2010 (11) TMI 589 - AT - Income Tax

Disallowance - Interest on borrowing to shareholders - DTAA - Held that - 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, and since the only business carried on by the assessee is operations in India, its entire profits are taxable in India. - 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 . - 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. Overriding effect of DTAA provisions of provisions of Income Tax - Proposed provisions of DTC - Held that - as introduced in section 129(9) of the Direct Taxes Code Bill, 2010, which provides that notwithstanding the treaty override provisions in section 129(8) which are in pari materia with section 90(2) of the Indian Income-tax Act, 1961 the provisions of the Direct Taxes Code relating (a) General Anti-Avoidance Rule under section 123; (b) levy of Branch Profit Tax under section 111; or (c) Control Foreign Company Rules referred to in the Twentieth Schedule, shall apply to the assessee referred to in sub-section (8), whether or not such provisions are beneficial to him . - In the scheme of things, as it exists in the Indian Income-tax 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.

Issues Involved:
1. Justification of disallowance of interest paid by the assessee to its shareholders.
2. Applicability of Article 7(3)(b) of the India-Belgium Double Taxation Avoidance Agreement.
3. Compliance with Reserve Bank of India guidelines.
4. Thin capitalization and its implications on interest deduction.
5. Recharacterization of debt as equity.
6. Treaty override provisions and their relationship with domestic tax laws.

Detailed Analysis:

1. Justification of Disallowance of Interest Paid by the Assessee to its Shareholders:
The primary issue was whether the Commissioner (Appeals) was justified in sustaining the disallowance of interest paid by the assessee to its shareholders, N.V. Besix SA Belgium and Kier International (Investments) Ltd., UK, aggregating to Rs. 5,73,90,519. The assessee argued that the borrowings were from the shareholders and not the head office, and thus, disallowance under Article 7(b) of the India-Belgium Double Taxation Avoidance Agreement should not apply. The Assessing Officer, however, viewed these payments as non-deductible under both the Income-tax Act and the Double Taxation Avoidance Agreement.

2. Applicability of Article 7(3)(b) of the India-Belgium Double Taxation Avoidance Agreement:
Article 7(3)(b) of the India-Belgium Double Taxation Avoidance Agreement was pivotal in this case. The Tribunal noted that the profits liable to be taxed in India are those attributable to the operations in India. The interest paid to shareholders was seen as a legitimate business expense, deductible under both the Indian Income-tax Act and the Double Taxation Avoidance Agreement, provided it was not an internal and notional charge. The Tribunal concluded that the interest paid to shareholders, being independent outside parties, did not fall under the restrictions of Article 7(3)(b).

3. Compliance with Reserve Bank of India Guidelines:
The Assessing Officer and the Commissioner (Appeals) had disallowed the interest deduction partly on the grounds that it violated Reserve Bank of India guidelines. However, the Tribunal found that this objection was not sustainable in law. The interest deduction was covered by section 36(1)(iii) of the Income-tax Act, which permits deduction of interest paid on capital borrowed for business purposes. Thus, the alleged violation of RBI guidelines did not affect the deductibility of the interest.

4. Thin Capitalization and Its Implications on Interest Deduction:
The Tribunal addressed the concept of thin capitalization, where a company is financed more by debt than equity. The revenue authorities argued that the debt-equity ratio of 248:1 indicated thin capitalization, and thus, the interest should not be deductible. However, the Tribunal noted that India did not have thin capitalization rules at the relevant time, and therefore, the interest paid on borrowings could not be disallowed on this basis.

5. Recharacterization of Debt as Equity:
The revenue authorities contended that the borrowings were essentially equity brought in the garb of debt for tax considerations. The Tribunal rejected this argument, stating that without specific thin capitalization rules in India, it was not permissible to recharacterize debt as equity for tax purposes. The Tribunal emphasized that the existing legal framework did not support such recharacterization.

6. Treaty Override Provisions and Their Relationship with Domestic Tax Laws:
The Tribunal highlighted that under section 90 of the Indian Income-tax Act, the provisions of a tax treaty override domestic tax laws unless the latter are more beneficial to the assessee. The Tribunal referred to the Supreme Court's judgment in the case of Union of India v. Azadi Bachao Andolan, which underscored that the absence of anti-abuse provisions in the treaty or domestic law does not render the treaty provisions inapplicable. Therefore, the Tribunal held that the interest paid by the assessee was deductible under the treaty provisions, and the revenue authorities could not apply domestic anti-abuse provisions in contravention of the treaty.

Conclusion:
The Tribunal allowed the appeal, directing the Assessing Officer to delete the disallowance of interest paid by the assessee to its shareholders. The Tribunal's decision was based on the interpretation of the India-Belgium Double Taxation Avoidance Agreement, the Indian Income-tax Act, and the absence of thin capitalization rules in India at the relevant time. The Tribunal emphasized the principle of treaty override and the need for specific legislative provisions to address thin capitalization and other anti-abuse measures.

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