Thin capitalisation norms to weigh on realty offshore funding – By Ruchir Sinha, Co-Head, Private Equity and M & A, Nishith Desai Associates

Whilst Union Budget 2017 – 18 has made significant progress for the affordable housing segment, offshore funding in real estate is likely to be severely impacted by the introduction of an irrational Thin Capitalisation Norms regime capping the interest deductions to a maximum of 30% of EBITDA of the borrower if paid to a non resident associated enterprise.

Budget 2017 has borrowed the provision from BEPS Plan Action 4 without realising that the term ‘associated enterprises’ under the Income Tax Act, 1961 (“ITA”) is extremely wide, and includes not just parent subsidiary relationship, but any person who lends an amount in excess of 50% of the book value of the assets of the borrowing company. Hence, the provision could rub the wrong way in many cases.

For instance, take the case of a special purpose vehicle funded by an offshore PE fund where the PE funding is largely in the form of structured debt. But since the book value of the assets is quite low, the offshore PE Fund could qualify as an associated enterprise since the debt maybe more than 50% of the book value of the assets. Even investments made in FDI instruments like compulsorily convertible debentures could be covered since until converted, such instruments would also qualify as debt. Hence, in such a situation any interest paid to such associated enterprise will be capped at 30% of the EBITDA.

The provision, not only applies to future investments, but also to the past borrowings and limits the extent of interest deductions that a borrower could claim on borrowings taken in the past so long as the interest payments need to be made FY 17 – 18 onwards. The thin capitalization norms, as proposed, shall be applicable to interest payments made from FY 17 – 18, and, hence, borrowers may need to renegotiate their debt agreements.

For instance, a company has borrowed INR 100 at an interest of 15% per annum. If there is an EBITDA of INR 30, the borrower can claim deductions only up to INR 9 (30% of INR 30) instead of its requirement to pay INR 15 to the lender. Thus, while the borrower will be required to pay an amount of INR 15 as per its loan agreement, interest expense over and above INR 9 will no longer be permitted as a deductible expense for the borrowing company, making the entire purpose of debt investment futile.

Transfer pricing on interest payments was always applicable on interest paid to non resident associated enterprises, but the parameter then was that interest deduction could be disallowed only if the interest paid was more than arm’s length, say in excess of 20% p.a. But now with this 30% EBITDA capping, interest expense could be disallowed even if the interest paid meets the arm’s length criterion if the borrower company has lower EBITDA.

With more than 70% of the foreign funding in real assets received in the form of structured debt, more particularly non-con vertible redeemable bonds, legitimate tax optimization of cash up-streaming in cash accretive assets (such as real estate, roads, hospitals, and infrastructure) is the cornerstone of any investment in these sectors globally. Debt is infused into these entities, not just for tax optimisation purposes, but because of the way the industry operates commercially, considering the risks and yields.

BEPS Plan Action 4 was meant more in context of group companies and is highly misplaced in the Indian context, and unless the definition of ‘associated enterprise’ is amended accordingly in the ITA, such thin capitalisation norms will be a major dissuading factor for any offshore PE fund to invest in Indian assets, particularly those demanding constant cash upstreaming.