TaxTMI 
TaxTMI 
2010 (11) TMI 589
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....ssessee company had an issued and fully paid up capital, at the relevant point of time, of BEF (Belgian Francs) 2,500,000 divided into 2,500 shares of BEF 1,000 each. Out of this equity capital of 2,500 equity shares, 60 per cent equity shares, i.e. 1,500 shares, were held by N.V. Besix SA, Belgium, and the remaining 40 per cent equity shares, i.e. 1000 shares, were held by Kier International (Investments) Limited, United Kingdom. These two shareholders thus own the equity shares in the ratio of 60:40. The total share capital was thus approximately US $ 83,334 or Rs. 38,20,000 (Approximate amount based on inputs from www.coinmill.com/BEF_calculator.html). The assessee also raised the capital by resorting to borrowings from the shareholders, Rs. 57,09,18,579 from NA Besix SA and Rs. 37,01,55,921 from Kier International (Investments) Limited, which was in the same ratio in which equity was held by the shareholders i.e. 60:40. This debt, as stated by the assessee, was raised by the permanent establishment directly from the shareholders, and not routed through the assessee company's head office. The assessee thus had an equity capital of Rs. 38 lakhs approximately, and a debt capital o....
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....nal debts and receivables should continue generally, subject to special problems of banks". A reference was also made to Klaus Vogel's oft quoted commentary 'Klaus Vogel on Double Taxation Convention' which observes that "it is undisputed the head office cannot charge interest for providing its permanent establishment with the necessary allotment of capital and other assets". The Assessing Officer also referred to OECD discussion draft on "Attribution of Profits to Permanent Establishment" which, broadly speaking, recognized the fact that a permanent establishment cannot be funded solely by debt capital. It was further observed that the Reserve Bank guidelines also recognize that expenses of the Indian office are to be met out of 'capital infusion' or remittance from head office, except in the case of banks where also some limitations have been placed. The Assessing Officer thus concluded as follows: In view of the above discussions, it is evident that, as per the provisions of Income-tax Act, provisions of the Double Taxation Avoidance Agreement between India and Belgium, present international consensus in this regard and also in view of specific guidelines of Reserve Bank of Ind....
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.... Member, the coordinate bench explained the scheme of the Act as follows : Under section 4 of the Act, it is total income of every 'person' which is taxable. Section 2(31), in turn, defines 'person' as including a 'company', which in terms of the provisions of section 2(23A), includes a 'foreign company' as well. Section 6(4) of the Act lays down that a company, unless it is an Indian company or unless it is controlled or managed entirely from India, cannot be said to be resident in India. A foreign company, which is not wholly controlled or managed in India, is therefore a non-resident so far as residential status under the Act is concerned. Section 5(2) further lays down that as far as a non-resident assessee is concerned scope of total income of such an assessee is confined to (i) an income which 'accrues or arises in India' or is 'deemed to accrue or arise in India' and (ii) an income which is received or is deemed to be received by or on behalf of such foreign company. This elementary analysis makes it clear that under the Income-tax Act, so far as foreign companies are concerned, taxable unit is a foreign company and not its branch or permanent establishment in India, even t....
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....s like this. Its taxability in India in respect of profits of such PE is limited to only such profits as accrue or arise in India, or are deemed to accrue or arise in India. As regards the income accruing or arising in India, as observed by the Hon'ble Supreme Court, "an income which accrues or arises to a foreign enterprise in India can be only such portion of income accruing or arising to such a foreign enterprise as is attributable to its business carried out in India" and "since there is no specific provision under the Act to compute profits accruing in India in the hands of the foreign entities, the profits attributable to the Indian PE of foreign enterprise are required to be computed under normal accounting principles and in terms of the general provisions of the IT Act". 11. Viewed in this perspective, in terms of the provisions of the Indian Income-tax Act, the profit of the assessee company that are liable to be taxed in India are such profits of the assessee company as are attributable to its operations in India. Since the only business carried out by the assessee is project in India, its entire profits are taxable in India and all its expenses, which are incurred to ea....
