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Transfer pricing regulations -- Finance Ministry may address thin capitalisation issues

Hema Ramakrishnan

K.R. Srivats

NEW DELHI, July 2

THE Finance Ministry is likely to address issues relating to ``thin or hidden capitalisation'' as a follow-up to the transfer pricing regulations formulated in this year's Union Budget.

Thin capitalisation is a mechanism wherein funds are infused into a company in the form of loan rather than equity to avail of tax benefits. This would also ensure that the capital of the company is very small or thin.

A higher debt component in the capital structure -- reflected by an exorbitantly high debt-equity ratio -- enables companies to save on taxes since interest on loans is normally deductible for calculating taxable profits. This is in contrast to dividends which are not deductible.

Sources said that the team from the Organisation for Economic Cooperation and Development (OECD), which met senior Finance Ministry officials recently, underlined the need to put in place a regulatory framework that would dissuade multinational and other companies from disguising equity investments as loans in order to reduce their tax liability in India.

Since the tax advantage is secured at the cost of the exchequer, governments, the world over, have enacted laws to prevent revenue losses through the device of ``thin or hidden capitalisation'', particularly when the lender is a ``related person''.

The intention to disguise dividend as interest or equity capital as loan becomes apparent if the debt-equity ratio of an assessee is very heavy in case of an organisation which has a special relationship (for eg ownership) with the company which provides a larger amount of loan capital than an independent institution would have done.

In that case, a part of the amount represents dividend but is paid as interest. An appropriate legal framework would enable tax authorities to tax such an amount as though it were dividends, on arm's length principle -- ie, by holding so much of the amou nt as loan as would have been agreed upon between unrelated parties engaged in similar conditions in an open market.

Although no proposal to counter ``thin capitalisation'' has been concretised as of now, tax authorities are of the view that this issue will have to be eventually addressed. The Government may consider the constitution of an expert committee to look into this issue.

``The Ministry has only recently formulated the legal provisions and the draft rules on transfer pricing. We have to first overcome teething problems, before we look at finer issues such as thin capitalisation and its impact on transfer pricing'', a seni or official said.