Thin Capitalisation: The Interest Deduction Cap
Thin capitalisation in India: the section 92(3) cap on the interest deductible on borrowings from associated enterprises — the arm’s length debt quantum and the disallowed interest.
Definition
Thin capitalisation is the question of how much of the entity’s capital is debt to the related party — and the rule that caps the deduction where it is too much. In India the provision is section 92(3): where the interest paid on money borrowed from an associated enterprise exceeds the interest that would have been payable had the borrowing not been from the associated enterprise — that is, on the quantum of debt an unrelated lender would in fact have extended to the borrower on the same facts (the credit, the security, the term, the market) — the excess interest is not deductible.
Deductible interest (s.92(3))
= the interest on the arm’s length debt quantum
(the debt an unrelated lender would have extended, on the borrower’s
credit, security, term and the market)
Disallowed interest
= the interest actually paid on the associated-enterprise debt
− the deductible interest (the excess is added back to the income)| The element | The content |
|---|---|
| The trigger | The borrowing from the associated enterprise (the intra-group debt — the parent’s loan, the shareholder’s advance carried as debt) |
| The cap | The arm’s length debt quantum — not an arm’s length rate on the actual debt: the quantum an unrelated lender would extend, and the interest on that quantum, at the rate |
| The consequence | The excess interest disallowed — added back to the income for the year; the TDS on the disallowed portion is a separate correction |
| The documentation | The credit assessment (the borrower’s profile, the security offered, the term, the market reference) — the same support chain the MAA carries for the loan’s rate, extended to the quantum |
The working distinction (the intercompany finance guide): the thin-cap rule caps the quantum, the rate rule (the MAA / the safe harbour) sets the rate — two questions on the same debt. The debt that is arm’s length in rate but above the arm’s length quantum is the debt the thin-cap adjustment reaches: the rate is defensible, the excess quantum’s interest is not deductible.
Example
An Indian company carries ₹300 cr of intra-group debt from its parent at the arm’s length rate (documented — the MAA support, the credit, the security, the market reference). On the credit assessment, an unrelated lender would have extended ₹200 cr to the borrower on the same facts (the credit profile, the security offered, the term — the bank’s lending position on the company’s balance sheet). The deductible interest is the interest on ₹200 cr at the documented rate; the interest on the ₹100 cr excess quantum is disallowed under s.92(3) and added back to the income. The rate was never the question — the quantum was.
See also
FAQ
Is the thin-cap test a rate test or a quantum test? A quantum test — s.92(3) caps the interest at the interest on the debt quantum an unrelated lender would have extended, at the rate. The rate’s arm’s length position is the separate question (the MAA / the safe harbour); the quantum is the thin-cap question. The debt can be right on the rate and disallowed on the quantum — and the documentation is the credit assessment that supports the quantum, not just the rate.
How is the arm’s length quantum determined? On the borrower’s credit facts: the balance sheet (the asset base, the security offered), the credit profile (the earnings, the cash flows, the existing commitments), the term, and the market (the lending position — the bank facilities available on the facts, the institutional lending). The documentation is the credit assessment built contemporaneously — the file the TPO examines when the quantum is the question, and the appeal argues from.
Does the safe harbour cover the thin-cap question? The safe harbour priced circumstances cover the eligible transactions’ rate (the loan at the prescribed circumstance) — the thin-cap quantum question runs on the credit assessment either way. The election prices the rate; the quantum is supported on the facts. The documentation carries both: the election for the rate, the credit assessment for the quantum.
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