Thin Capitalisation Rules: Section 94B Interest Limitation
📖 Section 94B (Indian Tax Law): A domestic anti-avoidance provision introduced by the Finance Act, 2017, effective from Assessment Year 2018-19, which disallows interest expenditure paid to associated enterprises in excess of 30% of EBITDA, with the disallowed interest eligible for carry-forward up to eight assessment years.
1. Background: Why India Introduced Thin Capitalisation Rules
For decades, multinational enterprises (MNEs) exploited the tax asymmetry between debt and equity. Interest on borrowed capital is tax-deductible, while dividends paid on equity are not. This created a powerful incentive for MNE groups to load their Indian subsidiaries with inter-company loans from parent entities in low-tax or no-tax jurisdictions.
The result was predictable: profits earned in India were effectively repatriated abroad in the form of interest payments, reducing the Indian entity’s taxable income to a bare minimum. The Organisation for Economic Co-operation and Development (OECD), under its Base Erosion and Profit Shifting (BEPS) initiative, identified this as a critical issue in Action Plan 4: Limiting Base Erosion Involving Interest Deductions and Other Financial Payments.
India, being a signatory to the BEPS Inclusive Framework, responded by introducing Section 94B through the Finance Act, 2017, applicable from 1 April 2018. This provision is India’s domestic implementation of the BEPS Action 4 recommendations, adapted to our specific economic and regulatory context.
1.1 Pre-Section 94B Landscape
Before Section 94B, the Income Tax Department’s primary weapon against excessive interest payments was transfer pricing provisions under Section 92, which required interest on inter-company loans to be at arm’s length. However, transfer pricing only tested the rate of interest — it did not address the quantum of debt. A company could borrow an absurdly large amount from its foreign parent at an arm’s length interest rate, and the full interest was deductible.
This gap is precisely what Section 94B addresses. It imposes a ceiling on the total quantum of interest that can be deducted, irrespective of whether the interest rate itself is at arm’s length.
2. Scope and Applicability of Section 94B
2.1 Who Is Covered?
Section 94B applies to an Indian company or a permanent establishment (PE) of a foreign company in India that:
- Is a borrower; and
- Pays or is liable to pay interest or similar consideration to a non-resident associated enterprise (as defined under Section 92A); or
- Pays interest to a non-resident non-AE lender where the AE has provided a guarantee, deposit, or counter-guarantee (back-to-back arrangements).
2.2 What Is Excluded?
The provision does not apply to:
- Banking and insurance companies: Entities engaged in the business of banking or insurance are explicitly excluded, recognising that their business model inherently involves significant debt.
- Domestic borrowings: Interest paid to resident lenders, even if they are associated enterprises, is outside the scope of Section 94B. The provision is targeted at cross-border profit shifting.
- Interest below the threshold: Where the total interest paid or payable to AEs does not exceed INR 1 crore in a given financial year, the provision does not apply.
2.3 Meaning of “Interest” and “Similar Consideration”
The term “interest” under Section 94B includes any amount paid by way of interest, discount, premium, fees, commission, or similar charges relating to any form of debt or credit. This covers:
- Interest on external commercial borrowings (ECBs)
- Guarantee commissions paid to AEs
- Discount on commercial paper or bonds placed with AEs
- Commitment fees and processing charges on AE facilities
- Any form of return on preference shares that is treated as debt under applicable accounting standards
3. The 30% EBITDA Cap: How It Works
3.1 Step-by-Step Computation
The computation under Section 94B follows a structured approach:
Step 1: Compute the total interest paid or payable to associated enterprises (including back-to-back arrangements) during the previous year.
Step 2: Compute the EBITDA of the borrower. The EBITDA for Section 94B purposes is computed as:
EBITDA = Profit before tax (as per P&L) + Interest expense + Depreciation + Amortisation
Step 3: Calculate 30% of EBITDA.
Step 4: Compare the AE interest (Step 1) with the higher of:
- 30% of EBITDA (Step 3), or
- INR 1 crore
Step 5: The excess of AE interest over the threshold determined in Step 4 is disallowed as a deduction in the current assessment year.
3.2 Worked Example
Consider Alpha India Pvt Ltd, a subsidiary of Alpha Global Inc (a US parent). For FY 2024-25:
| Particulars | Amount (INR Crores) |
|---|---|
| Profit before tax | 50.00 |
| Interest paid to Alpha Global (AE) | 40.00 |
| Interest paid to Indian banks | 10.00 |
| Depreciation | 15.00 |
| Amortisation | 5.00 |
EBITDA = 50 + 40 + 10 + 15 + 5 = INR 120 crores
30% of EBITDA = INR 36 crores
AE Interest = INR 40 crores
Disallowed Interest = 40 – 36 = INR 4 crores
Alpha India can deduct only INR 36 crores of the INR 40 crores interest paid to its US parent. The remaining INR 4 crores is disallowed under Section 94B but can be carried forward.
