REMEMBER Enron? The Company that cooked its books to overstate profits much like our very own Satyam. Today, searching for Enron gives us results in the form of case studies in crony capitalism. Enron was invited by the government in the early 90s to set up a mega power plant. It set up a company Dabhol Power Corporation (DPC) in joint venture with GE and Bechtel. Soon however the project ran into difficulties as a result of protests by environmentalists and others and the plant was shut down. The project was subsequently revived with the visit of Ms. Rebecca Mark, then CEO of DPC who confabulated with the powers that be. Revelations by the company in the USA show that it had claimed to have spent USD 20 million to 'educate' Indian bureaucrats and other people.
We do not knowexactly how Enron functioned in India and what all entities were involved. Case laws from time to time still throw out names that had association with the infamous company. Lingtec Constructors LP is such a name. In one case - 2012-TII-268-ITAT-MUM-INTL, it has been mentioned that Lingtec is a non-resident firm having its registered office in the State of Delaware and the principal place of business at Enron Corporation, 1400, Smith Street, Houston, Taxas 77002; that it had entered into a contract with Dabhol Power Corporation (DPC) for onshore construction work and onshore services in connection with Phase II Dabhol Power Project and the attached Liquefied Natural Gas unloading, storage and re-gasification.
A reference to this Lingtec is found in another case that is actually the subject matter of our attention now. Lingtec apparently entered into a contract with one Besix Kier Dabhol, SA (BKD) on 27th November 1998 to carry out the project of the construction of a fuel jetty near Dabhol. - 2010-TII-158-ITAT-MUM-INTL
From the case note, it is gathered that BKD is a company registered in Belgium. Its equity capital was divided in the ratio of 60:40 between two joint venture partners N V Besix SA, of Belgium and Kier International (Investment) Limited of the U.K.
Its sole business was carrying out the project for construction of fuel jetty near Dabhol. There was no dispute that BKD had a PE in India.
BKD claimed to have borrowed INR 94.10 crores and claimed interest payment of INR 5.73 crores on the same. The loan was apparently borrowed by the Indian Permanent Establishment directly from the shareholders and was not routed through the head office. The borrowing was in the same ratio as that of shareholding. Thus, INR 57.09 crores was borrowed from NV Basix SA and Rs.37.01 crores from Kier International.
The AO noted that the total equity capital of the taxpayer was only INR 38.00 lacs while its debt capital was of INR.9410 lacs. The AO also noted that the JV had no reserves, no provisions, no financial debts, no financial assets, and no assets anywhere in the world except in India and that its debt equity ratio worked out to a whopping 248: 1 whereas debt equity ratio of shareholder companies was not furnished.He considered the interest as payment to self and disallowed the claim. There are other issues and arguments that are not being considered for the present discussion.
When the matter reached the Tribunal, it held that a company and its shareholders have separate existence, that the contracts between a company and its shareholders are just as enforceable as contracts with any independent person, and that, therefore, interest paid to the shareholder can only be treated as interest paid to independent outside parties.
The Tribunal pointed out that the tax treatment being given to the equity capital and debt capital being fundamentally different, it is often more advantageous in international context to arrange financing of a company by loan rather than by equity. It affects the legitimate tax revenues of the source country in which business is carried out because while dividends and interest are generally taxable at the same rate in the hands of the recipient in the source country, interest is tax deductible and that results in lower corporate taxes in respect of PE profits. That is how tax considerations at times do result in a company being too thinly capitalized, financed by a disproportionate ratio of debts. The Tribunal pointed out that in order to protect themselves against such erosion in their legitimate tax base, several tax jurisdictions enact 'thin capitalization rules'. The Tribunal finally held that in the absence of such a rule in India at the relevant time, the interest had to be allowed.
The Tribunal did some research on its own and pointed out that thin capitalization rules exist in Belgium which perhaps explains, the peculiar capital structure adopted by the JV. The Tribunal speculated that since the then Belgian law restricted the interest deductions to the extent of debt capital ratio of 1:7 the particular mode of borrowings might have been resorted to by the Indian PE and not the Belgian enterprise directly.
