Interest on fully convertible bonds remains taxable borrowing cost, not dividend, and triggers withholding when chargeable in India.

Interest paid on fully convertible bonds until conversion was treated as interest on money borrowed or debt incurred, because conversion into equity did not change the underlying debt character; the payment was therefore taxable income in the hands of the non-resident recipient. The same payment was not dividend, since the bondholder remained a creditor rather than a shareholder, and the amount was payable irrespective of profits. Because the interest was chargeable to tax in India, the applicant was required to deduct tax at source, although the applicable rate was left for determination in separate proceedings.

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Issues: (i) Whether interest paid on fully convertible bonds up to the date of conversion constituted interest on money borrowed or debt incurred and was taxable as income in the hands of the non-resident recipient; (ii) Whether such payment could be treated as dividend income; (iii) Whether the applicant was liable to deduct tax at source on the interest payments.

Issue (i): Whether interest paid on fully convertible bonds up to the date of conversion constituted interest on money borrowed or debt incurred and was taxable as income in the hands of the non-resident recipient.

Analysis: The bond arrangement showed that funds were advanced to the applicant under an instrument acknowledging debt, with periodic interest payable until conversion. The form of repayment by conversion into equity did not alter the essential character of the liability as debt. The definitions in Section 2(28A) of the Income-tax Act, 1961 and Article 11(4) of the treaty covered interest on bonds and debentures. The legal effect of conversion was only constructive discharge of the debt, not destruction of the debt character. Accordingly, the periodic payments were interest on borrowed money and constituted taxable income in the hands of the recipient.

Conclusion: The issue was answered in the affirmative and in favour of Revenue.

Issue (ii): Whether such payment could be treated as dividend income.

Analysis: Dividend presupposes shareholding, whereas the bondholder remained only a creditor until conversion. The agreement also denied shareholder rights before conversion, and dividend is payable only out of profits. The interest payment was payable irrespective of profits and therefore lacked the essential attributes of dividend.

Conclusion: The issue was answered in the negative and in favour of Revenue.

Issue (iii): Whether the applicant was liable to deduct tax at source on the interest payments.

Analysis: Since the interest was chargeable to tax in India in the hands of the non-resident recipient, the statutory obligation to withhold tax on such payment was attracted. The rate of tax was left open for determination by the assessing authority in appropriate proceedings.

Conclusion: The applicant was liable to deduct tax at source.

Final Conclusion: The ruling treats the interest on fully convertible bonds as taxable interest income, rejects its characterization as dividend, and affirms the withholding obligation on the applicant.

Ratio Decidendi: Conversion of a debt instrument into equity by constructive repayment does not change the character of interest paid on the underlying borrowing, and such interest remains taxable and subject to withholding where otherwise chargeable in India.

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