By Cherry Bansal
Mar. 7 – These days, business has no boundaries. Entrepreneurs are investing worldwide and indulging in more and more cross border investments. While investing in various countries, investors can take advantage of low tax jurisdictions over high tax jurisdictions by structuring the funding in a tax efficient manner.
There are broadly two ways in which a company may be financed:
The method of funding affects the taxation of corporate income. In determining the level of equity and debt, taxation is one aspect which has a major influence apart from commercial considerations.
Taxation of the company and the person providing capital gets affected by the way in which the capital is provided. Different funding methods also affect the taxation of up-streaming and repatriation of funds (e.g. taxation on dividend distribution, taxation on interest income, withholding taxes). It also effects taxation of exit route mechanism (e.g. capital gains taxes in case of sale of shares held in a non-resident company).
Tax advantages derived from the use of loan capital rather than equity capital and the fact that these may induce the parties concerned provide what is essentially equity capital in the form of a loan. This is sometimes described as “hidden equity capitalization,” commonly known as “thin capitalization.”
An indication of the possible presence of thin capitalization is a high proportion of debt to equity as a feature of the company’s capital structure. In such a case, the company is sometimes said to have a “high debt/equity ratio.”
A high debt/equity ratio helps in achieving maximum flexibility in the movement of funds within a multinational enterprise at a minimum tax cost to the enterprise as a whole.
For example: the lender is subject to lower tax rates, or is exempt from tax, or has to carry forward losses, etc.
Foreign investors may obtain tax advantages in the country of source by artificially using loans rather than equity.
Advantages of debt financing over equity financing
Due to differences in the tax treatment of equity and debt financing, debt financing is often considered to be more favorable than equity financing. Some of the advantages of debt financing are discussed hereunder:
As this type of structuring leads to tax avoidance, some countries have framed rules for acceptable debt/equity ratios, interest on arm’s length price, or disallowance of excess interest paid to group enterprises. Therefore, one needs to be cautious about the tax rulings governing “thin capitalization.”
In India, currently there are no rules governing this tax avoidance method, but it is expected that something governing this will come in the 2012 Budget.
Dezan Shira & Associates is a boutique professional services firm providing foreign direct investment business advisory, tax, accounting, payroll and due diligence services for multinational clients in India. For more information, please contact firstname.lastname@example.org, visit www.dezshira.com, or download the firm’s brochure here.