TMI Blog2010 (11) TMI 589X X X X Extracts X X X X X X X X Extracts X X X X ..... eaty override provisions in section 129(8) [which are in pari materia with section 90(2) of the Indian Income-tax Act, 1961] the provisions of the Direct Taxes Code "relating (a) General Anti-Avoidance Rule under section 123; (b) levy of Branch Profit Tax under section 111; or (c) Control Foreign Company Rules referred to in the Twentieth Schedule, shall apply to the assessee referred to in sub-section (8), whether or not such provisions are beneficial to him". - In the scheme of things, as it exists in the Indian Income-tax Act, 1961, the treaty override over domestic law is much wider in scope. We cannot interpret the treaty provisions in such a manner so as to curtail, dilute or otherwise tinker with this comprehensive treaty override over the domestic tax law. - IT APPEAL NO. 4249 (MUM.) of 2007 - - - Dated:- 10-11-2010 - N.V. VASUDEVAN, PRAMOD KUMAR, JJ. Sunil M. Lala for the Appellant. Narendra Singh for the Respondent. ORDER Pramod Kumar, Accountant Member. The short issue that we are required to adjudicate in this appeal is whether or not the Commissioner (Appeals) was justified in sustaining the disallowance of interest paid by the assessee to its ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he Indian project office will meet all its expenses in India only out of inward remittances received from head office ; and that (ii) the Indian project office will not borrow or lend from/to any person in India without specific permission of the Reserve Bank of India. The Assessing Officer then required the assessee to show cause as to why such interest deduction not be declined since, in view of the provisions of Article 7(3)(b) of India Belgium Double Taxation Avoidance Agreement - which will apply on the facts of this case, interest on monies lent by the head office to branches was not allowable deduction. The assessee s contention was that the borrowings were from the shareholder companies and not from the head office, and that, for this reason, disallowance under Article 7(b) will not come into play. It was also submitted that the assessee had borrowed the monies from the outsiders, even if such outsiders happened to the shareholders, that interest has been paid on these borrowings, and that, under the Indo Belgium tax treaty, neither there is any restrictions on paying interest on loans, nor any requirements in respect of debt equity ratio. 4. None of these submissions, h ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... it has a debt equity ratio of 428:1 whereas debt equity ratio of shareholder companies have not been furnished by the assessee, that the ratio of borrowings is the same as of the equity capital, and that, in view of these facts, the interest payments by the assessee to NA Besix SA and Kier International (Investments) Ltd. cannot be allowed as deduction. Aggrieved, assessee carried the matter in appeal before the CIT(A) but without any success. The CIT(A) upheld the disallowance under the provisions of Article 7(3)(b) and he also held that the interest payment, having been made in violation of the Reserve Bank of India guidelines, is anyway not allowable as a deduction in view of the specific provisions of Explanation to section 37 of the Act. Not only that the disallowance was confirmed, but also further fortified by the CIT(A). The assessee is aggrieved of the stand so taken by the CIT(A) and is in further appeal before us. 6. We have heard the rival contentions at considerable length, perused the material on record and duly considered factual matrix of the case, as also the applicable legal position. 7. Let us first take a look at the capital structure of the assessee compan ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... for taxation of PE of a foreign enterprise, except taxation on presumptive basis for certain types of income..... Therefore, ascertainment of a foreign GE s taxable business profits in India involves an artificial division of the overall profits of the GE -between profits earned in India and profits earned outside India. Indian Income-tax Act can only be concerned with the profits earned in India, and, therefore, a method is to be found to ascertain profits accruing or arising in India. ........... The very concept of computation of PE profits is created as a fiction of tax law in order to demarcate tax jurisdiction over the operations of a company in a country of which it is not a tax resident. Unless the PE is treated as a separate profit centre, it is not possible to ascertain the profits of the permanent establishment which, in turn, constitute profits accruing or arising to the foreign GE in India. 9. This approach was approved by a subsequent decision of Hon ble Supreme Court in the case of CIT v. Hyundai Heavy Industries Ltd. [2007] 291 ITR 4821 wherein Their Lordships have held that under the Income-tax Act, a taxable unit is a foreign company and not its branch or PE in ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... which is relevant for the purpose of computing profits attributable to a permanent establishment, is as follows: Article 7 Business profits. (1) The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to (a) that permanent establishment; (b) sales in that other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment; or (c) other business activities carried on in that other State of the same or similar kind as those effected through that permanent establishment. 