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....ed imposes a restriction on the amount of the executive and general administrative expenses which may be allowed, and that restriction is relaxed or overridden by any Convention or Agreement between that State and a third State which is a member of the OECD which enters into force after the date of entry into force of this Agreement, the competent authority of that State shall notify the competent authority of the other Contracting State of the terms of the corresponding paragraph in the Convention or Agreement with that third State immediately after the entry into force of that Convention or Agreement and, if the competent authority of the other Contracting State so requests, the provisions of this sub-paragraph shall be amended by protocol to reflect such terms. (b) However, no such deduction shall be allowed in respect of amounts, if any, paid (otherwise than towards reimbursement of actual expenses) by the permanent establishment to the head office of the enterprise or any of its other offices, by way of royalties, fees or other similar payments in return for the use of patents or other rights, or by way of commission or other charges for specific services performed or for man....
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.... by the laws of the State in which PE is situated and certain specific limitations set out in Article 7 itself. 13. One of these limitations in Article 7 is that except in the case of banking companies, interest paid to the head office is not to be allowed as a deduction unless it is towards reimbursement of actual expenses. The scheme of the treaty provides that notional intra-organization deductions are not to be allowed unless these are backed by a corresponding third party outgo, and, to that extent, deduction on the basis of hypothetical independence are restricted. That limitation does not, however, affect the assessee. It is beyond dispute that the entire borrowings are for the purposes of business of the PE, which in fact is the only business carried on by the assessee, and, that the interest claimed as deduction has been paid by the assessee to an outside party i.e., shareholders. While on this aspect of the matter, it is necessary to bear in mind the fact that a company and its shareholders have separate existence, that the contracts between a company and its shareholders are just as enforceable as contracts with any independent person [Lee v. Lee's Air Farming Ltd. [196....
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....d the mere fact that those companies are shareholders in the assessee company does not vitiate that status. As regards the second objection, as learned counsel for the assessee rightly points, that limitation, even if applicable, comes into play in respect of deductions claimed under section 37, whereas the present deduction in respect of interest on borrowings is covered by the specific provisions of section 36(1)(iii) which permits deduction in respect of "the amount of the interest paid in respect of capital borrowed for the purposes of the business or profession". It is, therefore, not even necessary to examine whether or not the interest paid by the assessee company was in violation of Reserve Bank of India guidelines. 17. The above objections raised by the revenue authorities are, thus, not sustainable in law. The amount paid by the assessee, towards interest on borrowings for the purpose of business of the assessee, is thus deductible in computation of profits of the assessee which are exigible to tax in India. There is one more objection to this deduction, and this objection is on the conceptual plane rather than on PE profit determination mechanism in domestic law or in t....
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....nced by a disproportionate ratio of debts. In order to protect themselves against such erosion in their legitimate tax base, several tax jurisdictions enact rules to counter this vulnerability and these rules are termed as 'thin capitalization rules'. 20. It is for this background that many jurisdictions take several legislative anti-abuse measures including limiting deduction on interest when the company is considered to be too highly geared under applicable tax regulations. India has woken up now to neutralize this kind of manoeuvring and the Direct Taxes Code Bill, 2010, does seek to provide a legislative framework for remedial measures to counter erosion of tax base by thin capitalization. Under section 123(1)(f) of the proposed Direct Taxes Code Bill, 2010 (Bill No. 11 of 2010 as introduced in the Parliament on 30th August, 2010) as a part of the General Anti-Avoidance Rule, "any arrangement entered into by a person may be declared as an impermissible avoidance arrangement and the consequences, under this Code, of the arrangement may be determined by recharacterising any equity into debt or vice versa". That is the first step taken by the India's tax administration in the dir....
