CCDs and OCDs qualify as rupee-denominated bonds eligible for 5.46% concessional tax rate under section 194LD

ITAT Delhi ruled in favor of the assessee regarding taxability of interest income on CCDs and OCDs under section 194LD. The tribunal held that CCDs and OCDs qualify as rupee-denominated bonds of Indian companies, making them eligible for concessional tax rate of 5.46%. The court determined that until conversion, CCDs/OCDs retain debenture characteristics with same rights and obligations as regular debentures. The distinction between convertible and non-convertible debentures was deemed irrelevant for section 194LD purposes. Tax authorities erred in denying the concessional rate benefit to the assessee.

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1. ISSUES PRESENTED and CONSIDERED

The core legal questions considered by the Tribunal are:

• Whether interest income earned on Optionally Convertible Debentures (OCDs) and Compulsorily Convertible Debentures (CCDs) qualifies for the concessional tax rate of 5.46% under section 115A(1)(a)(BA)(ii) read with section 194LD of the Income Tax Act, 1961, as rupee denominated bonds issued by Indian companies to specified foreign investors; and
• Whether the Assessing Officer erred in computing the aggregate tax and interest liability, specifically regarding the application of the correct tax rate, leading to an incorrect demand raised against the assessee for Assessment Year 2021-22.

2. ISSUE-WISE DETAILED ANALYSIS

Issue 1: Applicability of concessional tax rate under section 194LD to interest income on OCDs and CCDs

Relevant legal framework and precedents:

Section 115A(1)(a)(BA)(ii) of the Act provides for a concessional tax rate on interest income earned by specified foreign investors on rupee denominated bonds issued by Indian companies. Section 194LD mandates deduction of tax at source at this concessional rate (5.46% including surcharge and cess) on such interest income. The conditions include that the interest is payable to Foreign Institutional Investors (FIIs) or Qualified Foreign Investors (QFIs), within a specified time frame, on rupee denominated bonds or government securities, and the interest rate does not exceed the notified maximum.

The terms "bond" and "debenture" are not defined in the Income Tax Act. However, the Companies Act, 2013 defines "debenture" to include debenture stock, bonds, or any other instrument evidencing a debt. Judicial precedents have held that bonds and debentures are debt instruments and the terms are often used interchangeably. The Delhi Tribunal in Heidelberg Cement AG held that non-convertible debentures (NCDs) qualify as bonds for the purpose of section 194LD. The Hon'ble Supreme Court in R.D. Goyal v. Reliance Industries Ltd. distinguished debentures from shares, emphasizing that debentures are instruments evidencing debt, whereas shares represent ownership.

Court's interpretation and reasoning:

The Tribunal examined whether OCDs and CCDs, prior to conversion, retain the character of debt instruments akin to bonds or debentures. It noted that the rights and obligations attached to OCDs and CCDs differ significantly from shares until conversion. For instance, debenture holders are creditors without voting rights, have priority in winding up, and hold a charge over company assets, unlike shareholders who are owners with voting rights and residual claims.

The Tribunal relied on the Companies Act provisions and judicial decisions to establish that OCDs and CCDs are distinct from shares and constitute debt until conversion. It emphasized that the payment of interest presupposes indebtedness, and conversion at a later date is a constructive repayment of debt. The uncertainty over whether OCD holders will convert does not alter the inherent debt nature of the instrument.

Further, the Tribunal considered the purpose of section 194LD, which is to provide concessional tax treatment on rupee denominated debt securities issued by Indian companies to foreign investors, thereby mitigating foreign exchange risk. It held that the distinction between NCDs and convertible debentures (OCDs/CCDs) is immaterial for this purpose, as both are rupee denominated debt instruments.

Key evidence and findings:

• The assessee is a Category II Foreign Portfolio Investor (FPI) registered with SEBI, qualifying as an FII under the Act.
• The interest income on OCDs and CCDs was earned within the prescribed time period and at rates not exceeding the maximum notified by the Central Government.
• The Assessing Officer denied concessional rate benefit on OCDs and CCDs, restricting it only to NCDs, based on an internal letter interpreting section 194LD.
• The Dispute Resolution Panel (DRP) directed the AO to follow the internal letter but did not specifically address the OCD/CCD issue.

Application of law to facts:

The Tribunal applied the definitions and judicial precedents to conclude that OCDs and CCDs are debt instruments until conversion, qualifying as rupee denominated bonds under section 194LD. Consequently, interest income on these instruments should be eligible for the concessional tax rate of 5.46%.

Treatment of competing arguments:

The Revenue argued that section 194LD applies only to rupee denominated bonds and not debentures, and that OCDs and CCDs are akin to shares, not debt. The Tribunal rejected this, distinguishing shares from debentures and emphasizing the debt nature of OCDs/CCDs prior to conversion. The Tribunal also noted that the AO and DRP erred in limiting the benefit only to NCDs, ignoring the broader statutory and judicial context.

Conclusions:

The Tribunal held that the interest income on OCDs and CCDs qualifies for the concessional tax rate under section 194LD and directed the Assessing Officer to grant the benefit accordingly.

Issue 2: Error in computation of aggregate tax and interest liability for AY 2021-22

Relevant legal framework and precedents:

The assessment order for AY 2021-22 involved computation of tax and interest liability based on the tax rates applicable to interest income. The correctness of the tax rate applied affects the demand raised.

Court's interpretation and reasoning:

The Tribunal observed that the Assessing Officer applied an incorrect tax rate without providing a basis, resulting in an inflated demand. The issue was not disputed by the DRP.

Key evidence and findings:

• The assessee's actual tax liability was INR 12,38,69,200, whereas the AO computed a liability of INR 23,40,74,700, leading to an incorrect demand of INR 10,70,62,680.

Application of law to facts:

In light of the Tribunal's finding on Issue 1 that OCDs and CCDs qualify for concessional tax rate, the tax computation must reflect this. The AO was directed to apply the correct tax rate accordingly.

Treatment of competing arguments:

The Revenue did not dispute the facts regarding the incorrect tax rate application, and the Tribunal found no merit in the AO's computation.

Conclusions:

The Tribunal allowed the ground raised by the assessee and directed the AO to recompute tax and interest liability applying the correct tax rate consistent with the decision on Issue 1.

3. SIGNIFICANT HOLDINGS

"In the absence of any specific definition of bonds in the Income-tax Act or in Section 194LD, the term 'bonds' used in the section should be considered as including non-convertible debentures."

"The nature, rights and obligations attached to OCDs / CCDs, cannot be equated with that of shares until conversion thereof; till then OCDs / CCDs retain the character of a debenture simplicitor."

"The payment of interest presupposes the fact that money has been borrowed or a debt has been incurred. The obligation to repay the amount is embedded in the concept of debt, the repayment need not be in the form of cash, it could be in kind. Conversion of bonds into fully paid-up equity shares at the end of the specified period at the conversion price amounts to constructive repayment of debt."

"For the purpose of Section 194LD, what is important is that the security should be rupee denominated. The distinction between OCD/CCD with NCD is of no consequence and they are debt instruments only like the bonds."

"The Assessing Officer erred in not granting the benefit of concessional tax rate under section 194LD to interest income on OCDs and CCDs."

"The Assessing Officer applied an incorrect tax rate resulting in an inflated demand. The AO is directed to recompute tax and interest liability applying the correct tax rate in light of the decision on the nature of OCDs and CCDs."

The Tribunal allowed the appeals for both assessment years with consequential directions to the Assessing Officer.

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