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Companies can use legal financial structures to save tax: ITAT
November, 15th 2010

In a ruling that will have a bearing on foreign companies operating in India, a Mumbai-based tax tribunal has held that tax-planning carried out within the provisions of law cannot be construed as a structured transaction carried out only for the purpose of evasion of taxes, even if the transaction helps the taxpaying company save taxes.

In its November 10 order, a division bench of the Income-Tax Appellate Tribunal (ITAT), Mumbai, comprising NV Vasudevan and Pramod Kumar, held that the finance structure used by the taxpayer had to be specifically prohibited for it to be illegal.

As long as the finance structure adopted by the taxpayer is not specifically prohibited by the applicable tax treaty provisions and as long as there are no specific anti-abuse provisions, the effect of the finance structure cannot be ignored.

Sanjay Sanghvi, tax partner of Khaitan & Co said: This is a significant ruling by ITAT. The tribunal has observed that when there are no anti-abuse provisions in the treaty concerned, it is not open to the tax authorities to apply general anti-avoidance rules of the I-T Act to deny a tax benefit to a foreign company.

The ITAT order was on an appeal filed by the Belgium company, Besix Kier Dabhol SA. The company, which has a permanent establishment (PE) in India, was engaged in the construction of a fuel jetty near Dabhol. The company, with a share capital of Rs 38 lakh, was owned by two foreign companies who had advanced Rs 94-crore loan.

Hence, the debt-equity ratio was an abnormal 248:1. The company paid Rs 5.73 crore as interest on the loans advanced to it by the lenders, and claimed this as deduction. This deduction was the bone of contention.

The assessing officer did not allow the deduction, saying the debt-equity ratio was abnormal and, therefore, the loan had to be treated as capital/loan taken from the head office. Borrowing from shareholders is tantamount to borrowing from the head office. Under the domestic tax laws, payment of interest on such borrowings do not constitute admissible deductions as these payments are from self to self, the officer held.

The officer held that the RBI had approved the PE on the condition that it should not borrow. Therefore, the loan was in contravention of law and the deduction of interest could not be allowed. The abnormal debt-equity ratio attracted thin capitalisation rule, a ground for treating debt as equities, the officer said.

After examining the finance structure, ITAT said since the company is taxable in India on the profit made in India, it is eligible for deduction on expenses incurred for generating the profit. It said the thin capitalisation rule, in existence in other countries, is not a law in India, except it being mentioned in the proposed Direct Tax Code. Also, the Indo-Belgium tax treaty did not have anti-treaty abuse provisions.

ITAT stated: It is also possible that tax consideration may have played a role in assessees planing the capital structure but an element of planning in structuring capital does not transform a tax deductible expense of interest into an expense that is non-tax deductible.

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