest computed only on maximum possible loan from unrelated vendors) Total Interest as per Books (500@9%) 45 Less Deemed dividend as above 18 Less Excess Interest paid considered as dividend 6 Net Interest allowed as deduction 21 Divakar Vijayasarathy & Associates 5
Tax Implications - Debt Equity of 2:1 Total Equity 100 Total Debt 500 Debt/Equity ratio 4:1 Maximum permissible ratio 2:1 Excesss Debt considered as equity 300 Interest payable on excess debt 9% Excess interest to be considered as dividend 27 Total Interest as per Books (500@9%) 45 Less Deemed dividend as above 27 Net Interest allowed as deduction 18-2.3 Substance over form: This is very similar to the anti abuse provisions incorporated in most treaties. According to this concept, if the fundamental nature of the debt arrangement has the characteristics of an equity participation, the same would considered as equity. Few of the common guiding principles for the concept are as follows: No provisions for fixed repayments Interest rate/payout linked to profitability Convertible loans There are no external lenders to offer similar credit facilities on identical terms (arm's length principle) Factual Update - Countries like Austria, Switzerland, Netherlands, Norway and USA have incorporated the principles of Substance over Form as part of their legislature. - United States has laid down the following parameters to determine the nature of a financial arrangement: Unconditional promise to repay and tenure of the arrangement Priority of repayment over other creditors/lenders Debt to equity ratio Right to enforce payment of interest and principal Right to participate in management Nexus between holders of debt instruments and capital Divakar Vijayasarathy & Associates 6
- 2.4 Interest disallowance: This is an extreme step adopted by certain economies where interest, beyond a threshold limit, is either disallowed or considered as equity. Factual Update - In Ireland: If a resident enterprise pays interest to a non resident enterprise which holds at least 75%interest in the resident company Such interest shall be considered as dividend - Effective 1 st January 2008, Germany and Italy have replaced the fixed debt to equity concept with a maximum interest payout of 30% of EBIDTA Divakar Vijayasarathy & Associates 7
3. Evasive Forms of Thin Capitalization The concept of thin capitalization have been camouflaged by the enterprises using certain innovative practices. Few of such practices have been explained below: - 3.1 Back to back loans: This is a scheme were the holding company gives a loan to an unrelated enterprise. The unrelated enterprise in turn provides loan to the subsidiary. - 3.2 Inter Corporate Guarantee for Third party loans: In this transaction, the holding company would provide guarantee to a bank, financial institution or an unrelated enterprise for extending loan to the subsidiary. - 3.3 Loans by group companies: In the case of complex holding structures with multiple layers of holding, loans and guarantees extended by group companies which are not direct holding or subsidiaries. - 3.4 Hybrid financial instruments: These are instruments which have the risks and rewards of both equity and debt. FCCBs, participating preference capital, convertible debentures etc are classic cases of hybrid instruments. Divakar Vijayasarathy & Associates 8
4. Administrative issues in Thin capitalization Thin capitalization A detailed study The concept of thin capitalization is simple to understand and interpret however the implementation of the same is fairly complex since in most cases, the tax authorities are required go beyond the financials of the assessees involved. Some of the practical issues involved are: - Ability to ascertain the holding structure of the group - Ascertainment of inter corporate guarantee arrangement - Timing of considering the proportion of debt and equity for D/E ratio - Classification of hybrid instruments - Timing of back to back loans and guarantees Divakar Vijayasarathy & Associates 9
5- Thin capitalization : Indian Perspective India though a developing country has one of the most advanced tax legislations in terms of thin capitalization regulations. India uses a mix of debt to equity and arm's length principle to curb thin capitalization situations namely: - Debt to Equity: Vide FEMA rules (Master Circular No 07/2008-09, dated 01.07.2008), the maximum debt to equity ratio for an investor for automatic approval cannot exceed 4:1. - Arm's length principle: Vide sec 92 of the Income tax Act Any income arising from an international transaction shall be computed having regard to the arm s length price. - Treatment of excess interest paid: Excess interest paid over and above the arm's length price shall be disallowed. Divakar Vijayasarathy & Associates 10
6- Thin capitalization and Treaty interpretation Article Description Remarks/Issues Additional References if any Article 9 Arm's length principle Article 10 Article 11 Dividends Interest Article 23 Credit in Country of Residence - Where a treaty exists between two countries - For application of domestic thin capitalization rules - It must be proved that the transactions are not on arm's length basis. For example, if the domestic rule does not permit a D/E of more than 2:1 and the subsidiary has a D/E of 3:1 from the holding company- if it is proved that the transactions are on arm s length basis, the provisions of thin capitalization will not apply - Most of the domestic legislations, consider excess interest, based on thin capitalization rules, as dividend. - Conflict arises whether such reclassification is permissible by the treaties in the case of cross border transactions. - Where the country of source reclassifies interest as dividend, - Would the country of residence of the lender also consider the same classification for taxation and tax credit - This is relevant to avoid double taxation or double non taxation. - The main issues to be considered are: a) Taxing at source such interest at the rate applicable for dividends b) Inclusion of such interest in the taxable profit of the lender enterprise Based on the Report of Committee on Fiscal Affairs: - Article 9 does not prevent the application of domestic thin capitalization rules to the extent relevant for determining the actual cost/profit to the borrower enterprise in arm s length transaction. (Rate of interest) - It is also relevant to determine the nature of the transaction ie Debt or equity (reclassification) - The rules of domestic thin capitalization should not increase the profits of the enterprise beyond the arm s length profit. Para 25 on Article 10 of OECD commentary clarifies: - Article 10 deals with dividends and interest on loans where the lender effectively shares the risk of the company. - Article 10 and 11 do not prevent such reclassification as per domestic thin capitalization norms. - The issue of sharing of risk by the lender should be considered on a case to case basis. Para 67 on Article 23 of OECD commentary clarifies: - The essential condition for reclassification should be the sharing of the risks by the lender - If the relevant conditions for reclassification (arm s length etc) are met, the country of residence of the lender is obliged to consider the reclassification and provide credit accordingly. - In certain cases the issue may be resolved through mutual agreement procedure. Divakar Vijayasarathy & Associates 11
Article 24 Non discriminati on - Article 24(4) of OECD Model Commentary requires non partisan treatment for the interest, royalty etc paid by a resident of the source country to a resident of the other state, subject to arm s length principle. - Article 24(5) of OECD MC states that there shall be no discrimination between enterprises with resident shareholders and other enterprises. - Since Article 24 is a specific provision it overrules Article 25. Para 56 clarifies: - Art 24(4) does not prohibit application of thin capitalization rules as long as it adheres to arm's length principle 2008 update by OECD has addressed the following issues in Art 24 with respect to thin capitalization: - Disallowance or deferrement of interest by the country of source - Extension of thin capitalization rules to debtor creditor relationships - Art 24(4) takes precedence over Art 24(5). Article 25 Mutual Agreement Procedure - Where the country of source makes a disallowance owing thin capitalization - The country of residence may make a change in the income of the lender to such effect - However, in the absence of co operation by the country of residence the issue should be resolved through mutual agreement procedure. Divakar Vijayasarathy & Associates 12
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