Deduction for Interest on Borrowed Capital
Introduction
Interest on capital borrowed for business or profession is allowable as deduction. However, interest relating to the period before a capital asset is put to use must be capitalised and added to the actual cost of the asset.
Conditions to Claim Deduction
Where money is borrowed to acquire an asset, interest up to the date the asset is first put to use is added to its actual cost in accordance with Section 43(1). After the asset is put to use, interest on such borrowings is deductible. Interest on borrowings for operational purposes is also deductible.
ICDS IX requires capitalisation of borrowing costs relating to qualifying capital assets; other borrowing costs are deductible in the year incurred. Borrowing includes periodical recurring subscriptions paid by members of Mutual Benefit societies that meet prescribed conditions.
Capital Must Be Borrowed
Interest must be paid on capital borrowed for business or profession. Borrowed “capital” refers to money, not assets. Purchase of an asset on deferred credit, even if interest is payable, is not treated as borrowing; interest on such credit purchases is not deductible under this section but may be allowable under Section 37(1).
Borrowings Used for Business
Interest is deductible only if the borrowed funds are used for business or professional purposes.
Interest Paid or Payable
Under the cash system, interest is deductible on payment; under the mercantile system, it is deductible on accrual.
However, interest payable to the following institutions is deductible only on actual payment in accordance with Section 43B:
- Public Financial Institutions
- State Financial Corporations
- State Industrial Investment Corporations
- Scheduled Banks
- Co-operative banks other than primary agricultural credit societies or primary co-operative agricultural and rural development banks
If paid on or before the due date for filing the return, deduction is allowed in the year of accrual; otherwise, it is allowed in the year of payment.
Interest Expense to Be Disallowed
Interest paid outside India without deduction of tax is disallowed under Section 40(a)(i).
Interest paid to a resident without deduction of tax results in 30% disallowance under Section 40(a)(ia).
Excessive interest (thin capitalisation rule):
If an Indian company or PE of a foreign company pays interest exceeding Rs. 1 crore to a non-resident associated enterprise, interest exceeding 30% of EBITDA is disallowed. Disallowed interest may be carried forward for up to 8 assessment years.
Interest for earning exempt income:
If borrowed funds are used to earn exempt income, interest and related expenditure are disallowed under Section 14A.
Interest paid to partners:
Interest paid by a firm to its partners is deductible only up to 12% per annum and only if authorised by the partnership deed.
Interest paid by AOP/BOI to members:
No deduction is allowed for any such interest.
Interest on own capital:
Interest on notional capital introduced by the assessee is not deductible.
Interest on money borrowed to pay tax:
Interest on borrowings used for payment of income-tax is not deductible.
Deduction for Interest Paid to Associated Enterprise
Introduction
Interest paid by an entity to its associated enterprise is deductible only to the extent of 30% of its earnings before interest, taxes, depreciation and amortisation (EBITDA) or the interest paid or payable to the associated enterprise, whichever is lower. Any excess interest disallowed may be carried forward for eight assessment years.
Purpose of the Provision
This provision restricts excessive interest deductions arising from high levels of debt, particularly in multinational group structures where interest can be used to shift profits outside India. It aims to counter cross-border profit shifting through inflated interest payments and protect the tax base.
When This Provision Applies
It applies where:
- The assessee is an Indian company or a permanent establishment of a foreign company in India;
- Interest expenditure exceeds Rs. 1 crore in respect of any debt issued by a non-resident; and
- The lender is an associated enterprise, or the associated enterprise has provided implicit or explicit guarantee to the lender, or deposited matching funds with the lender.
When This Provision Does Not Apply
This restriction does not apply if the entity:
- Is engaged in the business of banking or insurance;
- Is a notified class of non-banking financial company;
- Is a finance company located in an International Financial Services Centre carrying out specified lending, factoring, treasury or similar financial activities, provided the interest is payable in foreign currency.
Amount of Interest Deductible
Deduction is restricted to the lower of:
- Interest paid or payable to the associated enterprise; or
- 30% of EBITDA.
Negative EBITDA results in complete disallowance of interest. Disallowance applies even if the borrowing is for business purposes and the interest rate is at arm’s length under transfer pricing rules.
Carry Forward and Set Off of Excess Interest
Excess interest disallowed may be carried forward for up to eight assessment years. It may be claimed as deduction in a subsequent year to the extent of the maximum allowable limit (i.e., 30% of EBITDA after allowing current-year interest).
Computation of Excess Interest
The following steps are applied:
- Compute interest paid or payable to the associated enterprise.
- Compute EBITDA.
- Compute 30% of EBITDA.
- Determine deductible interest as the lower of steps 1 and 3.
