If thin capitalization rules are not in the domestic law/Treaty, there can be not be artificial disallowance of interest paid on borrowings

Court: Mumbai Tribunal

Citation: Besix Kier Dabhol, SA Vs. DDIT

Brief- This is an important decision of the Tribunal, which brings out the importance of a Double Taxation Avoidance Agreement (Treaty), that where thin capitalization rules are not in the domestic law/Treaty, there can be no artificial dis allowance of interest paid on borrowings.

Facts:

Besix Kier, Dabhol (assessee), a company registered under the laws of Kingdom of Belgium, was engaged in the business of carrying out project of construction of fuel jetty and a backwater near Dabhol, India, pursuant to a contract entered into by the asses see with Lingtec Constructors LP .The assessee company had issued 2,500 shares , at the relevant point of time, of Belgian Francs (BEF) 1,000 each amounting to BEF 2,500,000 , out of which, 60% equity shares, i.e. 1,500 shares, were held by N V Besix SA, Belgium, and the remaining 40% equity shares, i.e. 1000 shares, were held by Kier International (Investments) Limited, United Kingdom. The total share capital was thus approximately US $ 83,334 or Rs. 3 8,20,000.

The assessee also raised the capital by resorting to borrowings from the shareholders, Rs. 57,09,18,579 from NA Besix SA and Rs. 37,01,55,921 from Kier International (Investments) Limited, which was in the same ratio in which equity was held by the shareholders i.e. 60: 40. This debt was raised by the permanent establishment (PE) of the assessee directly from the shareholders, and not routed through the assessee’s head office. Thus, the assessee had an equity capital of Rs. 38 lakhs (Rs. 3.8 million) approximately, and a debt capital of Rs. 9,410 lakhs (Rs. 941 million) approximately. The debt equity ratio thus worked out to 248:1. It was in this backdrop that the assessee claimed deduction of interest in assessment year 2002- 03 on these borrowings from the shareholders.

The Reserve Bank of India (RB I) approved the assessee to set up a project office in India on the conditions that the Indian project office will meet all its expenses in India out of “inward remittances received from the head office and the Indian project office will not borrow or lend to any person in India without a specific permission of the RBI.

The Assessing officer (AO) disallowed interest payments on the footing that the borrowings from the shareholders were nothing but borrowings from the head office, and payments made by the branch office to the head office. Further, under the Income Tax Act, 1961 (Act) such payments of interest on borrowings do not constitute admissible deductions, as these payments are from “self to self”. Also, under the India-Belgium Double Taxation Avoidance Agreement (Treaty) in terms of provisions of Article 7(3)(b), interest payments from the branch to the head office, are de facto not deductible in computation of profits of the PE .

The AO also raised an objection that the borrowings by the assessee, on which interest had been claimed as deduction, were in fact part of the capital of the assessee which was brought in the garb of borrowings purely on tax considerations.

The Commissioner of Income Tax (appeals) [CIT (A)] upheld the dis allowance under the provisions of Article 7 (3)( b) of the treaty and held that interest payment having made in violation of RBI guidelines was not allowable as deduction in view of specific provisions of Explanation to Section 37 of the Act.

Aggrieved by the order of CIT (A), the assessee preferred an appeal before Income Tax Appellate Tribunal (‘Tribunal’).

Observation and decision of the Tribunal:

• · A taxable unit is a foreign company and not its branch or PE in India, though its tax ability is restricted to income which accrues or arise or is deemed to accrue or arise in India. In terms of the provisions of the Act, it is the profits of the assessee company that are liable to be taxed in India, and they are such profits of the assessee company as are attributable to its operations in India.
• · Since the only business carried out by the assessee is the project in India, its entire profits are taxable in India and all its expenses, which are incurred to earn the Indian income, are deductible in ascertainment of its taxable income.
• · Irrespective of whether the interest is paid by the head office or by the Indian PE, so far as its deductibility under the Act or Treaty is concerned, this mode of borrowing is tax neutral.
• · As per Article 7 of the Treaty the profits which can be brought to tax in the source state, i.e. India in the present case, include such profits as attributable to the PE, and that in determination of the profits of a PE, all expenses incurred for the business of the PE – whether in the source country or outside, are to be allowed as deduction – subject to the limitations placed by the laws of the State in which PE is situated and certain specific limitations set out in Article 7 itself.
• · Article 7 of Treaty puts down the limitation that except in the case of banking companies, interest paid to the head office is not to be allowed as a deduction unless it is towards reimbursement of actual expenses i.e notional intra organization deductions are not to be allowed unless these are backed by a corresponding third party outgo, and, to that extent, deduction on the basis of hypothetical independence are restricted.
• · That aforesaid limitation does not, however, affect the assessee. As it is a fact that a company and its shareholders have separate existence, that the contracts between a company and its shareholders are just as enforceable as contracts with any independent person. Hence, the interest claimed as deduction on borrowings for the purposes of business has been paid by the assessee to an outside party i.e. shareholders.
• · The deduction of interest on borrowings is covered by the specific provisions of Section 36(1 )(iii) which permits deduction in respect of “amount of interest paid in respect of capital borrowed for purposes of business or profession”. Hence, the provisions of Section 37 would not come into play. Thus, it was not even necessary to examine whether or not the interest paid by the assessee company was in violation of RBI guidelines.
• · India did not have any thin capitalization rules during the relevant assessment year nor does it have any thin capitalization rule at the present. Thin capitalization rules have not even reached the drawing board stage in India. Belgium has thin capitalization rules which restrict the deductions of interest payment only to extent of Debt/capital ration of 1:7 which is in sharp contrast to present case of 1:248 . But, these thin capitalization rules cannot be applied while computing PE’s taxable income in India, as limitations to be placed on deduction of expenses has to be under the laws of state in which PE is situated i.e. India. It is thus clear, that merely because a suitable limitation provision in the treaty or the domestic legislation is considered desirable, and attempts are being made to legislate the anti abuse provisions subsequently in the proposed Direct Taxes Code, 2010 Bill (DTC Bill), it would not render the effort to take advantage of existing provision of the treaty illegal.
• · It is also important to bear in mind that as the law stands now under Section 90 of the Act, the provisions of a tax treaty override the provisions of the Act, except to the extent the latter are beneficial to the assessee, .,. This is also clarified by the Central Board of Direct Taxes, vide circular no. 333 dated 2nd April 1982 [(1982) 137 ITR (St.) 1]
• · It is also important to bear in mind that when there are no thin capitalization rules vis-à-vis domestic thin capitalization situations, and in the light of the Section 90(2) as it exists at present, any attempts to neutralize thin capitalization vis-à-vis PEs of Belgian enterprise will be clearly contrary to the scheme of non discrimination envisaged by Article 24 (5) of the Treaty. In this view of the matter, it cannot be open to the revenue authorities to put any limitation on deduction of interest, in respect of funds borrowed by the PE, while computing income in accordance with the provisions of Article 7 of the India -Belgium tax treaty, when no such limitations are placed on the domestic enterprise.
• · Thus, it is clear that the impugned disallowance is indeed contrary to the scheme of the law as it exists; the grievance of the taxpayer deserves to be upheld, i.e. the interest on the borrowings are deductible expenditure for computing the profits attributable to a PE.

Our Comments:

The Tribunal decision clearly brings out the methodology in computing the profits attributable to a PE, wherein the expenditure incurred in earning the profits are deductible. Tax is to be levied on the basis of the law prevalent at the time, when the profits are assessable under the Act. Thus, if the domestic law does not provide for a dis allowance, then the revenue authorities cannot add to the law an artificial dis allowance. Thus, as the domestic law did not contain thin capitalization rules, they cannot be used as a philosophy to disallow interest expenditure.

NF