limitation on Debt interest deduction as expenses in cross-border transactions : Clause 177 of Income Tax Bill, 2025 Vs. Section 94B of Income-tax Act, 1961

Clause 177 Limitation on interest deduction in certain cases.

Income Tax Bill, 2025

Introduction

The limitation on interest deduction in cross-border transactions is a critical anti-avoidance measure in international taxation, designed to curb base erosion and profit shifting (BEPS) by multinational enterprises (MNEs). The Indian legislature first introduced such rules through Section 94B of the Income-tax Act, 1961, following the recommendations of the OECD's BEPS Action Plan 4. The provision has seen several amendments and clarifications, including the introduction of Rule 21ACA of the Income-tax Rules, 1962, which sets out specific conditions for Finance Companies in International Financial Services Centres (IFSCs).

With the proposed Income Tax Bill, 2025, Clause 177 seeks to consolidate, clarify, and possibly expand upon these existing provisions. This commentary provides a comprehensive analysis of Clause 177, compares it with Section 94B and Rule 21ACA, and discusses the implications for stakeholders, interpretational challenges, and the broader policy context.

Objective and Purpose

The core objective of Clause 177 (and its predecessor, Section 94B) is to prevent MNEs from eroding the Indian tax base through excessive interest deductions on cross-border debt, especially where the lender is an associated enterprise. The legislative intent is to align with international best practices, notably the OECD BEPS framework, and to ensure that India's tax regime is robust against profit shifting via thin capitalization structures.

Historically, Indian tax law did not have a specific cap on interest deduction for payments to non-resident associated enterprises, which allowed MNEs to leverage Indian operations excessively and reduce taxable profits through high interest outflows. The introduction of Section 94B in 2017, and now its proposed codification and refinement in Clause 177, reflects a policy shift towards protecting the domestic tax base while maintaining investor confidence and clarity.

Detailed Analysis of Clause 177 of Income Tax Bill, 2025

1. Scope and Applicability

Clause 177(1) applies to any expenditure by way of interest or similar payments in respect of excess interest (as defined) by:

• Indian companies, and
• Permanent establishments (PEs) of foreign companies in India.

The provision applies where such interest is paid or payable in respect of debt issued by an associated enterprise (AE) which is a non-resident, and where the aggregate such expenditure in a tax year exceeds INR 1 crore.

Section 94B(1) is substantially similar, covering Indian companies and PEs of foreign companies, with the same monetary threshold of INR 1 crore on deductible interest in relation to debt from non-resident AEs.

Key Points of Comparison:

• Both provisions override other provisions of the Act ("notwithstanding anything contrary in this Act").
• The monetary threshold ensures that only significant cross-border financings are targeted, not routine domestic borrowings.
• The focus is on cross-border related party debt, a common avenue for profit shifting.

2. Deemed Associated Enterprise Debt

Clause 177(2) and the proviso to Section 94B(1) address situations where the formal lender is not an AE, but an AE provides a guarantee or matching funds, thus economically connecting the debt to the AE.

The provision deems the debt to be from an AE if:

• An AE provides an implicit or explicit guarantee to the lender, or
• An AE deposits corresponding and matching funds with the lender.

This anti-avoidance measure prevents circumvention of the rule by routing loans through third parties while retaining economic substance with the AE.

Section 94B contains an identical deeming fiction, ensuring the provision's effectiveness even where the AE is not the direct lender.

3. Exceptions and Carve-outs

Clause 177(3) provides specific exclusions:

• Interest paid to a lender which is a PE in India of a non-resident engaged in banking business.
• Indian companies or PEs of foreign companies engaged in banking, insurance, or as Finance Companies in IFSCs or notified NBFCs.

Section 94B(1A) and (3) contain parallel exclusions, with additional clarity and cross-references to notified NBFCs and the definition of Finance Companies as per the IFSCA regulations.

These carve-outs recognize the economic reality of financial intermediation, where banking and insurance businesses inherently rely on leveraging and debt, and where IFSC Finance Companies are subject to separate regulatory regimes designed to encourage international financial activity in India.

4. Determination of "Excess Interest"

Clause 177(4) defines "excess interest" as the lower of:

• Total interest paid or payable in excess of 30% of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) of the borrower in the tax year, or
• Interest paid or payable to associated enterprises for that tax year.