- Excess interest = interest paid or payable minus deductible interest.
Profits and gains of business are then recomputed by adding excess interest disallowed and reducing any eligible set-off of carried-forward interest.
Meaning of Certain Terms
Associated Enterprise
Has the meaning assigned under Section 92A(1)/(2). It may include non-business entities if they meet the control or participation criteria.
Debt
Means any loan, financial instrument, finance lease, financial derivative or similar arrangement giving rise to interest, discounts or finance charges deductible in computing business income. Debt must be issued by a non-resident.
Permanent Establishment
A fixed place of business through which the enterprise wholly or partly carries on its business.
Interest
Includes interest payable in any manner on money borrowed or debt incurred, and fees or charges in respect of unused credit facilities.
Non-banking Financial Company
Includes financial institutions or companies engaged in accepting deposits or lending, and such notified non-banking institutions.
Meaning of Zero Coupon Bond under Income-tax
Introduction
Zero Coupon Bonds are bonds issued by specified entities and notified by the Central Government, where no payment or benefit is received or receivable by the investor before maturity. Only bonds notified by the Government qualify as Zero Coupon Bonds.
What is a Zero Coupon Bond
A Zero Coupon Bond is a bond issued on or after 1 June 2005 by:
- Infrastructure Capital Company
- Infrastructure Capital Fund
- Infrastructure Debt Fund
- Public Sector Company
- Scheduled Bank
No interim payment or benefit should be receivable before maturity. Such bonds must be notified by the Central Government in the Official Gazette.
How Zero Coupon Bonds Are Notified
As per Rule 8B, an application must be submitted in Form 5B at least three months before the proposed issue.
The application cannot relate to bonds to be issued beyond two financial years following the year of application.
Applications must be furnished electronically and are to be disposed of within six months of receipt.
Documents Required
Each application must include a copy of the incorporation certificate, registered trust deed or the relevant Act under which the applicant is constituted.
Conditions to Be Satisfied for Notification
The following conditions must be fulfilled:
- The life of the bond must be at least 10 years and not more than 20 years.
- The applicant must hold an investment-grade rating from at least two credit rating agencies.
- Arrangements must be made for listing the bonds on a recognised stock exchange in India.
Specific investment or utilisation conditions apply based on the category of issuer:
Infrastructure Capital Company/Fund or Infrastructure Debt Fund:
- At least 25% of the funds must be invested by the end of the next financial year after the year of issue.
- The balance must be invested within four financial years following the year of issue.
Public Sector Company:
- At least 15% must be invested or utilised by the end of the next financial year after the year of issue.
- The balance must be invested or utilised within six financial years following the year of issue.
Infrastructure Debt Fund:
- A sinking fund must be maintained to accumulate interest accruing on all Zero Coupon Bonds, and such interest must be invested in Government securities as defined under the Government Securities Act, 2006.
The Central Government, after ensuring compliance with all conditions, will notify the bond specifying the name, life of the bond, issue schedule, maturity amount, discount and number of bonds.
If conditions are not fulfilled, the application may be rejected after providing an opportunity of being heard.
Post-notification non-compliance may lead to withdrawal of notification.
Post-Notification Compliance
The issuer must submit a certificate in Form 5BA from a Chartered Accountant within two months from the end of each financial year in which investment or utilisation was required. The certificate must be e-filed.
Failure to comply may result in withdrawal of the notification by the Central Government.
Deduction for Employer’s Contribution to PF and Superannuation Fund
Introduction
Employer’s contribution to a recognised provident fund or approved superannuation fund is deductible on actual payment. The total deductible contribution to provident fund and superannuation fund together shall not exceed 27% of the employee’s salary as specified under Rule 87.
Deduction for Contribution to Provident Fund
Employer and employee contribute monthly to the provident fund account. Deduction for employer’s contribution is allowed in the year of actual payment, regardless of the method of accounting. If the contribution is paid on or before the due date of filing the return for the year in which liability accrues, the deduction is allowed in that year.
The employer must make effective arrangements to ensure deduction of tax at source under Section 192A on payments made from the fund that are taxable under the head Salaries.
Conditions to Claim Deduction (PF)
- Contribution must be actually paid.
- Payment made up to the due date of filing the return for the year of accrual is treated as paid during that year.
- Effective arrangements must exist to ensure TDS deduction on taxable payments from the fund.
Deduction for Contribution to Superannuation Fund
Superannuation is a retirement benefit funded by employer contributions. Employers may contribute up to 27% of an employee’s basic salary (including the PF contribution), and any excess is taxable in the employee’s hands.
