This write-up is based on a recent ruling of ITAT, Mumbai in case of Besix Kier Dabhol, SA vs. DDIT [131 ITD 299].

A Belgian Company opened a project office in India for the purpose of construction of Fuel Jetty. The Belgian Company did not have any other business activity except the Indian project office. The Indian project office was indisputably regarded a Permanent Establishment (PE) of the Belgian Company in India.
 
The total Paid-up Capital of the Belgian Company was only Rs 38 lakhs contributed by two shareholders. The PE of the Belgian Company, however, borrowed Rs 94 crores directly from the shareholders of the Belgian Company; in this manner the PE had a borrowing of Rs 94 crores as against a Share Capital of only Rs 38 lakhs. The PE claimed deduction of expenses on account of interest on the said borrowings against its income in India.

The Department was of the view that the payments made by the Indian PE did not constitute admissible deduction as these payments were from self to self. However, Honble Tribunal held that in the instant case interest was not paid by the Indian PE to its head office; the interest was paid to the shareholders of the parent company. It would amount as interest paid to independent outside parties.

The ITAT also observed that since the only business carried out by the assessee is the project in India, its entire profits are taxable in India and all its expenses, which are incurred to earn Indian income, are deductible in ascertainment of its taxable income.

Referring to Indo-Belgium Tax Treaty, the Honble Tribunal observed that although the treaty provides that notional intra-organization deductions are not to be allowed unless these are backed by a corresponding third party outgo, this limitation does not affect the present case because it is beyond dispute that the entire borrowings are for the purposes of the business of the PE.

Besides the above argument, the Revenue took a strong objection to allowability of interest on the ground of thin capitalization rule. It was argued that the borrowings of the assessee, on which interest has been claimed as deduction, are infact part of the capital of the assessee which is brought in the garb of borrowings purely on tax considerations. Company is so thinly capitalized that its entire debt capital should infact be re-characterized as equity capital.

Thin capitalization refers to a situation in which capital of a business is made up of a greater portion of debt than equity. This method is used as a tool in international tax planning. It is often more advantageous in international context to arrange financing of a company by loan rather than by equity. This treatment will certainly affect the legitimate tax revenue of the country in which business is carried out because interest is tax deductible and that results in lower taxes in respect of the profits of the PE of the assessee.

The Honble Tribunal after indepth analysis of the facts and law held that thin capitalization rules have not yet been introduced in India, although Direct-tax Code Bill, 2010 does contain a gist of such rules as a part of General Anti-avoidance Rule. Until and unless the rules are introduced in India, it is not open to tax authorities to re-characterize the debt capital as equity capital and make interest payment as non-deductible.

The Honble Tribunal while allowing the claim for deduction of interest paid to shareholders of the parent company did appreciate the stand taken by the Revenue but with the following curious remarks:

The Assessing Officer was clearly ahead on his times in disallowing the expenses based on his notions of thin capitalization rules, when such rules had not even reached the drawing board stage in India.

The foreign companies are however advised to keep the proposed thin capitalization rule in mind while doing business in India.