Thin capitalisation and blocked input credit in funding a greenfield plant
Nakshatra Ltd, an Indian manufacturer wholly owned by a Singapore parent, needs ₹800 crore for a greenfield plant. Two structures are on the table: the parent subscribes equity, or the parent lends ₹800 crore at 9% for eight years. Projected EBITDA is ₹180 crore a year and profit before interest is broadly the same; the company will be taxed at 25.168%, the s.115BAA rate. A bank has offered the same ₹800 crore at 8.5% if the parent gives a guarantee and a comfort letter. Interest received by the parent would bear 17% Singapore tax. Separately, Nakshatra needs a 60,000 sq ft warehouse. It can build one for ₹90 crore plus 18% GST, or lease a ready one from a developer for ten years at ₹11 crore a year plus 18% GST. The advisers confirm straight-line tax depreciation of 10% on the building, no residual value assumption, and a 10% discount rate.
1. Quantify the interest limitation if Nakshatra borrows from its parent, and explain whether the guaranteed bank loan escapes it. Show what the disallowance actually costs over the eight-year term.
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Does the limitation apply? The debt is from a non-resident associate enterprise and exceeds ₹1 crore, so the thin-capitalisation rule applies. Critically, it also applies where a lender who is not an associate lends under an explicit or implicit guarantee, comfort letter or back-to-back arrangement from an associate. The bank loan with a parent guarantee is therefore caught on exactly the same basis. Repackaging the lender does not repackage the debt.
The cap
| ₹ crore |
|---|
| Interest on parent loan (9% × 800) |
| 30% of EBITDA (30% × 180) |
| Deduction limited to the lower |
| Disallowed interest |
What the disallowance costs. Excess interest is carried forward for eight assessment years, but it can only be absorbed against the headroom left after that year's own interest charge. With flat EBITDA of ₹180 crore and interest of ₹72 crore, 30% of EBITDA is fully consumed by the current-year interest every year. There is never headroom. The ₹18 crore is therefore permanently lost, not deferred: ₹144 crore accumulates over eight years and lapses unused.
Lost tax shield = 18 × 25.168% = ₹4.53 crore a year. Present value at 10% over eight years (annuity factor 5.335) = ₹24.2 crore.
Effective after-tax cost of the parent loan
| ₹ crore |
|---|
| Cash interest |
| Less: shield on allowed interest (54 × 25.168%) |
| Add: shield permanently lost (18 × 25.168%) |
| Net economic cost |
| As a percentage of ₹800 crore |
The headline 9% becomes 7.87% after tax, not the 6.73% that a naive 9% × (1 − 25.168%) would suggest. The 1.14-point gap is the price of the limitation, and it must go into the project appraisal, not into a footnote.
2. Compare the parent loan, the guaranteed bank loan and equity from the group's perspective, and recommend a funding structure for the ₹800 crore.
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Bank loan at 8.5%. Interest 68 crore; cap 54 crore; disallowed 14 crore, shield lost 3.52 crore a year. After-tax cost for Nakshatra = (68 − 13.59 + 3.52) / 800 = 7.24%. But the interest leaves the group entirely. From the group's viewpoint the net cash cost is 68 − 13.59 + 3.52 = ₹57.93 crore a year. It is the worst of both worlds: a thin-cap drag plus an external leak of interest.
Parent loan at 9%. Nakshatra's own after-tax cost is 7.87%, higher than the bank loan. But on consolidation the interest is intragroup and eliminated; the group's real cost is the tax leakage:
| ₹ crore |
|---|
| Indian tax saved on allowed interest (54 × 25.168%) |
| Singapore tax on interest received (72 × 17%) |
| Net group tax benefit |
PV at 10% over eight years = 1.35 × 5.335 = ₹7.2 crore of value, created purely because the Indian rate (25.168%) exceeds the Singapore rate (17%) and the interest stays inside the group. The disallowed ₹18 crore earns no Indian deduction but is still taxed at 17% in Singapore - ₹3.06 crore a year of pure leakage, which is why the benefit is only ₹1.35 crore and not ₹4.4 crore.
Equity. No interest, no thin-cap issue, no Singapore tax on interest; profit is taxed at 25.168% in India and repatriated as dividend, which is not deductible. Against debt, the group gives up the 8.17-point rate arbitrage on the debt-funded portion.
Recommendation - size the debt to the cap. The optimum is not 800/0 and not 800/800. Set the debt so that interest equals 30% of EBITDA:
Debt = (30% × 180) / 9% = ₹600 crore, with ₹200 crore of equity.
That gives interest of ₹54 crore, no disallowance, no lapse, and the full 8.17-point arbitrage on ₹600 crore: an annual group tax benefit of 54 × (25.168% − 17%) = ₹4.41 crore, PV ₹23.5 crore over eight years - three times the 800/0 debt case.
Caveats to minuted: EBITDA growth raises the cap, so the structure can be revisited; the rate differential and the Singapore treatment are given facts that must be confirmed by Singapore counsel; a structure whose only purpose is the arbitrage invites general anti-avoidance scrutiny, so contemporaneous commercial documentation (a board note on the group treasury function, actual cash movement, arm's-length pricing) is essential; and the guarantee route should be abandoned, since it carries the thin-cap risk without the group benefit.
3. Evaluate the warehouse decision - build for ₹90 crore plus GST or lease for ten years at ₹11 crore a year plus GST - and state the residual value at which building becomes the better choice.
Read the worked answer
The GST trap. Input tax credit is blocked on goods and services used for construction of immovable property on own account, other than plant and machinery. The ₹16.2 crore of GST on the building (18% × 90) is therefore a real, non-recoverable cost and is capitalised: the depreciable cost is ₹106.2 crore, not ₹90 crore. On the lease, the GST is on a service and is creditable, so it is broadly cash-neutral and is excluded from the comparison.
Build
| ₹ crore |
|---|
| Capital cost including blocked GST |
| Tax depreciation (10% straight line × 106.20) |
| Tax shield (10.62 × 25.168%) |
| PV of shields, 10 years at 10% (× 6.1446) |
| PV of cost, before residual value |
Lease
| ₹ crore |
|---|
| Rent |
| GST (creditable) |
| After-tax rent (11 × (1 − 0.25168)) |
| PV, 10 years at 10% (× 6.1446) |
Breakeven residual value. Building matches leasing only if the PV of the terminal value equals 89.78 − 50.58 = ₹39.20 crore. Compounded at 10% over ten years (× 2.5937), that is a building value of ₹101.7 crore at the end of year 10 - essentially today's cost, implying a 0% real decline over a decade.
Recommendation: lease. The build case requires the property to hold its value in full for ten years before it breaks even, and that understates the true hurdle, because a sale of the building would itself be taxable and the blocked credit is never recovered. Add to this: capital is preserved for the plant itself, the developer carries construction and completion risk, and the ten-year lease gives flexibility if capacity plans change. Build only if the site has strategic value (expansion land, process integration), if the lease cannot be secured on acceptable terms, or if a credible valuation supports a terminal value above ₹102 crore - and if so, structure the lease as a shorter term with an option to purchase so the decision can be revisited.