Budget 2020: NBFCs expect exception from thin capitalisation rules

Sunil Badala, Waman Kale

Indian economy - boom or doom

The headlines today are engulfed with news on the unpredictable state of the Indian economy. Contentions in support of both, the boom and doom outlook are being put forth.

A persistent economic slowdown coupled with volatile macro and micro factors has resulted in Budget 2020 being a subject matter of intense scrutiny. The all-encompassing expectation from the second Union Budget of the second term of the central government is a pragmatic and swift resolution of the financial woes and fiscal challenges plaguing the country.

One sector that indisputably warrants urgent attention and decisive action is the liquidity-starved non-banking financial companies (NBFC) space. Apart from the regulatory incentives/relaxations, an exemption from the limitation of interest provisions (colloquially referred to as thin capitalisation) under the income-tax law can be a major booster for a part of the industry.

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What is thin capitalisation in India?

Multinational enterprises have the ability to finance group entities with debt from other group companies, in a manner which results in higher interest expense claims and lower taxable profits for the borrowing entity. Following the recommendations of Action Plan 4 of the Organisation of Economic Co-operation and Development /G20 BEPS project that deals with proposals to prevent base erosion through the use of interest expense, tax administrators of several countries have introduced a limit on the amount of interest that can be claimed by for tax purposes.

In India, this limit is set at 30 percent of the EBITDA (subject to conditions) and limits interest deduction in respect of debt from a non-resident related party. Further, not only the interest paid or payable to the foreign group entities, but also the interest on debt explicitly or implicitly guaranteed by the group entity is covered under the purview of these rules.

Thus, in cases where debt of the Indian entity is guaranteed by the group, there is ambiguity as to whether limitation of interest provisions would apply in the following situations : (a.) lender is a foreign entity or (b.) lender is an Indian branch of the foreign lender or (c.) Indian lender.

Indian entities engaged in the business of banking are exempted from these provisions of thin capitalisation. However, no such exception is made for NBFCs.

What is the grievance of NBFCs?

There are many foreign-owned and controlled NBFCs which are impacted by these provisions. There are captive NBFCs, which are wholly-owned subsidiaries of foreign operating companies (like automakers), which offer loans to customers to purchase the merchandise of their holding companies. Even foreign banking groups and financial institutions, wanting to render services permitted under the NBFC regulations have set up shop in India. These NBFCs predominantly rely on their foreign group entities to either directly fund or guarantee the funding of their operations and are thus hit by the thin capitalisation provisions.

For an NBFC (a bank for instance), securing debt is like procuring raw material for conducting its business. The resultant interest expenditure is generally always higher than 30 percent of its EBITDA. Also, interest is the main component of the total expenditure claimed by the NBFCs. Applying thin capitalisation rules results in disallowance of interest expense and consequent increase in tax outflows, impacting the profitability and viability of these entities.

What is the rationale for seeking relief?

The primary contention of the impacted NBFCs is that if banks are provided exemption from thin capitalisation rules, then NBFCs (which operate on similar modus operandi) should also be treated on the same footing. Just like the banks, even the NBFCs are functioning under a stringent regulatory framework in India. Similar to banks, operational aspects of NBFCs, like capital adequacy ratio, asset classification norms, minimum net-owned fund requirement, etc. are monitored under the vigilant aegis of the Reserve Bank of India. If all else is equal, then why the discrimination towards the impacted NBFCs?

India's never quenching quest for financing its growth can be satiated by tapping the foreign funding through the NBFC route. Due to certain regulatory constraints on banks, there are sections of borrowers which are catered to only by the NBFCs (also known as the shadow banking industry).

Captive NBFCs play an indirect catalyst role in supporting the government's bid to bolster the manufacturing sector in India. Take for instance, a captive NBFC of an automobile maker, manufacturing cars in India. The captive NBFC assists the customer in financing the purchase of the car - the purchase of the car boosts the demand of the car - the increase in demand of the car encourages the manufacture of the car and supports ancillary industries, generating employment opportunities in the country. Perhaps this is a valid cause to eradicate the thin capitalisation damper?

Even under the income-tax law, in the last Union Budget, the NBFCs have been granted parity with the banks. Just like banks, interest income from bad or doubtful debts is now taxable on receipt basis for NBFCs. This year the ask is for uniformity in treatment of interest expense.

(The author Badala is a Partner and Head of Financial Services, Tax at KPMG in India and Kale is a Chartered Accountant.)

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