ITO, BANGALORE vs. M/S CAE FLIGHT TRAINING PVT. LTD.,, BANGALORE

IN THE INCOME TAX APPELLATE TRIBUNAL “A” BENCH : BANGALORE

BEFORE SHRI ARUN KUMAR GARODIA, ACCOUNTANT MEMBER AND SMT. BEENA PILLAI, JUDICIAL MEMBER

Assessment Appeal No. Appellant Respondent Year M/s. CAE Flight Training (India) Pvt. Ltd., The Assistant Commissioner of Income Survey No. 26/27, IT(TP)A No. Tax, Bandaramanahalli Village, 2060/Bang/2016 Circle – 2 (1) (1), Anneshwara Panchayat, Bangalore. Kasaba Hobli, Devanahalli Taluk, Bangalore – 562 110. PAN: AADCC1248A 2009-10 M/s. CAE Flight Training (India) Pvt. Ltd., C.O. No. The Assistant Commissioner Survey No. 26/27, Bandaramanahalli 83/Bang/2017 of Income Tax, Village, Anneshwara Panchayat, (in IT(TP)A No. Circle – 2 (1) (1), Kasaba Hobli, Devanahalli Taluk, 2060/Bang/2016) Bangalore. Bangalore – 562 110. PAN: AADCC1248A M/s. CAE Flight Training (India) Pvt. Ltd., Survey No. 26/27, Bandaramanahalli The Income Tax Officer, IT(TP)A No. Village, Anneshwara Panchayat, Ward – 2 (1) (1), 84/Bang/2015 Kasaba Hobli, Devanahalli Taluk, Bangalore. Bangalore – 562 110. PAN: AADCC1248A M/s. CAE Flight Training 2010-11 (India) Pvt. Ltd., Survey No. 26/27, The Income Tax Officer, IT(TP)A No. Bandaramanahalli Village, Ward – 2 (1) (1), 63/Bang/2015 Anneshwara Panchayat, Bangalore. Kasaba Hobli, Devanahalli Taluk, Bangalore – 562 110. PAN: AADCC1248A M/s. CAE Flight Training (India) Pvt. Ltd., The Deputy Commissioner of Survey No. 26/27, Bandaramanahalli IT(TP)A No. Income Tax, Village, Anneshwara Panchayat, 2011-12 599/Bang/2016 Circle 2 (1) (1), Kasaba Hobli, Devanahalli Taluk, Bangalore. Bangalore – 562 110. PAN: AADCC1248A M/s. CAE Flight Training (India) Pvt. Ltd., The Deputy Commissioner of Survey No. 26/27, Bandaramanahalli IT(TP)A No. Income Tax, Village, Anneshwara Panchayat, 2012-13 2178/Bang/2016 Circle 2 (1) (1), Kasaba Hobli, Devanahalli Taluk, Bangalore. Bangalore – 562 110. PAN: AADCC1248A M/s. CAE Flight Training (India) Pvt. Ltd., Survey No. 26/27, The Income Tax Officer, ITA No. Bandaramanahalli Village, Ward – 2 (1) (2), 2013-14 2006/Bang/2017 Anneshwara Panchayat, Bangalore. Kasaba Hobli, Devanahalli Taluk, Bangalore – 562 110. PAN: AADCC1248A

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 2 of 48 M/s. CAE Flight Training (India) Pvt. Ltd., C.O. No. Survey No. 26/27, Bandaramanahalli The Income Tax Officer, 09/Bang/2018 Village, Anneshwara Panchayat, Ward – 2 (1) (2), 2013-14 (in ITA No. Kasaba Hobli, Devanahalli Taluk, Bangalore. 2006/Bang/2017) Bangalore – 562 110. PAN: AADCC1248A : Shri P. K. Prasad & Umashankar Gautam, Assessee by Advocates Revenue by : Smt. C. H. Sundar Rao, CIT (DR) Date of hearing : 27.06.2019 Date of Pronouncement : 25.07.2019

O R D E R Per Shri A. K. Garodia, Accountant Member Out of this bunch of six appeals and two Cos. for various years, the issue involved is one and common as to whether the Compulsorily Convertible Debentures (CCDs) are debt or equity and whether interest on CCDs is an allowable expenditure and if allowable then the amount allowable is as per LIBOR or PLR. Hence all these were heard together and are being disposed of by this common order for the sake of convenience. 2. The grounds raised by the revenue for Assessment Year 2009-10 in IT(TPA) No. 2060/Bang/2016 are as under: - “1. The Ld. CIT(A) has erred in not appreciating the fact that Compulsory Convertible Debenture (CCD) are in the nature of equity and not debt. 2. The Ld. CIT(A) has erred in not appreciating the fact and circumstances brought out by the TPO to arrive at the conclusion that CCDs are in the nature of equity and not debentures. 3. The Ld. CIT(A) has erred in allowing the interest expenditure incurred for CCDs without acknowledging the TPO's conclusion that CCDs are equity in nature.”

