Section 94B: Thin Capitalisation

The concept of thin capitalisation aims to achieve a distinction between the tax treatments of debt and equity. The Government of India (GoI) has stated its commitment to the Base Erosion and Profit Shifting (BEPS) initiative implemented by The Organisation for Economic Co-operation and Development (OECD). Several reforms were introduced in the domestic tax legislation to plug loopholes, prevent double non-taxation, and strengthen data sharing between contracting states. As part of this initiative, the GoI introduced Section 94B in the Income Tax Act of 1961. The new section was inserted by the Finance Act of 2017 to curb thin capitalisation. This article discusses the provisions of Section 94B and the associated rules.

What is Thin Capitalisation?

Financing projects is generally executed through equity, debt, or a combination of both. Equity is less attractive as it tends to be more expensive regarding cost and ownership. Conversely, debt is affordable to service, reduces tax liabilities, and increases return on equity. Many companies classify a large part of their capital as debt and claim the interest as a tax-deductible expense.
This strategy is mainly executed in cross-border transactions, where profit is shifted to a lower tax jurisdiction, and remitted as a loan. Interests on these loans are claimed as expenses to lower the company's tax burden. This mechanism to reduce tax burden is widely adopted by several Multi-National Corporations. Therefore, the rules on thin capitalisation are essential to prevent the solvency risks posed by highly leveraged entities.
Thin capitalisation rules are necessary to prevent tax avoidance through excessive leveraging. Although there is no specific benchmark rule for thin capitalisation, it was addressed at the G-20 summit. The OECD's Base Erosion and Profit Shifting Plan (BEPS) took up the issue of using excessive interest as a method to reduce taxable profits.
In alignment with this, the Finance Minister of India proposed Section 94B in the Income Tax Act of 1961 during Budget 2017. Applicable from Assessment Year 2018-2019 onwards, this section corresponds to BEPS Action 4 and is named "Limiting Base Erosion Involving Interest Deductions and Other Financial Payments".

Key Requirements of Section 94B

Section 94B of the Income Tax Act of 1961 provides the provisions for restricting interest payments made by a company in India or a foreign company with a permanent establishment in India to its associated enterprise established abroad.
Interest payments should be restricted to 30% of earnings before interest, taxes, depreciation, and amortisation, or interest paid to an associated enterprise, whichever is less. A period of 8 years is permitted to carry forward the disallowed portion. The provisions apply if an interest payment exceeds INR 1 Crore.
For example, if an Indian Company's EBITDA is INR 200 Crores, and the total interest payment is INR 65 Crores—split as INR 45 Crores to a Non-Associate Enterprise and INR 20 Crores to an Associate Enterprise—30% of the interest paid is subject to disallowance.
The disallowance calculation is the lower of 30% of tax sought to be evaded, or 20% of the sum payable to the associated enterprise. For instance, INR 20 lakhs would be payable as a penalty to the Income Tax Department out of Rs. 5 crores.

Strategies to Prevent Thin Capitalisation

Various jurisdictions use the following methods to curb thin capitalisation:

Fixed Ratio: Limits the level of interest expenses or debt concerning a fixed ratio of debt or equity, interest, or earnings.
Specified Percentage: Disallows a specified percentage of the interest expenses, regardless of the payment's nature or recipient.
Arm's Length Basis: Compares the level of interest or debt to a situation where the company deals entirely with third parties.
Anti-Avoidance Rules: Targeted anti-avoidance provisions that disallow interest on specific transactions.

Where Section 94B Applies

Section 94B applies under these conditions:

If the borrower is either an Indian Company or a foreign company's permanent establishment in India.
If the lender is a company located abroad, qualifying as an Associated Enterprise under Section 92A of the Income Tax Act.
If the expense is deductible under Profits and Gains of Business or Profession.
If the expense is similar to interest, discount, or finance charges, including debt in the form of a loan, financial lease, or derivative.

If borrowing is not direct but from a chain involving associated enterprises, it is covered under this section.

Exceptions to the Rule

Banking and insurance companies are excluded from thin capitalisation rules. However, Non-Banking Financial Companies (NBFCs) do not enjoy these exemptions.

Impact on Non-Banking Financial Companies (NBFCs)

Section 94B significantly impacts NBFCs:

NBFCs face disallowance of interest expenses if they breach prescribed threshold limits, affecting their tax liabilities.
Interest expense is a major cost for NBFCs. If funded by an Associated Enterprise, surpassing threshold limits results in increased tax liabilities.
If an NBFC's parent company is a Foreign-Owned Indian Company (FOCC), this section's provisions apply alongside transfer pricing rules, raising costs.
Interest guaranteed by an Associated Enterprise is disallowed under this section.
Core investment companies funded by associated enterprises face survival challenges.
Leveraging aims to enhance equity returns, reduce tax, and manage fund costs. Disallowance of interest expenses forces companies to balance debt and equity, influencing fund costs.

Impact on Other Sectors

The Central Board of Direct Taxes (CBDT) notes that this section significantly affects the following sectors:

Impact on Start-ups

Many start-ups are funded by foreign companies holding significant stakes in them. Given the broad definition of Associated Enterprises in this section, start-ups face hurdles. Start-up funding guarantees provided by Associated Enterprises also fall within the provisions, impacting operations.

Impact on Infrastructure Companies

Infrastructure Companies require substantial funding, often from Associated Enterprises. This section potentially impedes their operations. While regulatory aspects between banks and non-banking financial companies seem similar, the latter are not on the exclusion list, thus influencing fund costs and business capabilities.

Exploring tax deduction strategies poses another method to navigate the financial landscape affected by these sections.

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Frequently Asked Questions

Common questions about Section 94B Thin Capitalisation.

Section 94B aims to curb thin capitalization, which is the practice of financing a company with excessive debt to claim higher interest deductions and reduce taxable profits. The section limits the deductibility of interest payments made to associated enterprises located outside India.

Section 94B restricts the deduction of interest payments made by an Indian company or a foreign company's permanent establishment in India to an associated enterprise abroad. The deduction is limited to 30% of the company's earnings before interest, taxes, depreciation, and amortization (EBITDA) or the actual interest paid, whichever is less.

Section 94B applies only if the interest payment to the associated enterprise exceeds INR 1 crore (10 million rupees) in a financial year.

Yes, Section 94B does not apply to banking and insurance companies. However, non-banking financial companies (NBFCs) are not exempted from the provisions of this section.

Section 94B can significantly impact NBFCs as interest expenses are a major cost component for these companies. If an NBFC is funded by an associated enterprise and exceeds the threshold limit, it may face a higher tax outflow due to the disallowance of interest deductions.

Start-ups funded by foreign companies holding significant stakes may face challenges due to Section 94B. The broad definition of associated enterprises and the inclusion of implicit or explicit guarantees from associated enterprises can bring start-ups under the ambit of this section.

Infrastructure companies often require substantial funding from associated enterprises, which may be impeded by the interest deduction restrictions imposed by Section 94B.

Section 94B was introduced as part of India's commitment to the Base Erosion and Profit Shifting (BEPS) initiative by the Organisation for Economic Co-operation and Development (OECD). It aims to prevent tax avoidance through excessive leveraging and shifting of profits to low-tax jurisdictions.

Yes, the disallowed portion of interest payments can be carried forward for up to 8 years and claimed as a deduction in subsequent years, subject to the limitations specified in the section.

Different jurisdictions adopt various methods to curb thin capitalization, such as fixed ratio rules, specified percentage rules, arm's length basis rules, and targeted anti-avoidance rules. Section 94B follows a specified percentage approach by limiting interest deductions to 30% of EBITDA.