Section 94B(2) uses identical language and methodology.

This fixed ratio rule is consistent with BEPS Action 4 and is designed to strike a balance between allowing legitimate interest deductions and preventing excessive deductions that erode the domestic tax base.

5. Carry Forward and Set-Off of Disallowed Interest

Clause 177(5) and (6) permit the carry forward of disallowed interest expenditure for up to eight tax years, to be set off against future business profits, subject to the same 30% EBITDA limitation in subsequent years.

Section 94B(4) contains an identical mechanism, with the carry forward period capped at eight assessment years.

This approach prevents permanent disallowance of interest, recognizing that business income and debt servicing capacity can fluctuate over time, while still protecting the tax base in years of excessive interest expense.

6. Definitions

Clause 177(7) defines "debt" in broad terms to include loans, financial instruments, finance leases, financial derivatives, or any arrangement giving rise to interest or finance charges deductible under "Profits and gains of business or profession".

Section 94B(5) mirrors this definition and further cross-references the meaning of "associated enterprise", "permanent establishment", and "Finance Company" to other statutory provisions and regulations.

Rule 21ACA, relevant for the carve-out for IFSC Finance Companies, specifies the permissible activities and the requirement that interest paid by such entities must be in foreign currency.

7. Rule 21ACA: Operationalizing the IFSC Carve-out

Rule 21ACA was introduced to clarify the scope of the exception for Finance Companies in IFSCs u/s 94B (and now Clause 177). It stipulates:

• Permitted activities: lending, guarantees, securitisation, factoring, treasury functions, intra-group financing, etc.
• Interest payments by such Finance Companies must be made in foreign currency.
• Definitions of "Finance Company" and "IFSC" are aligned with the IFSCA regulations and SEZ Act, respectively.

This ensures that only genuine international financial service activities benefit from the exemption, preventing abuse by domestic entities masquerading as IFSC Finance Companies.

Comparison with Section 94B of Income-tax Act, 1961

Provision/Aspect	Section 94B of the Income-tax Act, 1961	Clause 177 of Income Tax Bill, 2025	Comments/Analysis
Applicability	Indian companies and PEs of foreign cos; interest > INR 1 crore on debt from non-resident associated enterprise	Similar scope and threshold	No substantive change; continuity in scope
Deemed Associated Enterprise Debt	Debt from non-associated lender deemed AE if AE provides guarantee or matching funds	Same	Anti-avoidance rule retained
Exclusions	Interest paid to PE in India of non-resident banker; Indian cos/PEs in banking, insurance, IFSC Finance Cos, notified NBFCs	Same	Maintains policy carve-outs
Excess Interest	Lower of (i) interest > 30% of EBITDA or (ii) interest paid to AE	Same	Identical mechanics
Carry Forward	Up to 8 assessment years	Up to 8 tax years	Terminology shift (assessment year to tax year) but substance unchanged
Definitions	"Debt," "Finance Company," "PE," etc. defined	Same, with cross-references updated	Alignment with new legislative framework

The comparison reveals that Clause 177 is largely a re-enactment and consolidation of Section 94B, with minor clarifications and terminological updates to fit the new Bill's structure. The overall policy, mechanics, and exclusions remain unchanged.

Specifics for Finance Companies in IFSCs :- Rule 21ACA of the Income-tax Rules, 1962

Rule 21ACA, notified in 2025, operationalizes the exemption for Finance Companies in IFSCs as provided u/s 94B (and now Clause 177).

• It specifies permitted activities for such Finance Companies, including lending, guarantees, securitisation, factoring, forfaiting, and treasury functions.
• It mandates that interest paid by such companies (as borrowers) in respect of debt issued by a non-resident must be in foreign currency.
• Definitions are provided for "Finance Company" and "International Financial Services Centre."

This rule ensures that only genuine, internationally-oriented financial operations benefit from the exemption, and prevents misuse by onshore finance entities.