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 3 of 48 ["Learned CIT(A)"] erred in not appreciating the fact that compulsorily convertible debentures ("CCD") are in nature of equity and not debt. 2. That the contention in the appeal filed by the revenue is bad in law while stating that the Learned CIT(A) has erred in not appreciating the fact and circumstances brought out by the Transfer Pricing Officer ("TPO") to arrive at the conclusion that CCDs are in nature of equity and not debentures. 3. That the contention in the appeal filed by the revenue is bad in law while stating that the Learned CIT(A) has erred in allowing the interest expenditure incurred for CCDs without acknowledging the TPO's conclusion that CCDs are equity in nature. 4. That the learned CIT(A) erred in rejection of comparability analysis undertaken in the Transfer Pricing documentation by the Respondent in accordance with the provisions of the Act read with the Income Tax Rules, 1962. That the Respondent craves leave to add to and/or to alter, amend, rescind, modify the grounds herein above or produce further documents before or at the time of hearing of this appeal.” 4. The grounds raised by the assessee for Assessment Year 2010-11 in IT(TP)A No. 84/Bang/2015 are as under: - “The grounds mentioned herein by the Appellant are without prejudice to one another. 1. That the order of the learned Income-tax Officer, Ward 2(1)(1), Bangalore ("Assessing Officer" or "AO") pursuant to the direction of the learned Dispute Resolution Panel (Tana), to the extent prejudicial to the Appellant, is bad in law and liable to be quashed. 2. On the facts and circumstances of the case and in law, the learned AO/ learned Panel erred in making an adjustment of INR 13,72,23,908 to the transfer price of interest paid on compulsory convertible debentures ("CCD"). 3. On the facts and circumstances of the case and in law, the learned AO/ learned Panel erred in making an adjustment of INR 13,72,23,908 to the transfer price of interest paid on compulsory convertible debentures ("CCD")by following an ad-hoc approach of using LIBOR rates thereby grossly erred in: 3.1. upholding the rejection of comparability analysis provided in the Transfer Pricing documentation in relation to interest paid on

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 4 of 48 CCDs; 3.2. disregarding the scientific basis followed by the Appellant in undertaking the benchmarking analysis so as to establish the arm's length nature of payment made in respect of interest paid on CCDs; and 3.3. by following an ad-hoc basis of granting the risks adjustments to the extent of 1% rather permitting tenable adjustments (country, currency and tenor risk adjustments) so as to increase the degree of comparability and to alienate differences on the interest rates adopted/ paid by comparables. 4. On the facts and circumstances of the case and in law, the learned AO/learned Panel erred in applying 12 month average of LIBOR rates in determining the arm's length price of international transaction with respect to interest paid on CCDs by the Appellant to its AEs. Further, adopting 12 month LIBOR rates was completely ad-hoc, as the learned AO/learned Panel did not undertake suitable adjustments thereby failing to align the LIBOR rates to the prevalent interest rates for CCDs. 5. On the facts and circumstances of the case and in law, the learned AO/learned Panel erred in not appreciating the Appellant's argument that the CCDs should be benchmarked only in the year of issue and that the terms and conditions prevalent at the time of issue continues to hold good until the redemption/ conversion of CCDs. 6. On the facts and circumstances of the case and in law, the learned AO/learned Panel erred in not appreciating that the CCDs were issued in INR and therefore the Prime Lending Rate ("PLR") followed by the Indian Public Sector Banks would be the ideal basis for determining the arm's length nature of interest payments on CCDs. That the Appellant craves leave to add to and/or to alter, amend, rescind, modify the grounds herein below or produce further documents before or at the time of hearing of this Appeal.”

