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Feb 21, 2018

Income Tax Limitation of Interest Deduction in Certain Cases

A company is typically financed or capitalized through a mixture of debt and equity. The way a company is capitalized often has a significant impact on the amount of profit it reports for tax purposes as the tax legislations of countries typically 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. Therefore, the higher the level of debt in a company, and thus higher the amount of interest it pays, the lower will be its taxable profit. For this reason, debt is often a more tax efficient method of finance than equity. Multinational Enterprises (MNEs) are often able to structure their financing arrangements to maximize these benefits. For this reason, tax administrations of several countries have introduced rules that place a limit on the amount of interest that can be deducted in computing a  company's profit for tax purposes. Such rules are designed to counter cross-border shifting of profit through excessive interest payments, and thus aim to protect a country's tax base.

46.2 Under the initiative of the G-20 countries, OECD in its Base Erosion and Profit Shifting (BEPS) project had taken up the issue of base erosion and profit shifting by way of excess interest deductions by the MNEs in Action plan 4 and has recommended several measures in its final report to address this issue.

46.3 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.

46.4 The provisions of the section 94B of the Income-tax Act shall be applicable to an Indian company, or a permanent establishment of a foreign company being the borrower who pays interest in respect of any form of debt issued to a non-resident or to a permanent establishment of a non-resident and who is an 'associated enterprise' of the borrower. Further, the debt shall be deemed to be treated as issued by an associated enterprise where it provides an implicit or explicit guarantee to the lender or deposits a corresponding and matching amount of funds with the lender.

46.5 The provisions of the said section 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 also allow deduction against the income computed under the head ‚Profits and gains of business or profession‛ to the extent of maximum allowable interest expenditure.

46.6 In order to target only large interest payments, the said section also provides for a threshold limit of interest expenditure of one crore rupees exceeding which the provision would be applicable.

46.7 Further, banks and insurance business have also been excluded from the ambit of the said provisions keeping in view of special nature of these businesses.

46.8 Applicability: This amendment takes effect from 1st April, 2018 and will, accordingly, apply from assessment year 2018-19 and subsequent years.
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