2008 (10) TMI 21 - AAR - Income Tax

Applicant borrow money from LMCC, USA by issuing fully convertible Bonds - non-resident s liability - interest paid to LMCC upto the date of conversion of bonds into equity shares has to be treated as interest as per Section 2(28A) and Article 11 of the India-USA DTAA and accordingly, liable to be taxed as income of LMCC under the Act and under Art.11.2 - interest payments cannot be construed as dividend income of LMCC - Under Section 195(1), the applicant is liable to deduct tax at source

Issues Involved:
1. Classification of interest payments under the Income-tax Act and the India-USA DTAA.
2. Nature of payments as business income or expenditure.
3. Classification of payments as dividend income.
4. Obligation to deduct tax at source.

Detailed Analysis:

Issue 1: Classification of Interest Payments
The applicant, a non-banking financial company in India, entered into a "Bond Subscription Agreement" with LMCC USA to issue fully convertible bonds. The applicant sought an advance ruling to determine if the interest paid to LMCC up to the date of bond conversion into equity shares should be treated as interest on borrowed money under Section 2(28A) of the Income-tax Act and Article 11 of the India-USA DTAA.

Both the applicant and the Department agreed that the interest paid falls within the definition of 'interest' as per Section 2(28A) of the Income-tax Act and Article 11 of the DTAA. Section 2(28A) defines interest as "interest payable in any manner in respect of any moneys borrowed or debt incurred...". Article 11 of the Treaty similarly defines interest as income from debt-claims of every kind, explicitly including income from bonds or debentures.

The ruling concluded that the payment made by the applicant by way of interest is indeed interest as per the definitions under both the Income-tax Act and the DTAA. The ruling emphasized that the issuance of debentures is a mode of borrowing money, and the interest paid is directly related to the debt incurred by the applicant. The conversion of bonds into equity shares at the end of the specified period amounts to constructive repayment of debt, satisfying the definition of interest under Section 2(28A).

Issue 2: Nature of Payments as Business Income or Expenditure
The applicant questioned whether the interest payments constitute expenditure incurred in connection with raising capital or any other payment being compensation to LMCC during the pre-conversion period, which would be business income/receipts not attracting tax under the DTAA.

The ruling did not directly address this part of the question, stating that it was not concerned with the applicant's tax liability or whether the interest paid could be claimed as a deduction under Section 37 or Section 36(1)(iii) of the Act. The focus was solely on the non-resident's liability, which was clarified under Issue 1.

Issue 3: Classification of Payments as Dividend Income
The applicant inquired whether the interest payments should be treated as dividend income of LMCC, which would be exempt under Section 10(34) of the Act.

The ruling clarified that interest payments cannot be construed as dividend income. Dividend presupposes that the payee holds shares in a company, and LMCC would only become a shareholder upon conversion of the bonds into equity shares. The agreement explicitly stated that bondholders would not have any rights as shareholders until conversion. Additionally, dividends can only be paid out of profits, whereas interest is payable to the bondholder irrespective of the applicant's profit status. Hence, this question was answered in the negative.

Issue 4: Obligation to Deduct Tax at Source
The applicant sought clarification on whether it was liable to deduct tax at source under the Act in respect of the interest payments to LMCC.

The ruling confirmed that under Section 195(1) of the Act, the applicant is liable to deduct tax at source at the applicable rates, as the interest paid to LMCC is chargeable to income tax in India. The rate of tax was left open for determination by the assessing authority in an appropriate proceeding.

Conclusion
The ruling provided comprehensive answers to the questions posed by the applicant, confirming the classification of interest payments under the Income-tax Act and the DTAA, clarifying the nature of these payments, rejecting their classification as dividend income, and affirming the obligation to deduct tax at source. The rate of tax was left for future determination by the assessing authority.

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