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Interest paid on debt by firms may be taxed

Vrishti Beniwal  |  New Delhi 

The Direct Taxes Code (DTC) will allow the government to tax a portion of the interest paid on debt by companies. Thin capitalisation rules, which help tax authorities reclassify part of the interest paid on debt as dividend and deduct tax on it, may come under General Anti Avoidance Rules (GAAR).

Thin capitalisation rules will be introduced to check possible tax evasion by companies that resort to the use of more debt than equity. Companies often opt for this route as interest paid on debt is allowed for tax deduction. Dividends, on the other hand, do not enjoy any deduction, as they are paid from the income after tax. Under the rules, the tax authorities can cap the debt proportion that qualifies for tax deduction.

Finance ministry officials said thin capitalisation rules could come under GAAR. DTC had proposed GAAR to check arrangements to obtain tax benefits as the main objective. The rules can only be invoked by a commissioner-rank officer and a final order can be passed only after ruling by a disputes resolution panel. Once Parliament clears the DTC Bill, the details of GAAR will be provided separately through rules framed by the finance ministry.

Anti-avoidance rules were just a tool to save the tax base and these would act as a shield, and not a sword, for the government, said an official, who did not wish to be identified.

Countries like 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 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 automatic route in various sectors. But companies can go for a higher debt to equity ratio after taking approval from FIPB. Moreover, FIPB norms are only to check foreign investment and do not apply to domestic investors. Thin capitalisation rules will apply to investments from all sources.

GAAR will be put to use only if an entity, apart from obtaining tax benefit, undertakes a transaction that is not at arm’s length. Alternatively, if the tax authorities find there has been a misuse or abuse of the DTC provisions, or a transaction lacks commercial substance, the tax officials can use GAAR. It will be invoked only where tax avoidance is beyond specified threshold.

GAAR will override the provisions of a Double Taxation Avoidance Agreement.

First Published: Fri, September 03 2010. 01:27 IST