Interest paid to a foreign company on convertible debentures (CDs) is like an interest taxable in India, according to a ruling by Authority for Advance Ruling (AAR), a quasi-judicial body on matters of tax.

In the order on an application filed by LMN, an Indian company, the AAR held that interest paid to the US company LMCC on fully convertible bonds cannot be construed as dividend income because dividend income can arise only from shares held in the company.

In this case, the bondholders would become shareholders only when the bonds are converted into shares. Therefore, interest paid up to the date of conversion of bonds to equity shares, are liable to be taxed in India and hence TDS has to be deducted from payment of interest to the US company.

LMNs question was whether interest payable on convertible debentures are within the definition of interest under the Income Tax Act and the Indo-US DTAA.

According to AAR, payment of interest presupposes money borrowed, or incurring of a debt. AAR said issuance of debentures is a form of borrowing money. Raising funds through fully convertible debentures is a common commercial practice and therefore, the interest in this case is related to the debt the Indian company has incurred.

Interest payment on the convertible debenture has all the characters of interest defined under the Income Tax Act and the treaty.

The mode of repayment by issuing equity shares, instead of paying in cash, does not change the legal character of debt and the interest associated with it, the AAR held. It said that under the Income Tax Act, interest payable in any manner to any kind of money borrowed is interest and liable to be taxed.

Under the provisions of the Indo American Double Taxation Avoidance Agreement too, income arising from any kind of debt claim is interest. The AAR held that payment of interest presupposes borrowing of money.