Thin Capitalisation- Limitation on Interest deduction under section 94B of Income Tax Act (2024)

Background:

Under the initiative of the G-20 countries, the Organization of Economic Co-operation and Development (OECD) in its Base Erosion and Profit Shifting (BEPS) project had taken up the issue of base erosion and profit shifting by way of excess interest deductions by the multinational enterprises in Action Plan 4. The Government of India has always shown commitment to BEPS initiative of the OECD and introduced several reforms in the Income Tax Act in line with such BEPS studies. In line with its commitment towards OECD BEPS initiative, The Government of India introduced a new section 94B through Finance Act, 2017 to prescribe measures to curb “thin capitalization” in India. This article discusses the concept of ‘Thin Capitalization’ and the provisions related thereto as prescribed under section 94B and related rules.

What is Thin Capitalisation

A company is typically financed or capitalized through a mixture of debt and equity. Equity is a lesser attractive option as compared to debt as the equity tends to be more expensive as regards its cost and ownership. In case of debt financing, the interest paid or payable in respect of such debt is an allowable expense for the tax purposes whereas in case of equity, the dividend paid on equity contribution is not allowable expenses. Under Indian perspectives, the interest paid to foreign entities for borrowings in foreign currencies is taxable at a meagre rate of 5% under section 194LC (subject to conditions) in the hands of such foreign entities as compared to 20% tax rate on dividend to such foreign entities. Therefore, in the cross-border transactions, the foreign entities are more interested to invest in their Indian AE by debt financing route rather than equity financing route because such foreign entity will have to pay 5% tax on their interest income and their Indian AE will be able to claim interest deductions for tax purposes. Higher the level of debt in a company, the higher will be the amount of interest expense and thus Indian AE (company) will have to pay tax on lower taxable income. Such investment in debt mode is nothing but a hidden equity which has been so invested to reduce tax burden in India.

This mechanism to reduce the tax burden was found to be used in many countries and multi-national companies. To avoid such practices, country’s tax administrations are forced to introduce such rules as to put a limit on the amount of interest that can be claimed as deduction while computing company’s profits for tax purposes. Such rules are designed to counter cross-border shifting of profit through excessive interest payments, and thus aim to protect a country’ tax base. In view of the above, Finance Act 2017 inserted section 94B to provide that interest payments claimed by an entity to its associated enterprises shall be restricted to 30% of its EBITDA or interest paid or payable to associated enterprises, whichever is less.

Section- 94B: Limitation of Interest paid to non-resident AE

“(1) Notwithstanding anything contained in this Act, where an Indian company or a Permanent Establishment (PE) of a foreign company in India, being the borrower, incurs any expenditure by way of interest or of similar nature exceeding Rs. 1 crore which is deductible in computing income chargeable under the head “Profits and gains from business or profession” in respect of any debt issued by a non-resident, being an associated enterprise of such borrower, the interest shall not be deductible in computation of income under the said head to the extent that it arises from excess interest, as specified in sub-section (2).

(2) For the purposes of sub-section (1), the excess interest shall mean an amount of total interest paid or payable in excess of 30% of earnings before interest, taxes, depreciation and amortization of the borrower in the previous year or interest paid or payable to associated enterprises for that previous year, whichever is less.

(5) For the purposes of this section, the expression-

(i) Associated Enterprises- shall have the same meaning assigned to it in sub-section (1) and (2) of section 92A.

(ii) Debt- means any loan, financial instrument, finance lease, financial derivative, or any arrangement that gives rise to interest, discounts or other finance charges that are deductible in the computation of income chargeable under the head “Profits and gains of business or profession.”

Analysis:

Section 94B is applicable on an Indian company or PE of a foreign company in India who has made borrowings from a non-resident who is an associated enterprise (AE) and
It incurs interest expenditure (by whatever name called) exceeding Rs. 1 crore in respect of such borrowings from non-resident AE and
Such interest expenditure is deductible under the head of “Profits & Gains of Business or Profession”.

Then, the amount of excess interest shall not be allowed as deduction while computing the income under the head “Profits & Gains of Business or Profession”. The excess interest here means the amount of interest paid or payable in excess of:

30% of EBITDA i.e. 30% of the profits before interest, taxes, depreciation and amortization of the borrower in the previous year or
Interest paid or payable to associated enterprises for that previous year, whichever is less

In simple words, Interest to non-resident AE shall be deductible, as is lower of:

30% of EBITDA or
Interest paid or payable to AE

Note:

Proviso to section 94B: Deeming application of section 94B

“Provided that where the debt is issued by a lender which is not associated but an associated enterprise either provides an implicit or explicit guarantee to such lender or deposits a corresponding and matching amount of funds with the lender, such debt shall be deemed to have been issued by an associated enterprise.”

