Treaty treatment of refund interest: non-resident refund interest taxed under Article 11(2), not as business profits.

Interest on an income-tax refund received by a non-resident with a permanent establishment in India was examined under the Indo-Australia DTAA, with Article 11(4) excluding the concessional interest article only where the debt is effectively connected with the permanent establishment. The text notes that section 90(2) requires the more beneficial treaty provision to apply, and that "effectively connected" is a wider test than a domestic income-head classification. On the facts, refund interest was found not sufficiently connected with the permanent establishment because it arose from tax deducted from business receipts, whereas bank interest had a closer link to permanent-establishment funds. Refund interest was therefore taxable under Article 11(2), not Article 7 read with Article 11(4).

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Issues: Whether interest on income-tax refund received by a non-resident assessee having a permanent establishment in India is taxable at the concessional rate under Article 11(2) of the Indo-Australia Double Taxation Avoidance Agreement or as business profits under Article 7 read with Article 11(4).

Analysis: The treaty permits taxation of interest in India at 15% on gross basis, but Article 11(4) takes the case out of that regime where the recipient carries on business through a permanent establishment in India and the indebtedness in respect of which interest is paid is effectively connected with that permanent establishment. The domestic law under section 90(2) of the Income-tax Act, 1961 requires application of the more beneficial provision. The expression "effectively connected" is wider than a mere connection under the domestic heads of income and cannot be tested only by whether the interest is business income. Interest on income-tax refund arises because tax has been deducted at source from business receipts, but the legal burden to pay tax remains that of the foreign company and the refund claim is in the nature of an appropriation of profit. That connection was held insufficient to establish effective connection with the permanent establishment. The bank interest, on the other hand, was treated as having a closer connection with the funds of the permanent establishment.

Conclusion: Interest on income-tax refund was held taxable under Article 11(2) and not under Article 7 read with Article 11(4); the assessee succeeded on this issue.

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