Interest on capital borrowed for business or profession is allowed as a deduction. However, interest payable on capital borrowed for acquiring a capital asset for extension of business or a new business, until the date such asset is first put to use, is not allowable as a revenue deduction.
Such interest shall be loaded on the cost of the capital asset and would be eligible for depreciation. The utilization of loans is an important factor in deciding the allowability of interest on the same. Interest on borrowings utilized for granting interest-free advances to related parties or sister concerns may not be allowed if the business expediency of such advance is not proven. Furthermore, interest on borrowings utilized for the purpose of earning tax-free income (e.g., dividend income) would be disallowed due to particular provisions of the ITA.
Several jurisdictions across the globe have specific thin capitalization rules to deter erosion of the tax base through excessive debt and, thereby, excessive interest payments. There is no specific thin capitalization provision under the ITA. As there are no enabling provisions to question whether a business should have raised funds through equity instead of a loan, interest deduction is allowed solely based on the principles laid down in the paragraph above. Interest payments to overseas related parties and in some specific instances, to domestic related parties would, however, be subject to transfer pricing provisions.
With effect from 1 April 2017, if the transaction of debt is construed by the tax authorities as solely for tax benefits, then the arrangement could be examined and disregarded under the General Anti-Avoidance Rules (GAAR).
Furthermore, a restriction has been introduced in the Finance Act, 2017, for interest deduction to the extent of 30% of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) in the case of interest paid by a resident company to a non- resident associated enterprise.