Thin Capitalization Rules (Section 94B)

By Anuj Singh | Updated March 2026

What Is Thin Capitalization?

Thin capitalization refers to a corporate financing structure where a company is funded with a disproportionately high level of debt relative to equity, typically through loans from its foreign parent or associated enterprises. India restricts this practice through Section 94B of the Income Tax Act, 1961, inserted by the Finance Act, 2017 and effective from Assessment Year 2018-19. The provision caps the deduction for interest paid or payable to a non-resident associated enterprise at 30% of EBITDA (earnings before interest, taxes, depreciation, and amortisation) of the borrower, or the actual interest paid to associated enterprises, whichever is lower.

For foreign investors setting up subsidiaries in India, this rule directly limits how much interest expense on intercompany loans can reduce taxable income. Before Section 94B, a foreign parent could lend heavily to its Indian subsidiary at high interest rates, extracting profits as interest (deductible in India) rather than dividends (subject to dividend distribution tax or withholding tax). Section 94B closes this avenue by disallowing interest deductions beyond the 30% EBITDA threshold.

The provision aligns India with the OECD's BEPS Action Plan 4 ("Limiting Base Erosion Involving Interest Deductions and Other Financial Payments"), which recommended that countries adopt a fixed ratio rule capping interest deductions at 10% to 30% of EBITDA. India chose the upper end of this range at 30%.

Legal Basis

The statutory and regulatory framework for thin capitalization in India:

• Section 94B of the Income Tax Act, 1961 — Inserted by Section 42 of the Finance Act, 2017, effective from April 1, 2018 (AY 2018-19). Limits deduction of interest paid or payable to a non-resident associated enterprise or to a lender where an associated enterprise provides an implicit or explicit guarantee.
• Section 92A of the Income Tax Act, 1961 — Defines "associated enterprise" for transfer pricing purposes. Section 94B borrows this definition, meaning any entity where one holds 26% or more of voting power, or exercises significant influence over the other, is covered.
• Section 94B(2) — Excess interest definition — Excess interest is the amount of total interest paid or payable in excess of 30% of EBITDA of the borrower in the previous year, or interest paid or payable to associated enterprises for that year, whichever is less.
• Section 94B(3) — Carryforward — Disallowed interest can be carried forward for up to 8 assessment years immediately succeeding the assessment year of disallowance and set off against profits and gains of business or profession, subject to the 30% EBITDA limit in each subsequent year.
• Section 94B(4) — Exclusions — Companies engaged in the business of banking or insurance are excluded. Notified NBFCs are also exempt.
• OECD BEPS Action 4 (2015) — International best practice recommendation that informed India's adoption of the fixed ratio rule.

How Section 94B Works: The 30% EBITDA Cap

The mechanics of Section 94B follow a precise calculation sequence that every Indian subsidiary of a foreign parent must understand.

Step-by-Step Calculation

Step 1: Compute the total interest paid or payable to non-resident associated enterprises during the previous year. This includes interest on all forms of debt — term loans, ECBs, debentures, trade credit, and any arrangement that is substantially a borrowing.

Step 2: Check the INR 1 crore threshold. If total interest paid or payable to associated enterprises does not exceed INR 1 crore, Section 94B does not apply at all. This de minimis threshold exempts small intercompany borrowings.

Step 3: Compute 30% of EBITDA. EBITDA is computed as profit before interest, taxes, depreciation, and amortisation as per the books of account. Note that India uses a book-based EBITDA, not a tax-adjusted EBITDA, which differs from certain other jurisdictions.

Step 4: The allowable interest deduction is the lower of: (a) interest actually paid or payable to associated enterprises, or (b) 30% of EBITDA.

Step 5: Any excess interest (the difference between actual interest paid and the allowable amount) is disallowed in the current year but can be carried forward for up to 8 assessment years.

EBITDA Calculation Example

Scope: Who Is Covered and What Counts as "Debt"

Section 94B applies to two types of borrowers:

1. Indian companies — any company incorporated under the Companies Act, 2013 that borrows from a non-resident associated enterprise
2. Permanent establishments (PEs) — the Indian PE of a foreign company that incurs interest on debt from its non-resident associated enterprise (including its own head office)

The Deemed Associated Enterprise Trap

A critical proviso in Section 94B(1) creates a deeming fiction: even if the lender is not an associated enterprise, the debt is deemed to have been issued by an associated enterprise if:

• An associated enterprise provides an explicit guarantee to the third-party lender (e.g., a parent company guarantee on a bank loan)
• An associated enterprise deposits a corresponding and matching amount of funds with the lender (back-to-back loan arrangement)
• An associated enterprise provides implicit support — this is the most contentious limb, as passive association or group affiliation could be interpreted as implicit guarantee

This means a loan from a third-party bank, guaranteed by the foreign parent, falls within Section 94B. Foreign parents routinely guarantee subsidiary borrowings, making this deemed association provision extremely broad in practice.

India vs. Global Thin Capitalization Rules

India's approach sits within a spectrum of global anti-avoidance measures. Understanding how India compares helps foreign investors plan multi-jurisdictional structures.

India's INR 1 crore (approximately USD 120,000) de minimis threshold is notably lower than Germany's EUR 3 million or the UK's GBP 2 million, meaning a larger number of mid-sized subsidiaries are captured by the Indian rules.

