"We'll just lend the Indian subsidiary money at whatever rate": What FEMA and transfer pricing actually require on intercompany loans

The moment a foreign parent decides to fund its new Indian subsidiary with a loan instead of equity, two separate Indian regulators quietly attach conditions to the interest rate — and most founders discover only one of them, if any. The finance team picks a number that feels fair, wires the money, and assumes a loan between two companies it owns is nobody else's business. In India it is very much someone else's business: the Reserve Bank of India (RBI) decides whether you are even allowed to charge that rate, and the Income Tax Department decides whether the rate is defensible. Get either wrong and the loan becomes a compliance problem long before it is ever repaid.

What the regulation actually says

A cross-border loan from a foreign parent to an Indian company is, in RBI language, an External Commercial Borrowing (ECB) — foreign currency or rupee debt raised by an Indian resident from a recognised non-resident lender. It is governed by the Foreign Exchange Management (Borrowing and Lending) Regulations, most recently overhauled by the Borrowing and Lending (First Amendment) Regulations, 2026 (Notification No. FEMA 3(R)(5)/2026-RB, in force from 16 February 2026), read with the RBI Master Direction on ECB.

Two layers apply to the interest rate.

Layer one — FEMA's all-in-cost ceiling. RBI does not let you charge whatever you like. The ECB framework caps the all-in-cost — interest plus most fees and charges — at a benchmark rate plus a spread ceiling. For foreign-currency ECBs the benchmark is the relevant risk-free reference rate for that currency (for US dollar borrowing, that is now SOFR — the Secured Overnight Financing Rate — which replaced LIBOR). The spread over the benchmark is capped by RBI (historically 500 basis points, i.e. 5 percentage points). A "parent lends generously at 12%" arrangement can breach the ceiling outright, making the loan non-compliant from day one. Most parent-to-subsidiary ECBs use the automatic route (no prior RBI approval, filed through your AD — Authorised Dealer — bank), provided the lender, amount, end-use and all-in-cost all sit inside the framework. Step outside any parameter and you fall into the government approval route, requiring a case-by-case RBI decision before the money can legally come in.

Layer two — transfer pricing's arm's length principle. Because parent and subsidiary are associated enterprises, the loan is an "international transaction" under Sections 92 to 92F of the Income-tax Act, 1961. The interest rate must be the arm's length price — the rate two unrelated parties would have agreed on the same terms. The tax method of choice is the Comparable Uncontrolled Price (CUP) method: build the rate from a base rate (the reference rate for the loan's currency — SOFR for USD, EURIBOR for euro, SBI's one-year MCLR for rupee loans) plus a credit spread that reflects the borrower's own credit risk, tenor, security and currency. A flat "we used the parent's cost of funds" will not survive scrutiny, because it ignores the Indian borrower's standalone risk profile.

India also offers a safe harbour for intra-group loans under Rule 10TD of the Income-tax Rules. If you opt in, a foreign-currency loan benchmarked to the relevant reference rate plus a prescribed spread tied to the borrower's credit rating (broadly in the 150–450 bps band), or a rupee loan benchmarked to SBI's MCLR plus a prescribed spread, is accepted without further challenge. Safe harbour trades a slightly conservative rate for certainty and lighter documentation — often a sensible bargain for a first India entry.

One more provision bites specifically on high rates. Section 94B (thin-capitalisation) restricts the interest a company can deduct on debt owed to a foreign associated enterprise to 30% of EBITDA where annual interest exceeds ₹1 crore. Load the subsidiary with expensive related-party debt and part of the interest simply stops being deductible.

Practical implications — what happens if you get this wrong

Breaching the FEMA all-in-cost ceiling is a contravention of FEMA, curable only through compounding before the RBI — a formal admission, a filed application, and a monetary penalty, all of which surface in later due diligence when you raise capital or exit. Charge above the cap without approval and the excess interest can be treated as an unauthorised outflow.

