Home >Markets >Stock Markets >Liberalization of debt financing norms: The need to evaluate investment models

Besides equity, debt instruments play an important role in financing any business. With the revision in Indian external commercial borrowings (ECB) framework, a careful evaluation of existing financing structures is needed for businesses and investors to ensure tax efficiency and cost optimization.

Debt financing through debentures and loans has traditionally been an important source of funds for businesses in India. Unlike equity financing, debt financing does not result in dilution of ownership; but it has higher costs associated with it. In general, the cost of raising and maintaining debt in India is quite high in comparison to many foreign countries.

This has made foreign debt financing through ECBs a popular mode of funding. ECBs in India are regulated by the Reserve Bank of India (RBI) and are primarily in the form of optionally convertible debentures, foreign currency convertible bonds (FCCBs) and non-convertible, optionally convertible or partially convertible preference shares.

As per RBI’s annual report for financial year 2017-18, despite increase in total ECB raised, India witnessed net outflows on account of higher repayments and strict norms for issue of rupee-denominated bonds. In order to boost capital inflows, RBI issued a new simplified framework for ECB replacing the erstwhile multi-tiered ECB structure with a simplified 2-Tier framework in January 2019.

A quick snapshot

Under the revised framework, ECBs have been categorized into following:

(a) Foreign currency denominated ECB (FCY ECB)

(b)Rupee denominated ECB (ECB in INR)

Some of the key highlights of the revised norms are below:

•Expansion of list of borrowers: Eligible borrowers now include all entities eligible to receive foreign direct investment vis-à-vis the earlier restricted list of specified entities. However, the revised regime provides that a borrower shall be classified as ‘untraceable’ and consequently become ineligible for raising ECB under automatic route if it fails to comply with certain regulatory requirements (such as non-filing of statutory auditor certificate and non-operational registered office, non-responsiveness of entity/promoters/auditors etc).

•Expansion of list of lenders: The revised framework expands recognized lender list to include resident of Financial Action Task Force (FATF) or International Organisation of Securities Commissions (IOSCO) compliant country. However, certain restrictions have been placed on individual foreign equity holders.

•Liberalization of end-use restrictions: The revised regime provides for a single negative list as against prescribed end-use restriction for each tier under the erstwhile regime. The single list of restriction on utilization of ECB proceeds (popularly known as end-use restrictions) inter alia includes:

-prohibition on real estate activities

-investment in capital market

-equity investment

-working capital/general corporate/repayment of domestic rupee loan purposes except from foreign equity holder

-on lending to entities for these activities.

However, in order to facilitate simpler resolution process for companies under insolvency, a relaxation has been provided to applicants undergoing insolvency, whereby they are allowed to raise ECBs for repayment of rupee term loans of the target company, subject to prior approval of RBI.

•Minimum average maturity period: The minimum average maturity period (MAMP) for all ECBs has been kept at three years. However, following exceptions have been prescribed:

*In case of a manufacturing company raising ECB up to $50 million per financial year, the MAMP is kept at one year

*In case of ECB raised by foreign equity holders and utilized for working capital, general corporate purposes or repayment of rupee loans, the MAMP has been kept at five years

•Other relaxations: Various other relaxations have been prescribed like:

*Relaxation of borrowing limit across sectors for raising ECB up to $750 million or equivalent per financial year under the automatic route replacing existing sector-wise limits.

*In case of foreign currency denominated ECB raised from direct foreign equity holder, the amount of ECB cannot exceed more than seven times the equity of the borrowing entity, except where the outstanding amount of the ECB’s is up to $5 million or equivalent.

Road ahead for foreign investors

The simplified ECB regime opens new avenues for foreign investors for financing their Indian ventures. At the same time, stricter compliance requirements, in relation to ineligibility for untraceable entities aim to ensure its optimal utilization for genuine business needs.

Further, expansion of the list of borrowers presents a unique opportunity for corporates to re-look at ECB option for fund-raising, especially for subsidiaries in India. It is also a welcome change for limited liability partnership (LLPs) and other sectors which were earlier ineligible to receive ECB like services sector and trading sector. It is pertinent to note that the liberalization of foreign direct investment together with no tax cost on repatriation of profits in case of LLPs has made it an attractive investment vehicle to do business in India.

Further, the Indian taxation regime currently provides for a lower base withholding tax rate of 5% on interest payments subject to fulfilment of certain conditions. While, this lower rate is presently available with a sunset clause of 1 July 2020 i.e. for loans raised before such period, it is interesting to note that the government has, in past, extended the sunset clause. One would hope that the government may extend the current sunset clause further to give a boost to foreign debt financing and investor sentiment.

Nevertheless, benefit of a lower tax rate, if any, can be availed under respective tax treaties, as applicable.

In nutshell, businesses and foreign investors should re-evaluate their existing and future financial models to factor in the revised ECB framework and the associated tax arbitrage, to have a right mix of equity v debt and also achieve cost optimization vis-à-vis their overall financing costs.

Does India have thin capitalization rules?

India has recently introduced thin capitalization norms as per which interest payments (exceeding `10 million) made to foreign associated entities shall not be allowed as a deduction for tax purposes if the same exceeds 30% of earnings before interest, tax and depreciation allowance (Ebitda). However, a taxpayer is entitled to carry-forward such excess interest ie. interest exceeding the 30% threshold, and claim a tax deduction of the same for a period of 8 years.

What are the reporting requirements under ECB regulations?

A borrower is required to obtain a loan registration number from the Reserve Bank of India (RBI). For this purpose, a duly certified Form ECB specifying the terms and conditions of the ECB is required to be submitted with the RBI through the Authorised Dealer Category-I Bank. Further, borrowers are also required to report (in Form ECB 2 Return) actual ECB transactions undertaken on a monthly basis.

Vikas Vasal is national leader tax, Grant Thornton India LLP.

Priyanka Duggal and Nandita Suri contributed to this article.

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