Interest limitation rules under the Income Tax Act

by Madeeh Ahmed

Interest payments from an accounting perspective means fewer profits and therefore, a deduction on interest payments allowed for tax purposes simply is a reduction in taxable income. Globally, multinational companies often use interest-bearing debts to reduce their worldwide tax liabilities and this is considered one of the most simple profit-shifting techniques available to businesses in international tax planning.

To discourage such profit shifting and aggressive tax planning, many countries have implemented interest limitation rules that limit the amount of interest a business can deduct for tax purposes. In the Maldivian context, the Income Tax Act1 (“ITA”) imposes three main measures to limit the deduction of interest; (1) a cap on interest rate (2) thin capitalisation rules and (3) transfer pricing measures. In this blog, I will broadly cover these three measures.

Interest rate cap

The ITA imposes a cap of 6% on interest paid on a loan unless the loan2 is from:

  1. a bank which is licensed by the central bank of the country in which the bank operates; 
  2. a housing finance company, or leasing finance company licensed by the central bank or regulatory body of the country of operation of those institutions;
  3. international financial institutions and agencies controlled by such institutions.

In a much general sense, what this means is that the maximum interest one could claim on private funding (loans from parties other than licensed banks and financial institutions) will be 6% of the principal outstanding amount of the loan.

It is worth noting that the term “interest” for the purpose of 6% cap is limited to interest on loans. The term “loan” can be defined as a sum of an amount (whether or not in money) due from one person to another. The ITA also extends this definition to include accounts payable and obligations arising under promissory notes, bills of exchange and bonds.3 Hence the term loan does not strictly apply to traditional loans, but one could also argue that it includes other types of debt arrangements such as finance leasing transactions (although this is something that is yet to be clarified by MIRA).

Regardless of whether a transaction is subject to the interest rate cap, there are further restrictions on how much you can claim as interest deduction, which is explained below.

Thin capitalisation

Thin capitalisation, as the name suggests, is the situation where a business has excessive debts compared with its equity. Thin capitalisation rules (“Thin Cap Rules”) are the rules and measures imposed to combat excessive interest deduction. The OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan, specifically Action 4,4 addresses the issue of profit shifting by entities through thin capitalisation. Thin Cap Rules implemented under the ITA shares similar features with the guidance by OECD in its 2015 Final Report on Action 4.5 That’s a bit of a background on how Thin Cap Rules come into play. Let us have a look at how the rules are implemented in practice under the ITA.

The ITA  imposes a limit on interest deduction which is 30% of tax-EBITDA – also referred to as the interest capacity. EBITDA is the taxable income left before deduction of interest, capital allowances and loss relief6 and is often used as a guide to determine whether an entity can meet its interest commitments.

Exemption from Thin Cap Rules

There are two exemptions from Thin Cap Rules under the ITA; (1) exemption available to certain types of taxpayers and (2) exemption from certain types of transactions. Exemption from Thin Cap Rules simply means that the 30% of tax EBITDA limit will not apply and a full deduction for such interest may be claimed if the interest deduction is not limited by other rules.

Listed below are the taxpayers exempt from Thin Cap Rules:

  1. Locally licensed banks, insurance businesses, finance leasing businesses, housing finance businesses;
  2. Locally licensed non-banking financial institutions;
  3. SMEs;
  4. State-Owned Enterprises of which the Government directly holds the majority of the ordinary share capital. 

Exempt transactions are interest payable to locally licensed banks or to an insurance business or finance leasing business or housing finance business. Again, if you enter into such a transaction (e.g., make a payment of interest to a local bank), such a deduction will not be limited by the Thin Cap Rules. However, interest payable to foreign banks or financial institutions (banks and financial institutions licensed by foreign authorities) are subject to Thin Cap Rules.

Where a transaction is subject to Thin Cap Rules and you do not have enough interest capacity (30% of tax EBITDA) to claim your current year interest expense, you can carry forward the unclaimed interest amount to be deducted against future interest capacity. This can be done for a period of 10 years.7

The term “interest” for the purpose of thin capitalisation differs from the definition of interest for purposes of 6% cap. Basically, Thin Cap Rules will apply to interest on all forms of debt and all payments economically equivalent to interest – such as payments under profit-participating loans, payments under alternative financing arrangements such as Islamic finance, the finance cost element of finance lease payments, certain foreign exchange gains and losses on borrowings and instruments connected with the raising of finance, guarantee fees and arrangement fees and similar costs related to the borrowing of funds.

Transfer pricing

The ITA requires taxpayers entering into transactions with related parties to make those transactions at ‘arm’s length terms’. Arm’s length terms are the terms at which a non-related party would enter into such a transaction under comparable circumstances.8 In other words, the price of transactions between related parties must approximately be at the market price for tax purposes.

