There are broadly two ways in which a company can be financed. One is by the issue of equity and the other is by debt i.e. borrowing. Financing with debt is considerably more efficient from the tax point of view than financing with equity. Like if the companies take the equity capital instead of loan, then the companies need to pay dividend which is almost like interest amount and the dividend is not tax free, one need to pay income tax first and then distribute dividend to the shareholders. The difference in tax treatment is an incentive to provide capital to the corporation in the form of debt instead of equity.
What is Thin Capitalization?
The expression ‘thin capitalisation’ is commonly used to describe a situation where capital structure of a company includes greater proportion of debt as compared to equity.
How it works?
From the above table, it is clear that the motive behind changing the proportion of debt and equity is to avoid tax as interest on debts would be eligible for tax deduction whereas dividend is subject to Dividend Distribution Tax.
What are Thin Capitalization Rules?
The proposed discussion paper on Direct Tax Code (DTC) introduces General Anti-Avoidance Rules (GAAR) to curb tax avoidance. It empowers the CIT to declare any arrangement as ‘impermissible avoidance arrangement’ (IAA), if the objective of that arrangement/transaction is to obtain tax benefit by creating rights or obligations amongst transacting parties which lacks commercial substance.
To avoid these types of arrangements/transactions thin capitalisation rules provides, “that any arrangement wholly or partly provides a tax benefit shall be assumed to have been drawn up for the main purpose of obtaining a tax benefit and qualify as impermissible avoidance arrangement (IAA) , unless the concerned person proves otherwise.”
These IAA are re-characterised from debt to equity (i.e. interest expenditure exceeds by a specified amount will not be eligible for deduction) and vice-versa. As for the purpose of GAAR, interest includes dividend. The re-characterisation of debt to equity is known as thin capitalisation and that of equity to debt is known as reverse thin capitalisation.
However there is no current indication regarding the debt-equity composition for the purposes of arm’s length, commercial substance and bona fide nature. While it is desirable to fix a safe harbor on debt-equity ratios for different type of industries in different stages of project cycle to control the concept of thin capitalisation.The revenue authorities also have other options to decide the nature of capitalisation of a company like:
- Fixed Ratio method : Under this D/E ratio for a specific industry is fixed and any excess interest paid on excess debt may be disallowed. It may be noted that the dis-allowance of interest may not reduce the interest income as well as the tax liability of the creditor; or
- The hidden profit method : Under this approach, the excess interest is treated as dividend which is liable to dividend distribution tax and taxed accordingly.
As the thin capitalisation rule introduced in the Code is appreciated, the Government synonymously take steps and provide:
- the minimum equity and debt thresholds for qualification of entities as associated enterprises (for the purpose of transfer pricing norms);
- the required guidance to multinational enterprises i.e. how the capital structures (debt-equity) should be formed or maintained.