A. Taxation as per Domestic Law:
A.1. Definition of Interest
2(28A) “interest” means interest payable in any manner in respect of any moneys borrowed or debt incurred (including a deposit, claim or other similar right or obligation) and includes any service fee or other charge in respect of the moneys borrowed or debt incurred or in respect of any credit facility which has not been utilised ;
2(28B) “interest on securities” means,-
(i) interest on any security of the Central Government or a State Government ;
(ii) interest on debentures or other securities for money issued by or on behalf of a local authority or a company or a corporation established by a Central, State or Provincial Act ;
Note: Article 11 of almost all the DTAAs contain definition of the term ‘interest’ and hence the definition under the Indian Domestic law may not be the guide where there is DTAA.
A.2. Income deemed to accrue or arise in India.
9. (1) The following incomes shall be deemed to accrue or arise in India :-
(v) income by way of interest payable by-
(a) the Government ; or
(b) a person who is a resident, except where the interest is payable in respect of any debt incurred, or moneys borrowed and used, for the purposes of a business or profession carried on by such person outside India or for the purposes of making or earning any income from any source outside India ; or
(c) a person who is a non-resident, where the interest is payable in respect of any debt incurred, or moneys borrowed and used, for the purposes of a business or profession carried on by such person in India ;
Note: interest payable by Indian resident to a non-resident for using the funds in business carried on outside India shall be non-taxable in India. So, Indian companies borrowing funds from foreign banks for using such funds in projects carried on outside India, interest payable thereon shall not be taxable in India.
A. 3. Specific Provisions for rate of Tax:
|Income Tax Proviso||Provisions||Domestic Tax Rate||Rate as per DTAA|
|115A||Interest received from Government or an Indian concern on monies borrowed or debt incurred by Government or the Indian concern in foreign currency||20%||10%/15%|
|194LC||Interest received from ‘Specified Company’|
(i) in respect of monies borrowed by it at any time on or after the 1st day of July, 2012 but before the 1st day of July, 2017 in foreign currency from a source outside India,-
(a) under a loan agreement; or
(b) by way of issue of any long-term bond including long-term infrastructure bond
Payer should be “specified company” means an Indian company engaged in the business of-(i) generation or distribution or transmission of power ; or (ii) operation of aircraft ; or (iii) manufacture or production of fertilizers ; or (iv) construction of road including toll road or bridge ; or (v) construction of port including inland port ; or (vi) construction of ships in a shipyard ; or (vii) construction of dam ; or (viii) developing and building a housing project5%10%/15%194LDThe income by way of interest of a person being a Foreign Institutional Investor(FII) or a Qualified Foreign Investor(QFI) payable by any person on or after the 1st day of June, 2013 but before the 1st day of July, 2017 in respect of investment made by the payee in-
(i) a rupee denominated bond of an Indian company ; or
(ii) a Government security5%10%/15%10(23FC)any income of a business trust by way of interest received or receivable from a special purpose vehicle.
Explanation.-For the purposes of this clause, the expression “special purpose vehicle” means an Indian company in which the business trust holds controlling interest and any specific percentage of shareholding or interest, as may be required by the regulations under which such trust is granted registration
“Business Trust” has been defined to mean a Trust registered as an Infrastructure Investment Trust or a Real Estate Investment Trust the units of which are required to be listed on a recognized Stock Exchange.0%10%/15%194LBATax is to be deductible if a business trust distributes any income referred to in section 115UA being of the nature referred to in section 10(23FC) to its unit holder being non-resident or foreign company5%10%/15%
Also, Interest from Indian co. for money borrowed in INR is taxable at 40%. Further Interest from NR for its business / PE in India is taxable at 40% subject to applicable deductions and allowances.
B. Taxation as Per DTAA:
Article 11 of DTAAs is divided into six paragraphs. Paragraph 1 provides the right of taxation of interest to the state of residence of the lender. Paragraph 2 gives the restricted right to the source state to tax the interest at a fixed percentage of the gross amount. Paragraph 3 defines the expression interest. Paragraph 4,5 and 6 brings about the exceptional scenarios such as where interest paid has a relation with the permanent establishment or a fixed base and where the interest is not negotiated at arm’s length price in case where a special relationship prevails.
As per Article 11(3) interest means income from debt-claims of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtors’ profits and in particular, income from government securities and income bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures. However, this article specifically excludes the penalty charges for late payment from the purview of interest.
DTAAs generally provide the maximum rate of taxation. The rate of taxation ranges from 10% to 15%. However, DTAAs with Greece, Libya, Mauritius, Egypt leave the rate of tax to be determined as per domestic laws.
