2008 (10) TMI 21 - AAR - Income Tax

Interest payments to US entity classified as interest under Income-tax Act & India-USA DTAA. Obligation to deduct tax at source.

The ruling confirmed that the interest payments made by the non-banking financial company to a US entity were classified as interest under both the ... Interest as income from debt-claims - definition of 'interest' under Section 2(28A) - treatment under Article 11 of India US DTAA - convertible debentures and constructive repayment - distinction between interest and dividend - obligation to deduct tax at source under Section 195Interest as income from debt-claims - definition of 'interest' under Section 2(28A) - treatment under Article 11 of India US DTAA - convertible debentures and constructive repayment - Interest paid to LMCC up to conversion is interest on money borrowed and taxable as income of LMCC under the Act and the India US DTAA. - HELD THAT: - The Agreement creates bonds described as promissory notes and acknowledges indebtedness; the payment obligation to pay periodic interest is tied to that indebtedness. Definitions in Section 2(28A) and Article 11.4 (which expressly includes income from bonds or debentures) both cover the payments made. Convertibility into equity does not alter the legal character of the obligation as a debt; constructive repayment by issuance of shares does not negate that the periodic payments are interest in respect of moneys borrowed. The ingredients of Section 2(28A) and Article 11 are satisfied and the payments therefore constitute taxable interest in the hands of the non resident recipient. [Paras 5, 7, 8, 9, 12]Affirmed: the payments up to conversion are interest on borrowed money and taxable as income of LMCC under domestic law and Article 11 of the DTAA.Convertible debentures and constructive repayment - interest as income from debt-claims - Whether such payments are expenditure of the applicant or raise questions of the applicant's deduction was not adjudicated; the Authority confines itself to the non resident's tax liability. - HELD THAT: - The Authority declined to decide the applicant's entitlement to claim the payments as business expenditure or deductions under sections such as S.37 or S.36(1)(iii). The ruling is expressly limited to the characterization and taxability of the receipts in the hands of the non resident investor, leaving the question of the applicant's deduction to appropriate proceedings of the assessing authority. [Paras 12]No ruling on the applicant's deduction entitlement; question left open for assessment proceedings.Distinction between interest and dividend - convertible debentures and constructive repayment - The payments cannot be treated as dividend income of LMCC prior to conversion. - HELD THAT: - Dividend presupposes shareholding and distribution out of profits; under the Agreement bondholders have no shareholder rights until conversion and interest is payable irrespective of profits. Accordingly, the periodic payments made prior to conversion do not constitute dividend but are interest. [Paras 12]Negative: the pre conversion payments are not dividends.Obligation to deduct tax at source under Section 195 - interest as income from debt-claims - treatment under Article 11 of India US DTAA - The applicant is obliged to deduct tax at source under Section 195 in respect of the interest payments chargeable to tax in India. - HELD THAT: - Because the payments constitute interest taxable in the hands of the non resident under domestic law and Article 11 of the DTAA, they are remunerations chargeable to tax in India. Consequently, the payer (the applicant) is required to deduct tax at source under Section 195(1). The Authority did not pronounce on the specific rate of deduction, leaving that to the assessing authority or appropriate proceedings as requested by the applicant. [Paras 12, 13]The applicant must deduct tax at source under Section 195; the rate is left to be determined separately.Final Conclusion: The Authority ruled that periodic payments to LMCC prior to conversion are interest on debt (covered by Section 2(28A) and Article 11 of the India US DTAA) and taxable as income of the non resident; they are not dividends; the applicant must deduct tax at source under Section 195, while the question of the applicant's own deduction and the precise rate of withholding are left open for determination by the assessing authority. Issues Involved:1. Classification of interest payments under the Income-tax Act and the India-USA DTAA.2. Nature of payments as business income or expenditure.3. Classification of payments as dividend income.4. Obligation to deduct tax at source.Detailed Analysis:Issue 1: Classification of Interest PaymentsThe applicant, a non-banking financial company in India, entered into a 'Bond Subscription Agreement' with LMCC USA to issue fully convertible bonds. The applicant sought an advance ruling to determine if the interest paid to LMCC up to the date of bond conversion into equity shares should be treated as interest on borrowed money under Section 2(28A) of the Income-tax Act and Article 11 of the India-USA DTAA.Both the applicant and the Department agreed that the interest paid falls within the definition of 'interest' as per Section 2(28A) of the Income-tax Act and Article 11 of the DTAA. Section 2(28A) defines interest as 'interest payable in any manner in respect of any moneys borrowed or debt incurred...'. Article 11 of the Treaty similarly defines interest as income from debt-claims of every kind, explicitly including income from bonds or debentures.The ruling concluded that the payment made by the applicant by way of interest is indeed interest as per the definitions under both the Income-tax Act and the DTAA. The ruling emphasized that the issuance of debentures is a mode of borrowing money, and the interest paid is directly related to the debt incurred by the applicant. The conversion of bonds into equity shares at the end of the specified period amounts to constructive repayment of debt, satisfying the definition of interest under Section 2(28A).Issue 2: Nature of Payments as Business Income or ExpenditureThe applicant questioned whether the interest payments constitute expenditure incurred in connection with raising capital or any other payment being compensation to LMCC during the pre-conversion period, which would be business income/receipts not attracting tax under the DTAA.The ruling did not directly address this part of the question, stating that it was not concerned with the applicant's tax liability or whether the interest paid could be claimed as a deduction under Section 37 or Section 36(1)(iii) of the Act. The focus was solely on the non-resident's liability, which was clarified under Issue 1.Issue 3: Classification of Payments as Dividend IncomeThe applicant inquired whether the interest payments should be treated as dividend income of LMCC, which would be exempt under Section 10(34) of the Act.The ruling clarified that interest payments cannot be construed as dividend income. Dividend presupposes that the payee holds shares in a company, and LMCC would only become a shareholder upon conversion of the bonds into equity shares. The agreement explicitly stated that bondholders would not have any rights as shareholders until conversion. Additionally, dividends can only be paid out of profits, whereas interest is payable to the bondholder irrespective of the applicant's profit status. Hence, this question was answered in the negative.Issue 4: Obligation to Deduct Tax at SourceThe applicant sought clarification on whether it was liable to deduct tax at source under the Act in respect of the interest payments to LMCC.The ruling confirmed that under Section 195(1) of the Act, the applicant is liable to deduct tax at source at the applicable rates, as the interest paid to LMCC is chargeable to income tax in India. The rate of tax was left open for determination by the assessing authority in an appropriate proceeding.ConclusionThe ruling provided comprehensive answers to the questions posed by the applicant, confirming the classification of interest payments under the Income-tax Act and the DTAA, clarifying the nature of these payments, rejecting their classification as dividend income, and affirming the obligation to deduct tax at source. The rate of tax was left for future determination by the assessing authority.