Besix Kier Dabhol SA vs. DDIT (ITAT Mumbai)

In absence of “thin capitalization rules”, interest paid to shareholders for loans cannot be disallowed despite capital-structure tax-planning

The assessee, a Belgium company, was set up to execute a project in India and had a PE in India. The assessee’s share capital of Rs. 38 lakhs was owned by two foreign companies (shareholders) in the ratio of 60:40. The said two shareholders also advanced loans to the assessee aggregating Rs. 94.10 crores in the same ratio in which they held shares in the assessee i.e. 60:40. The assessee’s debt-equity ratio was 248:1. The assessee paid interest of Rs. 5.73 crores on the loans obtained from its shareholders and claimed that as a deduction. The AO disallowed the claim on the ground that (i) though the moneys were borrowed from the shareholders, in view of the abnormal debt-equity ratio, they were to be treated as capital / loan taken from the Head Office and (ii) that as the RBI approval did not permit the PE to borrow, the loan was in contravention of law. This was upheld by the CIT (A). On appeal by the assessee, HELD allowing the appeal:

(i) Under Article 7 (1) & 7(3)(b) of the India-Belgium DTAA, the profits of the assessee as are attributable to the PE are chargeable to tax in India. In determining such profits, all expenses are allowable subject to limitations specified in the DTAA and the Indian laws. The only limitation is that notional interest paid by a branch to its HO is not allowable. This limitation does not apply as the assessee borrowed from an outside party, i.e. its shareholders;

(ii) The argument of the revenue that the abnormal debt-equity ratio attracts the “Thin Capitalization Rule” and that the “debt” should be characterized as “equity” for purposes of considering whether interest is deductible is not acceptable. Several countries have detailed “thin capitalization rules” (e.g. Belgium). However, there are no such rules in India though the DTC 2010 has proposed this vide s. 123(1)(f). In the absence of specific “thin capitalization” rules, it is not open to the revenue to characterize debt as equity and disallow the interest (principles in Azadi Bachao Andolan 263 ITR 706 (SC) followed). The domestic law limitation of Art 7(3) refers to the Source Country & not the Residence Country;

(iii) Imposing the “thin capitalization rules” on the assessee when domestic companies are not subject to such rules will violate the “non-discrimination” provision in Art. 24(5);

(iv) The argument that the finance structure should be treated as a “colourable device” and disregarded is not acceptable because there is no anti-abuse provision in the DTAA and in the absence of specific language (such as the proposed s. 129(9) of DTC 2010), the DTAA cannot be over-ridden by the Act;

(v) The Expl to s. 37 has no application to interest allowable u/s 36(1)(iii).