2003 (3) TMI 91 - HC - Income Tax

Court Rules Usance Interest as Taxable, Not Part of Purchase Price

The court held that the usance interest paid was considered 'interest' under the Income-tax Act, not part of the purchase price. Failure to deduct tax at ... Definition of 'interest' under section 2(28A) - deduction of tax at source under section 195(1) - disallowance under section 40(a)(i) - treatment of usance interest as part of purchase price - application of Double Taxation Avoidance Agreements to 'interest' from 'debt-claims of every kind' - manufacture or production for purpose of sections 80HH and 80-I - legal effect of irrevocable usance letter of credit on payer's statutory obligationsDefinition of 'interest' under section 2(28A) - treatment of usance interest as part of purchase price - Whether the usance interest payable under the memorandum of agreement formed part of the purchase price or was 'interest' within the meaning of section 2(28A). - HELD THAT: - The court examined the terms of the MOA, invoices, customs treatment and the contractual scheme of payment by 180 days usance confirmed irrevocable letter of credit and concluded that (i) the purchase price and the usance interest were separately stated in the contracts and invoices, (ii) customs duty was paid on the purchase price excluding interest, and (iii) the contractual arrangement established that the purchase price became due on delivery thereby creating a debt which gave rise to interest for the usance period. Having regard to the wide statutory definition in section 2(28A) which includes interest in respect of any moneys borrowed or debt incurred and to commercial and accounting principles recognising accrual of revenue and interest on outstanding price, the court held that the usance interest was interest within the meaning of section 2(28A) and not part of the purchase price.Usance interest was not part of the purchase price and was 'interest' within the meaning of section 2(28A).Deduction of tax at source under section 195(1) - disallowance under section 40(a)(i) - legal effect of irrevocable usance letter of credit on payer's statutory obligations - Whether the assessees were obliged to deduct tax at source under section 195(1) on the usance interest and consequently whether the disallowance under section 40(a)(i) for non-deduction was rightly made by the Assessing Officer. - HELD THAT: - Relying on the deeming provisions in section 9(1)(v)(b) and the charging and procedural provisions in sections 4 and 5, the court held that interest payable by a resident to a non-resident (unless falling within specified exceptions) is deemed to accrue or arise in India and is chargeable to tax; therefore the person responsible for payment must deduct tax at source at the time of credit or payment, whichever is earlier. The court rejected the contention that issuance or release of an irrevocable usance letter of credit discharged the buyer's obligation to deduct tax, explaining that a letter of credit is generally a conditional mode of payment that does not extinguish the buyer's contractual and statutory liabilities absent an express provision to that effect. Consequently the assessees were under statutory obligation to deduct tax; failure to do so justified the disallowance under section 40(a)(i).Assessees were liable to deduct tax at source under section 195(1) on the usance interest; the Tribunal erred in deleting the disallowance under section 40(a)(i).Application of Double Taxation Avoidance Agreements to 'interest' from 'debt-claims of every kind' - treatment of usance interest as part of purchase price - Whether the usance interest fell outside the article on 'interest' in the relevant DTAAs (and hence formed part of business profits taxable abroad) or whether it was 'interest' under those agreements. - HELD THAT: - The court analysed the DTAA wording (following the OECD Model) that defines 'interest' as 'income from debt-claims of every kind' and accepted the OECD commentary that payment by means such as a letter of credit constitutes fulfilment of the obligation to put funds at the creditor's disposal. Given that the purchase price became an outstanding debt on delivery and interest was contractually computed on that debt for the usance period, the court held that the usance interest fell squarely within the DTAA definition of 'interest'. The court further observed that treaty provisions do not immunize the payor from procedural modes of tax collection (such as deduction at source) available to the source State.Usance interest is 'interest' within the meaning of the relevant DTAAs; the Tribunal was wrong to treat it as not being 'interest' under the treaties.Disallowance under section 40(a)(i) - deduction of tax at source under section 195(1) - Whether the Tribunal was correct to hold that the assessees were not liable to deduct tax at source and therefore that the disallowance under section 40(a)(i) was unwarranted. - HELD THAT: - Applying the statutory scheme (sections 4, 5, 9 and 195) and commercial law principles on letters of credit, the court found that the Tribunal's conclusion ignored the deeming fiction that interest payable by a resident is income deemed to accrue in India and the payor's obligation to deduct tax at source on credit or payment. The court emphasised that the mode of payment (letter of credit) does not automatically shift the statutory duty to the issuing bank absent express contractual stipulation. Accordingly the Tribunal's deletion of the disallowance conflicted with the statutory provisions and was set aside.The Tribunal was wrong; the disallowance under section 40(a)(i) for non-deduction of tax on usance interest was justified.Manufacture or production for purpose of sections 80HH and 80-I - Whether ship breaking amounts to 'manufacture' or 'production of altogether new articles or things' so as to attract deductions under sections 80HH and 80-I. - HELD THAT: - The court examined statutory language, the object of sections 80HH and 80-I and relevant precedents. It concluded that the legislative purpose of those provisions is to encourage industrial undertakings engaged in manufacture or production of new articles or things. Ship breaking, which recovers existing components (steel plates, machinery, etc.) from an old vessel by dismantling, does not create a new article or thing; the items recovered