TMI Blog2020 (12) TMI 110X X X X Extracts X X X X X X X X Extracts X X X X ..... n 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 RBI guidelines, but then this fact, by itself and particularly in view of Explanation to s. 37 being confined to the amounts admissible as deduction u/s. 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 s. 37. 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 expense of interest into an expense that is non-tax deductible. In view of these discussions, 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. In our considered opinion, till the date of conversion, for allowability of inter ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... g interest payment on such CODs as expenditure. The Hon'ble CIT(A) erred in upholding the actions of the Ld. AO/ Ld. TPO. 3.3. The Ld. AO and Ld. TPO have erred in law by not appreciating that the thin capitalisation rules are not present in the Income-tax Act, 1961 (Act') for the year in question to deny any interest expenditure on debt and treat the debt as equity. The Hon'ble CIT(A) erred in upholding the actions of the Ld. AO/ Ld. TPO. 3.4 The Ld. AO and Ld. TPO have erred in law by not appreciating that CCDs till the date of conversion is debt instrument for the purpose of the Act. 3.5 The Ld. AO, Ld. TPO and Ld. CIT(A) have erred in law in applying the provisions of the Foreign Exchange Management Act, 1999 ('FEMA') and Foreign Direct Investment ('FDI') Regulations with respect to CCDs for the purpose of Act. 3.6 The Ld. AO and Ld. TPO have erred in law by holding that the Appellant was justified in not claiming the interest expense as a deduction in the computation of total income without appreciating that the expense was capitalised by the Appellant in accordance with the applicable accounting standards. The Hon'ble CIT(A) ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ly convertible debentures (CCD's) with a face value of rs.10/- each issued to Green Banatelis Ltd, Cyprus. This being in the nature of an international transaction, the AO referred the issue to the TPO, who in his report relying upon the regulations contained in Foreign Exchange Management Act (FEM) treated CCD's as Foreign Direct Investment (FDI). Further, the TPO in passing his order u/s 92CA has, apart from considering the facts of the case in detail, has relied upon the Reserve Bank of India (RBI) policy issued in 2007 which laid down that fully and mandatorily convertible instruments are to be considered as FDI. The TPO has concluded in his order that the amount of interest on CCD's are not to be treated as an expenditure at all and that the same is neither a revenue expenditure and nor is it a capital expenditure and capitalization in the books of accounts by the assessee is wrong. The AO has followed the TPO order and has disallowed capitalization of interest on CCD's and framed the assessment order accordingly. Aggrieved by the same the Appellant is in appeal. The assessee in defense of its claim for capitalization has urged that the RBI policy cannot and ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ity 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 results in lower corporate taxes in respect of PE profits. These tax benefits could be further optimized by hybrid financing instruments such as profit participating loans, convertible loans or where instrument is treated as debt in the source country of the income (i.e. resulting in tax deductible interest) and as equity in the residence country of the lender (i.e. where lender may claim the participation exemption of interest income because of its characterization as distribution of profits). That is how tax considerations at times do result in a compa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... n respect of the interest paid on the debt. Interest relating to debt in excess of this ratio is considered a non-deductible business expense [art. 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; @ p. 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 rules. The deduction of interest is denied if the statutory conditions for deductibility are not satisfied. Articles 26 and 54 are not concerned with the question whether the borrower is undercapitalized but only whether the interest charged is at arm s length. Excessive interest (i.e. interest charged above the prevailing market conditions) is not deductible. Article 198, 11 is concerned with undercapitalized companies. Interest is not deductible if the statutory 7 : 1 debt/equity ratio is exceeded. Article 18, 4 BITC belongs to second group of aforemention ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s 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 Anr. vs. Azadi Bachao Andolan Anr. (2003) 184 CTR (SC) 450 : (2003) 263 ITR 706 (SC) wherein their Lordships have, inter alia, observed as follows : 111. In para 3.3.1 after noticing the growing practice amongst certain entities, who are not residents of either of the two Contracting States to try and avail of the beneficial provisions of the DTAAs and indulge in what is popularly known as treaty shopping , the report says : 3.3.1 ..there is a need to incorporate suitable provisions in the chapter on interpretation of DTAAs, to deal with treaty shopping, conduit companies and thin capitalization. These may be based on UN/OECD Model or other best global practices. 