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NBFCs play a critical role in commercial lending. The RBI has tightened the NBFC regulatory framework over time, particularly for large and deposit-taking NBFCs, bringing it closer to the restrictions that apply to banks.

However, tax laws have not kept up, and there are a number of areas where NBFCs face higher tax costs or compliance burdens than banks. The essential improvements that must be made to bring NBFCs up to par with banks are outlined below.

NBFCs are exempt from the thin capitalization regulations

Transfer pricing rules now stipulate that when an Indian firm or a foreign corporation’s permanent presence pays interest to an affiliated enterprise, the total interest deduction is limited to 30% of EBITDA. This capitalization regulation, however, does not apply to an Indian bank or a foreign bank’s branch in India. 

Interest on nonperforming assets is taxed on an accrual basis

Interest income from nonperforming assets (NPAs) is taxed when it is credited to the profit and loss account or when it is received, whichever comes first. All banks, financial institutions, NBFCs, and HFCs are subject to this provision.

NBFCs and HFCs using IND AS accounting, on the other hand, must record interest income on the net carrying value of certain categories of loans in the profit or loss account, regardless of whether the company has received or realized the interest income.

This quirk defies the objective of the IT provision, which was introduced to tax such interest income on a receipt basis, and the NBFC/HFCs wind up paying tax on such interest income on an accrual basis because it is credited to the profit and loss account. As a result, the relevant regulations must be amended to tax such interest income only on the basis of receipt.

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