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 5 of 48 investment behavior in risky debt instruments. 3. On the facts and in the circumstances of the case whether or not DRP was justified in holding that in absence of thin capitalization rules in Transfer Pricing the TPO cannot re-characterize debt into equity. 4. On the facts and in the circumstances of the case whether or not funds brought in India declaring them as FDI as per RBI and FEMA Act can be characterized as equity. 5. On the facts and in the circumstances of the case whether or not the CCDs may be characterized as debt in spite of Hon'ble Supreme Court in the case of Narender Kumar Maheshwarai Vs Union of India 1989 SC whether or not the CCDs may be characterized as debt in spite of Hon'ble Supreme Court in the case of Narender Kumar Maheshwarai Vs Union of India 1989 SC 138 holding that compulsorily convertible debentures does not postulate any repayment of the principal and therefore it does not constitute a debenture in classic sense. 6. On the facts and in the circumstances of the case whether or not the DRP can hold a contrary view to the view of the Special Bench in the case of Ashima Syntex Vs ACTT 100 ITD 247 (ITATOSB) that there being no liability to pay as principal is retained as capital by conversion into equity shares, it was not borrowing. 7. On the facts and in the circumstances of the case whether or not DRP after concurring with the view of the TPO that the investment in assessee company by the AEs is not for earning interest. Rather, the investment is for the purpose of providing capital may hold that interest is payable on CCDs. 8. without prejudice to the above, the Hon'ble DRP erred in considering the average LIBOR rates of 2009 at 1.599% instead of 1.2848% which is the average LIBOR rate during the period. 9. For that the Hon'ble DRP erred in law as well as on facts, in directing the TPO to make an estimated 1% adjustment on account of Risk when Transfer pricing regulations in India is against any assumption in respect to any adjustment and further when there is also no reliable method to convert the qualitative difference into quantitative difference for making adjustment on account of risk level. 10. For these and other grounds that may be urged at the time of hearing, it is prayed that the directions of the Dispute Resolution Panel in so far as it relates to the above grounds may be reversed.

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 6 of 48

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 7 of 48 that the CCDs should be benchmarked only in the year of issue and that the terms and conditions prevalent at the time of issue continues to hold good until the redemption/ conversion of CCDs. The Appellant prays that the above legal argument be accepted. 4. On the facts and circumstances of the case and in law, the learned AO/learned Panel erred in not appreciating that the CCDs were issued in INR and therefore, the Prime Lending Rate ("PLR") followed by the Indian Public Sector Banks would be the ideal basis for determining the arm's length nature of interest payments on CCDs. The Appellant prays that the PLR should be considered for benchmarking the interest payments. That the Appellant craves leave to add to and/or to alter, amend, rescind, modify the grounds herein below or produce further documents before or at the time of hearing of this Appeal.”

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 8 of 48

2.3. upholding the approach of learned TPO of disregarding the commercial expediency for the issuance of CCD by the Assessee. 3. On the facts and circumstances of the case and in law, the learned AO/learned Panel erred in 3.1. not appreciating the Appellant's argument that the CCDs should be benchmarked only in the year of issue and that the terms and conditions prevalent at the time of issue continues to hold good until the redemption/ conversion of CCDs; 3.2. disregarding the arm's length price ("ALP") and the methodical benchmarking process carried out by the Appellant in the Transfer Pricing ("TP") documentation maintained by it in terms of Section 92D of the Act read with Rule ioD of the Rules; 3.3. not appreciating that the CCDs were issued in INR and therefore, the Prime Lending Rate ("PLR") followed by the Indian Public Sector Banks would be the ideal basis for determining the arm's length nature of interest payments on CCDs. 4. Assuming even if above grounds (Ground No.1 to 3) are adjudicated against the Appellant, the payment of interest on CCDs should be treated as a tax deductible expenditure under section 36(1)(iii) / 37 of the Act. 5. The learned AO and the learned Panel has erred in facts and law in considering that the payment of interest paid on CCD's as not an allowable expenditure under section 36(1)(iii) of the Act. 6. That the learned AO failed to provide an opportunity of being heard to the Appellant during the course of assessment proceedings and therefore the assessment is erroneous, contrary to the provisions of law, prejudicial to the interests of the Applicant and hence liable to be quashed. That the Appellant craves leave to add to and/or to alter, amend, rescind, modify the grounds herein below or produce further documents before or at the time of hearing of this Appeal.” 8. The grounds raised by the revenue for Assessment Year 2013-14 in ITA No. 2006/Bang/2017 are as under:- “1) In the fact of circumstances of the case, the CIT(A) has erred in allowing interest expenses of Rs. 15,68,93,828/- on compulsory

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 9 of 48 convertible debentures (CCDs) which are actually Equity capital in nature of FDI as per RBI guidelines.”