112. In para 3.3.2 the working group recommended introduction of anti-abus ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ntained in the IT Act, 1961. In fact the DTAAs which have been entered into by the Central Government under s. 90 of the IT 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 vs. CIT (1999) 154 CTR (SC) 88 : (1999) 237 ITR 889 (SC), their Lordships of Hon ble Supreme Court had an occasion to survey the judicial precedents on the question of binding nature of the CBDT circulars. After elaborately dealing with Hon ble Supreme Court s judgments in the cases of Navnit Lal C. Jhaveri vs. K.K. Sen, AAC (1965) 56 ITR 198 (SC) and K.P. Varghese vs. ITO Anr. (1981) 24 CTR (SC) 358 : (1981) 131 ITR 597 (SC), their Lordships concluded that the CBDT circulars inter alia can tone down the rigour of the law and such benevolent circulars are binding on the field authorities. It cannot therefore be open to a Revenue authority to disregard the CBDT circular even if it deviates from the law-as long as it is beneficial to the assessee. Thus, where a DTAA provided for a particular mode of compu ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ether 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 IT 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 IT 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. 29. It is also important to bear in mind that when there are no thin capitalization rules vis-a-vis domestic thin capitalization situations and in the light of the s. 90(2) as it exists at present any attempts to neutralize thin capitalization vis-a-vis PEs of Belgian enterprise will be clearly contrary to the scheme of non-discrimination envisaged by art. 24(5) which provides that, enterprises of a Contracting State, the capital of which is wholly or partly-owned or controlled, directly or indirectly, by one or more residents of the other Contracting ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... r s. 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 s. 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 expense of interest into an expense that is non-tax deductible. In view of these discussions, 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. We, therefore, direct the AO to delete the impugned disallowance. 23. As per above paras of this tribunal order, it comes out that even if Thin capitalization Principle is on Statute book of the other country, no disallowance can be made in India by applying this Principle. To this extent, we uphold the finding of CIT (A) by respectfully following this tribunal order. But the issue still remains because, the objections of AO/TPO are not merely on the basis of Thin capitalization Principle. Their basic objection is this that since the interest is paid on CCDs, this is not ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... benture and Part-B of ₹ 40 to be compulsorily converted into one equity share of the face value of ₹ 10 each at a premium of ₹ 30 per share on the expiry of 15 months from the date of allotment of the debenture. Part-B debenture was to carry an interest at the rate of ₹ 14 per annum till the date of conversion payable half yearly on 30th June and 31st December each year and on conversion. The issue in dispute in that case was regarding the allowability of expenses incurred on issue of such debentures and the issue in that case was not of interest on debentures before its conversion as in the present case. This is also an important aspect of the matter of that case that one part of the debenture was to be converted on the date of allotment of debenture itself, second part of the debenture has to be converted only on expiry of 15 months from the date of allotment of debenture and under these facts, it was held by Special Bench of the Tribunal in that case that the expenses incurred on issue of such debentures has to be considered as expenses incurred for issue of shares because it was found that first part of the debentures was to be converted into shares on t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... period or regarding granting of voting rights to the holders of such convertible debentures before the date of conversion. If you ask a question as to whether dividend can be paid on such convertible debentures in a period before the date of conversion or whether such holders of convertible debentures can be granted voting rights at par with voting rights of share holders during pre-conversion period, the answer will be a big NO. On the same analogy, in our considered opinion, the answer of this question is also a big NO as to whether interest paid on convertible debentures for pre-conversion period can be said to be interest on equity and interest on debentures allowable u/s. 36(1)(iii) of the IT Act. 26. Now we have to decide the second issue i.e. ALP of such interest on CCDs. We find that in the order of TPO and AO for the initial year i.e. A. Y. 2009 10, there is no discussion or decision on ALP aspect. Learned CIT (A) in that year has held in a very cryptic manner that 15% interest claimed by the assessee is not at arm s length because as per SBI Corporate Office Website, it is 12.25% on 01.01.2009 and 13.00% as on 10.11.2008. He directed the AO/TPO to rework the ALP a ..... X X X X Extracts X X X X X X X X Extracts X X X X
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