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....ments into dividends both for corporate tax purposes of debtor and for withholding tax purposes, while curiously it does not recharacterize debt into equity (neither for corporate tax, nor for capital duty purposes). In certain circumstances, the Belgian GAAR may have the potential to recharacterize purported debt into equity. In that case, it also belongs to the second set of rules. 22. It is thus only under the Belgian tax laws, which inter alia restrict the interest deductions only to the extent of debt capital ratio of 1:7 in sharp contrast to the debt ratio in the present case which is 1:248, that the mode of borrowings, i.e., via GE or via PE, may have some tax implication even though at somewhat superficial level. That perhaps explains as to why the borrowings are claimed to have been resorted to by the Indian PE and not the Belgian GE directly. If these borrowings were resorted to by the Belgian GE directly, prima facie the thin capitalization rules would have restricted the interest disallowance in excess of borrowings exceeding seven times the equity capital, whereas in the present case borrowings are two hundred forty eight times the equity capital. As the capital is st....
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....in the domestic law. 113. Finally, in paragraph 3.3.3 it is stated "The Working Group recommends that in future negotiations, provisions relating to anti-abuse/limitation of benefit may be incorporated in the DTAAs also." 114. We are afraid that the weighty recommendations of the Working Group on Non-Resident Taxation are again about what the law ought to be, and a pointer to the Parliament and the Executive for incorporating suitable limitation provisions in the treaty itself or by domestic legislation. This per se does not render an attempt by resident of a third party to take advantage of the existing provisions of the DTAC illegal." [Emphasis supplied] 25. It is thus clear that merely because a suitable limitation provision in the treaty or the domestic legislation is considered desirable, and attempt are being made to legislate the anti-abuse provisions subsequently, it would not render the effort to take advantage of existing provision of the treaty illegal. We are thus unable to accept the plea of the revenue authorities, and we uphold the claim of deduction of interest, in respect of capital borrowed from the shareholders or joint venture partners, by the assessee. 26. ....
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....Avoidance Agreement provided for a particular mode of computation of income, the same should be followed, irrespective of the provisions in the Income-tax Act. Where there is no specific provision in the Agreement, it is the basic law, i.e., the Income-tax Act, that will govern the taxation of income. When no such limitation of benefits or anti-abuse provisions are set out in the tax treaty, it cannot be open to the revenue authorities to apply the anti-abuse provisions based on the Judge made law in India - which is essentially to be treated as a part of the Income-tax Act as it is based on the interpretation of provisions under the Income-tax Act, and apply the same. As observed by this Tribunal, in the case of Motorola Inc. v. Dy. CIT [2005] 95 ITD 269 (Delhi) (SB), a tax treaty is an alternative tax regime. It has to be treated as a complete code in itself, in that sense. There are thus no legally sustainable merits in learned Departmental Representative's passionate plea for invoking principles laid down by Hon'ble Supreme Court in Mc Dowell & Co. Ltd. v. CTO [1985] 154 ITR 148, which, inter alia, holds that "colourable devices cannot be part of tax planning and it is wrong to....
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....y-owned or controlled, directly or indirectly, by one or more residents of the other Contracting State, shall not be subjected in the first-mentioned Contracting State to any taxation or any requirement connected therewith which is other, or more burdensome, than the taxation and connected requirement to which other similar enterprises of that first-mentioned State are or may be subjected in the same circumstances and under the same conditions". In this view of the matter, it cannot be open to the revenue authorities to put any limitation on deduction of interest, in respect of funds borrowed by the PE, while computing income in accordance with the provisions of Article 7 of Indo-Belgium tax treaty, when no such limitations are placed on the domestic enterprise. 30. For the reasons set out above, we are of the considered view that the assesse is indeed justified in claiming deduction on account of interest paid on borrowings from its shareholders/ joint venture companies. The international consensus that the Assessing Officer has referred to is for the need of thin capitalization rules, but then just because it is desirable to curb thin capitalization, the Assessing Officer cannot....