Bombay HC rules that interest payment on debt capital cannot be disallowed in the absence of thin capitalisation rules

The Bombay High Court (“HC”) has recently delivered an important ruling on the allowability of interest expense in the hands of the taxpayer in the absence of specific thin capitalisation rules under the current law.  The ruling was delivered on the admission of an appeal by the Revenue Authorities (“RA”) involving a question on the disallowance of interest on debt in the hands of an entity having an abnormally high debt equity ratio. The HC recognized that in the absence of thin capitalisation rules in force, re‑characterisation of debt into equity capital is not permissible and

went on to dismiss this question on which its ruling was sought, by stating that there was no substantial question of law involved.

Facts of the case

·          The taxpayer, Besix Kier Dabhol SA is a company registered under the laws of Kingdom of Belgium.  It was carrying on the project of construction of fuel jetty near Dabhol in India, through a Branch Office (“BO”).  The BO was duly registered with the Reserve Bank of India (“RBI”).  By virtue of the BO, a Permanent Establishment (“PE”) of the taxpayer was constituted in India and accordingly, it was assessable to tax in respect of the profits attributable to such PE in India. 

·          The equity capital of the taxpayer was held by joint venture partners from Belgium and UK in the proportion of 60:40.  The taxpayer had raised substantial loans from its shareholders for financing the operations of the BO, because of which the debt equity ratio of the taxpayer was 248:1. 

·          During the financial year in question, the taxpayer had paid an amount of Rs 57.3 million as interest on the loans borrowed from its shareholders and since the same was in respect of the income attributable to the PE, a deduction in respect of the interest was claimed in computing the income of the taxpayer’s PE in India.

·          During the course of regular assessment proceedings, the RA disallowed the aforementioned interest on two grounds:

-       The taxpayer was restricted to borrow funds without RBI approval; and

-       The interest paid on the money lent by the Head Office (“HO”) is not allowable as deduction under Article 7(3)(b)[1] of the India-Belgium Double Taxation Avoidance Agreement (“DTAA”)

·          On appeal the Commissioner of Income-tax (Appeals) [“CIT(A)”] upheld the order of RA by stating the following:

-       Article 7(3)(b) of the India-Belgium DTAA forbids allowance of any interest paid to the HO by the PE in India as a deduction. 

-       Further, the payment of interest violates the conditions imposed by RBI.

Observations of the Income-tax Appellate Tribunal (“Tribunal”)

·          A further appeal was made by the taxpayer before the Tribunal.  In the course of the proceedings before the Tribunal, the RA had sought for the re-characterisation of debt into equity by arguing that the financial structure was actually equity capital in the guise of a debt for tax considerations and hence the same should be treated as a “colourable device” and disregarded.

·          The Tribunal rejected the RA’s contention and held that it would not be possible to apply thin capitalisation rules and disallow the interest expense. The Tribunal observed that under the current Income-tax Act, 1961 (“the Act”) in India, there were no rules with regard to thin capitalisation so as to consider debt as equity.  It is only in the Direct Tax Code Bill of 2010 that as a part of the General Anti Avoidance Rules (“GAAR”), it is proposed to introduce a provision by which an arrangement may be declared as an impermissible avoidance arrangement and may be determined by re-characterising any equity into debt or vice versa.

Being aggrieved by the order of the Tribunal, the RA had preferred an appeal before the HC.

Ruling of the HC

This order was pronounced at the time of admission of the RA’s appeal against the order passed by the Tribunal wherein one of the questions that was posed before the HC was on the disallowance of interest in the absence of thin capitalisation rules.  The HC agreed with the Tribunal’s decision that, in the absence of thin capitalisation rules in India, the assessing officer cannot disallow interest payment on debt capital.  The HC stated that there was no question of law involved on this aspect and dismissed this appeal with regard to the question.