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 10 of 48 deduction it should be in the nature of interest. Further, the interest should be in respect to borrowed Capital. 1.2 Borrowed Capital is 'Debt' and it is different from equity capital. On equity capital one dividend is declared. Interest and dividend cannot be equated. Interest is deductible in computation of income, whereas dividend is not. Therefore, unless the nature of funds received by the Company is determined, it is difficult to say that amount paid in respect to funds is interest or dividend. 1.3 In Transfer Pricing, therefore, it is necessary to first determine as to whether funds received by the Company are in the nature of equity or debt. If the nature of funds received is determined as 'Debt' then only one may proceed to determine the arm's length price of the interest paid/payable on the borrowed capital by the Company. 2.1 In a third-party scenario no entity would lend any funds to a Company if its debt-equity ratio is skewed as evident on perusal of its balance sheet. In such circumstances the intention of the assessee for funding the Company will be that of an investor and not a lender. The arm's length principle focuses on determining the true nature and effect of each constituent of the arrangement and the arrangement as a whole, allowing due weight to the legal form of each constituent to the arrangement, the business context in which they occur and any relationship between different elements of the arrangement. Where, an investment in an associated enterprise may be structured in the form of interest-bearing debt when, at arm's length, having regard to the economic circumstances of the borrowing company, the investment would not be expected to be structured in this way. Depending on the facts and circumstances of the particular case, it may be appropriate for tax administrations in applying the relevant transfer pricing provisions to examine the purpose and object of providing the funding in the form of debt vis-à- vis infusion of equity. The permissibility of infusing additional amounts of funding required in the form of debt would need to be viewed from a commercial viability perspective and whether such loans would have been advanced by third parties in the instant case. 2.2 UK Transfer Pricing Guidelines which states thin capitalisation is nothing but a terminology used for addressing the companies which are structured to have excessive amounts of debt funding to extract profits in the

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 11 of 48 form of interest payments. Relevant extracts from different INTMs support the view for ascertaining the extent of arm's length debt amount. These have been reproduced for ease of reference as follows: "INTM542005 ... In the commercial world, a company is said to be thinly capitalised when it has more debt than equity, and many thin cap cases boil down to a company with more debt than it could and would have borrowed on its own resources, because it is borrowing either from or with the support of connected persons." "INTM542005 When a company operates at arm's length from its sources of funding, commercial considerations drive the decision to raise funds either through debt, equity, or a mixture of the two.... ...When a company borrows from or with the support of other group companies, funding decisions may not be driven by commercial considerations alone. The connection between the parties involved might allow them to change the way in which the funding is obtained in ways unavailable or unattractive to the borrower at arm's length, or to take on funding risks which an independent borrower would avoid. Factors such as group policy, strategy, and tax planning will sit alongside commercial considerations...." INTM542012 provides guidance as to how one would determine whether a company would have been able to source a loan on a standalone basis: "INTM 542012 Putting the parties at arm's length ... The application of the arm's length principle requires a judgment on the merit of each individual case to establish what would have happened at arm's length; the terms on which the company in question could have borrowed and would have borrowed (if anything),  as a separate entity  from a third-party lender unconnected with the borrower, and  without guarantees or other forms of comfort from any party connected with the borrower. There are two main ways of looking at the borrowing: what the lender would do and what the borrower would do if the circumstances were as outlined above, and these are expressed

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 12 of 48 as:  the "could" argument - what a lender would have lent and therefore what a borrower could have borrowed - and  the "would" argument - what a borrower acting in the best interests of their own business would have borrowed." "60. In the context of applying Australia's transfer pricing rules, the principal factors that will be taken into account in determining whether a particular loan agreement should be treated as equivalent to a contribution to equity1 are detailed below. (a) The legal effect of the transaction A loan would ordinarily create the legal relationships of creditor and debtor. Where the rights and obligations of the provider of funds are similar to the rights and obligations of a shareholder, this will be taken as a factor indicating that the contribution might be akin to the supply of equity capital. For example, the lender may have, in relation to the loan, voting rights, a return dependent upon profits, or other rights that usually attach to ownership. (b) Repayment of principal A loan repayable on demand or within a short period of time will not be considered as equivalent to equity unless other facts associated with the "loan" demonstrate conclusively that the "loan" is equivalent to a contribution to equity. Conditions regarding repayment of the loan that are not consistent with an equity investment would be a factor indicating that the loan is not equivalent to equity. Similarly, where the contributor's claim to repayment of the contribution is not effectively subordinated to the claims of other creditors, this is a factor indicating that the contribution is not the equivalent of equity. (c) Purpose of the contribution The use of the funds by the borrower for investment in fixed assets of a long-term nature for use as core assets of the business of the borrower may be a factor that might indicate that the funds are the equivalent of equity. This could be the case, for example, if it is customary in the particular industry or in the country in which the investment is made to use equity capital for the investments, (d) Debt equity ratio Where the ratio of debt to equity is very high compared to the average for the particular industry or in the country in which the investment is made, this would be one of the factors that might indicate that a part of the debt may be the equivalent of a

