2012 (10) TMI 817 - HC - Income Tax

Deduction of Interest claimed - Held that - Borrowings on which the interest has been claimed as a deduction are in fact capital of the assessee and brought only under the nomenclature of loan for tax consideration. Debt capital is required to be re-characterized as equity capital. However, the Tribunal held that in India as the law stands there were no rules with regard to thin capitalization so as to consider debt as an equity. It is only in the proposed Direct Tax Code Bill of 2010 that as a part of the General Anti Avoidance Rules it is proposed to introduce a provision by which a arrangement may be declared as an impermissible avoidance arrangement and may be determined by recharacterzing any equity into debt or vice versa. There were at the relevant time and even today no thin capitalization rules in force. Consequently, the interest payment on debt capital cannot be disallowed As no substantial question of law is involved - Appeal is admitted

Summary

Issues Involved:
1. Whether interest payment on debt capital can be disallowed in the absence of thin capitalization rules?
2. Whether the deduction of interest claimed was under section 36(1)(iii) or section 37 of the Income Tax Act?
3. Whether the interest payment made to shareholders with a high debt equity capital ratio is allowable as an expenditure?

Analysis:

Issue 1:
The respondent-assessee, a company incorporated in Belgium, had a debt equity ratio of 248:1 and paid interest on borrowings from its shareholders. The Assessing Officer disallowed the interest payment citing RBI's approval letter and the Double Taxation Avoidance Agreement. The Commissioner of Income Tax (Appeals) upheld the disallowance, but the Tribunal allowed the appeal. The Tribunal noted the absence of thin capitalization rules in India and rejected the re-characterization of debt as equity by the revenue. The High Court affirmed the Tribunal's decision, stating that without thin capitalization rules, interest payment on debt capital cannot be disallowed.

Issue 2:
The second question pertained to whether the deduction of interest claimed was under section 36(1)(iii) or section 37 of the Income Tax Act. The Commissioner of Income Tax (Appeals) held it to be disallowable under the Double Taxation Avoidance Agreement. However, the Tribunal disagreed, and the High Court admitted the appeal on this issue for further consideration.

Issue 3:
The third question raised concerns about the deductibility of interest payment made to shareholders with a high debt equity capital ratio. The revenue argued for re-characterization of debt as equity, but the Tribunal rejected this argument. The High Court found no fault with the Tribunal's decision, emphasizing the absence of thin capitalization rules and dismissing the question as not raising a substantial legal issue.

In conclusion, the High Court upheld the Tribunal's decision regarding the disallowance of interest payment on debt capital due to the absence of thin capitalization rules in India. The appeal was admitted for further consideration on the issue of the specific section under which the interest deduction should fall and the deductibility of interest payments based on the debt equity capital ratio.