2. Where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall be attributed to such permanent establishment the profits which it might be expected to derive if it were an independent enterprise engaged in the same or similar activities under the same or simila ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nagement, or, except in the case of a banking enterprise, by way of interest on moneys lent to the head office of the enterprise or any of its other offices. 4. Insofar as it has been customary in a Contracting State to determine the profits to be attributed to a permanent establishment on the basis of an apportionment of the total profits of the enterprise to its various parts, nothing in paragraph 2 or paragraph 3 shall preclude such Contracting State from determining the profits to be taxed by such an apportionment as may be customary; the method of apportionment adopted shall, however, be such that the result shall be in accordance with the principles laid down in this Article. 5. No profits shall be attributed to a permanent establishment by reason of the mere purchase by that permanent establishment of goods or merchandise for the purpose of export to the enterprise of which it is the permanent establishment. 6. For the purposes of the preceding paragraphs, the profits to be attributed to the permanent establishment shall be determined by the same method year by year unless there is good and sufficient reason to the contrary. 7. Where profits include items of income w ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... by the assessee company s head office. Frankly, in our considered view and for the reasons stated above, this is a non-issue inasmuch as whether the borrowing is by the PE or the GE, it is tax neutral - so far as Indian tax position is concerned. 15. As we have seen in the preceding discussions, profit of the assessee company that are liable to be taxed in India are such profits of the assessee company as are attributable to its operations in India, and since the only business carried on by the assessee is operations in India, its entire profits are taxable in India. As regards the limitation placed, under Article 7 (3)(b), on deductibility of interest paid to head office, as we have seen above, that limitation is relevant only when the interest payment is an internal and notional charge. 16. That leaves us with the objections raised by the revenue authorities, based on the limitations placed by the domestic tax legislation of the source country i.e., provisions of the Indian Income-tax Act, to deductibility of interest paid to joint venture partners. The objection is two fold - first, that a payment of interest is a payment from self to self as the payment is being made to a j ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... company is de facto minimum required capital to carry out the business in India, interest cannot be allowed as a deduction on the same. In other words, revenue s objection is that the assessee company is so thinly capitalized that its debt capital is required to recharacterized as equity capital for the purpose of examining claim of deduction for interest on such debt capital. 19. Thin capitalization refers to a situation in which capital of a business is made up of greater portion of debt than equity, and its such gearing or leverage ratio i.e., debt equity ratio, is too high. The tax treatment being given to the equity capital and debt capital being fundamentally different, it is often more advantageous in international context to arrange financing of a company by loan rather than by equity. It does affect the legitimate tax revenues of the source country in which business is carried out because while dividends and interest are generally taxable at the same rate in the hands of the recipient in the source country, e.g., under India-Belgium tax treaty WHT rate on interest, other than bank interest, as also dividend is at uniform 15 per cent, interest is tax deductible and that ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... (based on information as on 19th December, 1995) Belgium applies two sets of thin capitalization rules. Firstly, a 1:1 debt/equity ratio applies to loans granted by individual directors, shareholders and non-resident corporate directors to their company [Article 198(10) IR/WIB]. Interest relating to debt in excess of this ratio is recharacterized into a non-deductible dividend. Furthermore, the interest rate may not exceed the market rate. Secondly, a 7:1 debt/equity ratio applies to debt if the creditor (resident or non-resident) is exempt or taxed at a reduced rate in respect of the interest paid on the debt. Interest relating to debt in excess of this ratio is considered a non-deductible business expense [Article 198(11) IR/WIB]. In a 2008 IBFD publication International Tax Planning and Prevention of Abuse (by Dr. Luc De Broe; ISBN 978-90-8722-035-08; @ page 502), these thin capitalization