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 13 of 48 contribution of capital. (e) Factors affecting the form of investment in a particular country An investor may have a need to maintain flexibility of investment having regard to the investment regulations applying in a particular country. An example would be the existence of barriers to repatriation of equity in the country of residence of the recipient of funds. Another example would be where a country imposes a minimum shareholding requirement by domestic investors. In these cases, some contributions that are the equivalent of equity may be made in the form of loans to ensure that the percentage of the shareholding of domestic investors is not diluted. (f) Written loan agreement The absence of a written loan agreement in relation to the supply of funds will not be taken as determinative that the funds are a contribution to equity. (g) Ability to obtain finance from an unrelated third party Representations have been made that interest should not be attributed in the case of a loan if the circumstances of the borrower were such that an independent lender would not have provided credit to that borrower." As can be seen from the extracts of the Ruling, there are several clauses contained within the said Ruling which would apply to treat the loan provided as an equity contribution. 3.0 Further, the concept of thin capitalisation itself stems from the arm's length principle and therefore, it will not be right to argue that thin capitalization rules are not applicable. Therefore, in Transfer Pricing Analysis a debt may be characterized as equity investment, if under the conditions existing in related party transaction no third party would have given loan. A company is said to be thinly capitalized when its capital is made up of a much greater proportion of debt than equity, i.e. its gearing or leverage, is too high. This is perceived to create problems for two classes of people.  consumers and creditors bear the solvency risk of the company, which has to repay the bulk of its capital with interest; and  revenue authorities, who are concerned about abuse by excessive interest deductions. In view of Transfer Pricing issues, an entity (which may be part

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 14 of 48 of a group) may be said to be thinly capitalized when it has excessive debt in relation to its arm's length borrowing capacity, leading to the possibility of excessive interest deductions. An important parallel consideration is whether the rate of interest is one which would have been obtained at arm's length rate while comparing from independent lender as a standalone entity.

Arm's length Principle: In order to determine whether an entity (or a group of entities) is thinly capitalized, it is necessary to:  Ascertain how much the company or companies would have been able to borrow from an independent lender (the arm's length amount); and  To compare this with the amounts actually borrowed from group companies or with the backing of group companies. A comparison can then be made between the interest payable on the actual debt and that which would be payable on the amount which could and would have been borrowed at arm's length. Deductions for corporation tax purposes can be limited to those on the latter amount.2 3.1 Once the character of funds received by the Company from its AEs is determined as equity investment, no interest is payable and accordingly, no interest is allowable on such investment. Under this background discussion, when I analyze what are the characteristics of Compulsory Convertible Debentures (in short CCDs) I find that CCDs are considered similar to equity. On conversion of CCDs into equity there is no doubt that it is equity investment. But even before conversion of CCDs into equity, it is equity investment in view of the fact that the circumstances of the borrower when lender subscribed in CCDs were such that an independent lender would not have provided credit to the borrower. 3.2 The current norms do not allow ECBs in the sector except for projects with a minimum size of 100 acre and, therefore, treating CCDs as debt will amount to circumventing external commercial borrowing (ECB) guidelines applicable for the real estate sector. Still I could have treated CCD as debt if there had been buy back provisions in the contractual

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 15 of 48 agreements. This is because in many cases there are contractual agreements allowing Indian realty players to buy back the shares from foreign investors at a fixed price after conversion. In other words, the foreign investor has a put option. Thus, for the foreign investor, a CCD is similar to a debt instrument with a fixed rate of return rather than an equity investment. For instance, a local property firm raising $30 million by issuing CCDs will give an undertaking that it will buy back the securities after two years for $33 million. 3.3 While real estate companies are barred from tapping debt through ECBs (except for the 100-acre or more projects), there is no restriction on pure equity investment, subject to certain conditions such as minimum capital requirement and a three-year lock-in. CCDs are treated as FDI, so essentially there is nothing that contravenes the regulations. Put option on CCDs has the potential of being misused unless it is exercised post-conversion into equity. Analysts say CCDs are a financial innovation resorted to by companies to bring in foreign loans masquerading as equity. The option is used to sell securities to international investors who, in turn, are promised an assured return and an easy exit. 3.4 Once the conversion option is exercised, it becomes an equity investment. Since conversion is compulsory, it is normally treated as equity even as it has debt like features for some time. Confusion has arisen because sometimes CCDs are structured in a way that takes them closer to debt. For example, at times CCDs have a put option which requires the issuing companies to buy back the shares issues on conversion at a fixed price. This structuring makes it debt like. 3.5 Currently, under regulations of Foreign Exchange Management Act CCDs are treated as FDI. Hence, there is nothing that contravenes the regulations. 3.6. As per Reserve Bank of India (RBI) policy issued in 2007 only fully and mandatorily convertible instruments are considered to be FDI. All other preference shares and debentures (and including those that are optionally convertible) are considered to be debt and hence governed by the guidelines on ECBs. In its 2007 policy on convertible debentures, the RBI noted the reasons for this: "It has been noticed that some Indian companies are raising funds under the FDI route through issue of hybrid instruments such as optionally convertible/ partially convertible debentures which are intrinsically debt-like instruments. Routing of debt flows through the

