[Opinion] Limitation on Interest Deduction in Certain Cases (Section 94B)

CA Rohan Sogani & Samarth Vijay – [2024] 169 taxmann.com 579 (Article)

India’s commitment to combating tax avoidance has led to the introduction of several provisions in the Income Tax Act. Among them, Section 94B, introduced vide Finance Act, 2017, is a significant measure aimed at curbing thin capitalization—a practice where businesses use excessive debt from associated enterprises to shift profits and reduce tax liabilities.

This article explores the intricacies of Section 94B, examining its implications for corporate debt practices and outlining effective strategies, businesses can adopt to ensure compliance.

1. Understanding Thin Capitalization

Typically, capital employed by a company to run its business consists of own and borrowed capital. Own capital i.e. share capital and reserves, do not have interest liability, whereas borrowed capital, whether long term or short term, requires interest to be paid to external parties. Such interest cost, unless capitalised, is debited to the profit and loss account, and generally, allowed as a deduction under the domestic tax laws applicable to a company. If a company is having very high borrowed capital as compared to own capital, it shall incur high interest cost, and such capitalisation-mix is generally referred to as ‘thin capitalisation’. Thin capitalisation has a significant impact on the profitability and the consequent taxability of the company. On the other hand, if capital is financed by shareholders’ funds, the return on share capital is in the form of the dividend, and constitutes a below the line item in the books, and is not deductible from the taxable income of the company.

Thin Capitalisation is used by the entities mainly due to the following reasons:

1. Leverage interest deductions: Interest on loans is typically tax-deductible, reducing taxable profits by claiming it as an expense in P&L.
2. Shift profits to low-tax Jurisdictions: Multinational corporations (MNCs) often take loans through their associated enterprises operating in low/Nil tax jurisdictions, minimising overall tax liabilities due to charging the interest paid as an expense in the P&L on the one hand and thereby not paying any tax in the hands of the recipient in the country of residence of such recipient (Low tax Jurisdiction).

For instance, imagine an Indian subsidiary borrowing extensively from its parent company operating in a low-tax jurisdiction. The resulting interest payments significantly reduce the Indian subsidiary’s taxable income by claiming interest payment as an expense while increasing the profits of the parent company which is already situated in a low tax jurisdiction, affecting the tax collection in India.

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