pre-existed in the ship. The court warned against expansive results that would make scrap dealers entitled to industrial incentives and held that processes of dismantling and removal do not constitute manufacture/production in the sense contemplated by the statutes.Ship breaking is not manufacture or production of altogether new articles or things; assessees are not entitled to deductions under sections 80HH and 80-I and the Tribunal erred in allowing them.Final Conclusion: The appeals are allowed. The High Court held that the usance interest was 'interest' within section 2(28A) and under the DTAAs, that assessees were obliged to deduct tax at source under section 195(1); deletion of disallowance under section 40(a)(i) by the Tribunal was erroneous, and ship breaking does not qualify as manufacture or production for purposes of sections 80HH and 80-I. Issues Involved:1. Whether the usance interest paid by the assessee apart from the purchase price of the ship falls within the scope of the definition of 'interest' under section 2(28A) of the Income-tax Act, 1961.2. Whether the Appellate Tribunal was correct in deleting the disallowance under section 40(a)(i) for the failure of the assessee to deduct tax at source from usance interest paid to a non-resident under section 195(1).3. Whether the Appellate Tribunal was correct in holding that usance interest partakes of the character of purchase price and therefore not liable to deduction at source under section 195(1).4. Whether the Appellate Tribunal was correct in holding that usance interest is not interest as envisaged in the Double Taxation Avoidance Agreement (DTAA).5. Whether the Appellate Tribunal was correct in allowing the deduction under sections 80HH and 80-I to the assessee, holding that ship breaking activity gives rise to manufacture and production of altogether a new article or thing.Detailed Analysis:1. Definition of 'Interest' under Section 2(28A):The court held that the usance interest paid by the assessee was not part of the purchase price of the ships but was 'interest' within the meaning of section 2(28A) of the Income-tax Act, 1961. The definition of 'interest' under section 2(28A) includes interest payable in any manner in respect of any moneys borrowed or debt incurred and includes any service fee or other charge in respect of the moneys borrowed or debt incurred. The court found that the purchase price and the usance interest were separately mentioned in the Memorandum of Agreement (MOA) and were treated as distinct items by both parties. The court also noted that the customs duty was paid only on the purchase price, excluding the usance interest, further supporting that the usance interest was not part of the purchase price.2. Disallowance under Section 40(a)(i):The court concluded that the assessees who did not deduct tax at source under section 195(1) on the usance interest payable outside India were not entitled to deduct the amounts of such usance interest in computing their income chargeable under the head 'Profits and gains of business or profession.' The court emphasized that the liability to deduct tax at source arises when the credit entry is made or when payment is made by any mode, whichever is earlier. The court rejected the argument that the payment made to the issuing bank in India absolved the assessees from the obligation to deduct tax at source.3. Character of Usance Interest:The court held that the usance interest partook of the character of interest and not of the purchase price. The MOA clearly separated the purchase price and the usance interest, and the interest was calculated on the purchase price for the period of credit. The court observed that the interest amount was treated separately in the accounts and customs duty was paid only on the purchase price. Therefore, the court concluded that the usance interest was interest payable on a debt incurred, i.e., the unpaid purchase price of the ship.4. Usance Interest under DTAA:The court held that usance interest is 'interest' within the meaning of the article concerning taxation of interest in the relevant DTAAs. The DTAAs define 'interest' as income from debt claims of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtor's profits. The court rejected the argument that the usance interest was part of the business profits and not interest. The court noted that the expression 'debt claims of every kind' is broad and includes interest on deferred payment sales, even if not explicitly stated in the DTAA.5. Ship Breaking Activity:The court held that ship breaking activity is not an activity of manufacture or production of any article or thing for the purposes of availing of the benefit of deductions under sections 80HH and 80-I of the Income-tax Act, 1961. The court observed that ship breaking involves dismantling old ships and extracting existing materials, which does not result in the manufacture or production of new articles or things. The court emphasized that the benefit of sections 80HH and 80-I is intended for industrial undertakings engaged in the manufacture or production of new articles or things, not for activities like ship breaking that do not create new products.Decision:1. The usance interest paid by the assessees was not part of the purchase price of the ships and was interest under section 2(28A) of the Income-tax Act, 1961.2. The assessees who did not deduct tax at source on the usance interest payable outside India are not entitled to deduct the amounts of such usance interest in computing their income.3. The usance interest partook of the character of interest and not of the purchase price, and the assessees were liable to deduct income-tax thereon under section 195(1).4. Usance interest is 'interest' within the meaning of the article concerning taxation of interest in the relevant DTAAs.5. Ship breaking activity is not an activity of manufacture or production of any article or thing for the purposes of sections 80HH and 80-I, and the assessees are not entitled to deductions under these sections.The court set aside the impugned orders of the Tribunal to the extent they were challenged and allowed all the appeals with costs to be paid by the respondents assessees to the appellants, quantified at Rs. 10,000 for each appeal. The court rejected the prayer for a certificate of fitness for appeal to the Supreme Court and for staying the operation of the order.