India introduced thin capitalisation rules through Section 94B of the Income-tax Act, 1961 (the Act). The core objective of the thin capitalisation rules is to prevent multinational groups from excessively funding Indian entities through debt from associated enterprises (AEs) instead of equity. Excessive interest payments to AEs can erode the Indian tax base by shifting profits out of India.
While the intent of the provision is clear, its practical application raises certain interpretational challenges that are discussed in this article.
Meaning and computation of EBITDA
Section 94B requires disallowance of excess interest paid to a foreign AE by a resident taxpayer. The excess interest is defined as “an amount of total interest paid or payable in excess of thirty per cent of earnings before interest, taxes, depreciation and amortisation of the borrower in the previous year or interest paid or payable to associated enterprises for that previous year, whichever is less”.
The term ‘EBITDA’ has not been defined anywhere in the Act. EBITDA is a widely used accounting term, the calculation of which is generally derived from accounting profits.
However, the OECD’s BEPS Action 4 clearly states that EBITDA for interest limitation purposes should be calculated using tax numbers rather than accounting figures. One of the stated rationales is that linking interest deductions to taxable earnings means it is more difficult for a group to increase the limit on net interest deductions without also increasing the level of taxable earnings in a country.
In K P Varghese v The Income Tax Officer, Ernakulam, and Another (1981), the Indian Supreme Court held that where literal interpretation “leads to manifestly unreasonable and absurd consequences”, the same should be construed having regard to the object and purpose for which it has been enacted. Considering thin capitalisation rules stem from the BEPS Action 4, it seems reasonable to interpret EBITDA by using tax numbers.
Even if tax numbers are considered, further ambiguity arises as to whether tax considered in EBITDA should mean direct tax only or an aggregate of direct tax and indirect tax. The tax in the Act is usually defined as direct tax. However, in certain sections of the Act (such as Section 43B, which deals with the deduction of expenses on a payment basis), tax means indirect tax and not direct tax.
Meaning of ‘total interest’ under Section 94B
Another interpretational issue arises from the use of the term “total interest” in the definition of excess interest. The excess interest is calculated as the lower of:
Total interest in excess of 30% of EBITDA; or
Interest paid or payable to an AE.
Though the focus of the thin capitalisation rule is interest payable to an AE, in computing the disallowance, the section refers to “total interest”, without clearly specifying whether this refers to:
Only interest paid or payable to AEs (restrictive approach); or
Total interest debited to the profit and loss account, including interest paid to third-party lenders such as banks and financial institutions (inclusive approach).
If a restrictive approach is adopted in interpreting total interest, the “whichever is less” condition in Section 94B may lose much of its practical relevance. This is because the comparison would then be between AE interest and a percentage of EBITDA deducted from the AE interest base, which would always result in the latter being the lower of the two limits.
On the other hand, if an inclusive approach is adopted in interpreting total interest, the provision becomes mechanically more meaningful, as the overall interest cost is first evaluated against EBITDA and the disallowance is then restricted to AE interest. This seems logical, especially when the legislature has categorically used the phrases “total interest” and “interest paid or payable to associated enterprises” distinctively in the same provision and it is settled that a taxing statute must be read as it is, without adding or subtracting words on the grounds of legislative intent or otherwise (see State of Uttar Pradesh v Dr Vijay Anand Maharaj (1962), M V Joshi v M U Shimpi and Another (1961), and Godrej & Boyce Manufacturing Company v Deputy Commissioner Of Income Tax and Another (2017)). Even BEPS Action 4 favours an inclusive approach.
However, the Explanatory Notes to the Provisions of the Finance Act, 2017, which explain the intention behind the insertion of thin capitalisation rules, seem to favour the restrictive approach. The relevant part of the notes reads: “In view of the above, a new section 94B has been inserted in the Income-tax Act so as 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 [emphasis added].”
The primary goal of Section 94B is not to cap overall interest costs but to curb excessive interest paid to AEs. Considering the object of the provision and the explanatory notes, a case can be made for the restricted approach, even if it results in some redundancy in the drafting of the section.
Meaning of AE deposits
The thin capitalisation rule in the Act is not limited to direct borrowing from an AE but also extends to cases where the money is borrowed from third parties and the AE provides a guarantee to the lender or deposits a corresponding and matching amount of funds with the lender. It is unclear what the phrase “deposits a corresponding and matching amount of funds with the lender” means. The intent seems to be wide enough to cover all cases where an AE provides some sort of guarantee or deposit to the lender in respect of money borrowed.
However, there may be cases where the AE maintains bank accounts with the lender from which the resident taxpayer borrows money. In such a case, it is unclear whether the phrase is wide enough to cover deposits made by the AE with the lender without any intention or commitment to secure the money borrowed by the taxpayer.
Meaning of the term ‘interest’
Another ambiguity arises with respect to the meaning to be accorded to the term “interest” used in Section 94B. Will the term “interest” be restricted to interest on a loan paid to an AE or will it include connected expenses as well, such as loan processing charges, arrangement fees, guarantee fees, and exchange differences. Also, it is uncertain whether a finance leasing arrangement with an AE can be subject to thin capitalisation rules. The term “interest” has been defined in a wider manner in the Act to include any expense connected with borrowing. Considering the wider definition of interest, the aforesaid components have the potential of being included in the ambit of the term “interest”. However, one must be careful when interpreting the term “interest”, as it will have a direct impact on calculations of EBITDA.
Key takeaway
Thin capitalisation rules under Indian tax law are a critical anti-avoidance measure aligned with global BEPS standards. However, the absence of clear statutory definitions has resulted in many ambiguities. Until these issues are clarified through judicial decisions or administrative guidance, taxpayers must adopt consistent and well-reasoned positions, supported by international guidance and legislative intent.