C. Specific Indian Case Laws:
- Discounting Charges- Discounting of a promissory note/export sale bills does not involve creation of a debt or coming into existence of a debtor-creditor relationship, amount of discount cannot be termed as ‘interest’ within meaning of section 2(28A) ABC International Inc. USA, In re 2011 (5) TMI 342 – AUTHORITY FOR ADVANCE RULINGS ; CIT vs. Cargill Global Trading (P.) Ltd. 2011 (2) TMI 209 – DELHI HIGH COURT
- Upfront Appraisal fees: Assessee, a statutory company establishment in U.K., was advancing loans to Indian companies – It examined creditworthiness of borrower and financial efficacy of advancing credit facilities on basis of appraisal report of applicant for loan – For carrying out appraisal it charged upfront appraisal fees irrespective of fact as to whether loan/credit facility was advanced to applicant or not. Held, Upfront appraisal fee was not interest income from a debt claim. It was debt itself. Nor can the payments be said to be service fees or other charges ‘in respect of moneys borrowed or debt incurred or in respect of any credit facility which has not been utilized’. Thus, the income on account of the upfront appraisal fees was business income DIT vs. Commonwealth Development 2012 (9) TMI 647 – BOMBAY HIGH COURT
- Unpaid purchase price as loan: In order to import certain plant and machinery, assessee company entered into agreement with foreign company. 30 per cent of price was to be paid against three bills of exchange to be drawn by non resident company and assessee was also to pay interest on said bills of exchange. ITO held that in respect of that interest, assessee would be liable to pay tax. HELD, since non-resident company could not be said to have lent amount of unpaid purchase price to assessee-company either in cash or in kind, there was no question of interest payable assessee-company to non-resident company being deemed to be ‘income’ accruing or arising from any money lent at interest and brought into India in kind. CIT v. Saurashtra Cement and Chemical Industries Ltd. 1974 (9) TMI 34 – GUJARAT High Court
- Interest on compensation: If the amount is paid as interest to a non-resident in the usual course of business, then at the time of credit of such amount to the account of the payee, or at the time of payment thereof in cash, or by issue of a cheque or draft, the payer would be bound to deduct income-tax at the rate in force. However, as observed by the Supreme Court in All India Reporter Ltd. v. Ramchandra D. Datar 1960 (11) TMI 21 – SUPREME Court when such amount becomes part of a judgment debt, it loses its original character and assumes the character of a judgment debt. Once such an amount assumes the character of a judgment debt, the decree passed by the civil court must be executed subject only to the deductions and adjustments permissible under the Code of Civil Procedure, 1908. There is no provision under the Income-tax Act or under section 195 in particular or under the Code of Civil Procedure where the amount of the interest payable under a decree was deductible from the decretal amount on the ground that it was an interest component on which tax was liable to be deducted at source. Islamic Investment Co. v. UOI 2002 (3) TMI 3 – BOMBAY High Court
- Interest on bid money: Assessee-company was under liquidation. A mill belonging to assessee-company was sold in a public auction for a sum of ₹ 4.49 crores. A sum of ₹ 57.89 lakhs was paid by purchaser in name of ‘interest’ as directed by Company Court. HELD in view of provisions of section 2(28A), to call an amount received as interest, at least one of conditions should be satisfied, namely, same should have been received as a due on account of any money either borrowed or debt incurred. Since, in instant case, amount which was agreed to be paid by way of interest as per order of Company Court, was not on account of any money either borrowed or debt incurred, same could not be treated as interest at all as defined in above provision. For purpose of assessment of income-tax, it was part of sale consideration and, therefore, said amount was to be treated only as capital gain and not income from other sources Cauvery Spinning and Weaving Mills v. Dy. CIT 2010 (7) TMI 508 – MADRAS HIGH COURT
- Interest on convertible bonds: Applicant a non-banking financial company borrowed money from LMCC, USA by issuing fully convertible bonds. HELD, Payment made to LMCC in form of interest up to date of conversion of bonds into equity shares is nothing other than interest paid on money advanced to applicant or debt incurred by it and it satisfies definition of ‘interest’ under section 2(28A) as well as article 11 of DTAA between India and USA and it is, accordingly, liable to be taxed as income of LMCC under Act and under article 11 of DTAA. LMN India Ltd., In re 2008 (10) TMI 21 – AUTHORITY FOR ADVANCE RULINGS
- Sale of Compulsory Convertible Debentures: The gains arising to a non-resident investor from sale of compulsorily convertible debentures (‘CCDs’) in an Indian company do not assume the character of interest and should be treated as capital gains. Zaheer Mauritius v. Director of Income-tax (International Taxation) -II, 2014 (8) TMI 9 – DELHI HIGH COURT
