Thin Capitalisation Rules under the Income-tax provisions (section 94B of Income-tax Act, 1961)
‘Thin Capitalisation’ is a situation where an entity is financed at a relatively high level of debt compared to equity. Some multinational companies engage in aggressive tax planning techniques such as placing higher levels of third party debt in high tax countries, using intragroup loans to generate interest deductions in excess of their actual third party interest expense, using third party or intragroup financing to fund the generation of tax exempt income.
In order to curb such structuring by the multinational group Companies having their presence through subsidiaries/ associate companies or permanent establishments in India, the Finance Act 2017 introduced a new section 94B under the Income-tax Act, 1961 (‘the Act’), in line with the recommendations of OECD BEPS Action Plan 4, from the FY 2017-18, to provide that interest expenses claimed by an entity to its associated enterprises shall be restricted to:
– 30% of its earnings before interest, taxes, depreciation and amortization (EBITDA) (or)
– Interest paid or payable to associated enterprise
whichever is less
The provision shall be applicable to an Indian company, or a permanent establishment of a foreign company being the borrower who pays interest in respect of any form of debt issued to a non-resident or to a permanent establishment of a non-resident and who is an ‘associated enterprise’ of the borrower. Further, the debt shall be deemed to be treated as issued by an associated enterprise where it provides an implicit or explicit guarantee to the lender or deposits a corresponding and matching amount of funds with the lender.
Relaxations Provided
1. A threshold limit of interest expenditure of INR 1 crore (INR 10 million) is provided to carve-out entities which have a low level of interest expense on the borrowings from their non-resident associated enterprises.
2. Further, to reduce the impact of earnings volatility on the ability of an entity to deduct interest expense, the interest expense which is disallowed can be carried forward up to 8 immediately succeeding tax years.
3. Moreover, taxpayers engaged in the business of banking or insurance are excluded from the scope of this provision keeping in view their specific sector-related features.
In addition to the above, the provisions of GAAR will have to be simultaneously considered at the time of considering the transfer pricing implications on the transactions.
Frequently asked questions (FAQs)
- What is the definition of EBITDA?
EBITDA has not been defined in section or in the memorandum, however considering the language of the section, it can be interpreted to mean accounting EBITDA.
- Whether transfer pricing adjustment and other disallowances will be considered for the purpose of determination of EBITDA u/s 94B(2)? i.e. Tax EBITDA v/s. Accounting EBITDA?
The language of the section reads as ‘earnings before interest, taxes, depreciation and amortisation’ thereby giving room for adjusting only interest, taxes, depreciation and amortisation to the net earning and ruling out other disallowances, if any. However, if the transfer pricing adjustment has been made and if it falls within the purview of secondary adjustment (i.e. more than 1 crore) which will be accounted as receivable from the associated enterprise (u/s 92CE of the Income-tax Act, 1961), then the same may be considered for the purpose of calculating EBITDA.
- Whether interest paid to non-resident AE only to be considered for the purpose of disallowance under section 94B?
As mentioned in the below email, the provision shall be applicable to an Indian company, or a permanent establishment of a foreign company being the borrower who pays interest in respect of any form of debt issued to a non-resident or to a permanent establishment of a non-resident and who is an ‘associated enterprise’ of the borrower. Further, the debt shall be deemed to be treated as issued by an associated enterprise where it provides an implicit or explicit guarantee to the lender or deposits a corresponding and matching amount of funds with the lender. Therefore, the limit of INR 10 million of borrowing cost mentioned under provision of section 94B will apply to the borrowings of the nature mentioned above.
- Would hedging or swap cost be considered for this purpose or would the interest paid to AE be considered for this purpose?
As per section 94B of the Act, ‘… where an Indian company, or a permanent establishment of a foreign company in India, being the borrower, incurs any expenditure by way of interest or of similar nature exceeding one crore rupees which is deductible in computing income chargeable under the head “profit and gains of 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)’
Sub-section (2) states that ‘For the purpose of sub-section (1), the excess interest shall mean an amount of total interest paid or payable in excess of thirty per cent of earnings before interest, taxes, depreciation and amortisation of the borrower in the previous year or interest paid or payable to associated enterprises for that previous year, whichever is less.’
Therefore, a consolidated reading of the above would mean that for the purpose of calculation of initial limit of INR 10 million for the trigger of this section 94B, interest or sums of similar nature in respect of any debt issued is considered, whereas for the purpose of quantifying the amount of disallowance, only interest in excess of 30 percent of EBITDA is disallowed/ adjusted. However, it is pertinent to note that the word interest has been separately defined in the Act u/s 2(28B) as ‘”interest” means interest payable in any manner in respect of any moneys borrowed or debt incurred (including a deposit, claim or other similar right or obligation) and includes any service fee or other charge in respect of the moneys borrowed or debt incurred or in respect of any credit facility which has not been utilised”’
To conclude, even if one excludes the swap cost and other charges while interpreting section 94B of the Act, it will be included in accordance with the definition of interest under the Act.