How Much Deduction Is Allowed (Superannuation Fund)
Deduction for employer’s contribution is computed as follows:
Step 1: Employer’s annual contribution for an employee cannot exceed 27% of salary, reduced by the PF contribution (recognised or unrecognised) made for that employee.
Step 2: 80% of the amount actually paid constitutes the deductible allowance.
Step 3: One-fifth of the deductible allowance is allowed in the assessment year relevant to the year of payment, and the balance is allowed in equal instalments over the next four assessment years.
These additional conditions for percentage limitation and spreading over five years arise from CBDT instructions, not the Act.
Conditions to Claim Deduction (Superannuation Fund)
- Contribution must be actually paid.
- Payment made up to the due date of return filing for the relevant previous year is deductible in that year.
- Employer must ensure effective arrangements for TDS deduction on taxable payments from the superannuation fund.
Deduction for Employees’ Contribution to Welfare Fund
Introduction
Any sum received by an employer from employees as their contribution to a welfare fund such as provident fund or ESI is allowable as deduction only if it is deposited by the employer into the employee’s account in the relevant fund on or before the due date prescribed under the applicable Act.
Employees’ Contribution Treated as Employer’s Income
Under Section 2(24)(x), any amount received by an employer from employees towards their contribution to recognised provident fund, approved superannuation fund, approved gratuity fund or any other welfare fund is deemed to be business income of the employer and must be credited to the profit and loss account.
When Deduction Is Allowed
Deduction is allowed only if the employer deposits the employees’ contribution into the relevant fund on or before the statutory due date specified under the respective labour law or service contract.
The Explanation to Section 36(1)(va) clarifies that:
- “Due date” means the date by which the employer is required to credit the contribution under the relevant Act or contract.
- Section 43B does not apply for employees’ contribution and is deemed never to have applied for this purpose.
- Deduction is not allowedif the contribution is deposited after the statutory due date, even if paid before the due date for filing the income-tax return under Section 139(1).
Deduction for Bad Debts
Introduction
A deduction for bad debts is allowable in the year in which the debt is actually written off in the books of account. The debt must have been considered in computing taxable income or must represent money lent in the ordinary course of banking or money-lending business. Any subsequent recovery is taxable as business income in the year of recovery.
Conditions to Claim Deduction
Existence of Debt
There must be an admitted debt creating a debtor–creditor relationship. A debt not recorded in the books cannot be claimed as bad debt unless it was recognised for income computation under ICDS; in such cases it is deemed to be written off when it becomes irrecoverable.
Debt Must Be Written Off
The debt must be written off as irrecoverable in the accounts of the assessee during the year. A mere provision for bad and doubtful debts is not allowable, except for specified entities eligible under Section 36(1)(viia).
Debt Considered for Computation of Income
A bad debt is allowable only if the amount was previously taken into account in computing income or represents lending in the ordinary course of banking or money-lending. Bad debts cannot arise where accounts are maintained on cash basis. If a debt accounted for under ICDS becomes irrecoverable without being recorded in the books, the deduction is allowed on a deemed write-off basis.
Debt Must Be Incidental to Business
The debt must arise from business or professional activities. Debts unrelated to business or profession are not allowable as bad debts.
Continuity of Business
Deduction is allowed only for debts of a business carried on during the relevant previous year. A bad debt relating to a discontinued business is not deductible, unless the business continues through succession. The right to claim bad debts attaches to the business, not to the assessee.
Recovery of Bad Debts
If recovery is less than the outstanding amount, the deficiency is allowed as deduction in the year of final recovery.
If recovery exceeds the amount written off and allowed, the excess is taxable as business income in the year of recovery, irrespective of whether the business is in existence.
In cases of succession (including amalgamation, demerger, inheritance or partnership reconstitution), recovery is taxable in the hands of the successor if the deduction was earlier allowed to the predecessor.
Business losses from the year of discontinuance may be set off, even after expiry of the eight-year limit, against income deemed as business profits under this provision.
Deduction for Provision for Bad and Doubtful Debts
Introduction
The deduction for provision for bad and doubtful debts is available only to specified entities such as banks, financial institutions and NBFCs. The deduction allowed is the lower of the amount of provision created or the amount computed as a prescribed percentage of total income or rural advances, as applicable.
Eligible Assessees
The deduction is available to:
- Scheduled banks
- Non-scheduled banks
- Co-operative banks (other than primary agricultural credit societies or primary co-operative agricultural and rural development banks)
- Foreign banks
- Public financial institutions, State financial corporations and State industrial investment corporations
- NBFCs
Other assessees are not eligible for deduction of provision; they may claim only actual bad debts under Section 36(1)(vii).
Amount of Deduction
The deduction allowable is the lower of the actual provision created or the amount computed based on prescribed percentages of total income and, where relevant, aggregate average rural advances.
