Deductibility of shareholder loan interest upheld where actual borrowing financed Indian operations and no thin-capitalization bar applied.

Interest paid by a foreign enterprise on borrowings from shareholder-lenders or joint venture partners for Indian project operations was treated as deductible in computing profits attributable to its Indian permanent establishment. Article 7(3)(b) of the India-Belgium treaty was held to deny only internal interest-like charges between a permanent establishment and its head office, not actual interest paid to independent outside lenders who were also shareholders. The Explanation to section 37 of the Income-tax Act did not apply because the claim was made under section 36(1)(iii). In the absence of a specific Indian thin-capitalization rule, the deduction could not be denied on a generalized anti-abuse or recharacterisation theory.

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Issues: Whether interest paid by the foreign enterprise on borrowings from its shareholders or joint venture partners, used for its Indian project operations, was deductible in computing the taxable profits attributable to its permanent establishment in India.

Analysis: The taxability of a non-resident foreign company is confined to profits attributable to its Indian operations, and the profits of the permanent establishment are to be computed under the treaty and the domestic law governing India. Interest paid to independent shareholder-lenders was not an internal or notional charge of the enterprise itself. Article 7(3)(b) of the India-Belgium treaty only denies deduction for internal amounts paid by a permanent establishment to its head office by way of interest on moneys lent, and does not cover actual interest paid to outside lenders who happen also to be shareholders. The restriction in the Explanation to section 37 of the Income-tax Act, 1961 was inapplicable because the claim was for interest under section 36(1)(iii) of the Income-tax Act, 1961. In the absence of any Indian thin-capitalization rule, the revenue could not recharacterize the debt as equity or deny the deduction on a generalized anti-abuse theory. The treaty provisions and CBDT circulars governing treaty override also supported allowance of the claim.

Conclusion: The interest expenditure was allowable as a deduction and the disallowance was unsustainable.

Ratio Decidendi: In the absence of a specific domestic or treaty-based thin-capitalization restriction, actual interest paid on borrowings for business purposes to independent shareholder-lenders cannot be disallowed merely because the borrower is thinly capitalized or because the lenders are shareholders of the enterprise.

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