If a foreign company pays interest on loan for carrying out operations in India it will be allowed tax exemption under the Income Tax Act, 1961, a tax tribunal has ruled.

This has put to rest uncertainties on application of Thin Capitalisation rules that allow tax authorities to reclassify excessive debt as equity and tax it.

The Mumbai Bench of the Income Tax Appellate Tribunal has ruled that interest payments by Belgium-based Besix Kier Dabhols project office for debt taken to carry out operations in India, is an allowable expense under the Income Tax Act.

The revenue department had argued that the debt of the assessee should be re-characterised as equity, but the tribunal said it was not sustainable as thin capitalisation rules do not exist in India.

It said thin capitalisation rules or general anti-avoidance measures, proposed by the Direct Taxes Code cannot be applied to transactions which take advantage of treaty provisions, on the ground that some anti-abuse provisions will be introduced in the law in the future that may render such transactions illegal.

Thin capitalisation is a situation where a higher proportion of funds are infused into a company in the form of debt rather than equity because interest paid on loans is normally deductible for calculating taxable profits, whereas dividends are paid post tax.

By holding that thin capitalisation rules and other anti-avoidance measures cannot be applied in India unless DTC is enforced, the Tribunal has put to rest the uncertainty around the application of the provisions of the proposed DTC on matters pending before various courts/tribunals. This should provide some guidance to taxpayers in India, said Pranay Bhatia,

The tribunal held that the assessee in this case earns income only from its operations in India, and thus, the income earned by the project office n India will be computed as per the provisions of the Double Taxation Avoidance Agreement (DTAA).

There was no specific provision under the I-T Act which provides for computation of profits attributable to the Indian arm of a foreign enterprise. So the income is computed under normal accounting principles and in terms of general provisions of the Act.

Thin capitalisation rules exist in the US, Poland, Hungry, Germany, the Netherlands, Russia and China. Most countries define a maximum debt to equity ratio beyond which excess interest paid is disallowed, or penalty is imposed, or interest is reclassified as debt.

While some countries limit the amount a company can claim as tax deduction on interest paid to a cross-border or related company, some disallow interest deductions above a certain level from all sources.