3.3 EBITDA — Tax vs Accounting
A frequently debated question is whether EBITDA should be computed based on the profit and loss account (book EBITDA) or based on the taxable income under the Income Tax Act. The language of Section 94B refers to “income computed under the head ‘Profits and gains of business or profession'” before making any deduction for interest and depreciation. This points towards a tax-adjusted EBITDA rather than a pure book EBITDA, though the CBDT has not issued specific clarificatory guidance on this point.
In our practice at Virtual Auditor, we recommend computing both book EBITDA and tax EBITDA and taking the more conservative position, supported by detailed documentation.
4. Back-to-Back Loan Arrangements
Section 94B specifically targets arrangements where the actual lender is an unrelated third party, but the AE has provided an implicit or explicit guarantee. This is the classic “back-to-back” or “conduit” arrangement:
- The Indian subsidiary borrows from a foreign bank.
- The foreign parent guarantees the loan or places a deposit with the foreign bank as security.
- The Indian subsidiary pays interest to the bank, not to the AE.
Without Section 94B’s anti-avoidance sweep, such arrangements would escape the thin capitalisation net entirely. The provision deems such interest as if it were paid to the AE, bringing it within the 30% EBITDA cap.
4.1 Identifying Back-to-Back Structures
We advise our clients to examine the following indicators that a borrowing may be treated as a back-to-back arrangement:
- The AE has placed a deposit with the lending bank that is substantially equal to the loan amount.
- The AE has provided a corporate guarantee without which the Indian entity would not have obtained the facility.
- The lending bank’s credit appraisal is primarily based on the AE’s creditworthiness rather than the Indian entity’s standalone financials.
- The loan terms (tenor, rate, covenants) are linked to or referenced against the AE’s credit profile.
5. Carry-Forward of Disallowed Interest
The disallowed interest under Section 94B is not permanently lost. Sub-section (4) provides that the disallowed interest can be carried forward and set off against income in subsequent assessment years, subject to:
- A maximum carry-forward period of eight assessment years immediately succeeding the assessment year in which the disallowance was first made.
- In the subsequent year, the carried-forward interest is treated as interest paid or payable in that year and is again subject to the 30% EBITDA cap of that year.
This means that if the company’s EBITDA improves in future years, or if the AE interest reduces, the previously disallowed amount can be absorbed. However, the eight-year limitation means that persistent thin capitalisation will lead to permanent loss of deductions.
6. Interaction with Transfer Pricing Provisions
6.1 Section 94B vs Section 92: Dual Compliance
It is essential to understand that Section 94B operates independently of transfer pricing provisions under Sections 92 to 92F. An Indian company must satisfy both requirements:
- Arm’s length interest rate under Section 92: The interest rate on the inter-company loan must be benchmarked against comparable uncontrolled transactions.
- Quantum cap under Section 94B: Even if the interest rate is at arm’s length, the total interest deduction is capped at 30% of EBITDA.
For detailed guidance on transfer pricing compliance for inter-company financial transactions, refer to our transfer pricing services page.
6.2 Order of Application
Where both Section 92 and Section 94B apply, the adjustment under transfer pricing (i.e., recomputing interest at arm’s length rate) is made first. The Section 94B cap then applies to the arm’s length interest amount. The Transfer Pricing Officer (TPO) determines the arm’s length price; the Assessing Officer applies the Section 94B limitation on the adjusted figure.
7. OECD BEPS Action 4 and India’s Approach
7.1 The OECD Recommendation
BEPS Action 4 recommends a fixed-ratio rule that limits an entity’s net interest deductions to a fixed percentage (between 10% and 30%) of EBITDA. The recommendation also includes a group-ratio rule that allows entities to exceed the fixed-ratio limit if the worldwide group has a higher net third-party interest-to-EBITDA ratio.
7.2 India’s Adoption
India has adopted the upper end of the OECD-recommended range at 30%, without implementing the group-ratio rule. This is a simpler, more administration-friendly approach but can lead to harsh outcomes for genuinely capital-intensive industries where the group itself is highly leveraged with third-party debt.
Several industry bodies have represented to the CBDT for:
- Introduction of a group-ratio rule
- Sector-specific carve-outs (e.g., for infrastructure and real estate)
- Exclusion of existing borrowings entered into before 1 April 2017
As of the date of this article, none of these representations have resulted in legislative changes, though the government has indicated openness to reviewing the provision in the future.