Prescribed percentages depend on the category of institution.
Additional Deduction
Scheduled banks (other than foreign banks) and non-scheduled banks may claim an additional deduction equal to income derived from redemption of securities under a notified scheme, provided such income is disclosed under the head Profits and gains of business or profession.
Meaning of Key Terms
- Total income is computed before deduction under this provision and before Chapter VI-A deductions.
- Rural branch means a branch located in an area with population not exceeding 10,000 based on the latest published census.
- Aggregate average advances of rural branches are computed by taking the monthly outstanding advances of each rural branch, averaging them over the year, and aggregating such averages for all rural branches.
Claiming Deduction for Actual Bad Debts
For eligible entities, deduction for actual bad debts under Section 36(1)(vii) is allowed only to the extent the amount written off exceeds the credit balance in the provision for bad and doubtful debts account.
No deduction is allowed unless the bad debt is debited to this provision account.
Taxability of Recovered Debts
Any recovery of debts for which deduction has been allowed under this provision is taxable under Section 41(1) in the year of recovery.
Treatment of Urban and Rural Advance Provisions
Provisions for bad and doubtful debts relating to urban and rural advances are to be treated as a single consolidated account for all purposes.
Deduction for Sum Transferred in Special Reserve
Introduction
Banks, housing finance companies and financial institutions may claim deduction for amounts transferred to a special reserve account. Deduction is restricted to 20% of profits from eligible business. When the total balance in the special reserve exceeds 200% of the paid-up share capital and general reserves, no further deduction is permitted.
Eligible Assessees
The following entities may claim the deduction:
- Banking companies, co-operative banks and public financial institutions engaged in providing long-term finance for industrial or agricultural development, infrastructure facilities, or housing in India;
- Housing finance companies providing long-term finance for construction or purchase of residential houses;
- Other financial corporations providing long-term finance for development of infrastructure facilities in India.
Amount of Deduction
The deduction allowable is the lower of:
- Amount transferred to the special reserve during the previous year;
- 20% of profits derived from the eligible business;
- 200% of paid-up share capital and general reserves as on the last day of the previous year, reduced by the opening balance of the special reserve.
No deduction is permitted once the special reserve exceeds 200% of paid-up share capital and general reserves.
Consequences of Withdrawal
Any withdrawal from the special reserve is taxable in the year of withdrawal to the extent deduction was previously allowed. Taxability applies irrespective of whether the business is in existence during that year.
Business losses of the year in which business was discontinued may be set off, even after expiry of eight years, against income deemed as business income under this provision.
Meaning of Key Terms
Long-term finance
Loans or advances repayable, along with interest, over a period of at least five years.
Infrastructure facility
Includes roads, bridges, rail systems, highways and related activities, water supply and treatment systems, irrigation systems, sanitation and sewerage systems, solid waste management, ports, airports, inland waterways and similar public facilities as may be prescribed.
Conditions for Notification as Infrastructure Facility
A public facility must satisfy the following:
- It is owned by an Indian company, a consortium of such companies, or a statutory body;
- It is covered by an agreement with the Central or State Government or a local/statutory authority for developing, operating or maintaining a new infrastructure facility;
- It begins operations on or after 1 April 1995.
Deduction for Deficiency in Case of Trade, Professional, or Similar Associations
Trade, professional, or similar associations may claim a deduction for deficiencies incurred. This deduction is limited to 50% of the total income computed before allowing such deduction. No carry forward of unutilized deficiencies is permitted.
Doctrine of Mutuality
The doctrine of mutuality holds that no person can profit from transactions with themselves. Income derived by associations from general services to members is exempt if there is complete identity between contributors and beneficiaries of the surplus. However, exceptions to this rule include:
- Income from specific services performed for members (taxed as business income).
- Profits from insurance businesses computed per Section 44.
Applicability of Deduction
Eligible Entities:
- Trade, professional, or similar associations receiving amounts from members by subscription or otherwise (excluding remuneration for specific services).
- Associations that do not distribute income to members, except as grants to affiliated associations.
Ineligible Entities:
- Associations under Section 10(23A), such as those controlling or encouraging specific professions like law, medicine, accounting, material management, town planning, etc.
Conditions for Relief:
- The deficiency must result from excess expenditure for protecting or advancing members’ common interests.
Quantum of Deduction
- Calculation:
- Income from members (excluding remuneration for specific services).
- Less: Expenditure for common interests (excluding capital expenditure and deductions under other sections).
- The deficiency is deductible from income under “Profits and Gains of Business or Profession (PGBP)” first and then against income under other heads.
- Limit:
- Deduction is capped at 50% of the total incomebefore this deduction.