- Interest on Income tax refund: Interest on income-tax refund is to be taxed at rate of 15 per cent under Article 11(2) and not at rate of 40 per cent under Article 11(5) (as business profits) Asstt. CIT v. Clough Engineering Ltd. 2011 (5) TMI 562 – ITAT, DELHI
- Interest as capital gains: Interest received by assessee related to period prior to tendering and acceptance of shares, on account of delay in process of buy-back after public announcement, same would be considered as part of consideration received by assessee against shares tendered in open offer and would be taxed as capital gain and not as interest. Genesis Indian Investment Co. Ltd. V. CIT 2013 (8) TMI 838 – ITAT MUMBAI
- Prepayment Discount liable for TDS: Pre-payment discount given by assessee to foreign buyers in absence of any mention in purchase contract that assessee was obliged to give said discount, was in nature of interest and tax was deductible at source under section 195 (DCIT v. Kothari Food and Fragrances 2015 (1) TMI 356 – ITAT LUCKNOW
- Usance Charges: Usance charges paid to non-resident on import purchase by assessee would be considered as ‘interest’ income ACIT v. Bhavani Enterprises 2015 (3) TMI 545 – ITAT PANAJI
- Usance Interest: ‘Usance interest’ paid to non-residents by Indian company for availing credit under irrevocable letter of credit for delayed payments for purchase of raw materials is interest under section 2(28A), being an income deemed to have accrued or arisen in India under section 9(1)(v)(b) (Uniflex Cables Ltd. V. DCIT 2012 (4) TMI 190 – ITAT MUMBAI )
- Usance Interest on Ship breaking Activity: Usance interest is exempt if paid in respect of ship breaking activity and assessee was not liable to withhold tax at source. CIT v. Vijay Ship breaking Corporation 2008 (10) TMI 6 – SUPREME COURT
- Interest by Indian branch to its Head Office: Discussed in detail later:
C.1. Interest by Indian Branch to its Head Office: As amended by Finance act 2015
The issue with respect to payment of interest by branch/permanent establishment (PE) to its foreign bank/head office (HO), by the Indian PE to its HO was twofold, i.e. firstly, whether the interest paid by the Indian PE to its HO was liable to be taxed in the hands of the HO in India and whether such payment of interest would be deductible in the hands of the Indian PE.
This controversy was decided by the Special Bench of the Mumbai Tribunal in case of Sumitomo Mitsui Banking Corporation wherein the Mumbai ITAT held :Indian PE and the HO along with its other branches are the same legal entity and one cannot make profit out of self. Hence, interest paid by the Indian PE to the HO are neither taxable as income nor tax deductible as expenditure under the domestic tax law of India.
However, where the concerned tax treaty treated the PE and HO as separate entities and there existed specific provisions that enabled Indian PE to claim tax deduction of interest paid by Indian PE to HO. Hence, a deduction under the tax treaty was allowed. Nevertheless, there being no specific provision either under the domestic law or the tax treaty to charge to tax the interest being paid by the Indian PE to the HO, no such tax can be levied in India.
Position w.e.f 1.4.2015: The Finance Minister, with an intention to provide certainty, as indicated in the Memorandum to the Finance Bill, 2015, on this aspect has proposed to amend the Act to provide that, in the case of a non-resident assessee, engaged in the business of banking, any interest payable by the Indian PE to the HO or any PE or any other part of such assessee entity outside India shall be deemed to accrue or arise in India and would be chargeable to tax in addition to any income attributable to the Indian PE in India. The PE in India shall be deemed to be a person separate and independent of the non-resident assessee. Accordingly, the Indian PE shall be obligated to deduct tax at source on any interest payable either to the HO or any other branch or PE, etc. of the entity outside India. This amendment has been proposed to be brought out under section 9(1)(v) of the Income-tax Act, 1961 (the Act) by way of an Explanation and is proposed to be made applicable from the assessment year 2016-17.
The result of such an amendment can be understood from the numerical example tabulated below:
w.e.f 1.4.2015 Non-Treaty scenarioFavourable Treaty scenarioTreaty as well as non-treaty scenarioIncome of PE in India100100100Less: Interest payment to HO 2020Taxable income of the PE1008080Income of the HO-Nil20
D.1. Issues still to be Addressed: Interest payment from India
Though we have discussed so far India Income tax provisions, DTAA provisions and relevant case laws. Let us see the areas where there is no clarity as regards taxability as interest and hence present opportunity for tax planning:
a) Thin Capitalisation: Since interest unlike dividends, is generally allowed to be deducted from the company’s profit before corporation tax and since moreover, taxation of interest in the state of source is more beneficial than that of dividends, it is likely that company will prefer borrowings from shareholders’ to increase its shareholders’ contributions.
