Introduction: The Thin Cap Adjustment Provisions under Section 94B of the Income Tax Act of 1961 were introduced in India to address concerns related to base erosion and profit shifting, particularly through excessive interest deductions by multinational enterprises (MNEs). The provisions align with the recommendations of the Organization for Economic Co-operation and Development (OECD) under its Base Erosion and Profit Shifting (BEPS) project, specifically in Action Plan 4. Here’s an insightful look at the key features.
Here are the salient features of the Thin Cap Adjustment Provisions under Section 94B:
1. Restriction on Interest Deductions: Deductions claimed for interest expenses paid by an entity to its associated enterprises are restricted to 30% of its earnings before interest, taxes, depreciation, and amortization (EBITDA) or interest paid or payable to associated enterprises, whichever is less.
2. Applicability: The provision applies to an Indian company or a permanent establishment of a foreign company acting as the borrower, paying interest on any form of debt issued to a non-resident or to a permanent establishment of a non-resident that is an ‘associated enterprise’ of the borrower.
3. Implicit or Explicit Guarantee: The debt is deemed to be treated as issued by an associated enterprise if it provides an implicit or explicit guarantee to the lender or deposits a corresponding and matching amount of funds with the lender.
4. Carry Forward of Disallowed Interest Expense: Disallowed interest expense can be carried forward to eight assessment years immediately succeeding the assessment year for which the disallowance was first made. It can be deducted against the income computed under the head “Profits and gains of business or profession” to the extent of the maximum allowable interest expenditure.
5. Threshold for Applicability: The provision applies only to interest expenditures exceeding one crore rupees. It targets large interest payments.
6. Exclusions: Banks and insurance companies are excluded from the provisions, recognizing the special nature of these businesses. Non-banking financial companies may also be exempted, as notified by the Central Government.
7. Limitation of Deduction, Not Disallowance: Section 94B imposes a “limitation of deduction” and not a “disallowance” of interest expenses. The deduction is limited to 30% of EBITDA or interest paid to associated enterprises, whichever is less.
8. Carrying Forward Balance: Excess interest over 30% can be carried forward to the following assessment year(s) and allowed as a deduction against the profits and gains of any business or profession to the extent of the maximum allowable interest expenditure.
9. Debt Definition: “Debt” includes any loan, financial instrument, finance lease, financial derivative, or any arrangement giving rise to interest, discounts, or other finance charges deductible in the computation of income under the head “Profits and gains of business or profession.”
10. No Secondary Adjustment under Section 92CE: No secondary adjustment under Section 92CE is required on account of thin cap adjustment.
Illustration:
|
Sr No |
Particulars | FY 2017-18 | FY 2018-19 | FY 2019-20 |
| 1 | EBITDA | 100 | 100 | 200 |
| 2 | Interest paid/payable to a non-resident AE | 15 | 35 | 50 |
| 3 | Interest paid/payable to unrelated parties | 35 | 15 | 0 |
| 4 | Total interest expenditure (2+3) | 50 | 50 | 50 |
| 5 | 30 Per cent of EBITDA (allowable limit) | 30 | 30 | 60 |
| 6 | Interest paid/payable during FY over the allowable limit | 20 | 20 | 0 |
| 7 | Excess interest is least of (2) and (6) | 15 | 20 | 0 |
| 8 | Interest of the current year allowed {Total Interest-Excess interest (ie 4()-(7)} | 35 | 30 | 50 |
| 9 | Disallowed interest is carried forward to succeeding 8 years {(4)-(8)} and set off to the extent of allowable limit | 15 | 35 (20-current year add 15- earlier years) | -10 {10(set-off of b/f dos allowed interest),25(c/f to succeeding years) |
| 10 | Total interest deduction allowed under the head “profit and gains from business and profession” during the FY {(8) add set off under (9)} | 35 | 30 | 60 |
Impact of Section 94B on Non-Banking Financial Companies (NBFCs):
Section 94B of the Income Tax Act, 1961, has significant implications for Non-Banking Financial Companies. Here’s a detailed analysis of its impact on NBFCs:
1. Applicability to NBFCs: Section 94B applies to NBFCs, making their interest expenses subject to disallowance if they breach the prescribed threshold limits.
