Limitation of interest deduction under section 94B (Thin Capitalization) under the income tax act 1961

Many countries limit the amount of interest expenses of multinational companies (MNC). An enterprise who has borrowed capital in form of loan from its associate enterprises can claim deduction of interest paid and payable to associated enterprises. Foreign companies have several models to infuse capital in its associated company situated in another country. Some may chose to setup a company with large capital, while other may chose to have minimal capital and large share of debt financing. Thus “Thin Capitalization” chooses to have heavy funding through debt and minimum amount through equity.

In order to restrict the amount of interest expenses payable/paid to its associated enterprises, OECD has published it action plan 4 of BEPS. Indian government has also implemented this action plan and enacted Section 94B under the income tax act 2017, that was intend to place a limit on deductibility on interest expenditure. The following explanatory note to the provisions of the finance act, 2017 instead in Circular No 8 of 2018:

Under the initiative of the G-20 countries, 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   MNEs   in   Action   plan   4 and has recommended several measures in its final report to address this issue.

It is notes that the ‘Fixed Ratio Rules’ (maximum 30% in India) ‘Group Ratio Rules’ has also been stated in OECD report, which specified that:

A fixed ratio rule provides a country with a level of protection against base erosion and profit shifting, but it is a blunt tool which does not take into account the fact that groups operating in different sectors may require different amounts of leverage, and even within a sector some groups are more highly leveraged for non-tax reasons. If a benchmark fixed ratio is set at a level appropriate to tackle base erosion and profit shifting, it could lead to double taxation for groups which are leveraged above this level. Therefore, countries are encouraged to combine a robust and effective fixed ratio rule with a group ratio rule which allows an entity to deduct more interest expense in certain circumstances. A group ratio rule may be introduced as a separate provision from the fixed ratio rule, or as an integral part of an overall rule including both fixed ratio and group ratio tests.

The result of fixed ratio rule is that, it disallows excess interest in all cases where funds are received for AE or deemed to be received from AE.

  1. Eligibility of Interest: Interest expenses are allowed under section 36 of income tax act 1961 when it is in respect of capital borrowed for the purposes of the business or profession. Section 94B starts with “Notwithstanding anything contained in this Act” non-obstante clause and override the entire income tax act and limits the deduction of interest expenses as specified under sub-section (2) of section 94B.
  2. Limit of Rs. 1 crore: Section 94B(1) has given threshold and applies when interest expenses in respect of loan given by AE is more than Rs. 1 core.
  3. Maximum allowable interest: Section 94B(2) put restriction on interest expenses and allow lower of the following figure as an expenses in the previous year:
  4. 30 percent 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.
  • Carry forward and Disallowance : The  provisions  of the  said section  allow  for  carry  forward  of  disallowed interest  expense  to  eight  assessment  years  immediately  succeeding  the  assessment year for which the disallowance was first made and also allow deduction against the income  computed  under  the  head ‚Profits and gains of business or profession to the extent of maximum allowable interest expenditure.

 Further, banks and insurance business have also  been  excluded from  the ambit of the said provisions keeping in view of special nature of these businesses.

Definitions:

(i) “associated enterprise” shall have the meaning assigned to it in sub-section (1) and sub-section (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”;

(iii) “permanent establishment” includes a fixed place of business through which the business of the enterprise is wholly or partly carried on.

Conclusion: As per the International tax competitiveness Index 2020, Countries that limit interest deductions with only transfer pricing regulations receive the best score. Countries with debt-to-equity ratios receive an average score, and countries with interest-to-pretax-earning limits receive the worst score. Further Fixed ratio rule (i.e. 30%) may not be good a situation where business model is working completely on debt mode. It may restrict allowability of interest expense in current period and true profit may not be arrived in current period.

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