TaxTMI 
TaxTMI 
2023 (6) TMI 24
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....ss of Rs.3,14,904 and book loss of Rs.32,72,23,395 u/s 115JB. The case was selected for scrutiny under CASS and statutory notices were duly served on the assessee. 3. Since the assessee had international transactions with its AE i.e., Emirates Dubai and M/s. Flight Training Mauritius, the case was referred to TPO for computation of arm's length price (ALP) with respect to the international transactions carried out by the assessee. 4. The TPO proposed an adjustment of Rs.7,41,69,020 in respect of payment of interest of 15% on compulsorily convertible debentures (CCDs) using CUP as the most appropriate method and treating the ALP as NIL. The AO passed a draft assessment order incorporating the TP adjustment. Aggrieved, the assessee filed objections before the DRP who upheld the adjustment made by the TPO. The assessee is in appeal before the Tribunal against the final assessment order pursuant to directions of DRP. 5. The assessee raised various grounds with regard to the following issues:- Ground 1 - General Ground 2 (2.1 to 2.11) - TP adjustment with regard to payment of interest on CCDs by recharacterising the CCD as equity and redetermining the ALP. Ground 3 - Set off ....
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....f 15% interest on the funds borrowed'as detailed in the TP order dated 29.1.2013. The total payment of Rs. 7,68,26,983 was treated to be at Arm's length by the appellant in its TP Study by comparing it with 4 uncontrolled comparables (though of multiple years) by CUP method. However, the TPO was of the view that the comparison with non-convertible debentures of years other than the relevant FYs was not valid comparisons and therefore, the ALP determined by the appellant on the interest paid was rejected by the TPO. Also, the TP Officer examined whether the 'interest' paid of Rs. 7,68,26,983 was in the nature of `interest' at all. The Assessing officer concluded that the CCDs were actually equity and not debt since it was compulsorily convertible to equity shares and that the Reserve Bank of India also recognised CCDs as equity instruments. Also, the TPO was of the view that the appellant had junk credit rating, having no operating income or source of cash flow to service the interest payable at 15% and that no third party would make investment in CCDs and that the arrangement amounted to this capitalisation. Holding this, the amount of Rs. 7,68,26,983 was held t....
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.... Officer as detailed in the order dated 29.1.2013. ii) Whether borrowing is debt or equity; Whether thin capitalisation rules apply? The Assessing Officer has in effect held that CCDs amount to equity, and that the case is of thin capitalisation as the appellant has shown the funds as debt rather than equity although, the debt equity ratio has not been discussed in the order of the Transfer Pricing Officer. In the case of Besix Kier Dabhol, SA vs DDIT (I Tax),Circle3(2), Mumbai, ITAT, Mumbai in their order in ITA No.4249/Mum/07 dated 20.11.2010 have held on similar facts that in absence of specific thin capitalisation rules in India, re - characterisation of debt capital as equity capital and accordingly disregarding the interest payments as tax deductables is not in order. Drawing support from the above, I hold that the conclusion of the AO that the CCDs is equity and that interest payment is not allowable cannot be upheld. iii) Whether rate of interest charged is at arm's length? It is on record that the funds which have been raised by the appellant through CCDs and have been utilised for the business of the appellant. The appellant has paid 15% as the rate of int....
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....eing fundamentally different, it is often more advantageous in international context to arrange financing of a company by loan rather than by equity. It does affect the legitimate tax revenues of the source country in which business is carried out because while dividends and interest are generally taxable at the same rate in the hands of the recipient in the source country, e.g. under India Belgium tax treaty WHT rate on interest, other than bank interest, as also dividend is at uniform 15 per cent, interest is tax deductible and that results in lower corporate taxes in respect of PE profits. These tax benefits could be further optimized by hybrid financing instruments such as profit participating loans, convertible loans or where instrument is treated as debt in the source country of the income (i.e. resulting in tax deductible interest) and as equity in the residence country of the lender (i.e. where lender may claim the participation exemption of interest income because of its characterization as distribution of profits). That is how tax considerations at times do result in a company being too thinly capitalized, or, to put it differently, financed by a disproportionate ratio of....
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.... ratio is considered a non-deductible business expense [art. 198(11) IR/WIB]. In a 2008 IBFD publication "International Tax Planning and Prevention of Abuse" (by Dr Luc De Broe : ISBN 978-90-8722-035-08; @ p. 502), these thin capitalization rules are summed up as follows : "Belgium has five domestic law provisions that are relevant for the discussion of thin capitalization, i.e. art. 26 BITC; art. 54 BITC; art. 198, 11° BITC, art. 18, 4° BITC and the Belgian GAAR. Articles 26, 54 and 198 belong to the first group of aforementioned rules. The deduction of interest is denied if the statutory conditions for deductibility are not satisfied. Articles 26 and 54 are not concerned with the question whether the borrower is undercapitalized but only whether the interest charged is at arm's length. Excessive interest (i.e. interest charged above the prevailing market conditions) is not deductible. Article 198, 11° is concerned with undercapitalized companies. Interest is not deductible if the statutory 7 : 1 debt/equity ratio is exceeded. Article 18, 4° BITC belongs to second group of aforementioned rules; it re-characterizes certain interest payments into dividends bot....
