2025 (8) TMI 1269 - AT - Income Tax

Notional interest on ECBs and delayed receivables not taxable under Article 11 DTAA; only actual paid interest taxed

Volkswagen Aktiengesellschaft Versus Deputy Commissioner of Income Tax (International Taxation) -4 (3) (1), Mumbai

Volkswagen Aktiengesellschaft Versus Deputy Commissioner of Income Tax (International Taxation) -4 (3) (1), Mumbai - TMI ISSUES PRESENTED AND CONSIDERED 1. Whether a transfer-pricing driven notional or hypothetical interest adjustment, which was neither contractually receivable nor actually paid, can be taxed under Article 11 of the India-Germany Double Taxation Avoidance Agreement (DTAA) that refers to interest 'paid' to a resident of the other Contracting State. 2. Whether domestic transfer-pricing adjustments made under Chapter X/Section 92C of the Income-tax Act can, by operation of domestic accrual principles, override or displace the payment-based threshold for taxability contained in Article 11 of the DTAA. 3. Whether, in the absence of a definition of 'paid' in the DTAA, domestic law definitions (per Article 3(2) of the DTAA) may be invoked to treat a notional accrual as taxable interest for treaty purposes. ISSUE-WISE DETAILED ANALYSIS Issue 1 - Taxability of notional transfer-pricing interest under Article 11 (payment vs accrual) Legal framework: Article 11 of the DTAA provides that interest 'arising in a Contracting State and paid to a resident of the other Contracting State may be taxed' in the other state, with a concessional rate cap where the recipient is beneficial owner. The OECD Commentary defines 'paid' as the fulfilment of the obligation to put funds at the disposal of the creditor in the manner required by contract or custom. Precedent treatment: Multiple judicial decisions and tribunal authorities (including decisions of a High Court interpreting identical treaty wording and various Tribunal benches) have held that where a treaty uses the term 'paid', taxation is circumscribed by actual payment/receipt (or constructive receipt by enforceable obligation), and not by domestic accrual or notional computations. Interpretation and reasoning: The Court interprets the term 'paid' in Article 11 according to its plain meaning and the OECD Commentary: payment requires discharge of an enforceable obligation to place funds at the creditor's disposal. A notional interest computed solely for arm's-length benchmarking that neither arose as a contractual entitlement nor resulted in an actual receivable does not satisfy this threshold. The treaty's deliberate choice of 'paid' rather than 'accrued' or 'payable' is significant and restricts taxability to cases of actual payment/constructive receipt under contract/custom. Ratio vs. Obiter: The holding that notional transfer-pricing interest which is neither contractually payable nor actually paid is not taxable under Article 11 is ratio decidendi for the present dispute. Observations about the OECD Commentary and the required twofold condition (arising in contracting state and being paid to resident) form part of the core reasoning and are also ratio where they directly support the conclusion. Conclusion: A notional interest adjustment made solely by the Transfer Pricing Officer, which lacks contractual enforceability and actual payment, does not constitute 'interest paid' under Article 11 and therefore cannot be taxed under the DTAA. Issue 2 - Scope and limits of domestic transfer-pricing adjustments vis-à-vis treaty provisions Legal framework: Chapter X (Section 92C et seq.) of the Income-tax Act provides the mechanism to determine arm's-length price for international transactions and authorises adjustments where inter-company consideration departs from arm's-length. Section 90(2) of the Act (treaty override principle) mandates application of treaty provisions where they are more beneficial to the taxpayer than domestic law. Precedent treatment: Judicial authorities have recognised that transfer-pricing provisions determine arm's-length values but are not independent charging provisions; their effect is subject to the chargeability tests under domestic law and applicable treaties. High Court and Tribunal decisions have held that domestic TP adjustments cannot be operated in a manner inconsistent with treaty provisions prescribing payment-based taxability. Interpretation and reasoning: While the TPO has statutory power to benchmark and compute arm's-length prices, such adjustments create measures of income only for domestic assessment purposes and cannot expand the scope of taxable income beyond what the DTAA permits. Where the DTAA limits taxation of a category of income (here, interest) to cases of payment, the domestic TP machinery cannot be used to attribute notional items as taxable contrary to the treaty. Article 3(2) permitting reference to domestic definitions is qualified by 'unless the context otherwise requires'; here the context (use of 'paid') requires the ordinary/treaty meaning and forecloses importing accrual concepts from domestic law. Ratio vs. Obiter: The conclusion that TP adjustments must satisfy treaty chargeability conditions is ratio as applied to the facts. Statements emphasising that Chapter X is not a charging provision constitute binding reasoning within the scope of this issue. Conclusion: Domestic transfer-pricing adjustments cannot be used to tax notional interest where treaty text limits taxability to interest 'paid'; the treaty prevails where it is more beneficial, and the TPO's arm's-length add-back does not, by itself, create treaty-taxable income absent payment. Issue 3 - Use of domestic law definitions (Article 3(2)) to interpret 'paid' in Article 11 Legal framework: Article 3(2) of the DTAA permits domestic law to be referred to for undefined terms 'unless the context otherwise requires.' The Income-tax Act taxes interest on accrual/when it becomes due under domestic law. Precedent treatment: Courts have rejected invocation of domestic accrual concepts to re-characterise treaty terms where the treaty context and wording indicate a different meaning; tribunal and High Court authorities interpreting similarly worded treaty provisions have preferred the treaty/ordinary meaning of 'paid'. Interpretation and reasoning: The Court holds that Article 3(2)'s permissive cross-reference to domestic law is inapplicable where the treaty context indicates a specific, restrictive criterion (i.e., 'paid'). Because the treaty deliberately uses 'paid,' the context requires the ordinary/treaty meaning informed by the OECD Commentary. Allowing domestic accrual definitions to displace this meaning would nullify the treaty choice and undermine the reciprocal bargain between Contracting States. Ratio vs. Obiter: The ruling that domestic law cannot be imported to treat notional accruals as 'paid' under Article 11 is ratio with respect to treaty interpretation in this context. Conclusion: Article 3(2) does not permit treating a notional, non-contractual accrual as 'paid' for the purposes of Article 11 where the treaty context indicates payment-based taxation; hence domestic accrual concepts cannot be used to justify treaty taxation of the notional TP addition. Ancillary conclusion - Application of precedents and final disposition Precedent treatment: The Court relies on earlier High Court and Tribunal decisions interpreting identically worded treaty provisions to the effect that taxation is confined to receipt/payment; such precedents are applied to the facts where the adjusted interest is purely hypothetical and neither received nor payable. Interpretation and reasoning: Given the binding nature of those precedents and the treaty interpretation principles invoked (plain meaning, OECD Commentary, Article 3(2) caveat, and Section 90(2) treaty override), the notional addition fails the treaty's threshold. Ratio vs. Obiter: The application of existing precedents to delete the notional addition is ratio and determinative of the appeal. Conclusion: The transfer-pricing driven addition representing notional interest (no contractual entitlement, no actual receipt) does not constitute 'interest paid' under Article 11 of the India-Germany DTAA and is not taxable; the adjustment is accordingly deleted. All other grounds were not adjudicated as they became academic.