TAX NEWS - JUNE 2010

Thin capitalization for tax avoidance

The direct tax code is likely to include a new provision on thin capitalization to prevent companies from borrowing excessively with a view to reduce their tax liability.

There are other reasons why companies go in for thin capitalization. The choice between equity and debt is not free. That choice is decided by the solvency risk to be covered, the conditions in the capital market and, if these permit, by reduction in tax liability.

A new company would prefer equity to debt because interest cannot be postponed but dividend can. The deciding factor, however, is the market. If it is on the downturn companies will find it difficult to issue IPOs and consequently capitalization becomes thin.

Even when equity is easy companies will still go in partly for debt because equity is more expensive to service. Tax laws allow interest as cost while the whole of the profit becomes taxable. As such, debt, by reducing the tax liability, enhances the return on equity.

To prevent tax avoidance by excessive leveraging, many countries have introduced rules to prevent thin capitalization. On foreign investment, the FIPB has imposed norms in regard to the debt/equity ratio for different industries, mainly on the consideration of solvency risk. What is proposed now is to introduce rules in regard to thin capitalization for all companies.

There is no agreement on what constitutes thin capitalization. Two obvious measures are the debt/equity ratio and the ratio of interest to profits before tax. Both these concepts are used by different countries to frame rules to prevent thinning of capital to avoid tax liability.

Generally, it is the debt/equity ratio which is preferred because the share of interest in profits can vary with the rate of interest or the rate of profit. The financial institutions have been using debt/equity ratio to cover risk. The accepted level is 2:1.

In USA, the debt/equity ratio in excess of 1.5:1 is considered to amount to thinning. In China, for financial companies it is 5:1 and for non-financial companies 2:1.

Tax incidence has not been a major consideration in tax reduction for Indian companies. In recent years they have relied more on equity in preference to debt. Non-financial companies toned down the debt/equity ratio from 1.1:1 in 2002 to 0.8:1 in 2009. That is mainly because the capital market has been bullish. Consequently, capital raised annually by issue of shares increased from Rs. 111 billion to Rs. 1011 billion.

Surely, there are variations between industries. In sugar and textiles the ratio exceeds 2.5:1, in fertilizers, transport services and electricity a little over 1:1 and in most other industries it is less than that.

Clearly, the Indian companies have not used thinning of capital as a strategy to reduce their tax liability. If at all the Government has to bring in legislation on thin capitalization, it should be in terms of the debt equity ratio which, as a norm for taxation, should not be lower than 2:1.