Foreign investors in India adopt thinly capitalized or highly leveraged business structures. Thin capitalization implies a high debt-to-equity ratio, primarily designed to lower tax liability. The effective Dividend Distribution Tax rate in India is 20.36%, whereas, interest paid by a subsidiary to its foreign parent is subject to a withholding tax @5-20%. The Indian subsidiary also gets tax benefit on the interest paid to the parent. The thinly capitalized structures lead to an erosion of tax base and shifts profits to foreign jurisdictions, usually with a lower tax rate.
The Government has taken up the matter on priority under its Base Erosion and Profit Shifting (BEPS) project. A big step towards plugging the loophole is the introduction of Section 94B in the Income-tax Act, 1961 (Act) vide the Finance Act, 2017. On the other hand, the General Anti-Avoidance Rules (GAAR) have already gone into effect from this financial year.
The Government has taken up the matter on priority under its Base Erosion and Profit Shifting (BEPS) project. A big step towards plugging the loophole is the introduction of Section 94B in the Income-tax Act, 1961 (Act) vide the Finance Act, 2017. On the other hand, the General Anti-Avoidance Rules (GAAR) have already gone into effect from this financial year.
Income Tax lawyer, Suyash Sinha has explained the new provision in complete detail in his article "Understanding ‘Thin Capitalization’ norms in India – A double whammy to abusive tax structures". The article goes on to explain how the anti-avoidance rules (GAAR) can be applied in conjugation with Section 94B, which is a part of the Transfer Pricing norms .
"The Government has certainly shown its commitment to adhere to the BEPS project by introduction of thin capitalization norms in India, but questions such a double whammy TP adjustment along with Section 94B disallowance or simultaneous application of GAAR along with Section 94B remain open till further clarification from the CBDT. It would do good to clarify such fears that may discourage MNEs from investing in India."
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