India: Boost For Private Debt Players: No Interest Disallowance On Borrowed Funds Used For Equity Investments Till Receipt Of Dividends

Last Updated: 27 October 2014
Article by Shreyas Bhushan, Sriram Govind and Ruchir Sinha
  • Tribunal upholds that interest expenditure is not to be disallowed as per Section 14A in case of leveraged investments unless dividend income is actually received from the investment;
  • Private debt structures and leveraged acquisition structures may avoid tax hit if dividends are not declared;
  • However, uncertainty caused by contradictory decisions reveals urgent need to relook at the applicability of disallowance in such structures.

In a decision which further incentivizes structured leverage transactions, the Bangalore bench of Income Tax Appellate Tribunal ("Tribunal") in Alliance Infrastructure Projects v. DCIT1 has held that interest expenditure incurred on borrowed funds which are invested in the shares of a company cannot be disallowed unless the entity claiming such expenditure is in actual receipt of tax exempt income. The decision is a major shot in the arm for debt structured investments and importantly, comes at a time when the investment climate in India is on the rise.

BACKGROUND

Alliance Infrastructure Projects ("Alliance") is a company which had made investments in the shares of various companies as well as investments in a partnership entity (collectively referred to as the "Investments") during the assessment years 2009-2010 and 2010-2011. Alliance had also obtained loans from few of its group companies and had sought to deduct the expenditure incurred by way of interest paid on these loans from its total income. In fact, Alliance had not received any dividends from the aforesaid Investments for the concerned assessment years. However, the Assessing Officer ("AO") held that the loans taken by Alliance had been utilized to make Investments, the income (dividend) from which would be tax free income, and hence disallowed the interest expenditure claimed by it as per Section 14A of the Income Tax Act ("ITA").

Section 14A of the ITA essentially mandates that no deduction shall be allowed in relation to any expenditure incurred for earning income which is exempt from tax in India in a particular assessment year. The modalities surrounding the disallowance under Section 14A are further explained in Rule 8D of the Income Tax Rules, 1962 ("Rules"). This provision is of special relevance in case of borrowed funds being used for the purpose of acquiring equity shares to set up a parent-subsidiary relationship where dividend pay-outs are expected. This is because dividends are taxed out of the distributable profits in the hands of the subsidiary and not in the hands of the parent. On this basis, the tax authorities have taken the view that interest expenditure incurred in respect of the loan used for the purpose of acquiring shares should be disallowed under Section 14A since the shares lead to dividend pay-outs and dividends are 'exempt' in the hands of the parent (although taxed in the subsidiary's hands).

In the present case, the disallowance was made by the AO based on the following grounds:

  • That the interest expenditure incurred by Alliance during the concerned assessment years was not directly attributable to any particular income or receipt of any income [as per rule 8D (2) (ii) of the Income Tax Rules, 1962 ("Rules")] ("Disallowance 1");
  • That the income which may arise from the Investment made by Alliance will in any case not form part of the total income of Alliance which will be taxable [as per rule 8D (2) (iii) of the Rules] ("Disallowance 2").

On appeal, the Commissioner of Income-Tax (Appeals) ("CIT(A)") found that Alliance, in addition to the funds which it had borrowed from its group companies, also had interest free funds in excess of the Investments amount. As a result, the CIT(A) held that when there exists a mixed pool of funds, i.e. (i) funds on which interest is to be paid and (ii) interest-free funds, the presumption was that investments would be made out of interest-free funds. Therefore, the CIT(A) deleted the Disallowance 1 made by the AO; but insofar as the Disallowance 2 was concerned, the CIT(A) held that the AO's decision was correct on the basis that the relevant provision does not give scope for any other interpretation.

Aggrieved by the decision of the CIT(A), cross-appeals were filed by the Revenue and Alliance respectively contesting the deletion of Disallowance 1 and the retention of Disallowance 2 respectively.

RULING OF THE TRIBUNAL

The Revenue contented that the receipt of actual income was not a mandatory pre-requisite for disallowance to be made under Section 14A. To support this, the Revenue relied on the Cheminvest case2, which had held that an assessee does not need to be in receipt of actual tax exempt income in order for disallowance to be made under Section 14A of the ITA. On the contrary, Alliance contended that the Cheminvest case does not reflect the apt position of law in this regard, and that the case has been overruled by many High Court judgments delivered post the Cheminvest case. The submission of Alliance was that the disallowance under Section 14A cannot be made unless there is actual receipt of tax exempt income.

