The recent Income Tax Appellate Tribunal (ITAT) Order in CAE Flight Training (India) Pvt. Ltd. (TS-440-ITAT-2019 (Bang)) clarifies how Compulsorily Convertible Debentures (CCDs) are to be treated under Income Tax Laws.
Before delving into the Order and what the ITAT said in making it, it is important to understand the legal context in which this question arose in the first place. To do this, we first need to understand the nature of a CCD. A debenture is a debt-based security that may or may not be secured against the assets of the company. Although debentures are undisputedly debt instruments, CCDs are debentures that are mandatorily converted into equity according to pre-determined terms at a pre-defined time. In the pre-conversion stage, the CCD holder is considered as a debtor by the company and is required to be paid interest on its investment. Post-conversion, the debt becomes equity capital in the company, which results in such investor earning dividends from its holdings.
Under Section 36(iii) of the Income Tax Act, 1961 (IT Act) any interest payable on capital that is borrowed to run a business is deductible from the taxable income of the person being taxed. The use of the word "borrowed" in the section is important, because it means that if the company raises money through the sale of equity, it can't claim deductions in its taxable income. However, if CCDs are considered to be debt instruments, then the money that is paid as interest on them can be deducted from the taxable income of the company, meaning a company could potentially minimise its taxes if CCDs are considered debt as opposed to equity.
And this is where the concept of Thin Capitalisation comes in. A company is said to be thinly capitalised when its debt to equity ratio is high – i.e., it has more debt than it has equity. Having a high debt to equity ratio isn't necessarily a bad thing – especially in cases where money is borrowed to finance an expensive project that could have a long gestation period before it gives returns. Because the interest paid on debt is generally tax deductible, often we see the use of 'Thin Capitalisation Norms' to prevent companies from taking advantage of this deduction to reduce tax incidence.
The Indian Thin-Cap Rules were introduced in 2017 vide Section 94B of the IT Act. Under this, in respect of interest payable to a related party situated outside India, an upper limit has been placed on the amount of deduction that can be claimed for interest exceeding INR 10 million. This is set at 30% of a company's earnings before interest, tax, depreciation, and amortisation (EBITDA).
The fact scenario in the present case we're discussing in this blog arose before the introduction of Section 94B of the IT Act. Post the insertion of this Section, any interest paid that exceeds 30% of the EBITDA of the company would not be deductible.
Broadly speaking, the facts of the CAE Flight Training case were this: the Assessee (CAE Flight Training) had paid interest at 15% on CCDs that it had issued to three related companies (non-resident) over a few years. The Assessing Officer, while evaluating these transactions, had looked at this from a Transfer Pricing perspective, and the Transfer Pricing Officer decided that this could not possibly have been an arm's length transaction since no reasonable investor could possibly want to loan money to the Assessee given its financial position at the time. He therefore regarded the CCDs as equity and not debt. Accordingly, he denied the benefit of deduction of interest paid on the CCDs. After considerable back and forth on this issue, which also spread over a few Assessment Years, the matter reached the ITAT.
The main issue that the Tribunal had to consider in this case was whether the CCDs should be considered debt or equity. In order to do this, the Tribunal looked at a number of factors as detailed below:
- While determining the arm's length price, the Revenue made the argument that the principles of Thin Capitalization Norms should be applied to the Assessee in this case, since this is one of the anti-avoidance principles that serves as a limitation on the amount of deduction that can be claimed from one's taxable income on the grounds of interest payment. The Court examined the case of Besix Kier Dabhol (ITAT Mumbai, 2010), which had dealt with this issue earlier. In the Besix case, the argument was made that although India had no Thin Capitalisation Norms at the time, they existed in Belgium, where the company itself was incorporated. Continuing on this line of argument, the Income Tax Department in Besix had argued that by virtue of its existence in Belgium, the norms should be imposed on Besix Kier Dabhol in India as well, to prevent it from deducting the interest paid on its debt from its taxable income. Scoffing at this reasoning, the ITAT in Besix said that a rule that does not exist in India cannot be artificially imposed solely on its existence in another jurisdiction, and ruled in favour of the company. In CAE Flight Training, the ITAT accepted this judgment, but went on to say that it could not blindly be used to rule in favour of the Assessee in the present case, since the Revenue had also made the argument that the nature of CCDs was not as debt but equity, based on the point discussed below.
- The Revenue also placed reliance on Reserve Bank of India (RBI) comments on CCDs under the FDI Policy. In 2007, a policy statement by the RBI had acknowledged that parties were trying to overcome FDI norms by using convertible debentures with assured buybacks (thereby effectively securing term loans for themselves without triggering the FDI Policy), and reiterated the position that fully and compulsorily convertible debentures would be deemed to be equity under the law to prevent this circumvention. The ITAT did not agree with this stance and its application under the IT Act. It said that a direction given specifically under the FDI policy could not be blindly applied in other contexts. The ITAT did not consider that the RBI's statement was binding on them for characterising the nature of CCDs.
So on what basis did the ITAT decide this case? The ITAT drew an analogy. To quote:
"If you ask a question as to whether dividend can be paid on such convertible debentures in a period before the date of conversion or whether such holders of convertible debentures can be granted voting rights at par with voting rights of shareholders during pre-conversion period, the answer will be a big NO. On the same analogy, in our considered opinion, the answer of this question is also a big NO as to whether interest paid on convertible debentures for pre-conversion period can be said to be interest on equity and interest on debentures should be allowed u/s. 36(1)(iii) of the IT Act."
Takeaway: The interest paid on CCDs is indeed deductible from the taxable income of the payer company until the CCD is converted into equity, and Thin Cap Rules cannot be invoked before they were introduced in the statute. However, since the imposition of Section 94B of the IT Act in 2017, this deduction is now capped at 30% of the EBITDA of the company – hence, foreign investors should structure their capital infusion in Indian companies accordingly.
*The authors were assisted by Associate, Aditya Karekatte
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