Interest paid directly to shareholders by taxpayer’s PE is allowable as a deduction while computing taxable profits of PE in India.

The taxpayer, a Belgian company, was constituted as
a joint venture (between Belgium and UK shareholder contributing to equity
capital in 60 : 40 ratio). It was set up for construction of a fuel jetty in
India. The operations were intended to be carried out through the taxpayer’s
project office (PE in terms of Article 5 of DTAA) situated in India. To fund the
project, taxpayer raised debt funds from its two shareholders, in the same ratio
as their equity stake in the JV i.e., 60 : 40. The loan resulted in
significantly high debt-equity ratio of 248 : 1 for the taxpayer.

The taxpayer claimed interest payments on such
borrowed funds as deductible expense in computing profits of PE.

Relying on Article 7(3)(b) of the DTAA, the Tax
Authority, disallowed the interest payments by equating the same to payments
made by a branch to its HO.

On the following grounds, the ITAT held that
interest paid directly to shareholders would be allowable as a deduction :

(i) The taxable entity is the Belgian company
(i.e., taxpayer) and not the Indian PE, even though tax liability of the
taxpayer is confined to profits attributed to its PE in India.

(ii) The profits attributable to the Indian PE
are required to be computed under normal accounting principles and in terms of
general provisions of the ITA. This accounting approach has been approved by
the Supreme Court in Hyundai Heavy Ind Ltd.2

(iii) Since the only business carried out by the
assessee is the project in India, its entire profits are taxable in India and
all expenses incurred to earn such income are deductible in computing its
taxable income.

(iv) A company and its shareholders have a
separate existence as well as identity and contracts between a company and its
shareholders are just as enforceable as contracts with any independent person.
The limitation contained under Article 7(3)(b) restricts deduction for
interest paid to HO (except for banking companies), unless it is for
reimbursement of actual expenses. In the current case, interest has been paid
to an outside party i.e., shareholders. Hence, the limitation in Article
7(3)(b) cannot apply.

(v) Thin capitalisation rules have been resorted
to by various jurisdictions in order to protect themselves against erosion in
their legitimate tax base by financing a disproportionate ratio of debts.
Belgium also has thin capitalisation rules which restrict interest deduction
if the debt-equity ratio exceeds 1 : 7. In India, the proposed DTC 2010 seeks
to provide for remedial legislative framework to counter erosion of tax base
under General Anti-Avoidance Rules (GAAR) by permitting re-characterisation of
debt into equity. Currently however, India does not have any thin
capitalisation rules and there cannot be adverse implications on that count.

(vi) Merely because a suitable limitation
provision is considered desirable and attempts are being made to legislate
anti-abuse provisions, it would not render the effort to take advantage of
exiting provision of the DTAA illegal.