8. Compliance and Documentation Requirements
8.1 Transfer Pricing Documentation
Entities subject to Section 94B must maintain detailed documentation, including:
- Computation of EBITDA for each financial year
- Details of all interest payments to associated enterprises
- Analysis of back-to-back arrangements, if any
- Computation of the disallowed interest and carry-forward schedule
- Board resolutions justifying the debt-equity structure
8.2 Tax Return Disclosures
The disallowed interest under Section 94B must be added back in the computation of total income. The carry-forward amount must be tracked and disclosed in the income tax return for the relevant assessment year. Additionally, the transfer pricing report (Form 3CEB) should contain details of international transactions involving interest payments.
8.3 Withholding Tax Implications
Section 94B does not affect the withholding tax obligation. Even if the interest is disallowed under Section 94B, the Indian entity is still required to deduct tax at source (TDS) under Section 195 on the full interest payment made to the non-resident AE. The TDS rate depends on the applicable tax treaty, and the payer must obtain a certificate under Section 195(2) or 197 if a lower rate is sought.
9. Judicial Developments and Interpretive Issues
9.1 Emerging Litigation
Given that Section 94B has been in operation since AY 2018-19, we are now seeing the first wave of assessments and disputes reaching the appellate tribunals. Key interpretive issues include:
- Definition of EBITDA: Whether the computation should follow accounting EBITDA or a tax-adjusted figure.
- Set-off of carried-forward interest: The sequencing of set-off vis-a-vis business losses and unabsorbed depreciation.
- Guarantee commission: Whether a guarantee commission paid to an AE constitutes “interest” for Section 94B purposes.
- Convertible instruments: Treatment of interest on compulsorily convertible debentures (CCDs) issued to AEs.
9.2 International Comparisons
India’s approach is broadly consistent with the regimes in Germany (interest barrier rule), the United Kingdom (Corporate Interest Restriction), and Australia (thin capitalisation provisions). However, the absence of a group-ratio rule and sector-specific exceptions makes India’s provision relatively stricter in application.
10. Planning Strategies Within the Legal Framework
We at Virtual Auditor assist clients in optimising their capital structure while remaining fully compliant with Section 94B. Legitimate strategies include:
- Rebalancing debt-equity: Converting a portion of AE debt into equity (share capital or share premium), reducing the interest outflow subject to the cap.
- Domestic borrowing substitution: Replacing AE debt with domestic bank borrowings, which are outside the scope of Section 94B.
- EBITDA enhancement: Ensuring that all revenue streams are properly recognised in India to maximise the EBITDA base.
- Timing of interest payments: Structuring repayment schedules to align interest peaks with years of higher EBITDA.
- Monitoring carry-forward utilisation: Proactive tracking of disallowed interest and planning to utilise the carry-forward within the eight-year window.
For assistance with structuring your group’s financing arrangements, please contact us.
11. Impact on Specific Sectors
11.1 Infrastructure and Real Estate
Infrastructure projects, by their nature, involve heavy debt financing and long gestation periods. During the construction phase, EBITDA is typically nil or negligible, leading to a complete disallowance of AE interest under Section 94B. While the eight-year carry-forward provides some relief, many infrastructure projects take longer than eight years to achieve stable EBITDA, resulting in permanent loss of deductions.
11.2 Start-ups and Growth-Stage Companies
Start-ups funded through inter-company loans from foreign parent companies face similar challenges. With negative or low EBITDA in the initial years, interest deductions are systematically disallowed. This increases the effective cost of capital and can make India a less attractive destination for debt-funded investments.
11.3 Financial Services
While banking and insurance companies are excluded from Section 94B, non-banking financial companies (NBFCs) are not. NBFCs that borrow from foreign AEs are subject to the 30% EBITDA cap, which can significantly impact their cost of funds and competitive positioning.
12. Section 94B and the New Tax Regime
With the introduction of the new tax regime under Section 115BAC (for individuals) and Section 115BAA/115BAB (for corporates), the interaction between Section 94B and these concessional rate provisions requires careful analysis. Under Section 115BAA, the company opts for a lower tax rate of 22% but forgoes most deductions and exemptions. The question is whether Section 94B disallowance applies before or after the election under Section 115BAA. The prevalent view is that Section 94B applies to the computation of income under the head “Profits and gains of business or profession,” which is a step prior to the election of tax rate under Section 115BAA.
13. Proposed Reforms and Future Outlook
Several stakeholders have advocated for reforms to Section 94B, including:
- Introduction of a group-ratio rule to permit higher deductions where the worldwide group’s leverage is genuinely high.
