Tax Hotline December 03, 2010

No Application of Thin-Capitalization Rules Under Income Tax Act, 1961 Regime: ITAT, Mumbai

In a recent ruling, the Mumbai Bench of Income Tax Appellate Authority (“ITAT”) has refused to apply anti-avoidance provision against thin-capitalization (a phenomenon where investments are primarily structured as debt instead of equity capital, in order to get favorable treatment under tax laws of a country) to deny the benefits available to a resident of Belgium, under tax treaty for avoidance of double taxation between India and Belgium (“Treaty”). The ITAT held that the Income Tax Act, 1961 (“ITA”) does not provide for any limitations on the benefits in form of any anti thin-capitalization rules and therefore it was not permissible for the tax department to deny such benefits to the taxpayer.

Background:

Besix Kier Dhabol, SA (“Taxpayer”) is a company registered in Belgium and is engaged in the business of carrying on the project of construction of fuel jetty and a backwater near Dhabol, India. Two other companies, NV Besix SA, Belgium and Kier International Investments Ltd., United Kingdom hold respectively 60% and 40% shares of the Taxpayer (collectively referred to as “Shareholders”). The Taxpayer has set up a project office in India for its above stated business which qualified as a Permanent Establishment (“PE”) of the Taxpayer in India. The Indian project office of the Taxpayer borrowed monies for the Shareholders in the same ratio of their shareholding in the Taxpayer. As of result of the borrowing, the Taxpayer had a debt capital of INR 9,4,10,00,000 as against the equity capital of INR 38,00,000 with a debt-equity ratio of 248:1. A diagrammatic representation of this transaction is provided in Fig 1 below.

Assessment and Proceedings Before Tax Department:

For the Assessment Year 2002-03, the Taxpayer claimed deduction of the interest paid by its Indian project office to the Shareholders against its income taxable in India. However, upon further investigation, the Assessing Officer (“AO”) called upon the Taxpayer to show cause as to why the interest payments should not be disallowed since Article 7(3)(b) of the Treaty provided that interests on loans taken by a PE from head office was not allowable for deduction. The Taxpayer defended its stand before the AO, by stating that the borrowings were in fact from the Shareholders and not the head office. It stated that the Shareholders were separate and distinct from the Taxpayer itself, and hence the above quoted provision of the Treaty was not applicable in its case. However upon consideration of the matter, the AO refused to allow such a deduction applying Article 7(3)(b) of the Treaty. The AO also asserted that the loan was in contravention of the Reserve Bank of India (“RBI”) guidelines which required that the expenses of an Indian office of an offshore company are required to be met out of capital infusion/ remittance from its head office only, except in case of banks. The AO also observed that the Taxpayer had a high debt-equity ratio and that the ratio of borrowing was in the same ratio of the equity capital of the Shareholders in the Taxpayer and hence the interest paid by its Indian project office to the Shareholders should not be treated as interest, but as equity.

On appeal before the Commission of Income Tax, Appeals (“CIT, A”), the CIT, A upheld the AO’s decision and further held that since the borrowings were in contravention of the RBI guidelines, interest deduction could not be allowed in light of the Explanation to section 37 of the ITA which prohibits deduction of any expenditure in contravention in law. The Taxpayer appealed from the order of the CIT before the ITAT.

Proceedings before the ITAT:

At the outset, the ITAT clarified that while taxing profits of the Taxpayer which are attributable to its Indian PE, all expenses incurred for the business of such PE are allowed as deduction, subject to limitations placed under Treaty and the ITA. However, in this case, the limitation placed under Article 7 of the Treaty regarding allowance of intra-organizational loans was not applicable in its view, since the borrowings were accepted by the PE from the Shareholders, and not from the Taxpayer itself. The ITAT recognized that the Shareholders of the Taxpayer have a separate existence under law, from the Taxpayer and the loan could not be treated as being taken from the Taxpayer itself. The ITAT also held that the interest on borrowings in this case could said to be covered under the specific provision of section 36(1)(iii) of ITA, which permits deduction of interest paid in respect of capital borrowed for the purpose of business or profession. Therefore, it was not necessary to consider if the borrowing was in contravention of law, or not since the Explanation of section 37 was not applicable to this case.

In relation to the thin- capitalization of the Taxpayer, the ITAT observed that since India has no anti-thin capitalization rules in force, the tax department could not place any limitation on allowing of interest as deductions on this ground. Referring to the landmark ruling of the Supreme Court of India in the case of Azadi Bachao Andolan (263 ITR 706), the ITAT held that merely because the suitable limitation provisions under the ITA and the Treaty are considered desirable, any effort to take advantage of the provisions of a treaty cannot be considered illegal, specifically in absence of any law limiting such benefits. The ITAT also cited the ruling in UCO Bank v. CIT (237 ITR 889) to hold that in absence of a specific legislation curtailing a benefit available under tax laws, it is not open to tax department to limit benefits available to a taxpayer by applying anti-abuse provisions. Interestingly, the ITAT also held that since domestic thin-capitalization provisions were absent in the ITA, it would be contradictory to the scheme of non-discrimination envisaged by Article 24(5) of the Treaty to apply it in case of non residents. In light of the above reasoning, the ITAT directed the AO to delete the disallowance in respect of the interest in question before it.

Analysis:

The above summarized ruling, has laid down many significant principles of international taxation. Firstly, this ruling has upheld the fundamental principle of treating the shareholders of a company as separate and distinct from the company itself. The ITAT clearly held that a transaction entered into with the Shareholders could not be treated as being entered with the Taxpayer. Secondly, the ITAT rightly refused to apply tax avoidance provisions i.e. anti thin-capitalization rules since such provisions were not even in force at present. Moreover, the ITAT has also upheld the sanctity of the non-discrimination clause of tax treaties by holding that applying an anti-abuse provision to an international transaction, when such provisions are absent in the domestic context would be contradictory to the non-discriminatory provisions of these treaties.

In the above context, the ITAT also observed that the Direct Taxes Code Bill, 2010 or DTC (Bill No. 11 of 2010 as introduced to the Parliament on August 30, 2010) proposes to introduce various anti-avoidance provisions like General Anti-Avoidance Rule or GAAR which permitted the tax authorities to re-characterize the nature of a transaction for instance treat equity as debt and vice versa (section 123(1)(f) of DTC) and the treaty override provisions (129(9) of DTC). In view of these provisions, it is significant to bear in mind that once the DTC comes into play the international transactions would be prone to the scrutiny of these considerably wide anti-abuse provisions.

- Vivaik Sharma & Rajesh Simhan

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