M/S. KOLTE PATIL DEVELOPERS LTD., (ERSTWHILE:M/S. BELLFLOWER PROPERTIES PRIVATE LIMITED,),PUNE vs. DEPUTY COMMISSIONER OF INCOME-TAX, CIRCLE - 1(1),, PUNE

आदेश / ORDER PER R.S.SYAL, VP :

Total interest payment of Rs.6,32,68,595/- was claimed as deduction. The assessee was show-caused as to why the transaction of funding by the assessee through the issue of debentures be not considered as issue of shares inasmuch as it was in the nature of ‘Shareholder activity’. To support his view point, the TPO relied on definition of the term “Shareholder activity” in the OECD guidelines. The assessee submitted that its shareholders were Kolte Patil Developers Ltd. (KPDL) and Portman Holdings (Hyderabad) Ltd. holding 50.01% and 49.99% shares respectively. It was further explained that it had undertaken development and construction of the project “Margosa” in Pune which was a big project comprising of total saleable area of 10.00 lakh sq.ft. Such project started in the year 2007-08 and required further developments including acquisition of land for which funds were required. Out of various options available, the assessee decided to issue debentures to its joint venture partners. The assessee tried to controvert the notion of the TPO about the `Shareholder activity’. The TPO defended his view point of the transaction of funding as a `Shareholder activity’ by finding that the availing of funds by the assessee from its AEs was through hybrid instruments as these were convertible into shares. He further noticed that the assessee’s paid up capital was Rs.99.99 lakh with Reserves & Surplus at Rs.18.40 crore and long term borrowings at Rs.23.32 crore. Considering the assessee’s ratio of capital to borrowings at 1:23 and RBI Master Circular No.07/2009-10 dated 01-07-2009 stipulating Debt Equity ratio of 4:1 on External Commercial Borrowings (ECB), the TPO came to hold that no independent third party would have invested in the convertible debentures issued by the assessee except by way of participation in equity. He also took note of the Thin capitalization principle of having higher proportion of debt vis-à-vis equity and General Anti-Avoidance Rules (GAAR) resulting into tax avoidance. This convinced him to hold that the amount raised by the assessee in the form of debentures had a substance of equity on which no interest was payable. In reaching this conclusion, he took note of certain Tribunal orders and also the judgment of the Hon’ble Delhi High Court in CIT Vs. EKL Appliances Ltd. (2012) 349 ITR 241 (Delhi) holding that re-characterization of transactions was permissible in two circumstances, inter alia, where the economic substance of a transaction differed from its form.

The TPO, therefore, recharacterized the transactions of issue of debentures into shares and determined Nil ALP of international/specified domestic transactions of payment of Interest on debentures at Nil leading to proposing transfer pricing adjustment of Rs.6,32,68,595/-.

There are advantages and disadvantages of both the streams of funding, namely, capital and debts. However, in tax regime, their consequences are varying. Por una parte, a debt entails its service by interest, which is deductible in the computation of total income of payer, por otra parte an equity requires its service by payment of dividend, which is not only an application of income and hence not deductible but also requires the payer company to pay dividend distribution tax. The BEPS Action plan 4 notified the device of thin capitalization as a measure adopted by some related companies to erode taxation base from the concerned countries by unnecessarily opting for borrowings rather than capital so as to reduce its burden of taxation. Giving effect to the BEPS Action plan 4 and with an aim to reduce the needless claim of deduction of interest, India has introduced thin capitalization rule for the first time by means of a direct provision in the shape of section 94B by the Finance Act, 2017.

