Budget 2017 - Curbing Thin Capitalisation

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