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 16 of 48 FDI route circumvents the framework in place for regulating debt flows into the country. It is clarified that henceforth, only instruments which are fully and mandatorily convertible into equity, within a specified time would be reckoned as part of equity under the FDI Policy and eligible to be issued to persons resident outside India under the Foreign Direct Investment Scheme in terms of Regulation 5 (1) of Foreign Exchange Management (Transfer and Issue of shares by a Person Resident outside India) Regulations, 2000 notified vide Notification No. FEMA 20/2000-RB dated May 3, 2000." In 2007, disturbed by excess debt inflows, RBI had banned debt structures like partially convertible preference shares. The regulator said only compulsory convertible preference shares (CCPS) and compulsory convertible debentures (CCDS) would be permitted since these are equity instruments.3 8. The TPO holds the view that amount Rs 76826983/- is in the nature of interest because CCDs issued by the Assessee are not debt. Interest arises on debt i.e. on borrowed capital and not on investment in the share capital. On perusal of the balance sheet it is found that share capital of the Assessee Company is 12.73 Crores whereas the unsecured loans are 110.29 Crores. Thus, the balance sheet of the Assessee Company as at 2009 is highly skewed. This position of the Company is after taking amount from AEs through CCDs. The ratio of debt (if for a time being CCDs are considered as debt) and equity capital is 8.1 In this highly skewed balance sheet the operating revenue is very small compared to expenditures. The operating revenue is only 7.73 Crores whereas the expenditures are 28.41 Crores. It includes interest on debenture from December 2008 to March 2009 on CCDs for Rs 5.38 crores whereas revenues are for the whole period. When in subsequent period when interest ill be payable On CCDs for whole year revenues will not be enough to service the debt. Even in FY 2008-09 relevant for AY 2009-10 the revenues are not sufficient and there is loss Rs 20.67 Crores. In such company no third party would invest in the debts of the company which has very low credit rating which is even lower than investment grade bonds having BBB (—)credit rating. Thus, in the case of Assessee having junk credit rating, having no operating income, no source of cash flow to service the interest payable at the rate of 15%, no third party would make investment in CCDs. Therefore, it is nothing but thin capitalization. In Transfer Pricing thin capitalization is the outcome of the study of debt equity ratio and analysis as to

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 17 of 48 whether Assessee could have borrowed from third parties. I find that the financial position of the Assessee Company is absolutely critical and no third party would have invested in the debt instruments of the Assessee. 8.2 Therefore I do not consider CCDs issued by the Assessee as debt and hence amount paid to its AEs Rs. 76826983/- is not in the nature of interest. Therefore, it is not allowable as deduction in computation of income. Further, CCDs are in the nature of equity capital as discussed in para 7. It has been elaborately discussed that CCDs are investment in equity and not debt. If CCDs are considered as debt it will be in violation to the policy of the RBI as existing and in force. It is also provided in the policy of RBI issued in 2007 that CCDs are equity capital. Currently, under regulations of Foreign Exchange Management Act CCDs are treated as FDI. Hence, there is nothing that contravenes the regulations. All the facts discussed in 7.0 are squarely applicable in this case and therefore I consider CCDs are not debt and therefore amount paid Rs. 76826983/- is not in the nature of interest. Therefore, ALP of interest using CUP as most appropriate method is nil. Accordingly, adjustment in this case is proposed for Rs. 76826983/- 9.0 The transfer Pricing Order is passed U/s 92CA (3) of the Income Tax Act 1961 for AY 2009-10 proposing an adjustment of Rs76826983/-. Accordingly, the total income of the Assessee will be increased by Rs76826983/- on account of Arm's Length Price of international transactions determined in this case.

1 It should be noted herein, that no where it is mentioned that all the conditions mentioned below should be met collectively for the recharecterisation of loan to equity.

2 http://www.transferpricing-india.com/Thin_Capitalization.htm 3http://www.moneycontrol.com/news/cnbc-tv18-comments/ccps- ccds-cannot-have-fixed-exit-prices-rbi_402506.html” 11. In A. Y. 2009 – 10, the assessee carried the matter in appeal before CIT (A), who held that CCDs are debt and not equity and hence, interest on it is allowable but he also held that as against the claim of interest @ 15%, interest should be allowed @ 12.62% being ALP of interest. The revenue is in appeal against this finding of CIT (A) that CCDs are Debt and not Equity. The assessee has filed CO for A. Y. 2009 – 10 but the grounds raised by