Though many countries have passed legislation designed to prevent such devices resulting in tax avoidance and particularly envisaging that interest paid be treated as dividend in cases where there appears to be thin capitalisation or under capitalisation. India is still an exception and presents opportunity to explore such option to reduce tax outflow on dividend and pay interest instead of dividend. In India, payment of dividend is liable for additional tax@18% in addition to corporation tax @ 33% on entire income. However, interest is subject to maximum withholding tax of 20% ( 10%/15% under DTAA).
However, such arrangement shall not be permissible in respect of transactions with countries which DTAAs have already a GAAR clause. Eg. DTAA with Ukraine contains anti abuse provision within Article 11- Interest itself.
Also, such transaction shall not be permissible with countries like Belgium where DTAA specifically provides that Dividend also include income even paid in the form of Interest- derived from capital invested by the members of a company other than a company with share capital which is resident of Belgium.
b) Credit card interest: Banks providing credit card facilities is different from debt created between lender and borrower. The service charges received from credit card holders on overdue payments is not interest on loan and thus amount due from card holders is not taxable as interest.
c) Credit Guarantee fees: Guarantee fees are payments for a possible future action and thus be treated as compensation for services performed rather than interest. A common practice in this regard has been to analogize the guarantee fee payment to an interest payment. There is no current Indian jurisprudence pertaining to Credit Guarantee fees.
-In the case of Container Corporation vs. Commissioner [134 T.C. No. 5 (February 17, 2010)], Vitro, Mexico Parent, did not loan money to its U.S.-based subsidiary, International. Instead, Vitro promised to pay notes issued by International in the event of a default. International paid its parent company a guaranty fee in exchange for that service. The US Subsidiary paid a guarantee fee to the Mexican Corporation and did not withhold US Income tax from the guarantee. The tax court concluded that the Guarantee fee is not interest because the Mexican parent did not make a loan to the U.S. Subsidiary and that the guarantee fees is not compensation for services because the value of the guarantee stems from the promise made, not from an applied intellectual or manual skill.
-The term interest has been defined in India to include any service fee or charge in respect of money borrowed or debt incurred. Thus, going by the definition, it can be said that the guarantee fees partakes the character of interest. However, in view of the reasoning given in Container Corporation(above) it can be argued that same is not a service fee and hence not in the nature of interest.
-Also, going by the DTAAs, guarantee fees may qualify as business income under Article 7 or Other income under Article 21 but not as interest income. Hence, guarantee fees is not taxable in India as interest income.
d) Loan from Banks - Taxation by the State of source is typically levied on the gross amount of the interest and therefore ignores the real amount of income derived from the transaction for which the interest is paid, is particularly important in the case of financial institutions. For instance, a bank generally finances the loan which it grants with funds lent to it and, in particular, funds accepted on deposit. Since the State of source, in determining the amount of tax payable on the interest, will usually ignore the cost of funds for the bank, the amount of tax may prevent the transaction from occurring unless the amount of that tax is borne by the debtor.
For that reason, many States provide that interest paid to a financial institution such as a bank will be exempt from any tax at source.
Though India allows the reduced/nil tax rate on interest paid to financial institution but such reduction is subject to approval by central government.
However, there are certain DTAAs where lower rate of taxation is prescribed where loan is taken from a bank or financial institution even without any specific approval from Government. DTAA with Mauritius provides NIL rate of taxation where interest is paid to bank carrying on bonafide banking business. And DTAA with USA/UK/Denmark/Turkey/Singapore/Philippines/Nepal/Korea provides reduced rate of taxation (10% as against general rate of 15%). DTAA with UAE provides 5% for bank and 12.5% for other entities. Thailand DTAA (10% for banks and 25% for others)
-Hence, where loan is proposed to be taken from above mentioned countries, it would be better if loan is sourced directly from foreign banks to avail lower rate of taxation and hence reduced cost of borrowing. Such loan may be guaranteed by foreign holding company for which guarantee fees may be paid which again is not taxable as interest.
Interest payment and underlying taxability of same is an area of extensive tax planning. However, these are to be determined on the basis of facts of each case.
In India, interest payment where loans are taken for infrastructure projects is taxable at much reduced rate in India(5%) and hence no application of DTAA is required.
In other cases, DTAA offers a much reduced rate of 10% for taxability of Interest in the source country.
(Author can be reached at firstname.lastname@example.org for any queries)
Thanks and best regards,
CA. Rohit Gupta
B.Com, FCA, LLB,
CIA, DISA, CertIFRS
Certificate in International Taxation(IFA)