- Grandfathering of pre-existing borrowings entered into before 1 April 2017.
- Sector-specific exemptions for infrastructure, real estate, and NBFCs.
- Clarification on the computation of tax-adjusted EBITDA.
- Extension of the carry-forward period beyond eight years for capital-intensive sectors.
For any disputes arising from Section 94B disallowances, our income tax appeal services team provides end-to-end representation before the Commissioner of Income Tax (Appeals) and the Income Tax Appellate Tribunal.
“In our practice, we have seen several multinational groups structure their Indian operations with debt-equity ratios of 4:1 or even higher, often without appreciating the impact of Section 94B until the first assessment year hits. The common mistake is to focus solely on the arm’s length interest rate under transfer pricing and overlook the quantum limitation under thin capitalisation rules. Our recommendation is to model the Section 94B impact at the time of structuring the investment itself — not as an afterthought during tax compliance. For groups already in this situation, a phased restructuring of AE debt into equity or substitution with domestic borrowings is usually the most effective remedy. We also advise maintaining detailed contemporaneous documentation of the commercial rationale for the chosen capital structure, as this is the first thing the Transfer Pricing Officer examines during scrutiny.”
- Section 94B caps interest deduction on AE borrowings at 30% of EBITDA or INR 1 crore, whichever is higher.
- Back-to-back arrangements (AE guarantee + third-party lender) are also covered.
- Banking and insurance companies are excluded; NBFCs are not.
- Disallowed interest can be carried forward for up to eight assessment years.
- Section 94B operates independently of transfer pricing — both arm’s length rate and quantum cap must be satisfied.
- Documentation must cover EBITDA computation, AE interest details, and commercial rationale for the capital structure.
- Infrastructure, start-ups, and NBFCs face disproportionate impact due to low or negative EBITDA in early years.
- Proactive capital structuring and periodic review of debt-equity mix are essential to minimise disallowances.
Frequently Asked Questions (FAQs)
Q1. Does Section 94B apply to interest paid to a resident associated enterprise?
No. Section 94B applies only to interest paid or payable to a non-resident associated enterprise. Interest on domestic inter-company borrowings is outside the scope of this provision, though it remains subject to transfer pricing under Section 92.
Q2. Can the disallowed interest under Section 94B be carried forward indefinitely?
No. The carry-forward is limited to eight assessment years from the assessment year in which the interest was first disallowed. Any unabsorbed amount after eight years lapses permanently.
Q3. Does Section 94B apply to ECBs obtained from non-AE foreign banks?
Section 94B applies to interest on ECBs only if the non-resident lender is an associated enterprise or if an AE has provided a guarantee, deposit, or implicit support. Pure third-party ECBs without any AE nexus are outside the scope.
Q4. How is EBITDA computed for Section 94B — on a book basis or tax basis?
The provision refers to income computed under the head “Profits and gains of business or profession.” The prevalent interpretation is that it refers to tax-adjusted EBITDA, though there is no specific CBDT clarification. We recommend computing both and documenting the basis adopted.
Q5. Is guarantee commission paid to an AE treated as “interest” under Section 94B?
This is a debated issue. The provision covers “interest” and “similar consideration.” A guarantee commission can arguably be treated as similar consideration, as it is payment for credit support. However, this interpretation is not free from doubt and is likely to be tested in litigation. We recommend treating it as covered and disclosing it in the computation.
Q6. What happens if Section 94B and Section 40(a)(i) both disallow the same interest?
Section 40(a)(i) disallows interest where TDS has not been deducted or deposited. If both provisions apply, the interest is disallowed under whichever provision results in a higher disallowance. There is no double disallowance of the same amount.
Q7. Does Section 94B apply to interest on compulsorily convertible debentures (CCDs)?
CCDs are typically treated as equity under FEMA and sometimes under accounting standards. However, for income tax purposes, until actual conversion, the interest or coupon on CCDs is treated as interest on debt. Section 94B should therefore apply to such interest if the CCD holder is a non-resident AE.
Virtual Auditor — AI-Powered CA & IBBI Registered Valuer Firm
Valuer: V. VISWANATHAN, FCA, ACS, CFE, IBBI/RV/03/2019/12333
Chennai (HQ): G-131, Phase III, Spencer Plaza, Anna Salai, Chennai 600002
Bangalore: 7th Floor, Mahalakshmi Chambers, 29, MG Road, Bangalore 560001
Mumbai: Workafella, Goregaon West, Mumbai 400062
Phone: +91 99622 60333 | Email: support@virtualauditor.in
Book a Free Consultation