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 18 of 48 the assessee are merely in support of the order of CIT (A) and apart from that, there is no ground or grievance. 12. In A. Y. 2010 – 11, the assessee carried the matter in appeal before DRP against the Draft Assessment order passed by the AO in line with the order of TPO by holding that no interest on CCDs is allowable and made adjustment of Rs. 16,54,49,612/-. DRP in this year held that CCDs are Debt and not equity. DRP also held that Thin Capitalisation principle is not applicable. Having held this, DRP also held that ALP for interest on CCDs has to be worked out at LIBOR Plus rate and directed the AO to adopt ALP of interest on CCDs at 1.559%. DRP also held that additional 1% should be added to the prevailing LIBOR rate of interest to cover risk adjustment. Against this direction of DRP, the revenue is in appeal. One of the issues raised by the revenue is this that CCD is equity and not debt and hence, interest on CCDs is not an allowable expenditure. Second issue raised is this that even if it is held that interest on CCDs is allowable, the ALP should be 1.2848% as against 1.559 %. Third issue raised is about granting of 1% Risk Adjustment. 13. In this year, the assessee has also filed an appeal. One of the issues raised by the assessee is this that interest on CCDs should be benchmarked in the year of issue only and not every year. Second issue raised is this that since CCDs are issued in INR, PLR of Indian Public Sector Banks should be used for ALP of interest on CCDs and not LIBOR. 14. In A. Y. 2011 – 12, the TPO proposed addition of Rs, 16,54,49,610/- being the entire interest on CCDs on the same basis that CCDs are equity and not Debt and the AO passed Draft Assessment order accordingly. The assessee in this year also carried the matter to DRP. The DRP in this year held that the CCDs are equity and not Debt and hence, interest on CCDs is not allowable. As a consequence, the ALP of interest aspect was not decided by holding that it s academic. Now the assessee is in appeal on the ground that CCDs are Debt and not equity. This issue is also raised that Principle of Thin Capitalisation as contained in legislation from United

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 19 of 48 Kingdom is not applicable in India. This issue is also raised by the assessee that interest on CCDs should be benchmarked in the year of issue only and not every year. Second issue raised is this that since CCDs are issued in INR, PLR of Indian Public Sector Banks should be used for ALP of interest on CCDs and not LIBOR. 15. In A. Y. 2012 – 13, the facts, disputes and grounds raised by the assessee before the tribunal are same and even the amount is same. 16. In A. Y. 2013 – 14, the assessee carried the matter in appeal before CIT (A), who held that CCDs are debt and not equity and hence, interest on it is allowable but he also held that as against the claim of interest @ 15%, interest should be allowed @ 13.25% being ALP of interest by adopting lowest PLR. The revenue is in appeal against this finding of CIT (A) that CCDs are Debt and not Equity. The assessee has filed CO for this year also but the grounds raised by the assessee are merely in support of the order of CIT (A) and apart from that, there is no ground or grievance. 17. Hence, it is seen that there are two C. Os. filed by the assessee for A. Y. 2009 – 10 & 2013 – 14 and both these C. O are liable to be dismissed straight away as these are merely in support of the order of CIT (A). Now we are left with three appeals of the revenue one each in A. Ys. 2009 – 10, 2010 – 11 & 2013 – 14 and three appeals of the assessee for A. Y. 2010 – 11, 2011 – 12 & 2012 – 13. 18. The issues to be decided can be listed as under:- (a) First and most important issue to be decided by us is this that whether CCDs are Debts or equity and interest on it is allowable or not? For deciding this issue, we should also examine and decide the applicability Thin Capitalisation Principle invoked by the TPO/AO. (b) If we come to this conclusion that it is equity and interest on it is not allowable than nothing remains to be decided further but if we come to this conclusion that it is Debt and interest on it is allowable then we have to decide this second issue as to what should be the amount to be allowed which essentially means what is ALP of such interest to be allowed? For

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 20 of 48 quantifying the ALP, this is the first aspect as to whether it should be bench marked in A. Y. 2009 – 10 only being the year of issue or in each year? Second aspect is this as to whether it should be bench marked on the basis of LIBOR plus or PLR. Third aspect is this that if LIBOR is adopted then whether Risk Adjustment is to be allowed or not and if it is to be allowed, at what rate?

