Impact of Thin Capitalization Rules on Indian Startups & MNC Subsidiaries

In today’s global economy, businesses rely heavily on international financing, especially in the early and expansion stages. Startups and subsidiaries of multinational corporations (MNCs) often seek funds through external borrowings rather than equity, as debt is cheaper and offers tax benefits. However, to curb aggressive tax planning through excessive interest deductions, thin capitalization rules have become a key area of focus in India’s tax landscape.

This blog explores the impact of thin capitalization rules on Indian startups and MNC subsidiaries, analyzing how these rules affect funding strategies, tax deductions, and overall financial planning.

What Are Thin Capitalization Rules?

Thin capitalization rules are regulatory provisions that limit the amount of interest expense that can be deducted for tax purposes when a company is financed through excessive debt from its foreign-associated enterprises. These rules are intended to prevent base erosion and profit shifting (BEPS), where companies reduce their taxable income in high-tax jurisdictions like India by inflating interest payments on intra-group borrowings.

In India, the introduction of thin capitalization rules under Section 94B of the Income Tax Act, 1961, aligns with Action Plan 4 of the OECD’s BEPS initiative. This provision came into effect from the financial year 2017–18.

Key Provisions of Section 94B

Section 94B applies to Indian companies or permanent establishments of foreign companies that incur interest expenses exceeding ₹1 crore in a financial year to their non-resident associated enterprises.

The major features include:

1. Interest Deduction Cap: Only 30% of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is allowed as a deduction for interest payments to foreign-associated entities.

2. Carry Forward: Disallowed interest can be carried forward for up to 8 assessment years.

3. Threshold Limit: The rules are applicable only if the total interest paid to non-resident associated enterprises exceeds ₹1 crore in a financial year.

4. Exceptions: Indian banks and insurance companies are excluded from these provisions.

Impact on Indian Startups

1. Early-Stage Funding Constraints

Indian startups frequently depend on debt funding from their overseas investors or parent companies. However, thin capitalization rules limit how much of this interest expense can be deducted, making debt financing less attractive. For early-stage startups operating on thin margins, this can significantly impact cash flow and raise their effective tax liability.

2. Reduced Tax Shield

Startups usually use interest expense as a tool to reduce taxable income. With restrictions under thin capitalization rules, they lose this leverage. In some cases, startups may have to reconsider their funding model altogether, shifting toward equity financing, which may dilute ownership and control.

3. Compliance and Complexity

Startups, especially those with limited resources, may struggle with compliance burdens. Understanding the arm’s length principle, maintaining proper documentation for inter-company loans, and managing transfer pricing become mandatory under thin capitalization rules, increasing operational complexity.

Impact on MNC Subsidiaries in India

1. Shift in Global Funding Models

MNC subsidiaries often receive loans from their parent entities abroad. With the enforcement of thin capitalization rules, there has been a noticeable shift in how global corporations fund their Indian arms. Debt-heavy structures are being reviewed and replaced with balanced debt-equity strategies.

2. Profit Repatriation Gets Costlier

Earlier, many MNCs used interest payments as a method of repatriating profits from India to low-tax jurisdictions. With only 30% of EBITDA allowed as deductible, the rest of the interest becomes taxable, making this route less tax-efficient.

3. Transfer Pricing and Benchmarking

MNCs now have to pay closer attention to transfer pricing documentation. Thin capitalization introduces another layer of scrutiny. Indian tax authorities may challenge the commercial substance of the debt, require benchmarking interest rates, and examine whether the loan qualifies as equity in disguise.

Strategic Implications for Both

1. Re-evaluating Capital Structure

Both Indian startups and MNC subsidiaries are now compelled to maintain a healthier debt-to-equity ratio. Excessive leverage, especially from associated enterprises, no longer offers the tax benefits it once did.

2. Tax Planning and Forecasting

With interest deductions capped, companies need to forecast their EBITDA with greater precision. Since the disallowed portion can be carried forward, long-term financial planning becomes crucial.

3. Use of Hybrid Instruments

Some businesses are exploring hybrid financing tools—like convertible debt or preference shares—to bypass thin capitalization rules. However, tax authorities are increasingly skeptical and may recharacterize such instruments as equity.

Case Study: A Startup’s Realization

Consider an Indian SaaS startup, backed by a US-based venture capital firm, which received a $3 million loan from its parent. The interest on this loan amounted to ₹1.5 crore annually. With an EBITDA of ₹3 crore, the startup could only claim ₹90 lakh (30% of EBITDA) as a deduction. The remaining ₹60 lakh added to its taxable income, increasing its tax outgo despite being cash-strapped.

This forced the startup to convert future funding into equity and revise its capital structure. While this avoided the impact of thin capitalization rules, it diluted the founders’ stake and complicated shareholder agreements.

Recommendations

For Startups:

• Seek Equity Funding where possible to avoid disallowed interest deductions.

• Plan Loan Structures carefully, ensuring they’re within permissible limits of Section 94B.

• Engage Tax Experts early on to handle compliance and documentation under thin capitalization and transfer pricing rules.

For MNC Subsidiaries:

• Balance Debt and Equity based on EBITDA projections to maximize interest deduction.

• Ensure Arms-Length Pricing for intra-group borrowings.

• Explore Alternate Routes of profit repatriation such as dividends, subject to tax efficiency evaluations.

Conclusion

While the thin capitalization rules aim to promote fair taxation and prevent base erosion, they pose significant implications for Indian startups and MNC subsidiaries. Businesses must adapt to these rules by rethinking their financing strategies, maintaining robust documentation, and planning for tax impacts well in advance.