Thin Capitalization- Section 94B- Operational Analysis

Thin Capitalization- Section 94B- Operational Analysis

1.       Applicability to

a)       Indian Company

b)      Permanent Establishment of Foreign Company

(Referred to as Entity in subsequent discussion)

2.       Charging Provision

a)       Entity incur DEDUCTIBLE Interest expenditure in Previous Year in computing income under the head PGBP, in respect of debt (direct & Indirect) taken from Associated Enterprise.

b)      The amount of such deductible Interest expenditure exceeds Rs. 1 Cr.

c)       If afore-said conditions are satisfied, then Excess Interest will be disallowed to Entity in a previous year.

d)      When Entity borrow money from Non-AE, but Associated enterprise either provides implicit or explicit guarantee to lender (for amount lend to entity) or deposit equivalent amount with lender, then it shall be treated as indirect borrowing from AE

e)      Section 94B is not applicable where entity is engaged in banking or insurance business.

Analysis - Deductible expenditure against PGBP

i)                    If Interest expense is being disallowed u/s 40a(i), then same being not deductible expenditure in a previous year, it will not be taken into consideration in computing One Crore yardstick

ii)                   Suppose an Indian company borrow money from AE. It could not deploy the funds in business project and earn interest income by investing the borrowed funds. Since the said interest income is chargeable to tax under the head Income from other sources and Interest payable to AE is being set-off against said interest income, said Interest expense will not be considered for calculating One Crore Benchmark, as same was not deductible expenditure under PGBP.

3.       Computation of Excess Interest

The Excess Interest is lower of the following: -

i)                    Total Interest Expenditure (Payable to AE and Non-AE) Less 30% of Earning before Interest, Taxes Depreciation and amortization (EBITDA) or

ii)                   Interest paid or payable to Associated Enterprise

Analysis

i)                    EBITDA is not defined in section 94B. The point for consideration is whether EBITDA is to be computed as per books of accounts or same is to computed with by imputing provision of Income Tax Act.

ii)                   My view is that EBITDA be computed as per books of accounts. Income tax legislation used the terminology as Gross Total Income or Total income or Income under respective head and nowhere it used the words “Earning” or “Amortization”. EBITDA is term used in accounting parlance and legislator must have used the definition in the same sense only.

iii)                 Illustration of computation of Excess Interest

                

S.No	Particulars	Case 1	Case 2	Case 3
1	EBITDA	5,00,00,000	5,00,00,000	5,00,00,000
2	Interest Paid to Non-AE	30,00,000	1,50,00,000	70,00,000
3	Interest Paid to AE	1,10,00,000	1,10,00,000	1,10,00,000
4	TOTAL Interest Expenditure	1,40,00,000	2,60,00,000	1,80,00,000
5	30% of EBITDA	1,50,00,000	1,50,00,000	1,50,00,000
6	Total Interest- 30% of EBIDA	-10,00,000	1,10,00,000	30,00,000
7	Interest Paid to AE	1,10,00,000	1,10,00,000	1,10,00,000
8	Excess Interest - Lower of 5 or 6	0	1,10,00,000	30,00,000
9	Interest Allowed (4-8)	1,40,00,000	1,50,00,000	1,50,00,000
10	Excess Interest Carried Forward to Next year (8)	0	1,10,00,000	30,00,000

iv)                 The excess interest is allowed in subsequent year to the extent of limits specified in point 3 above i.e. aggregate of Interest (Current year and unabsorbed Interest) should not exceed 30% of EBITDA

4.       Treatment of Excess Interest of First Year Carried forward to next year/subsequent year.

a)      Whether carried forward Excess Interest be considered in computing benchmark of 1 Cr of subsequent year or not

i)                    Suppose Interest Payable to AE in next year is Rs. 80 lacs. Whether we need to add the excess interest (case 2) of Rs. 110 lacs to Rs. 80 lacs, to arrive at benchmark interest amount of Rs 1 Cr determining the applicability of Charging provision of section 94B.

ii)                   In my understanding, it should not be added. The reasons are two-folded:-

a.       Section 94B(1), charging section, used the words where entity “incurs any expenditure by way of Interest-----“. Thus benchmark is to be evaluated based on Interest expenditure incur in previous year

b.       Considered the case- 3 above. In this case, it is indeterminable whether excess Interest relates to AE or non-AE. Since the law does not provide the basis for evaluation of the same, it is not possible to assess the subsequent year benchmark by adding previous year excess Interest.

b)      Limit on deduction of Excess Interest in Subsequent year, if charging provision is not applicable in said subsequent year

i)                    The Itinerary of section 94B is as under: -

a.       Section 94B(1) is charging section, which disallow the excess interest, if the Interest payable to AE is in excess of Rs 1 Cr.

b.       Section 94B(2) provide for computation of Excess Interest.

c.       Section 94B(3) provides the exclusion of section 94B to Banking or Insurance Company.

d.       Section 94B(4) provides for carry forward of excess Interest and further provides for its deduction in subsequent year to the extent specified in section 94B(2). Section 94B(4) reads as under:-

“Where for any assessment year, the interest expenditure is not wholly deducted against income under the head "Profits and gains of business or profession", so much of the interest expenditure as has not been so deducted, shall be carried forward to the following assessment year or assessment years, and it shall be allowed as a deduction against the profits and gains, if any, of any business or profession carried on by it and assessable for that assessment year to the extent of maximum allowable interest expenditure in accordance with sub-section (2)” (Emphasis supplied)

ii)                   Under Section 94B(2), Maximum allowable Interest is to the extent it does not exceed Excess Interest. The Excess Interest is computed only, when charging provision as per section 94B(1) is applicable. If charging provision is not applicable, then there is no computation of excess Interest, hence no restriction on allowability of Interest. In this scenario, Excess interest of past year, should be allowed in entirety in next year, in my view.