This section provides a limit of deductible interest at 30% of earnings before interest, taxes, and depreciation where payment of interest exceeds Rs.1.00 crore. In the pre-insertion era, there was no direct statutory provision for making any transfer pricing adjustment on this score. Side by side, Chapter X-A of the Act containing GAAR has also been made applicable from the 1st day of April, 2018. Starting with a non-obstante clause, section 95(1) provides that an arrangement entered into by an assessee may be declared an impermissible avoidance arrangement and the consequence in relation to tax arising therefrom may be determined subject to the provisions of this Chapter. An Impermissible Avoidance Arrangement (IAA) has been defined in section 96(1) of the Act to mean an arrangement, the main purpose of which is to obtain a tax benefit in certain situations subject to certain conditions. One of the requisites of an IAA is an arrangement lacking commercial substance, which has further been explained in section 97. Clause (a) of section 97(1) states that an arrangement shall be deemed to lack commercial substance, if `the substance or effect of the arrangement as a whole, is inconsistent with, or differs significantly from, the form of its individual steps or a part’. In other words, where the form of an arrangement differs from its substance, it can be declared as IAA. Similarly clause (d) states that an arrangement shall be deemed to lack commercial substance, if `it does not have a significant effect upon the business risks or net cash flows of any party to the arrangement apart from any effect attributable to the tax benefit that would be obtained (but for the provisions of this Chapter).’ On declaring an arrangement as IAA, the consequences, as set out in section 98 follow, as per which the transaction can be, inter alia, recharacterized. It is apposite to note that the AO cannot simply at his sweet will declare a transaction as an IAA. There is a strict procedure enshrined in section 144BA, which needs to be followed for taking recourse to the GAAR. Thus it is overt that the legislation has been provided with teeth to tackle the excess payment of interest in case of transactions of borrowing and lending between two associated enterprises specifically with section 94B and generally with the GAAR. However, it is pertinent to note that both these provisions have been brought in the statute prospectively w.e.f.1.4.2018. The TPO, for treating the assessee’s debt as equity, drew support from the assessee’s debt equity ratio in the light of the RBI’s debt equity ratio for ECBs. However, section 94B, even after insertion at a later point of time, does not prescribe any debt equity ratio as a thin capitalization rule, thereby rendering the action of the TPO meritless. Whatever is not prohibited under the Act - generally or specifically - is impliedly permissible. In the absence of any existing provision under the Act at the relevant point of time, the TPO could not have ventured to recharacterize the transaction of debt into equity.

Whereas, some countries like Austria provide for a specific debt equity ratio (4:1) only as a thin capitalization rule, others like Norway and Poland only limit the amount of interest on debts not exceeding a particular percentage of earnings before interest, taxes and depreciation etc. if deduction on account of interest exceeds a particular amount. While still some others countries like Denmark have a combination of both the debt- equity ratio as well as a cap on the deductibility of interest subject to maximum of certain percentage of a defined base, such as, profit before interest and depreciation etc. India has enshrined thin capitalization rule u/s 94B by providing a limit on the amount of deductible interest at 30% of earnings before interest, taxes, depreciation, where payment of interest exceeds Rs.1.00 crore. India has chosen not to statutorily provide any debt equity ratio as a thin capitalization rule.

Throughout the Chapter there is a focus on determining the arm’s length price of the international transaction, as has been entered. In other words, if transaction X has been entered at price A, then the emphasis is on ascertaining if the price A is at arm’s length by finding suitable comparables. There is no mandate for changing the colour of transaction from X to Y.

This Chapter does not call for redetermining the nature of transaction in a way different from what has been actually entered into between two related enterprises. It simply requires redetermining the price of the transaction actually entered into.

Thus, save and except a case falls within the purview of specific or general tax avoidance provision, the authorities cannot dub a genuine transaction as sham or anti-avoidance and proceed to disregard or recharacterize the same.

“ (a) Costs of activities relating to the juridical structure of the parent company itself, such as meetings of shareholders of the parent, issuing of shares in the parent company and costs of the supervisory board; (b) Costs relating to reporting requirements of the parent company including the consolidation of reports; (c) Costs of raising funds for the acquisition of its participations.”

This argument is sans merits. Primarily, the term “Investor” from the stand point of the person investing does not confine itself to investment in shares only but equally to debentures also. Secondly, hardly any authority is needed to emphasize that nomenclature given in any agreement cannot be decisive of the true nature of the transaction.

When the Revenue brought the matter finally before the Hon’ble High Court for consideration, their Lordships accorded their imprimatur to the Tribunal order by observing that Rule 10B(1)(a) did not authorize disallowance of any expenditure on the ground that it was not necessary or was un-remunerative.

That is how, the Hon’ble High Court set to naught the rule of `necessity’ resorted to by the authorities for making the disallowance. In the passing, it also dealt with the transfer pricing guidelines issued by the OECD providing for recharacterization of transactions only in two exceptional circumstances. Insofar as the issue before the Hon’ble High Court on transfer pricing addition was concerned, that was not made by the AO/TPO on recharcterizing the transaction of payment of brand fee/royalty. Thus the ratio decidendi of the decision is that the AO/TPO cannot determine Nil ALP of a transaction of payment of an expenditure by holding that the assessee-company did not require the service etc. for which payment was made as expenditure. On the other hand, the discussion regarding OECD transfer pricing guidelines is obiter dictum.

