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A company is financed with a combination of debt and equity. Thin capitalization refers to the situation in which a company's capital is thinly capitalized. It means that company is financed through a relatively high level of debt compared to equity. Thinly capitalized companies in corporate finance terms also referred to as 'highly leveraged' or 'highly geared'.

The way a company is capitalized often has a significant impact on the amount of profit it reports for tax purposes as the tax laws allow a deduction for interest paid or payable in arriving at the profit for tax purposes while the dividend paid on equity contribution is not deductible.

Before budget 2017, a foreign company investing funds into an Indian associated enterprise often brings funds through high level of debt as compared to equity. This helps the Indian company to save corporate income tax of at-least 30% on interest expenses in India as interest paid to its foreign AE is an allowable expense. On the other hand the foreign company ends up paying 15% maximum interest rate based on Income Tax Act read with relevant DTAA between the two contracting countries. Multinational groups are often able to structure their financing arrangements to maximize these benefits.

In view the of above, budget 2017 has introduced section 94B to provide that interest expenses claimed by an entity to its associated enterprises shall be restricted to 30% of its earnings before interest, taxes, depreciation and amortization (EBITDA) or interest paid or payable to associated enterprise, whichever is less.

Further, proviso to sub section 1 has widen the scope to cover any indirect transaction which provides that where the debt is issued by a lender which is not associated 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, such debt shall be deemed to have been issued by an associated enterprise.

The provisions 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 deduction against the income computed under the head "Profits and gains of business or profession to the extent of maximum allowable interest expenditure.

The section is not applicable in the following cases;

  1. Where interest expenses are not more than one crore rupees (to target only large interest payments) or;
  2. Company which is engaged in the business of banking or insurance.

Illustration:

 Foreign company (F.Co) have invested INR 1000 crores in its AE in India (I.Co). Capital is financed by 10% Debt: INR 900 crores, Equity: INR 100 crores. Let EBITDA: INR 150 crores, and depreciation be zero. 

(all figures in crores)


Particulars

Before section 94B

After section 94B

EBITDA

150

150

Less: Interest

90

45*

EBT

60

105


*Actual interest expenses are INR 90crores, but due to capping to 30% of EBITDA, interest allowed would be INR 45 crores (150*30%). Interest of INR 45 crores would be disallowed and can be carried forward and adjusted in next eight assessment years.

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Category Income Tax, Other Articles by - CA Nirmit Sharma 



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