A Rs 400 crore solar project company has 70% bank debt. The sponsor can put in its Rs 120 crore as equity or as a shareholder loan at 12%, with tax at 25%. Compare the sponsor's return and cash timing, and say why shareholder loans are used and what limits apply.

The shareholder loan gets the sponsor more cash, sooner: Rs 16.48 crore in year 1 against Rs 11.55 crore, Rs 215 crore by year 10 against Rs 175 crore, and a return of 18.1% against 15.4%. Two reasons: interest is tax-deductible in the project, and loan repayments escape the rule that dividends need profits, so cash is not trapped. The limits are interest deduction caps, arm's-length pricing, lender subordination and the sponsor's own tax on the interest.

Think of parents funding a child's first flat. If they gift the money, they get nothing back until the flat is sold; if they lend it, the child repays a little every month and the parents see cash along the way. A shareholder loan does the same for a sponsor: it is still the sponsor's money at risk, ranking behind the banks, but it comes back as interest and principal rather than waiting for dividends. In a project company that matters for two reasons, tax and trapped cash.

The project earns Rs 62 crore and pays the banks Rs 45.27 crore of interest and principal either way. On the equity route, profit before tax is Rs 15.40 crore, tax is Rs 3.85 crore and net profit Rs 11.55 crore. The project has Rs 12.88 crore of cash, but the dividend cannot exceed profit, so Rs 1.33 crore stays trapped. On the loan route, Rs 14.40 crore of interest wipes out almost all the taxable profit, tax falls to Rs 0.25 crore, and all Rs 16.48 crore of spare cash reaches the sponsor as interest and principal.

Because depreciation and debt repayment do not match. Depreciation of Rs 20 crore reduces profit but not cash, while bank principal of Rs 18.67 crore uses cash but does not reduce profit. Whenever depreciation exceeds principal, the project has more cash than distributable profit, and the gap is trapped; after the bank loan is repaid in year 15 the full Rs 20 crore a year is stuck, building to Rs 120 crore by year 20. The model assumes it earns nothing and comes out only at the end; in practice a capital reduction can release it earlier, but slowly and at a cost.

Only partly, and saying so is what separates a good answer. The project saves Rs 27.1 crore of tax, but the sponsor receives Rs 108.4 crore of interest, and if it pays 25% on that, Rs 27.1 crore comes straight back as tax at its end. The group-level saving survives only where the sponsor is taxed less on the interest than the project saves, as some fund structures are. What survives in every case is timing: cash out years earlier, with nothing trapped.

Four things. Interest deduction rules: many tax systems, India's included, cap the deduction for interest paid to related lenders, especially non-resident ones, at a share of EBITDA above a threshold; confirm the current thin-capitalisation rules and thresholds before relying on the deduction. Transfer pricing: the 12% rate must be what an unrelated lender would charge for a loan this junior, or the excess is disallowed. Lenders: banks accept a shareholder loan only if it is subordinated to them, counted as equity in their gearing tests, and paid only when cover ratios are met, so in a bad year the sponsor's interest stops first. And the sponsor's own tax and withholding on the interest, as above.