1. Meaning of Thin Capitalisation

Thin capitalisation refers to a situation where a company is financed through excessive debt compared to equity, particularly from related parties, to shift profits through interest deductions instead of taxable dividends.

Tax Concern:

Interest is tax-deductible

Dividends are not deductible

Leads to base erosion

2. International Context – BEPS Action 4

OECD BEPS Action 4 recommends:

Limiting net interest deductions to a fixed percentage of EBITDA

Targeting related-party debt and guaranteed loans

India adopted this framework through the Finance Act, 2017.

3. Statutory Framework in India

Section 94B – Interest Limitation Rule

Applies from Assessment Year 2018-19 onwards.

Conditions:

Indian company or PE of foreign company

Interest expenditure exceeds ₹1 crore

Interest paid to:

Non-resident associated enterprise, or

Third party but guaranteed by associated enterprise

4. Quantum of Disallowance

Interest deduction is restricted to:

Lower of: (a) 30% of EBITDA, or (b) Actual interest paid or payable

Excess interest:

Disallowed in current year

Can be carried forward for 8 assessment years

5. Exclusions from Section 94B

Banking and insurance companies

Interest paid to Indian lenders not guaranteed by AE

Indian companies engaged in infrastructure lending (specific cases)

6. Definition of Associated Enterprise (AE)

As per Section 92A:

≥26% voting power

Control over management

Guarantee of ≥10% of borrowing

Significant influence over financing

7. Interaction with Transfer Pricing Provisions

Section 94B operates in addition to transfer pricing:

Even arm’s length interest may be disallowed

TP determines rate

Thin cap determines quantum

8. Judicial Principles Governing Interest Deductibility

Note: Since Section 94B is relatively new, courts rely on pre-94B thin capitalisation and interest deduction jurisprudence.

1. CIT v. Reliance Utilities & Power Ltd.

(Bombay High Court)

Held:

Presumption that investments are made from own funds if available

Interest disallowance requires clear nexus with borrowed funds

Relevance:

Taxpayer-friendly presumption against excessive debt misuse

2. SA Builders Ltd. v. CIT

(Supreme Court)

Held:

Interest allowable if borrowed funds used for commercial expediency

Revenue cannot substitute business judgment

Relevance:

Defence against denial of interest deduction

3. Hero Cycles (P) Ltd. v. CIT

(Supreme Court)

Held:

Disallowance requires proof of diversion for non-business purposes

Relevance:

Interest cannot be disallowed merely on suspicion

4. EKL Appliances Ltd. v. CIT

(Delhi High Court)

Held:

Tax authorities cannot question necessity of borrowing

ALP, not wisdom of transaction, is relevant

Relevance:

Limits Revenue’s power to re-characterise debt

5. CIT v. Tata Chemicals Ltd.

(Bombay High Court)

Held:

Thin capitalisation doctrine not applicable unless legislatively enacted

Relevance:

Justification for introduction of Section 94B

No implied thin cap before statutory backing

6. Perot Systems TSI (India) Ltd. v. DCIT

(ITAT Delhi)

Held:

Arm’s length interest is deductible even if AE funded

No automatic recharacterisation as equity

Relevance:

Continues to apply for periods not covered by Section 94B

7. Bharti Airtel Ltd. v. ACIT

(ITAT Delhi)

Held:

Guarantee by AE triggers scrutiny

Substance of financing arrangement matters

Relevance:

Relevant for third-party loans covered under Section 94B

9. Thin Capitalisation vs Dividend Distribution

Excessive debt may be recharacterised under GAAR

Interest may be treated as:

Dividend equivalent, or

Non-deductible expenditure

10. Interaction with GAAR and Treaty Provisions

11. Practical Structuring Considerations

Maintain debt-equity ratio benchmarking

Avoid AE guarantees where possible

Capitalise projects adequately

Monitor EBITDA thresholds annually

Use hybrid instruments cautiously

12. Summary Table

13. Conclusion

India’s thin capitalisation regime under Section 94B marks a decisive shift from judicial tolerance to statutory restriction of interest deductions. While courts continue to protect commercial borrowing decisions, the quantum of deductibility is now legislatively capped, aligning Indian law with global anti-BEPS standards.