Treaty attribution of permanent establishment profits does not by itself create taxable head-office interest income.
A treaty fiction treating a permanent establishment as a distinct enterprise applies only to attribute business profits, and a banking protocol may permit deduction of interest on funds lent to the permanent establishment. On that basis, interest payable by an Indian branch to its foreign head office and overseas branches is deductible in computing branch profits where the treaty so allows. However, the same internal payment is not taxable in India in the hands of the head office unless the treaty or domestic law expressly creates such charge. As the amount was not chargeable to tax in India, no withholding obligation arose and disallowance under the Income-tax Act could not stand.
Issues: (i) Whether interest payable by the Indian permanent establishment of a foreign bank to its head office and overseas branches is deductible in computing the profits of the permanent establishment under the applicable tax treaty. (ii) Whether such interest is chargeable to tax in India in the hands of the foreign head office so as to attract tax deduction at source and disallowance under the Income-tax Act, 1961.
Issue (i): Whether interest payable by the Indian permanent establishment of a foreign bank to its head office and overseas branches is deductible in computing the profits of the permanent establishment under the applicable tax treaty.
Analysis: The treaty provisions governing business profits require the permanent establishment to be treated as a distinct and separate enterprise for the limited purpose of computing profits attributable to it. The protocol specifically permits deduction of interest on monies lent to a permanent establishment in the case of a banking institution. This treaty mechanism overrides the domestic law position that such a payment is otherwise a payment to self and not deductible.
Conclusion: The interest was held deductible in computing the profits of the Indian permanent establishment, in favour of the assessee.
Issue (ii): Whether such interest is chargeable to tax in India in the hands of the foreign head office so as to attract tax deduction at source and disallowance under the Income-tax Act, 1961.
Analysis: The Court held that under the domestic law, a branch and its head office are not separate taxable persons, and a payment by one part of the same entity to another part does not generate taxable income. The relevant treaty provisions did not contain any express charging provision to tax such internal interest payment in India. The separate enterprise fiction under the business profits article was confined to attribution of profits and could not be extended to create notional interest income under the interest article. As the amount was not chargeable to tax in India, the obligation to deduct tax at source did not arise and disallowance under the withholding provision could not be sustained.
Conclusion: The interest was held not chargeable to tax in India in the hands of the head office, in favour of the assessee.
Final Conclusion: The questions referred to the Special Bench were answered in favour of the assessee, and the internal interest paid by the Indian branch to the foreign head office and overseas branches was held deductible under the treaty but not taxable in India in the hands of the foreign enterprise.
Ratio Decidendi: A treaty fiction treating a permanent establishment as a distinct enterprise for attribution of profits does not, by itself, create a taxable interest income in the hands of the head office unless the domestic law or the treaty expressly so provides; a payment between the permanent establishment and its own head office is not taxable as income on the principle that one cannot make profit out of oneself.