In recent years, the Indian government has introduced several measures to prevent tax base erosion and profit shifting, especially in cross-border transactions. One of these key provisions is Section 94B of the Income Tax Act, introduced by the Finance Act, 2017. This section limits the amount of interest expense that can be claimed as a deduction by Indian companies or permanent establishments (PEs) of foreign companies in certain situations, particularly where excessive interest payments are made to associated enterprises (AEs). In this blog, we’ll dive into the details of Section 94B, its applicability, recent amendments, and how businesses can comply with these regulations.
Table of Contents
- What is Section 94B of the Income Tax Act?
- Applicability of Section 94B
- Limitation on Interest Deduction
- Carry Forward of Disallowed Interest
- Exceptions to Section 94B
- Recent Amendments to Section 94B
- Conclusion
- FAQs
What is Section 94B of the Income Tax Act?
Section 94B was introduced as part of India’s efforts to align with the Base Erosion and Profit Shifting (BEPS) project led by the G20 and the Organisation for Economic Co-operation and Development (OECD). The objective of this section is to prevent the shifting of profits from high-tax jurisdictions (like India) to low-tax jurisdictions through excessive interest deductions. It specifically targets situations where Indian companies or the permanent establishments of foreign companies pay interest to their associated enterprises (AEs).
Applicability of Section 94B
Section 94B applies if the following conditions are met:
- Assessee: The taxpayer must be an Indian company or a permanent establishment (PE) of a foreign company in India.
- Debt: The interest expense must arise from a debt. A debt can be a loan, financial instrument, finance lease, or any other arrangement that gives rise to interest or similar financial charges.
- Associated Enterprise (AE): The debt should be issued either by an associated enterprise (AE) of the borrower or by a third party, where an associated enterprise provides a guarantee or deposits matching funds.
- Interest Expense: The interest paid to the AE should exceed ₹1 crore in the relevant financial year.
When all these conditions are fulfilled, the provisions of Section 94B come into play, potentially limiting the amount of interest that can be deducted.
Limitation on Interest Deduction
Under Section 94B, the deduction for interest expense is capped at 30% of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) of the borrower. The excess interest is the amount that exceeds this 30% cap or the interest paid to associated enterprises, whichever is lower.
Example:
Suppose an Indian company has an EBITDA of ₹100 crore and pays ₹40 crore in interest to an associated enterprise. Under Section 94B, the maximum allowable interest deduction would be ₹30 crore (30% of ₹100 crore). The excess ₹10 crore would not be deductible.
Carry Forward of Disallowed Interest
If any portion of the interest is disallowed in a given assessment year due to the 30% EBITDA cap, the excess interest can be carried forward for up to 8 subsequent assessment years. The carried forward interest can then be deducted in future years, subject to the same 30% limit.
Example:
In the above scenario, the disallowed ₹10 crore of interest can be carried forward to the next 8 assessment years and deducted when the company’s profits allow for it, as long as the deduction doesn’t exceed the 30% EBITDA limit in those years.
Exceptions to Section 94B
There are specific exceptions where the provisions of Section 94B do not apply:
- Banking or Insurance Companies: Indian companies or permanent establishments engaged in the business of banking or insurance are exempt from the provisions of this section.
- Permanent Establishment of Non-Resident Banks: Effective from 1st April 2021, the limitation on interest deductions does not apply to interest paid to a permanent establishment of a non-resident that is engaged in banking activities in India.
- Notified NBFCs: From 1st April 2024, certain non-banking financial companies (NBFCs), as notified by the Central Government, will also be exempt from the provisions of Section 94B.
Recent Amendments to Section 94B
Several amendments have been made to Section 94B to address various practical challenges:
- Finance Act, 2021:
- Interest paid to a permanent establishment of a non-resident, engaged in the business of banking, is exempt from the interest limitation rules.
- Finance Act, 2023:
- Sub-section (3) of Section 94B has been amended, and sub-section (5)(iia) has been inserted to exempt certain non-banking financial companies (NBFCs), which will be notified by the Central Government from the limitation on interest deduction starting from 1st April 2024.
FAQs
1. What is the purpose of Section 94B of the Income Tax Act?
Section 94B limits the amount of interest deduction available to Indian companies and permanent establishments of foreign companies, particularly when interest is paid to associated enterprises, to prevent tax base erosion.
2. How much interest can be deducted under Section 94B?
The deduction is limited to 30% of the borrower’s EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).
3. Can disallowed interest be carried forward?
Yes, disallowed interest can be carried forward for up to 8 subsequent assessment years and deducted subject to the 30% limit in those years.
4. Does Section 94B apply to all companies?
No, there are specific exceptions for companies engaged in the business of banking, insurance, and certain NBFCs notified by the government.
5. What amendments were introduced by the Finance Act, 2023?
The Finance Act, 2023 introduced amendments exempting certain NBFCs, notified by the government, from the provisions of Section 94B, effective from 1st April 2024.
By understanding Section 94B, businesses can better manage their financial and tax strategies to ensure compliance while maximizing allowable deductions.
Conclusion
Section 94B plays a critical role in preventing excessive interest deductions, which could otherwise erode India’s tax base. By capping interest deductions at 30% of EBITDA, the government aims to ensure that profits are reported and taxed appropriately within the country. Indian companies and foreign companies with a permanent establishment in India should carefully evaluate their interest expenses, especially when dealing with associated enterprises, to comply with the provisions of this section.
If you are an Indian company or a PE of a foreign company, it’s essential to understand the limitations under Section 94B and make informed financial decisions to optimize your tax deductions while staying compliant.