The Tribunal, after examining several High Court judgments3 on the point, agreed with the submissions made by Alliance and held that the Cheminvest case, in fact, stands impliedly overruled. The Tribunal noted that Alliance did not receive any dividends during the assessment years involved and that it did not receive any exempt income during the period. On this basis, the Tribunal overruled the disallowances made by the CIT(A) and ruled that a disallowance under Section 14A of the ITA read with Rule 8D of the Rules can be made only upon receipt of tax exempt income by Alliance.

CONCLUSION AND ANALYSIS

While the Tribunal's decision is certainly a positive development, there is still a sense of ambiguity surrounding the application of Section 14A of the ITA. Despite several judgments holding that a disallowance under Section 14A can be made only upon receipt of tax exempt income, a recent CBDT circular4 has stated that disallowance under Section 14A can be made even where the taxpayer has not earned any exempt income during a particular year. Nonetheless, judicial authorities across the country have unanimously decided in favour of the taxpayers in this regard and the Tribunal following t he same in the present case is a most welcome trend.

However, it is important to note that the Tribunal has failed to address the larger question as to whether a disallowance under Section 14A read with Rule 8D is warranted at all in case of investments in shares of a company. Section 14A of the ITA was introduced by the Finance Act, 2001 primarily to ensure that taxpayers do not reduce their tax liability by claiming expenditure on certain categories of income which are completely tax exempt, such as agricultural income.5 However, the broadly drafted wording of the provision has meant that the tax department has used the provision indiscriminately to disallow any expenditure in earning of any income which may be characterized as exempt in the hands of the taxpayer. Therefore, this provision i s increasingly being used by the revenue authorities to disallow expenditure incurred in respect of investment in equity of a company on the ground that dividends are now exempt in the hands of the shareholder, foregoing the fact that dividends are subject to tax at the company level.

It is an accepted canon of tax law that each transaction should only be taxed once, so as to avoid 'economic double taxation'.6 Therefore, it may be noted that dividends are made exempt in the hands of the shareholder purely because they are made taxable at the company level. In such a situation, it is hard to understand how expenditure incurred in relation to investment in shares may be termed as expenditure incurred to earn 'exempt income' since dividend income is bound to be taxed at one level. This position is even more difficult to understand in case of an investment in unlisted equity shares since a later disposal of the shares may lead to taxable capital gains income in the hands of the shareholder.7

Private debt leverage is being increasingly used by foreign players in the real estate, infrastructure, IT and ITES industries for tax-efficient up-streaming of money from India since up-streaming by way of dividends is subject to dividend distribution tax, which may not be creditable in the foreign jurisdiction (please see our research paper on Private Equity and Private Debt Investments in India here for more details). Section 14A of the ITA is extremely significant in private debt transactions and structured leverage transactions since the use of borrowed funds to acquire equity may result in large interest disallowances, which is a major commercial consideration for market players. In this context, the present decision provides respite to the taxpayer to the extent that interest may not be disallowed for the years in which dividend has not been declared. Therefore, taxpayers who seek to retire equity for debt for more efficient up-streaming may rely on this position and claim deductions so long as dividends are not declared. Further, listed market promoter financing structures where debt in the form of non-convertible debentures is used to purchase equity in listed companies and returns are serviced as a function of the underlying equity pricing (in a quasi-PIPE model) which are prevalent in the market today have been blessed as per the present case from a tax perspective until dividends are declared.

However, as discussed earlier, Section 14A seems to be achieving an object which is beyond the scope for which the provision was introduced. One can only hope that in light of the object and purpose of the provision, clarifications are introduced to the extent that Section 14A is allowed to be used only in cases where the transaction as such is exempt from taxation.

Footnotes

* Special assistance from Joachim Saldanha

1 ITA Nos. 220 & 1043 (BNG)/2013.

2 Cheminvest v ITO, 121 ITD 318

3 CIT v. Shivam Motors (P) Ltd., ITA No.88/2014 (All HC); CIT v. Corrtech Energy (P) Ltd., ITA No. 239/2014 (Guj HC); CIT v. Winsome Textile Industries Ltd., (2009) 319 ITR 204 (P&H);

4 Circular No.5.2014, dated 11.02.2014

5 Circular No.11/2001, dated 23.07.2001

6 See Lang, Introduction to the Law of Double Taxation Conventions, 2010, IBFD, at p. 23-25; The principle has also been upheld by the Mumbai bench of the Tribunal in Linklaters LLP v. ITO, [2010] 40 SOT 51 (Mum).

7 This logic was followed by the Delhi High Court recently in CIT v. Holcim India (P) Limited, ITA No. 299,486 of 2014 while overturning a disallowance under Section 14A.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Shreyas Bhushan
Sriram Govind
Ruchir Sinha
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions