2012 (4) TMI 80 - AT - Income Tax

Interest Paid by Foreign Bank's PE to Head Office Not Deductible Domestically but Allowed Under Indo-Japan DTAA

The ITAT Mumbai held that interest paid by the Indian PE of a foreign bank to its head office or overseas branches is not deductible under domestic law as ... Deductibility of interest under permanent establishment fiction (article 7) - chargeability of interest to source State under interest article (article 11) - interaction of domestic charging provisions with DTAA (section 90(2) and treaty primacy) - tax deduction at source and disallowance for failure to deduct (section 195 & section 40(a)(i)) - doctrine of mutuality / payment to selfDeductibility of interest under permanent establishment fiction (article 7) - doctrine of mutuality / payment to self - Interest payable by the Indian permanent establishment to its foreign head office/overseas branches is allowable as a deduction when computing profits attributable to the PE under article 7(2) and 7(3) read with protocol paragraph 8 (banking exception). - HELD THAT: - Article 7(2)-(3) together with protocol paragraph 8 treat a PE, for the limited purpose of computing profits attributable to it, as a distinct and separate enterprise dealing independently with the general enterprise. For banking enterprises the protocol expressly permits deduction for interest on moneys lent to the PE. Although under domestic law payments between parts of the same entity are payments to self and not deductible, the treaty fiction is applicable for determining the PE's profits and therefore the PE may deduct such interest in computing profits attributable to it. The Tribunal accepted that the AO and Revenue did not materially dispute the treaty-based allowability for banking institutions and held that the treaty (to the extent beneficial) governs the determination of PE profits. (See findings and conclusion at paras 51-53 and 88.) [Paras 51, 52, 53, 88]Deduction allowed to the PE under article 7(2) and 7(3) read with protocol paragraph 8 for interest payable to the head office/overseas branches (banking enterprise).Chargeability of interest to source State under interest article (article 11) - interaction of domestic charging provisions with DTAA (section 90(2) and treaty primacy) - tax deduction at source and disallowance for failure to deduct (section 195 & section 40(a)(i)) - doctrine of mutuality / payment to self - Interest payable by the Indian PE to its foreign head office/overseas branches is not chargeable to tax in India in the hands of the foreign GE; consequently section 195 and section 40(a)(i) cannot be invoked to disallow the PE's deduction. - HELD THAT: - The primary question is whether domestic law charges the interest to tax in India. The Tribunal held that under domestic law the PE and GE are not separate taxable persons; the consolidated enterprise is the taxable person and internal payments (payment to self) do not give rise to taxable income (doctrine of mutuality), citing Kikabhai Premchand and Betts Hartley Heutt. Article 11(2) permits source-State taxation only if the State's domestic law provides for taxing such interest; moreover article 11(6) applies only where the debt-claim is effectively connected with the PE (i.e., economic ownership allocated to the PE), a circumstance not present here. The separate-and-independent-enterprise fiction in article 7 is limited to attributing profits to the PE and does not, by itself, create a charging provision to tax the GE on interest in the source State. Section 90(2) means treaty provisions operate only to the extent they are more beneficial; a treaty cannot impose tax where domestic law does not. Having held the interest is not domestic-law chargeable income of the GE in India, the obligation to withhold under section 195 and the consequent disallowance under section 40(a)(i) do not arise. (See findings and reasoning at paras 55-56, 64-68, 71-76, 86-88.) [Paras 71, 72, 73, 74, 88]Interest is not taxable in India in the hands of the foreign head office/overseas branches (payment to self); therefore section 195 is not attracted and no disallowance under section 40(a)(i) can be made.Final Conclusion: The Special Bench held that (i) for a banking enterprise the interest paid by the Indian permanent establishment to its foreign head office/overseas branches is allowable as a deduction in computing profits attributable to the PE under article 7(2)&(3) read with protocol paragraph 8; and (ii) such interest is not chargeable to tax in India in the hands of the foreign general enterprise (being a payment to self), so section 195 (TDS) and disallowance under section 40(a)(i) are not attracted. Issues Involved:1. Deductibility of interest payable by the Indian PE of a foreign bank to its Head Office (HO) and other overseas branches.2. Taxability of interest income payable by the Indian PE to its HO and branch offices abroad.Issue-Wise Detailed Analysis:1. Deductibility of Interest Payable by Indian PE to HO and Overseas Branches:Arguments by Assessee:- The assessee, a foreign banking company with branches in India, argued that interest payable by its Indian branches to its HO and other overseas branches should be deductible while computing the profits attributable to the Indian PE. This was based on Article 7(2) and 7(3) of the Indo-Japanese DTAA.- The assessee contended that the PE and HO are not separate entities under Indian tax law and thus, interest payable by the PE to the HO does not constitute income. They relied on the principle that no person can make profit out of oneself, as established in the case of CIT v. Kikabhai Premchand.Arguments by Revenue:- The AO disallowed the interest deduction by invoking Section 40(a)(i) of the Income-tax Act, 1961, due to the failure to deduct tax at source as required by Section 195.- The Revenue argued that the PE should be treated as a separate entity for tax purposes, and interest payable to the HO is taxable in India under Article 11 of the DTAA.- The Revenue relied on the decision of the Hon'ble Supreme Court in the case of Hyundai Heavy Industries, which treated the PE as a separate profit center.Tribunal's Analysis:- The Tribunal noted that under domestic law, the PE and HO are not separate entities, and interest payable by the PE to the HO is a payment to self, which does not give rise to taxable income.- However, under Article 7(2) and 7(3) of the Indo-Japanese DTAA, the PE is treated as a distinct and separate entity for determining the profits attributable to it. Paragraph 8 of the protocol to the DTAA allows deduction of interest payable by a banking institution's PE to its HO.- The Tribunal concluded that the interest payable by the Indian PE to the HO is deductible under the DTAA, even though it is not deductible under domestic law.2. Taxability of Interest Income Payable by Indian PE to HO and Overseas Branches:Arguments by Assessee:- The assessee argued that interest payable by the Indian PE to the HO is not chargeable to tax in India under domestic law, as it is a payment to self.- They contended that Article 11(2) of the DTAA, which allows taxation of interest in the source country, is not applicable because the interest is not taxable under Indian law.- The assessee also relied on Article 11(6) of the DTAA, which states that interest effectively connected with a PE should be taxed under Article 7, not Article 11.Arguments by Revenue:- The Revenue argued that interest payable by the PE to the HO is taxable in India under Article 11(2) of the DTAA at a concessional rate.- They contended that the deeming fiction in Article 7(2) should be extended to Article 11, treating the PE and HO as separate entities for tax purposes.- The Revenue relied on the CBDT Circular No. 740, which treats the branch of a foreign company in India as a separate entity for taxation.Tribunal's Analysis:- The Tribunal held that under domestic law, interest payable by the PE to the HO is not taxable as it is a payment to self.- The Tribunal noted that Article 11(2) of the DTAA allows taxation of interest in the source country only if it is chargeable under the domestic law. Since the interest is not taxable under Indian law, Article 11(2) does not apply.- The Tribunal also rejected the Revenue's argument to extend the deeming fiction of Article 7(2) to Article 11, as the fiction is limited to determining the profits attributable to the PE.- The Tribunal concluded that the interest payable by the Indian PE to the HO is not taxable in India under the DTAA or domestic law.Conclusion:The Tribunal ruled in favor of the assessee on both issues:1. Interest payable by the Indian PE to the HO and overseas branches is deductible under the DTAA.2. Such interest is not taxable in India under the DTAA or domestic law.The decision ensures that the provisions of the DTAA, which are more beneficial to the assessee, override the domestic law. The Tribunal emphasized the principle that no person can make a profit out of oneself, aligning with the legal precedents and the specific provisions of the DTAA.