Overview on Thin Capitalisation

1. Overview on thin capitalization
Overview on Thin
Capitalisation

2. Overview on thin capitalization
THIN CAPITALISATION – SECTION 94B
Introduction:
Thin capitalisation refers to a situation in which a company is financed through relatively high level of debt as compared to equity resulting into a
thin capital structure. Generally, such a practice is followed for jurisdictions with high tax rates to avert the dividend distribution tax and,
alternatively, upstream cash vide interest payments on debts availed. Due to such high debt, companies may claimexcessive deduction of interest
payment from taxable income.
The taxation regime in India seems to be undergoing crucial changes. The principles of thin capitalisation as prescribed in the Organization for
Economic Cooperation and Development (‘OECD’) Base Erosion and Profit Shifting (‘BEPS) Action Plan 4 have been introduced in the Indian Income
Tax Act, 1961 vide Finance Act, 2017.
Section 94B of the Income Tax Act, 1961 governs the provision of Thin Capitalisation in India. Under this section, deduction for interest expense is
restricted in following cases:
1. Interest expense is incurred by a company on debt from an AE; and / or
2. Interest expenses on debt from an unrelated party which is based on guarantee or funds provided by an AE

3. Overview on thin capitalization
The below is the brief gist of the applicability, disallowance and exclusions provided in Section 94B.
•Indian Company or PE of a Foreign Company
•Interest or similarconsideration paid in respectof any debt from
AEs or debts guaranteed by AEs
Applicability
•Interest or similarconsideration for debt issueby a Non-resident AE
exceeding INR 1 Crore, which is deductiblein computing business
income - The excess interest will bedisallowed.
What isdisallowed?
•Foreign Company engaged in Bankingand insuranceis excludedExclusions
•Amount of total interest paid or payablein excess of 30% of EBITDA,
or
•Interest paid/payableto AE; whichever is lower
Meaningof excessinterest
•By Associated Enterprise to the lender not associated
•Implicitor explicitguaranteeor depositof corresponding/ matching
amounts with lenders by AE
Guarantee
•For 8 assessmentyears
Carry forwardof unamortised
interest

4. Overview on thin capitalization
LIMITATION OF INTEREST DEDUCTION
The thin capitalisation provisions state that excess interest (i.e. interest amount that exceeds 30% of earnings before interest, tax, depreciation
and amortization [‘EBITDA’] or the total interest amount payable to Associated Enterprise, whichever is less) shall not be available for deduction.
However, such disallowed interest expenditure can be carried forward for eight assessment years, but deduction of the same cannot exceed the
excess interest.
The same is explained by way of few examples:
EXAMPLE 1:
1. Foreign AE provides debt to an Indian Co. or Permanent Establishment of a Foreign Co.
2. Indian Co. or PE of Foreign Co. pays interest exceeding INR 1 Crore in respect of such debt
Provides debt Outside India
India
Pays interest
Foreign AE
Indian Company or PE of
Foreign Company

5. Overview on thin capitalization
EXAMPLE 2:
1. Lender provides debt to an Indian Co.
2. AE of Indian Co. provides guarantee or deposits sum of equivalent amount with lender
3. Indian Company pays interest exceeding INR 1 Crore in respect of such debt or guarantee
Provides guarantee
Provides debt
Pays interest
Lender
Indian Company
AE of Indian Company

6. Overview on thin capitalization
The thin capitalisation provisions applies to transactions where the debt is issued by a non-resident, being an associated enterprise. Further, it
also extends to debt from lender which is not an associated enterprise but an associated enterprise either provides an implicit or explicit
guarantee to such lender or deposits a corresponding and matching amount of funds with the lender.
Therefore, in both the above examples, interest paid above 30% of EBITDA not to be allowed as tax deduction. Excess interest paid to be allowed
to be carried forward for 8 years.

7. Overview on thin capitalization
LOAN BORROWED IN INDIA – WHETHER SECTION 94BAPPLICABLE?
The provisions of the Act are drafted in such a way that the implications of the Section may also arise to loans which are borrowed in India. The
same is explained in few examples below:
EXAMPLE 1
ABC Inc is Associated Enterprise of ABC India. ABC India borrows from an Indian Bank against which ABC Inc. provides guarantee.
Provides guarantee
Provides
loan
Interest payment
ABC Inc.
ABC India
Indian BankAE of Indian
Company
The Section applies to obtaining debt from non-resident lender. Here, in this case, since the lender is resident in India, the provisions of 94B
will not be applicable. Therefore, there won’t be any limit for disallowance of any interest in this Section.

8. Overview on thin capitalization
EXAMPLE 2
ABC Inc is Associated Enterprise of ABC India. ABC India borrows from a branch of Foreign Bank in India against which ABC Inc. provides guarantee.
Provides guarantee
Provides
loan
Interest payment
ABC Inc.
ABC India
Branch of Foreign BankAE of Indian
Company
Sub-section (1) of Section 94B specifically requires the lending to be from a non-resident AE for the section to be triggered. However, branches or
permanent establishments of foreign banks are also “non-residents” for the purposes of the Income-tax Act.
Therefore, since the lender is non-resident, the provisions of Section 94B will be applicable.

9. Overview on thin capitalization
94B– ISSUES FOR CONSIDERATION
There are few businesses which operates mainly on the debt raised. Therefore, these Companies have huge expense with respect to interest,
disallowance of which may impose hardship on such business. Keeping in mind the law as well as the practical perspective, below can be the issues
which may arise:
1. Thresholds of 30% is applied regardless of the business, strategic situation, industry, or economic environment
2. High degree of debt / equity ratio is quite common in sectors like Steel, Petroleum, Automobile, Power, Infrastructure, etc. Therefore, for
such sectors disallowance of interest may hamper their business
3. Infrastructure companies having large gestation periods and losses in initial years. Therefore, there would be unnecessary limitation on
interest deduction in initial years
4. Start-ups could have losses / low profitability in initial years, resulting in higher sunk cost and thereby, limiting the investment potential,
despite the inherent business strength
5. Section 40(a)(i) and Section 94B – the order of applicability is not clear

10. Overview on thin capitalization
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About CA. Sudha G. Bhushan
Sudha is qualified Chartered Accountant and a Company Secretary with more than a decade of experience in the Foreign
Exchange Management Act, RBI, Transfer pricing and International taxation matters. She is a noted speaker and author.
Her articles are regularly published in the Journals of several institutes and at various other forums and has authored the
following books:
Practical aspects of FDI in India published by Institute of Company secretaries of India
Due Diligence under Foreign Exchange Management Act, 1999 published by CCH.
Comprehensive Guide to Foreign Exchange Management in two volumes published by CCH.
Practical Guide to Foreign Exchange Management published by CCH, a Wolter Kluwer’s company.
Handbook on FEMA, Publication of Institute of Chartered Accountants of India
A scholar throughout her life she has been awarded many awards and recognitions including “Women Empowerment through CA Profession” by
Northern India Regional Council (NIRC) of Institute of Chartered Accountants of India (ICAI). Backed by experience in International firms she has
extensive experience of handling international transactions. She advises corporate as wellas government authorities in lot of intricate transactions.
Rendering tax and regulatory advisory services, she has overseen and played a crucial role in the execution of complex international transactions
involving issues revolving around tax, repatriation, minimization of tax exposure, Foreign Investment (Inbound and outbound) etc.