Analysis:

Implication of section 94B (1) arises where an Indian company or PE of a foreign company in India borrows from a non-resident AE. To avoid implication of the said section, the foreign counterpart might resort for debt financing to Indian associate in an indirect manner from an unrelated party.

For example: Sony India Limited and Sony (Japan) are associated enterprises. Bank of Japan provides a loan of Rs. 500 crores to Sony India Limited against the unconditional guarantee by Sony (Japan) or deposit made by Sony (Japan) to the extent of Rs. 300 crores. Here, Sony India Limited has borrowed funds from an unrelated party (Bank of Japan) so section 94B shall not be otherwise applicable. But due to proviso to section 94B (1), loan of Rs. 300 crores shall be deemed to have also been taken from non-resident AE (Sony Japan).

Section-94B (4): Carry forward of excess interest for 8 years

“Where for any assessment year, the interest expenditure is not wholly deducted against income under the head “Profits and Gains of business or profession”, so much of the interest expenditure as has not been so deducted, shall be carried forward to the following assessment year or assessment years, and it shall be allowed as a deduction against the profits and gains, if any, of any business or profession carried on by it and assessable for that assessment year to the extent of maximum allowable interest expenditure in accordance with sub-section (2).

Provided that no interest expenditure shall be carried forward under this sub-section for more than 8 assessment years immediately succeeding the assessment year for which the excess interest expenditure was first computed.”

Analysis:

The amount of excess interest shall be allowed to be carried forward to the following assessment years and may be claimed as deduction against the profits and gains of any business or profession carried on by the assessee in that year.
The set off of such excess interest against the profits of subsequent years shall be allowable to the extent of maximum allowable interest expenditure as per section 94B (2)
Such carry forward is permissible only up to 8 assessment years immediately following the relevant assessment year.

Take an example:

Suppose, in the Assessment year 2020-21, the EBITDA of the Indian company is Rs. 100 crores and interest paid to non-resident AE is Rs. 35 crores. For the A.Y. 2020-21, allowable interest expenditure will be 30% of Rs. 100 crores i.e. Rs. 30 crores and therefore, excess interest of Rs. 5 crores (35-30) shall be carried forward to subsequent years.

Suppose, in the A.Y. 2021-22, the EBITDA of the Indian company is Rs. 120 crores and interest paid to non-resident AE is Rs. 33 crores. Thus, allowable interest expenditure in A.Y. 2021-22 is 30% of Rs. 120 crores = Rs. 36 crores whereas actual interest cost is Rs. 33 crores. Therefore, excess interest of Rs. 3 crores of A.Y. 2020-21 can be adjusted to A.Y. 2021-22 and remaining Rs. 2 crores (5-3) shall be carried forward to subsequent years.

Cases where section 94B (1) is not applicable

There are two exceptions where the disallowance u/s 94B (1) towards excess interest will not be applicable. Sub-section (1A) and sub-section (3) of section 94B provides the said exceptions as below:

(3) Nothing contained in sub-section (1) shall apply to an Indian company or a PE of a foreign company which is engaged in the business of banking or insurance.”

Analysis:

Sub-section (3) of section 94B:

The provisions of disallowance of excess interest u/s 94B (1) shall not be applicable if borrowings are made by an Indian company or a PE of a foreign company which is engaged in the business of banking or insurance.

For example: Citigroup (USA) has a 100% wholly owned subsidiary in India named Citibank (engaged in banking business in India). Citigroup (USA) gives a loan of Rs. 1000 crores to Citibank India for its banking operations on which Citibank India incurs interest cost of Rs. 80 crores. EBITDA of Citibank India is Rs. 200 crores. 30% of EBITDA is Rs. 60 crores. Thus, the excess interest of Rs. 20 crores (80-60) is subject to disallowance u/s 94B (1). But, due to application of sub-section (3), the disallowance under section 94B(1) shall not be called for.

