Why in news?
The steps were taken in Union Budget 2017 to address the issue of thin capitalisation.
What is Thin Capitalisation?
When a local company has more debt than equity, then the arrangement is called thin capitalisation.
Why is thin capitalisation bad?
- Generally interest paid for a debt is not taxed.
- Therefore an Indian unit would pay high interest to the foreign associated firm to avoid tax.
- Also the interest paid by the local company to the foreign associate was taxable at a lower rate when the foreign company was registered in a tax treaty country.
What is EBITDA?
- Earnings before interest, tax, depreciation and amortization (EBITDA) is a measure of a company's operating performance.
- It is a way to evaluate a company's performance without having to include financing decisions, accounting decisions or tax environments.
What are the measures taken?
- Section 94 B of the Finance Bill, 2017 increased the tax burden on local company with thin capitalisation.
- If the interest paid by a local company is more than 30% of Ebitda, it will not beallowed any tax exemption.
- Section 94 B is applicable to an Indian firm or MNC operating via permanent establishment in India, which has debt from a non-resident associated enterprise and pays interest or similar consideration of over Rs 1 crore to the associated enterprise.
What are the consequences?
- Introduction of thin capitalisation rules is in line with international practice.
- But it also has some negative effects.
- Tax payment of several companies with high debt and low Ebitda could increase, reducing their profitability.
- This provision could have an adverse impact on capital intensive and highly leveraged companies.
- This will affect the capacity of a borrower to repay the interest on borrowings and therefore it is a negative for banks too.
- New companies setting up branches or subsidiaries will also need to factor in the thin capitalisation limitations while determining their funding structure i.e might deter new investments.
Source: Business Standard
