In a recent judgment passed by the Authority of Advance Ruling (AAR) in the matter LMN India Limited (AAR No. 769 of 2007), it was held that payment made to a foreign company (LMCC US) in the form of interest until the conversion of bonds into equity shares, is considered as interest paid on the debt incurred by the applicant (LMN).
It is thus liable to be taxed as income of LMCC US under section 2 (28A) of the Income Tax Act, 1961, (ITA) and under article 11.2 of the double tax avoidance agreement (DTAA).
In this case, LMN, a non-banking financial company incorporated in India, for the purpose of funding its business activities, proposed to borrow money from LMCC US by issuing fully convertible bonds under the foreign direct investments scheme.
LMN and LMCC US entered into a bond subscription agreement where the bonds were to be treated as debt securities before their conversion into equity shares.
According to the agreement, by virtue of conversion, there would be a constructive payment of borrowed money to the bond holder, i.e. LMCC US, and the interest on the bonds would be payable irrespective of whether LMN was profitable or not.
The questions relating to LMCC US’ tax liability in India include (a) whether the interest payable to LMCC until the date its bonds were converted into equity shares could be treated as interest on debt incurred under section 2 (28A) of the ITA and under article 11 of the India-US DTAA; and (b) whether the interest should be treated as dividend income of LMCC US and therefore exempt under section 10(34) of the ITA.
Another issue was whether LMN was liable to deduct tax at source (TDS) under the section 195(1) of the ITA, dealing with non-resident taxation.
Addressing the first issue, AAR drew references to various provisions of the agreement that clearly indicated that the parties had treated the payment to LMCC US as interest.
According to the agreement, the bonds were to be converted into equity shares at the end of five years from the date of issue, unless extended for a further period of five years. The interest on the bonds would be payable by LMN in rupees in cash on a half yearly basis, whether LMN made a profit or not.
The agreement also stipulated that the registered bond holders should be entitled to the payment of interest in their name and that all payments of interest would be subject to withholding tax, at the applicable rate.
Furthermore, it is specified in the agreement that LMCC US would apply the amount receivable on the redemption of bonds, by subscribing to fully paid up equity shares of LMN.
Prior to conversion, LMCC US would not be entitled to the rights of equity shareholders, such as voting rights.
According to the AAR, the payment of interest presupposes money borrowed, or incurring of a debt. The AAR held that the issuance of debentures was a common commercial form of borrowing money and raising funds and therefore, in this case, the interest was related to the debt incurred by LMN.
Repayment through the issue of equity shares, instead of cash payments, did not alter the legal character of the debt and the interest allied with it.
The AAR also maintained that under section 2 (28A) of the ITA, interest payable in any manner on any kind of money borrowed or debt incurred was interest and liable to be taxed. Under article 11.2 of the India-US DTAA, income arising from any kind of debt claim is classified as interest.
Taxability of interest paid
Addressing the second issue, the AAR held that that interest paid to LMCC US on fully convertible bonds could not be construed as dividend income because dividend income could arise only from shares held in the company.
In the present case, LMCC US would become shareholders only when the bonds were converted into shares. Furthermore, dividends can only be paid out of profits, whereas in the present case, as stipulated in the agreement, interest was payable to LMCC US, irrespective of LMN’s profitability.
Therefore, interest paid up to the date of the conversion of bonds was liable to be taxed in India and withholding tax, in terms of section 195(1) of the ITA, was required to be deducted from the payment of interest to LMCC US.
Sumes Dewan is a partner and Shradha Puri is a senior associate at KR Chawla & Co Advocates & Legal Consultants. The firm is headquartered in New Delhi and has offices in Chennai and Bangalore as well as a representative office in Singapore.
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