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....les, in India. 23. The question then arises whether even in the absence of any specific thin capitalization rules in India, it could be open to the Revenue authorities to re-characterize the debt capital as equity capital and, accordingly, disregard the interest payments as tax deductibles. 24. We find guidance from Hon'ble Supreme Court's judgment in the case of Union of India & Anr. vs. Azadi Bachao Andolan & Anr. (2003) 184 CTR (SC) 450 : (2003) 263 ITR 706 (SC) wherein their Lordships have, inter alia, observed as follows : "111. In para 3.3.1 after noticing the growing practice amongst certain entities, who are not residents of either of the two Contracting States to try and avail of the beneficial provisions of the DTAAs and indulge in what is popularly known as 'treaty shopping', the report says : '3.3.1 ..there is a need to incorporate suitable provisions in the chapter on interpretation of DTAAs, to deal with treaty shopping, conduit companies and thin capitalization. These may be based on UN/OECD Model or other best global practices.' 112. In para 3.3.2 the working group recommended introduction of anti-abuse provisions in the domestic ....
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.... Act, 1961. In fact the DTAAs which have been entered into by the Central Government under s. 90 of the IT Act, 1961, also provide that the laws in force in either country will continue to govern the assessment and taxation of income in the respective country except where provisions to the contrary have been made in the agreement." 27. In the case of UCO Bank vs. CIT (1999) 154 CTR (SC) 88 : (1999) 237 ITR 889 (SC), their Lordships of Hon'ble Supreme Court had an occasion to survey the judicial precedents on the question of binding nature of the CBDT circulars. After elaborately dealing with Hon'ble Supreme Court's judgments in the cases of Navnit Lal C. Jhaveri vs. K.K. Sen, AAC (1965) 56 ITR 198 (SC) and K.P. Varghese vs. ITO & Anr. (1981) 24 CTR (SC) 358 : (1981) 131 ITR 597 (SC), their Lordships concluded that the CBDT circulars inter alia can tone down the rigour of the law and such benevolent circulars are binding on the field authorities. It cannot therefore be open to a Revenue authority to disregard the CBDT circular even if it deviates from the law--as long as it is beneficial to the assessee. Thus, where a DTAA provided for a particular mode of computation....
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....), whether or not such provisions are beneficial to him". The treaty override is thus quite restricted in scope in this new paradigm. Unlike in the proposed code and in sharp contrast to this paradigm, the treaty override in the IT Act, 1961, save and except for the higher tax rate being permitted for the foreign companies, is unqualified. In the scheme of things, as it exists in the Indian IT Act, 1961, the treaty override over domestic law is much wider in scope. We cannot interpret the treaty provisions in such a manner so as to curtail, dilute or otherwise tinker with this comprehensive treaty override over the domestic tax law. 29. It is also important to bear in mind that when there are no thin capitalization rules vis-a-vis domestic thin capitalization situations and in the light of the s. 90(2) as it exists at present any attempts to neutralize thin capitalization vis-a-vis PEs of Belgian enterprise will be clearly contrary to the scheme of non-discrimination envisaged by art. 24(5) which provides that, "enterprises of a Contracting State, the capital of which is wholly or partly-owned or controlled, directly or indirectly, by one or more residents of the other Contracting ....
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.... under s. 37, does not render the interest paid by the assessee as not deductible, and it is not even necessary to examine the scope of Explanation to s. 37. It is also quite possible that tax considerations may have played a role in assessee's planning the capital structure, but an element of planning in structuring capital does not transform a taxdeductible expense of interest into an expense that is non-tax deductible. In view of these discussions, it is clear that the impugned disallowance is indeed contrary to the scheme of the law as it exists; the grievance of the taxpayer deserves to be upheld. We, therefore, direct the AO to delete the impugned disallowance." 23. As per above paras of this tribunal order, it comes out that even if Thin capitalization Principle is on Statute book of the other country, no disallowance can be made in India by applying this Principle. To this extent, we uphold the finding of CIT (A) by respectfully following this tribunal order. But the issue still remains because, the objections of AO/TPO are not merely on the basis of Thin capitalization Principle. Their basic objection is this that since the interest is paid on CCDs, this is not an i....
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....to be compulsorily converted into one equity share of the face value of Rs. 10 each at a premium of Rs. 30 per share on the expiry of 15 months from the date of allotment of the debenture. Part-B debenture was to carry an interest at the rate of Rs. 14 per annum till the date of conversion payable half yearly on 30th June and 31st December each year and on conversion. The issue in dispute in that case was regarding the allowability of expenses incurred on issue of such debentures and the issue in that case was not of interest on debentures before its conversion as in the present case. This is also an important aspect of the matter of that case that one part of the debenture was to be converted on the date of allotment of debenture itself, second part of the debenture has to be converted only on expiry of 15 months from the date of allotment of debenture and under these facts, it was held by Special Bench of the Tribunal in that case that the expenses incurred on issue of such debentures has to be considered as expenses incurred for issue of shares because it was found that first part of the debentures was to be converted into shares on the date of allotment itself and the second pa....
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.... the holders of such convertible debentures before the date of conversion. If you ask a question as to whether dividend can be paid on such convertible debentures in a period before the date of conversion or whether such holders of convertible debentures can be granted voting rights at par with voting rights of share holders during pre-conversion period, the answer will be a big NO. On the same analogy, in our considered opinion, the answer of this question is also a big NO as to whether interest paid on convertible debentures for pre-conversion period can be said to be interest on equity and interest on debentures allowable u/s. 36(1)(iii) of the IT Act. 26. Now we have to decide the second issue i.e. ALP of such interest on CCDs. We find that in the order of TPO and AO for the initial year i.e. A. Y. 2009 - 10, there is no discussion or decision on ALP aspect. Learned CIT (A) in that year has held in a very cryptic manner that 15% interest claimed by the assessee is not at arm's length because as per SBI Corporate Office Website, it is 12.25% on 01.01.2009 and 13.00% as on 10.11.2008. He directed the AO/TPO to rework the ALP at 12.62% which appears to be average of thes....