Thin capitalization refers to ratio of debt to equity. Where entity is heavily capitalized by debt, it consider to be thinly capitalized. In other word, it referred to a situation where an entity is highly geared. That is proportion of debt capital is much higher as compared to equity capital of an entity. Interest payment on debt capital is referred as finance charges and is tax deductible item and consequently reduced tax cost of an entity overall. While dividend payment on equity capital is referred as distribution by an entity from profit after tax and same is not tax deductible item. Further, dividend payment is possible only when company has distributable surplus.

Section 94B was inserted in the Income-tax Act, 1961 through the Finance Act, 2017 in order to implement the measures recommended in final report on Action Plan 4 of the Base Erosion and Profit Shifting (BEPS) project under the aegis of G-20-Organisation of Economic Co-operation and Development (OECD) countries to address the issue of base erosion and profit shifting by way of excess interest deductions.

Capitalization

94B. (1) Notwithstanding anything contained in this 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 “Profits 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):

Analysis:

  • Sec 94B start with non-obstacle clausee. has overriding effect over other provision of the Act.
  • Sec 94B applies to
    • an Indian company being borrower or
    • a PE of foreign company in India being borrower.
  • Sec 94B applies when it incurs any expenditure by way of Interest or of similar nature exceeding 1 Cr.
  • Expenditure by way of Interest or of similar nature has to be,
    • deductible under head PGBP and
    • in respect of debt issued by non-resident associated enterprise of borrower.
  • Then Interest is not deductible under PGBP to the extent it arise from excess interest as specified in sub-section (2).

Hence, provision of this Sec 94B shall not apply when,

  • Assessee being non-corporate entity, whether resident or non-resident.
  • Where interest or similar nature expenses is in respect of debt issue by other than NR-AE.
  • Where interest or similar nature expenses in respect of debt issued by NR-AE is not exceeding 1 Cr.
  • Where interest or similar expenses are deductible under head other than PGBPg. interest may deductible under head IFOS.

Further, where interest or similar expenses are otherwise disallowed under head PGBP e.g. disallowance u/s 14A, 36(1)(iii), 40(a)(i), 40A(2), could provision of Sec 94B trigger?

Particulars

(Rs in Cr)

Total interest expenses for the year as per profit or loss statement, in respect of borrowing from non-resident associated enterprise

1.20

Interest to be disallowed u/s 14A r.w rule 8D/36(1)(iii)/40(a)(i)/40A(2)

0.30

Whether in above case provision of Sec 94B is applicable?

No

As amount of interest expenses not exceeds Rs 1 Cr, which is deductible under head PGBP.

Let’s say where interest or similar expenses capitalized in books of account, could provision of Sec 94B trigger?

Interest or similar expenses incurred for the purpose of business or profession are allowable as deduction under Sec 36(1)(iii). However, due to proviso to Sec 36(1)(iii) and explanation 8 to Sec 43(1), said interest or similar nature expenses are required to capitalized to block of assets and same to be depreciated. Hence, on such interest or similar nature expenses which are capitalized and not claimed as deduction, provision of Sec 94B will not apply. Going step further, depreciation claimed on such portion of interest capitalized liable for disallowance?

Further, limit of Rs 1 Cr in respect of interest or similar nature expenses which are deductible under head PGBP in respect debt issued by non-resident associated enterprise, to be seen in total or NR-AE wise?

Section 94B start with non-obstacle clause as “Notwithstanding anything contained in this Act…” it means this section has, overriding effect or prevail, over other provision of the Act. Further, Section 95 (Applicability of General Anti-Avoidance Rule) also start with non-obstacle clause as “Notwithstanding anything contained in this Act…”. Now, question may arise which section prevail over another one. Section 94B is Specific Anti-Avoidance Rule (SAAR) while Section 95 is General Anti-Avoidance Rule (GAAR). CBDT has clarified vide circular no 7/2017 that SAAR and GAAR may co-exit and applicable as case may necessary as SAAR may not address all the situation of abuse and there is need to have GAAR in domestic law.

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