Although it was not necessary to decide the case, it is seen that the Tribunal took recourse to one additional reason for deleting the disallowance and this may have implications for the current rules that are being framed by the Government regarding limiting interest deductions following the OECD-G-20 BEPS action point 4. In paragraph 29 of the order, the Tribunal observed as follows:
"It is also important to bear in mind that when there are no thin capitalization rules vis-à-vis domestic thin capitalization situations, and in the light of the Section 90(2) as it exists at present, any attempts to neutralize thin capitalization vis-à-vis PEs of Belgian enterprise will be clearly contrary to the scheme of non discrimination envisaged by Article 24 (5) which provides that, "enterprises of a Contracting State, the capital of which is wholly or partly-owned or controlled, directly or indirectly, by one or more residents of the other Contracting State, shall not be subjected in the first- mentioned Contracting State to any taxation or any requirement connected therewith which is other, or more burdensome, than the taxation and connected requirement to which other similar enterprises of that first- mentioned State are or may be subjected in the same circumstances and under the same conditions". In this view of the matter, it cannot be open to the revenue authorities to put any limitation on deduction of interest, in respect of funds borrowed by the PE, while computing income in accordance with the provisions of Article 7 of Indo Belgium tax treaty, when no such limitations are placed on the domestic enterprise."
It may also be observed that the decision was upheld by the High Court - 2012-TII-46-HC-MUM-INTL although this particular observation was not under challenge by the Revenue.
With this background, let us examine the newly introduced interest deduction provision 94B introduced in the Budget, 2017
'94B. (1) Notwithstanding anything contained in this Act, where an Indian company, or a permanent establishment of a foreign company in India, being the borrower, pays interest or similar consideration exceeding one crore rupees which is deductible in computing income chargeable under the head "Profits and gains of business or profession" in respect of any debt issued by a non-resident, being an associated enterprise of such borrower, the interest shall not be deductible in computation of income under the said head to the extent that it arises from excess interest, as specified in sub-section (2):
Provided that where the debt is issued by a lender which is not associated but an associated enterprise either provides an implicit or explicit guarantee to such lender or deposits a corresponding and matching amount of funds with the lender, such debt shall be deemed to have been issued by an associated enterprise.
(2) For the purposes of sub-section (1), the excess interest shall mean an amount of total interest paid or payable in excess of thirty per cent. of earnings before interest, taxes, depreciation and amortisation of the borrower in the previous year or interest paid or payable to associated enterprises for that previous year, whichever is less.
(3) Nothing contained in sub-section (1) shall apply to an Indian company or a permanent establishment of a foreign company which is engaged in the business of banking or insurance.
(4) Where for any assessment year, the interest expenditure is not wholly deducted against income under the head "Profits and gains of business or profession", so much of the interest expenditure as has not been so deducted, shall be carried forward to the following assessment year or assessment years, and it shall be allowed as a deduction against the profits and gains, if any, of any business or profession carried on by it and assessable for that assessment year to the extent of maximum allowable interest expenditure in accordance with sub-section (2):
Provided that no interest expenditure shall be carried forward under this sub-section for more than eight assessment years immediately succeeding the assessment year for which the excess interest expenditure was first computed.
(5) For the purposes of this section, the expressions–
(i) "associated enterprise" shall have the meaning assigned to it in sub-section (1) and sub-section (2) of section 92A;
(ii) "debt" means any loan, financial instrument, finance lease, financial derivative, or any arrangement that gives rise to interest, discounts or other finance charges that are deductible in the computation of income chargeable under the head "Profits and gains of business or profession";
(iii) "permanent establishment" includes a fixed place of business through which the business of the enterprise is wholly or partly carried on.'.
In brief, only interest paid to related non-resident parties are the subject matter of limitation. Banks and insurance companies are not covered. Interest expenditure below INR 1 crore is not subject to any additional restriction. Beyond that, interest deduction will be subject to a limit of 30% of earnings before interest, taxes, depreciation and amortisation (EBIDTA) of the borrower. The disallowed interest will be allowed to be carried forward for 8 years to be adjusted against future business profits subject to the same limitation of 30% of EBIDTA.
Commentators have flagged certain issues, for example the fact that the method of calculation of EBIDTA has not been defined and it is not clear whether the earnings will be the earnings as per the books or as determined by the tax authorities. There are however, a few more fundamental issues that need to be examined.
The way the provision has been drafted; comparison has to be made of the following figures:
- Total interest paid or payable in excess of 30% of EBIDTA
- Interest paid or payable to the AEs
The least of the two figures will be disallowed. In other words, if there is overall interest payment to non-residents(and to residents) but no interest payment to a non-resident AE, then there is no disallowance under this section. Assuming EBIDTA at INR 1000, if the total interest paid is 500, and interest paid to AE is 300, then the comparison will be between [500-30% of 1000=200] and 300. Accordingly, 200 being the lesser of the two figures will be the amount disallowable. If there is no other interest at all then, in this example, the related party interest being within the limit there will be no disallowance.
