Page 72 - Focus Group

BEPS action number 4

and working with THIN

CAPITALIZATION RULES

The OECD defines tax arbitrage as “Process of entering into a tax motivated transaction (i.e. to obtain profit
from the application of tax rules)”. Before the changes brought by tax laws following OECD’s BEPS action plans,
MNE’s had created tax avoidance stratagems with such intricacy that the techniques have gained names
of their own like, Double Irish and Dutch sandwich. Today tax planning is no longer an avenue to look for
large arbitrage opportunities; but a way of optimizing profits within the limits of tax regulation and ensuring
compliance in more than one aspect, across tax domains. Beyond commercial considerations, business
decisions for cross border trade and investment involve a careful consideration of tax rules, hygiene checks
form AML perspective, and currency risks. Each of these areas place their own set of constraints.

Thin-capitalization rules are made to prevent businesses from using debt financing or international debt
shifting for tax planning reasons. A thinly capitalized entity is one whose assets are funded by a high level of
debt and relatively little equity. There are two most common thin capitalization rules across countries today.
One restricts the amount of debt for which interest is tax-deductible by defining a debt-to-equity ratio (safe
harbour rule) and the second limits the tax-deductible share of debt interest to pretax earnings (earnings
stripping rule)

Most European countries have thin capitalization rules based on debt equity ratio with some variations. The
debt equity ratio in some tax territories has an uplift for arms-length debt and global debt ratios. India has
adopted the earnings stripping rule. Section 94B of the IT act lays down the limits on interest deductibility. In
broad terms interest or payments of similar nature in excess of INR one crore are restricted to 30% of EBITDA

72 TAX JOURNAL 2020 The Institute of Chartered Accountants of India (Dubai) Chapter NPIO