The focus of the Revenue in the instant case is on such first exception. It goes without saying that the obiter of a judgment of a higher forum also needs utmost respect. The first exception, which the ld. DR has vigorously accentuated, applies where the amount is, in fact, taken as equity but because of close relation between the assessee and its lender, the same has been reflected in the accounts as a borrowing or vice-versa so as to take home some tax advantage. It is in such circumstances that the apparent transaction of loan can be altered so as to bring on record the real or intended transaction of equity. It does not say that in all cases of borrowings made from related entities, it must be invariably taken as equity. If a certain sum of money was understood and accepted as a loan and also reflected in the same way, the case will not fall within the ambit of the first exception. On the facts of the extant case, we find that there is no difference in the form and substance of the transaction. The amount was raised through debentures, reflected in the same way in its accounts and then such debentures also got redeemed by the assessee company. The position would have been different, if the assessee had taken the amount as equity but reflected it only as a debenture and also eventually converted into equity after some time. All the cases relied by the Department fall in such category where the amounts were, in fact, taken as equity but not declared as such and the intention behind the apparent transaction got unearthed due to surrounding circumstances. On the other hand, we are confronted with a situation in which the assessee was in need of funding for its ongoing projects. It took loan through debentures, which were eventually redeemed. So the instant case falls in the general provision of accepting the transaction as such and not in the exception requiring recharacterization of the transaction of debt into equity. De hors the provisions of section 94B and the GAAR in the period anterior to their applicability, the obiter in the case of EKL Appliances (supra) also supports the view canvassed by the ld. CIT(A) in not approving the recharacterization of the transaction of debt into equity. Thus, the first issue raised by the Revenue in its appeal is determined against it.

The ld. CIT(A), relying on his order for the assessment year 2011-12, worked out Arm’s Length rate of interest at 13.75% on the basis of the interest paid by the assessee to its banker as a comparable uncontrolled transaction. Both the sides have come up in appeal on this issue.

417 ITR 103 (Bom). In the light of these judgments, the rate of interest to be taken into consideration for our purpose is the rate payable in India since the assessee is recipient of the loan in the form of debentures. In principle, the ld. CIT(A) is correct in taking cognizance of the rate of interest payable on borrowings in India.

The ld. CIT(A), considering the interest paid by the assessee to IDBI Bank as Internal Comparable under the CUP method, determined the ALP of interest at 13.75%. Both the assessee as well as the Revenue preferred appeals against the order passed by the CIT(A) for the assessment year 2011-12. The Revenue did not dispute the determination of the arm’s length rate of interest at 13.75% though it preferred appeal on disallowance u/s 14A of the Act. The assessee also preferred appeal against restricting the rate of interest at 13.75%, but, the ld. AR submitted that the assessee has filed application for settlement of the dispute under the Vivad Se Vishwas Scheme. It is thus vivid that the decision of the ld. CIT(A) for the assessment year 2011-12, considering internal comparable instance of interest payment by the assessee to IDBI as a benchmark, has attained finality. On a pointed query as to what rate of interest was paid by the assessee during the year under consideration on the borrowings made from IDBI Bank, the ld. AR could not point out any such rate except referring to the Sanction letter dated 07-02-2011 issued by IDBI bank enhancing the assessee’s credit facility to Rs.24.50 crore. However, on examination of the assessee’s Balance sheet for the year under consideration, a copy placed at pages 152 onwards of the paper book, it emerges that the amount payable to IDBI bank stands at Nil. This shows that the interest rate paid by the assessee to IDBI Bank that was considered as an internal comparable under the CUP method for the earlier year, is no more relevant for the year under consideration. The exercise of ALP determination has to be undertaken each year separately by considering the facts and circumstances that are relevant and germane to the issue for that particular year. Given the fact that the basis for the determination of arm’s length rate of interest for the preceding year 2011-12 does not survive and the ld. AR could not point out the rate of interest at which the assessee made borrowings from bank in the year under consideration, we are satisfied that it would be appropriate if the impugned order on this score is set-aside and the matter is restored to the file of AO. We order accordingly and direct the AO/TPO to find out the rate at which interest was paid by the assessee to its bank in the year under consideration and then apply the same as arm’s length rate for determining the ALP of the International/Specified Domestic transactions of payment of interest. Needless to say, the assessee will be allowed opportunity of hearing in such fresh determination. The cross grounds raised by both the sides on this issue are allowed for statistical purposes.

“The assessee submits that the education cess and secondary and higher education cess amounting to Rs.18,97,751/- may kindly be allowed as a deduction while computing the total income of the assessee.”

Order pronounced in the Open Court on 08th December, 2020.