rules are summed up as follows : Belgium has five domestic law provisions that are relevant for the discussion of thin capitalization, i.e., Art 26 BITC; Art 54 BITC; Art 198 11 BITC, Art 18 4 BITC and the Belgian GAAR. Articles 26,54 and 198 belong to the first group of aforementioned r ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... f the State in which PE is situated i.e., India. It may be useful to recall that in terms of the provisions of Article 7(3)(b) of Indo-Belgian tax treaty, In the determination of the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the business of the permanent establishment including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere, subject to the limitations of the taxation laws of that State . Admittedly, there are no limitations on deduction of interest expenses on borrowings, which can be attributed to thin capitalization rules, in India. 23. The question then arises whether even in the absence of any specific thin capitalization rules in India, it could be open to the revenue authorities to recharacterize the debt capital as equity capital, and, accordingly, disregard the interest payments as tax deductibles. 24. We find guidance from Hon ble Supreme Court s judgment in the case of Union of India v. Azadi Bachao Andolan [2003] 263 ITR 706 wherein Their Lordships have, inter alia, observed as follows : 111 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ust in case there were any doubts on this fundamental legal position, the Central Board of Direct Taxes, vide Circular No. 33, dated 2-4-1982 [(1982) 137 ITR (St.) 1], has set the same at rest. This circular deals with the question as to what the Assessing Officers will do when they find that the provisions of the Double Taxation Avoidance Agreement are not in conformity with the provisions of the Income-tax Act, 1961. Then it was laid down by the Board in the said Circular as follows : The correct legal position is that where a specific provision is made in the Double Taxation Avoidance Agreement, that provision will prevail over the general provisions contained in the Income-tax Act, 1961. In fact the Double Taxation Avoidance Agreements which have been entered into by the Central Government under section 90 of the Income-tax Act, 1961, also provide that the laws in force in either country will continue to govern the assessment and taxation of income in the respective country except where provisions to the contrary have been made in the Agreement. 27. In the case of UCO Bank v. CIT [1999] 237 ITR 889 (SC), Their Lordships of Hon ble Supreme Court had an occasion to survey t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... in the tax treaty itself, the effect of the finance structure could not be ignored. 28. It is interesting to take note of the paradigm shift with regard to the treaty override, as introduced in section 129(9) of the Direct Taxes Code Bill, 2010, which provides that notwithstanding the treaty override provisions in section 129(8) [ which are in pari materia with section 90(2) of the Indian Income-tax Act, 1961] the provisions of the Direct Taxes Code relating (a) General Anti-Avoidance Rule under section 123; (b) levy of Branch Profit Tax under section 111; or (c) Control Foreign Company Rules referred to in the Twentieth Schedule, shall apply to the assessee referred to in sub-section (8), whether or not such provisions are beneficial to him . The treaty override is thus quite restricted in scope in this new paradigm. Unlike in the proposed Code and in sharp contrast to this paradigm, the treaty override in the Income-tax Act, 1961, save and except for the higher tax rate being permitted for the foreign companies, is unqualified. In the scheme of things, as it exists in the Indian Income-tax Act, 1961, the treaty override over domestic law is much wider in scope. We cannot inter ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... in Article 7(3)(b) on intra-organization notional payment of interest on capital, whereas the interest payment in the present case did not constitute an intra-organization transaction at all. Even if these interest payments were to be treated as intra-organization transactions by treating the same as payments made to the GE, and not to the joint venture partners, these payments cannot be viewed as notional payments because in such a situation the GE will have corresponding liability to pay the same to the joint venture partners. We have also noted that the interest paid by the assessee may have been contrary to the spirit, if not letter, of the Reserve Bank of India guidelines, but then this fact, by itself and particularly in view of Explanation to section 37 being confined to the amounts admissible as deduction under section 37, does not render the interest paid by the assessee as not deductible, and it is not even necessary to examine the scope of Explanation to section 37. It is also quite possible that tax considerations may have played a role in assessee s planning the capital structure, but an element of planning in structuring capital does not transform a tax deductible exp ..... X X X X Extracts X X X X X X X X Extracts X X X X
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