2. Major Cost Component – Interest Expense: Interest expenses are a major cost component for NBFCs, as they raise funds from investors and earn interest income. The disallowance of interest expenses, especially when funded by an Associated Enterprise, can result in a substantial tax outflow for the company.
3. FOCC Parent Impact: If the parent company of an NBFC is a Foreign Owned and Controlled Corporation (FOCC), Section 94B applies, adding to the overall cost burden due to both transfer pricing provisions and rules.
4. Implicit or Explicit Guarantee Clause: The section specifies that interest implicitly or explicitly guaranteed by an Associate Enterprise would be disallowed. This provision could pose challenges for core investment companies reliant on associated enterprises for funding.
5. Balancing Debt and Equity: The disallowance of interest expenses compels NBFCs to strike a balance between debt and equity. This strategic shift aims to negate disallowances but may impact the cost of funds, influencing the overall viability of the business.
Impact on Other Sectors:
1. Start-ups: Start-ups, often funded by foreign companies with significant stakes, may face hurdles due to the broad definition of Associated Enterprises. Funding secured with guarantees from associated enterprises could be affected, impacting operations.
2. Infrastructure Companies: Infrastructure companies, requiring substantial funding, are typically funded by Associated Enterprises. Section 94B is likely to impede their operations, impacting fund costs and the ability to conduct business.
Global Approach:
1. Debt-to-Equity Ratios: Countries like Brazil, Canada, China, Indonesia, Mexico, Russia, and Switzerland prescribe threshold ratios of debt to equity, ranging from 1.5:1 to 4:1.
2. Interest to EBITDA Ratios: India, Germany, Luxembourg, Malaysia, the Netherlands, US, and UK adopt an upper cap for interest expense deduction in the form of interest to EBITDA ratio, ranging from 10% to 50%.
3. Hybrid Approaches: France, Korea, and Japan use a hybrid approach, employing both debt-to-equity and interest-to-EBITDA parameters to test thresholds.
Conclusion: Section 94B significantly impacts NBFCs, start-ups, and infrastructure companies, necessitating a careful review of funding structures and a strategic balance between debt and equity. The global approach highlights the diversity in regulatory measures adopted by different countries to address thin capitalization concerns. As tax laws are dynamic, businesses must stay abreast of changes to ensure compliance and strategic financial planning.
Author Bio
Section 94B of the Indian Income Tax Act deals with the limitation on interest deduction in certain cases, particularly in relation to interest on loans taken from associated enterprises or related parties.
Here’s a breakdown of how this section might apply to your situation:
1. Loan from an Indian Bank:
– If the loan is taken from an Indian bank, Section 94B does not directly apply, because this section specifically targets loans taken from a non-resident associated enterprise or a foreign lender.
– The main focus of Section 94B is on “excessive interest” paid on borrowings from outside India from a related party or where the loan is guaranteed by a related party.
2. Guarantee by Holding Company:
– If the holding company, which is a related party, guarantees the loan, the situation could still fall under the purview of Section 94B.
– The section applies if the Indian entity is paying interest on a loan where either the lender or a guarantor is a non-resident associated enterprise.
3. Related Party Definition:
– For Section 94B to apply, the lender needs to be an associated enterprise or the loan needs to be guaranteed by an associated enterprise.
– Since the loan is from an Indian bank, the bank itself is not a related party under this section.
– However, if the holding company (which is a related party) guarantees the loan, the guarantee can trigger the application of Section 94B, even though the loan is from an Indian bank.
Conclusion:
– While an Indian bank is not a related party for the purposes of Section 94B, if the loan is guaranteed by a holding company (which is a related party), Section 94B could still apply.
– Therefore, even though the loan is from an Indian bank, if a non-resident associated enterprise is involved as a guarantor, you need to assess the application of Section 94B, especially concerning the interest deduction limitation.
what if loan is taken from Indian Bank but guaranteed by Corporate (Holding Company).
does 94B applies on such interest ?
Main concern to understand is whether such Indian Bank will be considered as Related Party ? Since 94B says loan from outside India