Treaty non-discrimination overrides thin-capitalisation disallowance where interest to non-residents is treated less favourably.

Article 24(4) of the India-Denmark DTAA required interest paid by an enterprise of one state to a resident of the other state to be deductible on the same conditions as interest paid to a resident, and section 94B was held to create residence-based differential treatment because it restricted deduction only for borrowings from a non-resident associated enterprise. Article 12(7) did not sustain the disallowance because the transfer pricing order accepted the arm's length nature of the interest and the addition arose only from the EBITDA-based thin-capitalisation rule. In the absence of a treaty carve-out for thin capitalisation, the domestic restriction could not override treaty protection, and the disallowance was deleted.

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Issues: Whether disallowance of interest under section 94B of the Income-tax Act, 1961 was barred by the non-discrimination clause in Article 24(4) of the India-Denmark DTAA and whether the disallowance could be sustained on the basis of Article 12(7) of the DTAA.

Analysis: Article 24(4) requires that interest paid by an enterprise of one contracting state to a resident of the other contracting state be deductible under the same conditions as if paid to a resident of the first state. Section 94B restricts interest deduction only where the borrowing is from a non-resident associated enterprise, and no corresponding restriction applies to resident associated enterprise borrowings. The differential treatment therefore turns on residence. Article 12(7) concerns excess interest arising from a special relationship and an arm's length deviation. Here, the transfer pricing order accepted the arm's length nature of the interest and made no adjustment on that basis; the impugned disallowance arose only from the statutory EBITDA-based limitation. In the absence of a treaty carve-out for thin capitalisation, the domestic restriction could not override the treaty protection. The alternative computational objections were treated as academic once the legal ground succeeded, though the claimed concerns on EBITDA and double inclusion of non-deductible items were also found to be sustainable.

Conclusion: The disallowance under section 94B could not be sustained in view of Article 24(4) read with section 90(2) of the Income-tax Act, 1961, and the entire addition was deleted in favour of the assessee.

Final Conclusion: The appeal succeeded because the treaty-based non-discrimination protection prevailed over the domestic thin-capitalisation disallowance in the facts of the case.

Ratio Decidendi: Where a domestic interest-limitation provision discriminates against payments to non-residents but the relevant treaty does not carve out thin-capitalisation rules, the treaty non-discrimination clause prevails and the restriction cannot be applied merely on residence-based differential treatment.

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