On the tax side, an interest rate the tax officer considers non-arm's-length triggers a transfer pricing adjustment: income is re-computed as if a defensible rate applied, tax is levied on the difference, and penalties for under-reporting follow. Because loans recur every year, one weak position compounds across every year the loan is outstanding. Miss the documentation and there is a separate penalty just for that — ₹1,00,000 for failing to maintain the prescribed transfer pricing documentation, plus 2% of the transaction value for failing to furnish it, entirely independent of whether the rate itself was right.

When it is time to exit or refinance, an acquirer's diligence will pull every FC-GPR and ECB filing and every Form 3CEB. Unresolved compounding, a pending TP adjustment, or a disallowed interest deduction all become price-chip or deal-delay items. The cheapest time to price the loan correctly is the day you sign it.

Step-by-step: what to do

• Decide debt vs equity deliberately. Equity comes in as FDI and is reported on Form FC-GPR within 30 days of allotment; a loan is an ECB with its own rules. Do not default to a loan just because it feels reversible — model the Section 94B interest-deduction cap first.
• Confirm you fit the automatic route. Check eligible-lender status (a parent qualifies), permitted end-use, the minimum average maturity, and the all-in-cost ceiling under the RBI ECB Master Direction. If any parameter is off, plan for the government approval route before remitting.
• Obtain a Loan Registration Number (LRN). File Form ECB with your AD Category-I bank to get the LRN from RBI. No drawdown should happen before the LRN is issued.
• Build the arm's length rate, in writing. Start from the correct base rate for the loan currency (SOFR for USD — never legacy LIBOR), add a credit spread supported by the borrower's credit profile and comparable third-party loans under the CUP method. Or elect Rule 10TD safe harbour and apply the prescribed spread for certainty.
• Keep the all-in-cost inside both ceilings at once. The rate must simultaneously be arm's length for tax and within FEMA's benchmark-plus-spread cap. The workable rate is the overlap of the two.
• Report drawdowns and service on Form ECB-2. File the monthly Form ECB-2 return with the AD bank for every drawdown and every interest/principal payment, so RBI's records stay current.
• Prepare the TP file and Form 3CEB. Maintain contemporaneous documentation and file Form 3CEB (accountant's report on international transactions) with the tax return. This is where your benchmarking analysis lives.
• Deduct withholding tax on interest. Interest paid to the foreign parent attracts TDS under Section 195, at the rate in the Act or the applicable Double Taxation Avoidance Agreement (DTAA), whichever is beneficial — subject to the parent furnishing a Tax Residency Certificate and Form 10F.

FAQ

Can the parent give the Indian subsidiary an interest-free loan?
Not cleanly. FEMA's ECB framework contemplates a priced loan within the all-in-cost ceiling, and for tax the arm's length principle expects a market rate — a zero rate invites a transfer pricing adjustment that imputes interest income. If the intent is genuinely no return, equity (FDI) is usually the correct instrument, not a loan.

Do we still use LIBOR as the benchmark?
No. LIBOR has been discontinued and RBI's ECB framework references modern risk-free rates — SOFR for US dollar borrowing, and equivalent reference rates for other currencies. Any loan agreement still citing LIBOR should be repapered, and the spread revisited so the post-transition rate remains arm's length.

Is a parent-to-subsidiary loan automatic route or approval route?
Usually automatic, if lender, amount, maturity, end-use and all-in-cost all sit within the ECB framework — filed through your AD bank with no prior RBI clearance. It shifts to the government approval route only when a parameter falls outside the framework, in which case RBI must approve before drawdown.

Closing

Intercompany loan pricing in India is not one decision but two, sitting on top of each other: RBI tells you the ceiling, the Income Tax Department tells you the floor of defensibility, and your rate has to live in the gap between them. Planning India entry? Start with a free structure review at makeitlegit.in.

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See Also

• "A Transfer Pricing Dispute in India Ends in Indian Courts": Why MAP Under DTAA Is the Bilateral Exit Most Foreign Groups Miss
• "It's just a cost reimbursement, not income": What Indian transfer pricing law actually requires for cost-sharing agreements