This is not something which is specific to interest, but it is important to note it here because if you enter into a loan transaction or a debt arrangement with a related party, you are required to consider the market rates for tax purposes. Further, in case of related party interest, one should first apply the transfer pricing test before applying any further limitation rules under the ITA.

There are various methods of assessing the transfer price, but I do not intend to go into the details of those methods, here.

The Transfer Pricing Regulation9 (“TPR”) exempts taxpayers from keeping transfer pricing documents in relation to:

  1. Related party domestic loan where the lender is not in the business of borrowing and lending money10;
  2. Related party loans not exceeding MVR15 million, on which indicative margin is applied.11 The MIRA is yet to publish the indicative margins.

An exemption from transfer pricing documentation requirement, from a practical point of view, means that the transaction will be “less risky” from an audit perspective of the MIRA and that the MIRA is “less likely” to make an adjustment of tax in relation to those transactions.

IFRS 16 interest

Now that you know the interest limitation rules applicable under the ITA, let us have a look at the impact of IFRS 16 Leases from an interest deduction perspective.

IFRS 16 Leases, which became effective from 1 January 2019, brings about significant changes for lessees, especially those who were holding ‘operating leases’. It introduces a single lessee accounting model and requires a lessee to recognise assets and liabilities for all leases with a term of more than 12 months unless the underlying asset is of low value.12 A depreciation expense on the amortization of the Right of Use (RoU) asset and interest on the outstanding lease liability is recognised subsequently in the income statement.

The ITA gives no special treatment for IFRS 16 Leases13 which essentially means that you are required to follow the requirements of IFRS 16 in accounting for leases for tax purposes. The ITA, however, has maintained the definition of a finance lease which is similar to the classification test applied by lessors under IFRS 16 where a finance lease is a lease which substantially transfers the risks and rewards incidental to ownership of an asset to the lessee.14 Under a finance lease, in effect, the lessor is treated as having made a loan to the lessee at the commencement of the lease and each lease payment is in part repayment of the principal under the loan and in part payment of interest.

Interest on a finance lease is within the definition of “interest” for both interest cap purposes as well as Thin Cap purposes. The ITR makes it very clear that interest on a finance lease is within the general definition of interest under the ITA.15 

However, interest on leases which do not substantially transfer the risks and rewards incidental to the ownership of the underlying asset to the lessee (in other words, ‘IAS 17 operating leases’) are not economically equivalent to interest and therefore not counted towards the interest cap as well as Thin Cap Rules. Hence, even though IFRS 16 makes no distinction between finance and an operating lease for lessees, the interest arising on most of the transactions which used to be recognised as an operating lease under the previous leasing standard IAS 17, will not be considered as interest for the purpose of thin capitalisation as well as 6% interest cap.

Concluding remarks

There are three main limitations on interest deductions under the ITA; transfer pricing rules, interest cap, and Thin Cap Rules. Although the ITA and its Regulation do not make it very clear which one of these limitation rules should be applied first, it is expected that the arm’s length test (transfer pricing rules) should be passed first before the application of any other interest limitation rules. Following the arm’s length test, the 6% cap is likely applied second following which the Thin Cap Rules are applied. Hence, a deduction of 6% interest also depends on whether the taxpayer has enough interest capacity under the Thin Cap Rules.

In practice, one of the major contentious areas when it comes to interest deduction is transfer pricing. The Transfer Pricing Regulation issued by MIRA provides some degree of certainty to taxpayers in the sense that the Regulation is in line with international best practices and guidelines.

In view of the above, it is important to consider the deductibility of interest expense before obtaining an interest-bearing debt and deciding whether debt or equity is the most efficient way of injecting funds into a business. Where a taxpayer incurs interest expense in relation to a loan from an overseas (non-resident) lender (including a related party), additional issues such as non-resident withholding tax implications on the interest income also need to be considered. Further, it must also be noted that any deduction under the ITA must first satisfy the “general deduction rule”-  the expense must be incurred in that period and must wholly and exclusively be for the purpose of production of income. 


Law Number 25/2019.
Income Tax Act, s 22. See also Income Tax Regulation (Regulation Number 2020/R-21), s 52.
Income Tax Act, s 79(rr).
‘Action 4 Limitation of Interest Deductions’ (OECD) <> accessed 8 July 2020.
OECD, Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4 – 2015 Final Report (OECD Publishing 2015). <> accessed 8 July 2020.
Income Tax Act, s 71(f)(5).
Income Tax Act, s 71(d).
Income Tax Act, s 79(r).
Regulation Number 2020/R-43.
10 Transfer Pricing Regulation, s 7(d).
11 Transfer Pricing Regulation, s 7(e).
12 Income Tax Act, s 71(f)(5).
13 Income Tax Act, s 71(f)(5).
14 Income Tax Act, s 79(dd).
15 Income Tax Regulation, s 129(a).