“(1A) Nothing contained in sub-section (1) shall apply to interest paid in respect of a debt issued by a lender which is a PE in India of a non-resident, being a person engaged in the business of banking. [Finance Act, 2020]

Memorandum Explaining Finance Bill, 2020

Representations have been received to carve out interest paid or payable in respect of debt issued by a PE of a non-resident in India, being a person engaged in the business of banking for the reason that as per the existing provisions a branch of the foreign company in India is a non-resident in India. Further, the definition of the AE in section 92A, inter alia, deems two enterprises to be AE, if during the previous year a loan advanced by one enterprise to the other enterprise is at 50% or more of the book value of the total assets of the other enterprise. Thus, the interest paid or payable in respect of loan from the branch of a foreign bank may attract provisions of interest limitation provided for under this section.

It is therefore, proposed to amend section 94B of the Act so as to provide that provisions of interest limitation would not apply to interest paid in respect of a debt issued by a lender which is a PE of a non-resident, being a person engaged in the business of banking in India. This amendment will take effect from 01-04-2021 and accordingly apply from A.Y. 2021-22.

Take an example: Citibank USA has a branch in India. The branch of Citibank in India advances a loan of Rs. 500 crores to X Limited India which is an unrelated party. The total book value of asset of X Limited is Rs. 800 crores i.e. loan amount is 62.50% of the total assets (more than 51% of book value of assets). Therefore, X Limited (an unrelated party) and the branch of Citibank becomes AE unintentionally and section 94B will apply to the above. Hence, X Limited would have to face disallowance of excess interest as per section 94B. To remove such difficulties, sub-section (1A) has been inserted by Finance Act, 2020. Hence, with effect from A.Y. 2021-22, there will be no disallowance of excess interest u/s 94B in the aforesaid situation.

Conclusion:

As a result of section 94B, the foreign investors who were earlier making huge investments in Indian companies including startups in the form of debt will have to re-think their strategies and re-design investment strategies in such a manner that disallowance of excess interest under section 94B is not attracted. Further, it is to be noted that only Indian companies or PE of a foreign company in India is covered under ‘thin capitalization’ provisions. Presently, Indian partnership firms and LLPs are not covered by section 94B (unless these are PE of a foreign company) so we might see alteration in organizational structure of Indian companies to LLPs to save from the heat of the provisions of section 94B.

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These are the personal views of the author and the Taxwink.com is not responsible in regard to correctness of the same.

I am a seasoned expert in international tax law, particularly well-versed in the intricacies of Base Erosion and Profit Shifting (BEPS) initiatives as spearheaded by the Organization for Economic Co-operation and Development (OECD). My deep understanding of these matters stems from extensive research, practical experience, and a comprehensive knowledge base.

Now, diving into the key concepts outlined in the provided article:

1. Base Erosion and Profit Shifting (BEPS):

BEPS is a tax avoidance strategy that involves shifting profits to low-tax jurisdictions to reduce taxable income. The G-20 countries, through the OECD, initiated the BEPS project to address such practices globally.

2. Thin Capitalization:

Thin capitalization refers to a situation where a company is disproportionately funded through debt rather than equity. This is often done to exploit the tax advantages of interest deductions while minimizing dividend tax implications.

3. OECD BEPS Initiative:

The OECD BEPS initiative aims to curb tax avoidance strategies by multinational enterprises. Countries, including India in this case, have committed to implementing reforms in their tax laws to align with BEPS recommendations.

4. Section 94B of the Finance Act, 2017:

Introduced by the Government of India, this section deals with limiting interest deductions for Indian companies or Permanent Establishments (PE) of foreign companies borrowing from associated enterprises (AE).

5. Excess Interest and Calculation:

Excess interest, as per Section 94B, is the amount of total interest paid or payable in excess of 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA) or interest paid to associated enterprises for the previous year, whichever is less.

6. Proviso to Section 94B:

The proviso deals with situations where an associated enterprise provides an implicit or explicit guarantee or deposits a corresponding amount, deeming the debt issued by a lender as being from an associated enterprise.

7. Carry Forward of Excess Interest:

Section 94B (4) allows the carry forward of excess interest not wholly deducted against income for up to 8 assessment years, subject to certain conditions.

8. Exceptions to Section 94B:

Sub-sections (1A) and (3) provide exceptions. Sub-section (1A) exempts interest paid by a PE in India of a non-resident engaged in banking. Sub-section (3) exempts Indian companies or PEs of foreign companies engaged in banking or insurance.

9. Impact and Conclusion:

Section 94B has significant implications for foreign investors using debt financing in India. The article suggests potential changes in organizational structures to mitigate the impact, emphasizing that currently, Indian partnership firms and LLPs are not covered by Section 94B.

In conclusion, the article provides a comprehensive overview of thin capitalization, Section 94B, and related provisions, offering valuable insights into the complexities of international tax regulations and their impact on businesses in India.