2010 (7) TMI 58 - AAR - Income Tax

Special Reserve - Section 36(1)(viii) - Tripartite Agreement - a public financial institution (corporation) and state electricity board and state government - deduction upto 20% u/s 36(1)(viii) - whether issuance of bonds and accrual of interest be held as income from Long Term Finance for the purpose of Deduction u/s 36(1)(viii)? - department contended that the direct nexus is lacking in the instant case because the income has been earned by the applicant on bonds issued by the Government of M.P. which has never taken any loan. It is pointed out that there is no real connection between the interest earned on bonds and the business of the assessee i.e. financing Power Projects - Held that - The direct link is not in any way snapped and the interest income accruing from the issue of bonds by the State Government is in our view directly and inextricably related to the long term loan provided by applicant to MP SEB to which the M.P. Government stood as a guarantor. The execution of bonds is a part of the same transaction. The guarantor assumed the position of principal debtor pursuant to the tripartite agreement. - applicant is eligible for deduction upto 20% u/s 36(1)(viii) - pre-payment premium to repay the long term loan before its maturity received by the applicant is income from long term finance for the purpose of deduction under section 36(1)(viii) - Instead of receiving interest over a long period a time as per the original loan agreement a lump sum amount has been received by the applicant in full satisfaction of its claim. - the fact that the entries were made in the accounts showing the same as other income is not really material to determine the true character of the receipt. The pre-payment premium with which we are concerned in the present application is no different from the swapping premium - answered in favor of assessee

Summary

Issues Involved:
1. Deduction under section 36(1)(viii) of the Income Tax Act for interest income derived from bonds.
2. Deduction under section 36(1)(viii) for pre-payment premium received for early loan repayment.

Issue-wise Detailed Analysis:

1. Deduction under section 36(1)(viii) for Interest Income from Bonds:
The first issue concerns whether the applicant, a public financial institution, is entitled to a deduction under section 36(1)(viii) of the Income Tax Act for interest income derived from bonds issued by the Madhya Pradesh Government in lieu of outstanding loans and interest from the Madhya Pradesh State Electricity Board (MPSEB).

Key Points:
- The applicant sanctioned loans to MPSEB, guaranteed by the Madhya Pradesh Government.
- Due to MPSEB's default, a tripartite agreement was made, where the Madhya Pradesh Government issued bonds to settle part of the debt.
- The applicant claimed that interest from these bonds should be considered as profits derived from eligible business, i.e., providing long-term finance.

Legal Interpretation:
- Section 36(1)(viii) allows a deduction for profits derived from eligible business, which includes providing long-term finance for infrastructure development.
- The Supreme Court's interpretation of "derived from" in various cases (e.g., National Organic Industries, Sterling Foods, Pandian Chemicals) emphasizes a direct nexus between the income and the business activity.

Ruling:
- The Authority ruled that the interest income from the bonds has a direct and inextricable link to the long-term finance provided to MPSEB. The settlement and issuance of bonds by the Madhya Pradesh Government were seen as part of the same transaction.
- Therefore, the interest income qualifies for the deduction under section 36(1)(viii).

2. Deduction under section 36(1)(viii) for Pre-payment Premium:
The second issue is whether the pre-payment premium received by the applicant for the early repayment of a long-term loan qualifies for deduction under section 36(1)(viii).

Key Points:
- The applicant received Rs.46.34 lakhs as pre-payment premium from Arkay Energy Limited for agreeing to the early closure of a loan.
- The premium was charged to compensate for the loss of interest over the loan period.

Legal Interpretation:
- The premium is integrally connected to the long-term financing transaction.
- The loan agreement specifically provided for pre-mature repayment, including a premium for such pre-payment.

Ruling:
- The Authority found that the pre-payment premium is directly related to the business of providing long-term finance. It is not merely incidental income but part of the profits derived from the financing activity.
- The premium is comparable to a "swapping premium," previously ruled as deductible under section 36(1)(viii) in AAR No. 758 of 2007.
- Thus, the pre-payment premium qualifies for the deduction under section 36(1)(viii).

Conclusion:
Both issues were resolved in favor of the applicant, affirming their entitlement to deductions under section 36(1)(viii) for both the interest income from bonds and the pre-payment premium. The ruling was pronounced on 23rd July 2010.