FOR any one during business in India, interest on borrowed capital is a deductible expenditure, the only rider being that the borrowing must be for the purpose of the business. The same is true for foreign companies or their subsidiaries as well. The business purpose test is interpreted quite liberally in India. Courts in India have held that the law does not require the taxpayer to show that the borrowing of the capital was necessary for the business. Thus, even if at the time of borrowing, the taxpayer had sufficient capital of its own, it cannot be argued by the Revenue that the taxpayer need not have borrowed the money and hence disallow the interest on such borrowings.

The proposed Direct taxes Code (DTC) does not seem to have any radical departure in this regard except for the fact that instead of the term ‘interest’, the term ‘finance charges’ has been used.  The proposed section 34(1) (a) allows finance charges on any capital borrowed or debt incurred. Thus, interest is allowable as a deduction in the hands of the payer, provided, of course, that appropriate tax has been deducted at source. For the recipient of interest, the same will be chargeable to tax as per the applicable provisions. Thus, if interest is the only income, and it does not exceed the minimum amount not chargeable to tax, the tax, if deducted at source will have to be refunded since there is no concept of final withholding tax in India in most of the cases. In other circumstances, interest will be charged at appropriate domestic rate or the treaty rate applicable to the particular treaty country.

On the other hand, dividends paid by a company to its shareholders are not allowable business expenditure. This is the praxis in most countries of the world, including India. However, in so far as taxation of dividends is concerned, in India, since 1997 we have a dividend distribution tax (DDT), which is levied on the company paying the dividend. The shareholders are not separately taxed. The Dividend distribution tax is kind of a surrogate tax for the tax which would normally be payable by the shareholders of the company.  The system described as unfair by many is proposed to be continued in the DTC. It is interesting to note that the rationale given for the continuation in the discussion draft of the DTC as follows: “A tax on dividend can either take the form of a tax in the hands of the shareholder at his personal marginal rate or take the form of a flat rate upon distribution of dividend by the company. The first method of taxation has been found to be administratively cumbersome and prone to leakage. Therefore, under the code, dividends will be taxed under the second method in respect of dividend distributed by a resident company.” With comprehensive computerization, the leakage theory does not hold much water, and there are not many countries in the world that follow this system. Nevertheless, that is the system of dividend taxation that we have been following in India for over a decade now and it is an additional tax, which is to be paid by a company, which distributes dividends.

A foreign company can do business in India either by forming a subsidiary or through a branch. Thin capitalization is not normally concerned with this aspect. However, having established a subsidiary, the parent company can finance the Indian company either through equity capital or through loan capital.  If the activities of the subsidiary are entirely financed through equity capital, the profits earned by the Indian company can be repatriated in the form of dividends. However, dividend is not a tax deductible expense. On top of it, the subsidiary has to pay DDT of 15%. Of course, the dividend will be tax free in the hands of the parent even though tax treaties give India the right to withhold tax at varying percentage.

If, on the other hand, the capital contribution by the parent or some other related party is in form of loan capital, the interest payable will be tax deductible and can also be repatriated. The only limitation is that there will be deduction of tax at source which is 20% under the domestic law but is reduced to 10% in respect of most of the treaty countries. Before the introduction of transfer pricing (TP) legislation, almost any amount of interest could be charged. After the introduction of the TP rules, the rate of interest charged has to conform to the arm’s length principle. However, it is doubtful if the quantum of loan capital can be questioned on the basis of the TP regulations alone. On balance, it seems that financing through loan capital will be distinctly advantageous.

It is in this background that we need to examine one of the hot topics of international taxation i.e., thin capitalization.

Considering the differential treatment of interest and dividends as mentioned above, multinationals might be tempted to provide what should have been equity capital in the form of loan capital. This phenomenon is known as hidden capitalization or thin capitalization. There will be nothing illegal about it. Under the Indian tax laws, Courts have held that how a business is run is not the business of the tax authorities. Therefore, in the absence of special enabling provisions, the tax authorities are unlikely to succeed in questioning the form of capital contribution-loan or equity that is used. It is therefore, theoretically possible to take away large profits from India in the form of interest. In fact,  it is understood that the experience of the developing countries in Latin America has been that in the absence of any rules, almost all the operating profits of a company earned in a source country can be paid away as interest.

To counter this strategy, almost all OECD countries and many non-OECD countries as well have, therefore, adopted thin capitalization legislations to protect their tax base. China and Brazil have followed suit in 2008 and 2009 respectively. Such a legislation is normally aimed at borrowing between related parties where normal market forces  do not operate, the policy assumption being that excessive debt funding would not occur between independent parties and in essence the rules/legislations try to rrestrict the deduction on account of the claim of interest deduction. As for the particular approach or legislation to be followed, there seems to be no uniformity. Broadly speaking, the approaches used by countries can be categorized as fixed debt to equity approach, earnings stripping approach and arm’s length or independent banker’s approach.

In the fixed debt to equity approach which is also the most common, no questions are asked so long as the debt/ equity ratio is up to a certain level, normally 3:1. Beyond that, interest payment can be denied. The earnings stripping approach is used by the US and applies only when a safe harbour debt/equity ratio of 1.5:1 is exceeded. Thereafter, to the extent that net interest expense exceeds 50% of the adjusted taxable income of the company, deduction is denied for interest payable to related parties. The rules prevent more than half of the earnings of the subsidiary company from being eroded from the US tax base through payments of interest on loan capital to related non-resident parties. In the arm’s length approach one has to determine how much the concern could have borrowed from an independent banker taking into account the market conditions at the time of the borrowing. A variant  of the debt/equity ratio approach could be  the use of  debt to equity ratio with an arm’s length let out. In other words, a taxpayer exceeding the fixed ratio could still show that the interest paid was at arm’s length. All the methods have their positives and negatives and the adoption of one method or the other would depend on the balance that the particular jurisdiction would like to achieve.

It may be noted that the above stated  thin capitalization rules can also be avoided by resorting to various strategies notably the use of  sale and leaseback transactions or back to back loan transactions, loans from banks with guarantee by parent, to name a few and hence to be effective, such rules have to be in conjunction with the other anti avoidance rules.

The DTC seems to adopt a half away house approach in this regard. There is no reference to thin capitalization rules as such either in the original DTC or in the revised version. The discussion draft makes no mention of any thin cap rule. However, in the context of the general anti avoidance rules, it has been provided that if a taxpayer enters into an arrangement whose main purpose is to obtain a tax benefit and the arrangement has been entered into in a manner not normally employed for bona fide business purposes, or created rights and obligation which would not normally be created by persons dealing at arm’s length or lacks commercial substance, then the commissioner can declare the arrangement as impermissible and, amongst other steps, may  re-characterize any debt financing transition as  an equity financing  transaction or any equity financing transaction as a debt financing transaction. This is the position both in respect of domestic as also foreign companies.

However, thin capitalization is essentially a cross border issue. There is a strong possibility of excessive interest claims by subsidiaries of multi-nationals, particularly considering the prevailing legal framework and perhaps it may be necessary to have fully fledged thin capitalization rules based on similar practice elsewhere. It will also be desirable to undertake a proper study to gauge the magnitude of the problem and, if found necessary, to come out with proper guidelines about the appropriate capital structure in different industries rather than leaving the problem to be sorted out by the general anti avoidance rule alone.