How This Affects Foreign Investors in India

Thin capitalization rules have direct strategic implications for any foreign company funding its Indian operations:

Parent Company Loan Structuring

A foreign parent planning to fund its wholly owned subsidiary or joint venture in India must model the subsidiary's projected EBITDA before deciding the debt-to-equity split. Loans that push interest above 30% of EBITDA will result in non-deductible interest — effectively increasing the subsidiary's tax cost. At India's corporate tax rate of 25.17% (for companies opting for Section 115BAA), disallowed interest of INR 2.50 crore means an additional tax cost of approximately INR 62.93 lakh per year.

ECB and Intercompany Debt Planning

Foreign parent companies often extend external commercial borrowings (ECBs) to Indian subsidiaries. The interest on these ECBs is subject to Section 94B if the lender is an associated enterprise. Since ECB interest rates are governed by RBI's all-in-cost ceiling (currently benchmark rate + 450 bps for ECBs with maturity over 5 years), the combination of RBI rate caps and Section 94B interest caps requires careful financial modelling.

Impact on Permanent Establishments

Foreign companies operating through a branch office or project office in India must also consider Section 94B. Interest attributed to the PE on head-office borrowings can be disallowed if it exceeds the 30% threshold. This is particularly relevant for construction and infrastructure projects financed through overseas debt.

Exceptions and Carve-Outs

Section 94B(4) provides specific exclusions:

• Banking companies: Companies engaged in the business of banking under the Banking Regulation Act, 1949 are fully excluded. Interest is the core business expense for banks, making the EBITDA cap inappropriate.
• Insurance companies: Companies carrying on insurance business under the Insurance Act, 1938 are excluded for the same rationale.
• Notified NBFCs: The Central Government has excluded certain non-banking financial companies (NBFCs) registered with the RBI from Section 94B, recognising that their business model inherently relies on leveraged funding.
• INR 1 crore threshold: If interest paid or payable to associated enterprises does not exceed INR 1 crore in a previous year, Section 94B does not apply.

Common Mistakes

• Ignoring the deemed associated enterprise proviso for guaranteed loans. Many foreign parents guarantee their Indian subsidiary's bank loans as a matter of routine treasury practice. This guarantee converts a third-party bank loan into "deemed AE debt" under Section 94B, pulling the bank interest into the 30% EBITDA cap. Restructure guarantees or remove them where possible.
• Using tax-adjusted EBITDA instead of book EBITDA. Unlike Germany or the UK, India's Section 94B uses book-level EBITDA (profit before interest, tax, depreciation, and amortisation as per financial statements). Applying tax adjustments to compute EBITDA inflates or deflates the cap incorrectly, leading to wrong disallowance calculations.
• Failing to track carried-forward disallowed interest across assessment years. Disallowed interest can be carried forward for 8 years, but only to the extent of the 30% EBITDA headroom in each subsequent year. Companies that do not maintain a running ledger of cumulative disallowed interest lose legitimate deductions permanently after the 8-year window expires.
• Not considering Section 94B when computing advance pricing agreement or arm's length pricing for intercompany loans. Even if the interest rate passes the transfer pricing arm's length test, the quantum of interest can still be disallowed under Section 94B. Transfer pricing and thin capitalisation are separate, cumulative restrictions — passing one does not exempt you from the other.
• Overlooking the interaction with DTAA provisions. Section 94B is a domestic anti-avoidance rule. Some taxpayers assume that a favourable DTAA interest article overrides Section 94B, but the section operates as a deduction limitation (not a taxing provision), so DTAA relief on withholding tax rates does not prevent the domestic disallowance of excess interest.

Practical Example

NovaTech GmbH, a German technology company, sets up a wholly owned subsidiary in India — NovaTech India Pvt Ltd — with the following capital structure:

• Equity: INR 5 crore (share capital + share premium)
• Intercompany loan from NovaTech GmbH: INR 40 crore at 8% interest per annum
• Debt-to-equity ratio: 8:1

In FY 2025-26, NovaTech India reports the following:

In this scenario, the interest of INR 3.20 crore is fully deductible because it falls below the 30% EBITDA cap of INR 5.40 crore. The 8:1 debt-to-equity ratio, while aggressive, does not trigger disallowance because the interest expense is within the EBITDA limit.

Now consider a downturn in FY 2026-27 where revenue drops to INR 35 crore:

The revenue decline compresses EBITDA, and INR 1.10 crore of interest is disallowed. At a corporate tax rate of 25.17%, this results in an additional tax outflow of approximately INR 27.69 lakh. The disallowed INR 1.10 crore can be carried forward and claimed against profits in future years (within 8 assessment years), subject to the 30% EBITDA limit in each year.

Had NovaTech GmbH structured the investment as INR 25 crore equity and INR 20 crore debt, the annual interest would have been INR 1.60 crore — comfortably within the 30% EBITDA cap even in the downturn year. This illustrates why upfront debt-equity structuring, modelled against stress-tested EBITDA scenarios, is essential.

Key Takeaways

• Section 94B caps interest deductions on debt from non-resident associated enterprises at 30% of EBITDA, effective from AY 2018-19
• The INR 1 crore de minimis threshold exempts small intercompany borrowings, but most foreign-funded subsidiaries will exceed this
• Parent company guarantees on third-party bank loans trigger the deemed AE provision, pulling those loans into the 30% EBITDA cap
• Disallowed interest can be carried forward for 8 assessment years, but expires permanently if unused
• Banking, insurance, and notified NBFCs are excluded from Section 94B
• Section 94B operates independently of transfer pricing — even arm's length interest rates can be disallowed if the total quantum exceeds 30% of EBITDA

Planning intercompany debt for your Indian subsidiary or need to optimise your capital structure under thin capitalisation rules? Beacon Filing provides transfer pricing advisory, Section 94B compliance, and intercompany loan structuring for foreign-owned Indian entities.