Section 94B Limitation on Interest Deduction in Certain Cases – Explained

Introduction

Not every expense you claim is fully allowed.

And interest is one of the biggest examples of that.

If your company borrows funds—especially from a related foreign entity—you might assume the entire interest payment reduces your taxable income.

But under Section 94B of the Income Tax Act, that assumption can be wrong.

This provision quietly limits how much interest you can actually deduct, & if you ignore it, your tax liability can increase without warning.

What Section 94B Actually Does

At its core, this section is about control.

Section 94B imposes a cap on the deduction of interest expenses when certain conditions are met. It was introduced to stop companies from using excessive borrowing—especially from related foreign entities—as a tool to reduce taxable profits.

In technical terms, it is known as a thin capitalisation rule."

But in practical terms, it simply means:"

You cannot claim an unlimited interest deduction if your borrowing structure is heavily debt-driven".

Who This Rule Applies To

This is not a general rule for all taxpayers.

Section 94B of the Income Tax Act applies specifically to:

• Indian companies"
• Permanent establishments (PE) of foreign companies in India"

And even then, only when interest is paid to:

• A non-resident associated enterprise (AE)

So, if your borrowing is from unrelated domestic sources, this restriction does not apply.

When Does the Restriction Start

The law gives a clear threshold.

It applies only when:

Expenditure by way of interest or of similar nature exceeds ₹1 crore

Below this level, the section does not interfere.

But once you cross ₹1 crore, the deduction calculation changes.

The 30% EBITDA Rule — The Core Formula

This is where the real impact comes in.

Section 94B would restrict the deduction of interest to 30% EBITDA.

That means your allowable deduction becomes:

• 30% of EBITDA
  or
• Actual interest paid

 Whichever is lower.

So even if your company pays high interest, only a portion of it may actually be allowed as a deduction.

What Happens to the Excess Interest

One important thing to understand is that the disallowed interest is not permanently lost.

Instead:

Section 94B requires disallowance of excess interest paid to a foreign AE by a resident taxpayer, but allows it to be carried forward.

This excess amount can be:

• Carried forward for up to 8 years
• Claimed later, subject to the same limits

So the benefit is delayed—not completely denied.

Why This Section Was Introduced

Before this rule existed, companies had a loophole.

They could:

• Borrow heavily from foreign group entities"
• Pay high interest"
• Reduce taxable profits in India"

This resulted in significant tax loss for the government.

To address this, Section 94B has been inserted in Income Tax Act to ensure that interest deductions reflect genuine business needs, not tax strategies.

A Real-World Example

Let’s make this easier to understand.

Assume:

• Interest paid = ₹3 crore
• EBITDA = ₹5 crore

Now:

• 30% of EBITDA = ₹1.5 crore

 Allowed deduction = ₹1.5 crore
 Remaining ₹1.5 crore = disallowed 

Even though the company actually paid ₹3 crore, only half of it is allowed as a deduction in that year.

Impact on Taxable Income

This section directly affects your bottom line.

When interest deduction is restricted:

• Taxable income increases
• Tax liability increases
• Financial planning becomes more important

This is why companies need to evaluate their borrowing structure carefully.

What Businesses Often Overlook

Many companies focus only on raising funds.

They do not think about how those funds are structured.

Common mistakes include:

• Excess reliance on debt from foreign AEs"
• Ignoring EBITDA limits"
• Not tracking interest thresholds"
• Assuming full deduction is always allowed"

These mistakes can lead to unexpected tax adjustments.

How Section 94B Changes Financial Strategy

This provision forces companies to rethink how they finance operations.

Instead of relying heavily on debt, businesses may:

• Balance debt & equity
• Reduce related-party borrowings
• Plan interest expenses more strategically

In short, it promotes healthier financial structuring.

Global Context — Not Just an Indian Rule

This is not a random local regulation.

Thin capitalization rules like Section 94B exist globally.

They are part of international efforts to prevent profit shifting & tax avoidance.

So this rule aligns India with global tax standards.

Final Thought

Section 94B of the Income Tax Act may look technical, but its message is simple:

Interest deductions should be reasonable, not excessive.

If your company deals with foreign associated enterprises, this section is not optional—it is critical.

Understanding it early can save you from higher taxes, compliance issues, & financial surprises.

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