Companies may soon find it unviable to take large loans for claiming tax deduction on the interest paid on debt. The government is planning to introduce 'thin capitalisation' rules to check such tax avoidance, by capping the debt proportion that will qualify for tax deduction.
Thin capitalisation is where a higher proportion of funds are infused into a company in the form of debt rather than equity, because interest paid on loans is deductible for calculating taxable profits, whereas dividends are paid post-tax. With thin capitalisation rules, tax authorities will be able to reclassify some part of the interest paid as dividend and deduct tax on it.
"A committee, headed by a director general of income tax, was asked to frame thin capitalisation rules. It has submitted its report. The rules are seen more as a mechanism for checking tax avoidance rather than revenue generation," said an official in the finance ministry on condition of anonymity.
Private sector analysts, however, say infusing funds through debt or equity into a company is purely a financing decision, and thin capitalisation rules should not affect investment into the country, provided the government limits the debt to equity ratio in accordance with the needs of various sectors.
"It may affect foreign investment to the extent that the cost of financing equity is higher than debt. (But) If the rules are not framed arbitrarily, there will not be much impact, because taxation benefits alone do not drive investment decisions," said Amitabh Singh, partner, Ernst & Young.
Countries such as the US, Poland, Hungary, Germany, the Netherlands, Russia and China already have thin capitalisation rules. Most countries define a maximum debt to equity ratio beyond which excess interest paid is disallowed, or a penalty is imposed, or interest is reclassified as debt. While some countries limit the amount a company can claim as a tax deduction on interest paid to a cross-border or related company, some disallow interest deductions above a certain level from all sources.
In India, the Foreign Investment Promotion Board (FIPB) has defined the debt to equity ratio limit for the automatic investment route in various sectors. However, companies can always go for a higher debt to equity ratio after taking approval from FIPB. Moreover, FIPB norms are only for checking foreign investment and this does not apply to domestic investors. Thin capitalisation rules will apply to investments from all sources.
The first draft of the new Direct Taxes Code also tried to highlight the issue to some extent. It had proposed that any arrangement entered into by a person for availing tax benefits would be declared an impermissible avoidance arrangement, unless the person obtaining the tax benefit proved otherwise.