Here, an interesting issue may also arise from the combined provisions of section 92 and section 94B. Since the interest is paid to an AE, obviously the transfer pricing provisions will also apply. Assuming that out of the total interest paid to the AE of 300, the arm's length interest is determined at 250 by applying the transfer pricing provisions, then from the language of the proposed section, it is not clear which figures will be compared.
It may be noted that the OECD action 4 recommendation is not limited to related party interest but applies to the entire interest paid. In fact, the report while surveying the country practices in the context of thin capitalization rules that many countries already have, observed: "Where thin capitalisation rules apply solely to interest deductions on intragroup debt, these rules are effective in reducing intragroup debt but then lead to an increase in third party debt, although this may not be to the same extent."
Secondly, even though the newly introduced provision is being called thin capitalisation rule, strictly speaking it is not so. Thin capitalisation rules adopted in many OECD countries can take different forms but mostly are in the form of a fixed debt: equity ratio. But these rules were not sufficient to counter the base erosion through interest deductions claimed by MNC firms. Thus, the general limitation of interest deduction rules was formulated. In fact, base erosion through interest payment is so grave that Action 4 recommends that in addition to the interest limitation rules, a country may also apply other general interest limitation rules, such as arm's length rules, rules to disallow a percentage of all interest expense and thin capitalisation rules.
The BEPS Action point 4 also considered the question as to whether the general interest limitation rule should apply to gross interest expense or to net interest expense after offsetting for any interest that it might receive. The report observed that although a gross interest rule has the benefit of simplicity and is also likely to be moredifficult for groups to avoid through planning such a rule could lead to double taxation where each entity is subject to tax on its full gross interest income, but part of its gross interest expense is disallowed. Accordingly in paragraph.62, it is mentioned: "the general interest limitation rules contained in this report apply to an entity's net interest expense paid to third parties, related parties and intragroup, after offsetting interest income." Section 94B, however, does not follow this line.
Moreover considering that some groups could be highly leveraged with third party debt for non-tax reasons, the OECD report proposed a group ratio rule alongside the fixed ratio rule that would allow an entity with net interest expense above a country's fixed ratio to deduct interest up to the level of the net interest/EBITDA ratio of its worldwide group. The report also recommends that countries may apply an uplift of up to 10% to the group's net third party interest expense to prevent double taxation. This part of the report has not been implemented in India probably because of difficulties in obtaining the information at the group level.
In addition, there are some other discussions in the OECD report that may nullify the efforts made in the budget. In several places in the report, it has been mentioned: "Where a country does not apply a group ratio rule, it should apply the fixed ratio rule consistently to entities in multinational and domestic groups, without improper discrimination. (For example, in Para 119 of the report)." The implication is that according to the OECD and the framers of the report (including India) such a course will amount to discrimination and may be contrary to the Non-discrimination article of the existing treaties. The issue assumes added importance in view of the observations of the Tribunal in the Besix case as mentioned earlier.
Although the Tribunal refers to Article 24(5), more relevant provision will be 24(4)in the context of interest disallowance of Indian subsidiaries of foreign companies. According to OECD Commentary, Article 24(4) is lexspecialis. It states as follows:
"Except where the provisions of paragraph 1 of Article 9, paragraph 6 of Article 11, or paragraph 4 of Article 12, apply, interest, royalties and other disbursements paid by an enterprise of a Contracting State to a resident of the other Contracting State shall, for the purpose of determining the taxable profits of such enterprise, be deductible under the same conditions as if they had been paid to a resident of the first mentioned State…"
The OECD Commentary on Article 24 does state that paragraph 4 does not prohibit the country of the borrower from applying its domestic thin capitalisation rules in so far as these are compatible with paragraph 1 of Article 9 or paragraph 6 of article 11. These paragraphs refer to the arm's length standard. Thus, when the thin capitalisation rules are not based on the arm's length principle but are based on some fixed ratio rule, it is likely to fall afoul of the non-discrimination article contained in most of the tax treaties unless those treaties contain some specific derogation. Therefore, it seems some reworking will be required in the newly introduced section 94B. |