Comparative Analysis: Clause 177, Section 94B, and Rule 21ACA

• Substantive Parity: Clause 177 and Section 94B are substantively identical, with Clause 177 updating cross-references and integrating the provision into the new legislative framework.
• Rule-based Detailing: Rule 21ACA provides operational clarity for the exemption to IFSC Finance Companies, a necessary adjunct to both Section 94B and Clause 177.
• Policy Continuity: The overarching policy of limiting interest deduction to 30% of EBITDA, with carry forward and specific carve-outs, is maintained throughout.
• International Alignment: The provisions remain aligned with OECD BEPS Action 4, which recommends a fixed ratio rule (30% of EBITDA) as a minimum standard for interest deduction limitation.

Practical Implications

1. For Multinational Enterprises

• Cross-border group financing structures involving Indian entities must be reviewed to ensure compliance with the 30% EBITDA cap on interest deduction.
• Indirect funding, through unrelated lenders but with group guarantees or funding support, will be caught by the deemed AE rule.
• Excess interest disallowed can be carried forward, but only for eight years, affecting long-term financing plans.

2. For Financial Sector Entities

• Banks, insurance companies, IFSC Finance Companies, and notified NBFCs are exempt, recognizing their unique leverage and business models.
• Rule 21ACA ensures that only bona fide IFSC Finance Companies engaged in specified international activities qualify for exemption.

3. For Tax Administrators

• Tax authorities must scrutinize group financing arrangements for disguised AE debt and ensure proper application of the EBITDA threshold.
• Verification of activities and compliance for IFSC Finance Companies u/r 21ACA will be critical.

4. For Tax Advisors and Accountants

• Advisors must factor in the interest limitation in structuring intra-group financing, mergers, and acquisitions.
• Proper documentation and evidence of business purpose, arm's length terms, and compliance with Rule 21ACA are essential.

Key Issues and Potential Ambiguities

1. Definition of EBITDA

While the provision uses the term "earnings before interest, taxes, depreciation and amortisation," the precise computation methodology (e.g., whether extraordinary items are included/excluded, treatment of non-operating income, etc.) may be subject to interpretation and litigation.

2. Interaction with Transfer Pricing Provisions

Section 94B/Clause 177 operates "notwithstanding anything contrary," but does not override the need for interest rates and terms to be at arm's length under transfer pricing rules (Sections 92-92F). Both provisions may apply cumulatively, potentially leading to double disallowance if not carefully coordinated.

3. Treatment of Hybrid Instruments

The definition of "debt" is broad, including financial instruments, leases, derivatives, and arrangements that give rise to finance charges. The characterization of hybrid instruments (e.g., convertible debentures) may be contentious.

4. Carry Forward and Set-off Mechanism

Carry forward is allowed for eight years, but only "to the extent of maximum allowable interest expenditure as per sub-section (4)" each year. This may require complex tracking and allocation, especially for groups with multiple financing arrangements.

5. Scope of Exemptions

The exemption for "such class of non-banking financial companies as notified by the Central Government" introduces a discretionary element, potentially leading to uncertainty for NBFCs not specifically notified.

Comparative International Perspective

India's interest limitation rule (30% of EBITDA) is consistent with OECD BEPS Action 4 recommendations and similar to regimes in several other jurisdictions (e.g., UK, Germany, Australia). Some countries have adopted stricter or more flexible ratios, or group-wide tests, but the fixed ratio rule is widely accepted as a minimum standard.

India's carve-outs for banks and regulated financial entities are also in line with international practice, recognizing the systemic importance and regulatory oversight of these sectors.

Conclusion

Clause 177 of Income Tax Bill, 2025, represents a continuation and consolidation of India's policy to limit excessive interest deductions in cross-border related party financing, with a view to curbing BEPS practices. The provision is fundamentally aligned with Section 94B of the Income-tax Act, 1961, and is supported by Rule 21ACA, which clarifies the position for IFSC Finance Companies.

The framework is robust, internationally aligned, and carefully balances anti-avoidance objectives with commercial realities, especially for the financial sector. However, certain interpretational challenges, especially around the calculation of EBITDA, the interaction with transfer pricing, and the treatment of hybrid instruments, remain and may require further clarification through rules, guidance, or judicial interpretation.

Stakeholders must ensure ongoing compliance, maintain robust documentation, and monitor future legislative or regulatory developments, particularly as the new Bill is implemented and interpreted in practice.

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Full Text:

Clause 177 Limitation on interest deduction in certain cases.

 

Dated: 26-4-2025