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 21 of 48 ITA.No.4249/Mum/07 dated 20.11.2010. The learned AR also placed reliance on this decision of Mumbai ITAT and another decision of AAR in the case of M/s GE Strategic Investment India (at page 286 of the PB). 4. Arguing against the CIT(A)'s finding that the ALP adjustment was made by the TPO invoking thin capitalisation rules, the undersigned drew the attention of the Hon'ble Bench to the fact that though there was discussion on thin capitalisation rules, the TPO has ultimately applied Arm's Length Principle to make the adjustment by arguing that a company like assessee would not have been able to borrow such a huge amount from an independent lender without offering any security by way of floating CCDs. This is evident from the discussion on page 9 of the TPO's order. 5. In support of the TPO's conclusion that the money collected through CCDs is in the nature of equity, reliance was placed on the decision of the Hon'ble ITAT, Special Bench in the case of Ashima Syntex Ltd. vs ACTT, Central Circle-2(3) reported at (2006) 100 lTD 247 (AHD.)(SB) and a copy of the same was submitted to the Hon'ble Members during the hearing. In this decision, it was held that in the case of convertible debenture, it is nothing but raising capital by way of equity shares increasing the capital base via media being issue of convertible debentures. The loan or borrowings are not to be repaid but retained by converting into equity shares and therefore, it cannot be said to be a borrowing or a loan. In so far as the decision of ITAT, Mumbai Bench in the case of Besix Kier Dabhol, SA on which the learned AR placed reliance, it was argued that facts in that case are different and distinguishable. In that case, the assessee company raised foreign borrowings from its shareholders and claimed interest deduction u/s.37(1) of the I.T.Act, 1961 which was denied by the AO on the reasoning that in view of provisions of Article 7(3)(b) of Indo- Belgium DTAA, the interest on monies lent by the head office to branches was not an allowable deduction. The assessee's contention in that case was that the borrowings were from the shareholders and not from the head office and for that reason, the disallowance was not called for. So, in that case, the borrowing was a Loan simpliciter whereas in the instant case, the funds were raised by way of floating CCDs and therefore they are not of the same nature. 6. Besides the above arguments, attention of the Hon'ble Bench was invited to the observations of the TPO on RBI policy and FEMA Regulations at para 3.5 of the TP0's order based on which the TPO interpreted the CCDs as equity capital. As per RBI circular issued in 2007, it was clarified that only instruments which are fully and mandatorily convertible into equity within a specified time would be

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 22 of 48 reckoned as part of equity under the FDI policy and eligible to be issued to persons resident outside India under the FDI scheme in terms of Regulation 5(1) of FEMA (Regulations 2000). The TPO held that if CCDs are considered as debt, it will be in violation of the RBI policy then in force. It was only after making these observations that the TPO treated the CCDs as equity and following CUP method, determined ALP of interest as 'Nil' and accordingly made adjustment of Rs.7,68,26,983/-. 7. It was further pointed out that the RBI, disturbed by excessive debt inflows into the country, had banned in 2007 the debt structures like partially convertible preference shares and laid down a policy that only compulsory convertible preference shares (COPS) and compulsory convertible debentures (CCDs) would be permitted since these are equity instruments. Keeping in view of this policy, the issue of CCDs post 2007 should be treated differently and therefore, reliance has been wrongly placed on the decision of the AAR in the case of GE Strategic Investment India. Further, in this decision, the policy aspects have not been considered. For better appreciation by the Hon'ble Members, a copy of the Press Release of the RBI dated 8.6.2007 and RBI Master Circular on Foreign Investment in India dated 02.07.2007, are annexed herewith highlighting the relevant portions. Even in Master Circular issued by the RBI on 01.07.2008, there is no change in the policy in so far as the CCDs are concerned . A copy of this Circular is also enclosed. 8. As the assessee issued CCDs pursuant to Convertible Debentures subscription agreement with the subscribers entered into on 24.12.2008 (kindly see page 250 of PB), the above RBI Circulars shall apply. Therefore, the TPO has rightly relied on these policy circulars to treat CCDs as equity capital and proceeded to make ALP adjustment. 9. In the light of the above submissions, it is respectfully prayed that the Hon'ble Bench may be pleased to uphold the ALP adjustment made by the TPO and render justice.”

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 23 of 48 63/Bang/2015 and Assessee Appeal No.- 84/Bang/2017); Assessment Year 2011-12 (Assessee Appeal No.- 599/Bang/2016); Assessment Year 2012-13 (Assessee Appeal No.- 2178/Bang/2016); Assessment Year 2013-14 (Deptt. Appeal No.- 2006/Bang/2017 and Assessee CO No.- 09/Bang/2018). May it please the Honbl. Bench, 1.1. The Honbl. Bench was very kind to hear the captioned consolidated appeals on the 27th June' 2019. There are common issues entailed in all the involved Assessment Years for all the captioned appeals. Appeal for Assessment Year 2009-10 was taken as the lead appeal as it is the earliest Assessment Year in the lot. All the denotations henceforth, therefore, are with reference to appeal for Assessment Year 2009-10. The same shall naturally be relevant contextually for all the captioned appeals. 1.2. Upon conclusion of the hearing, the Honbl. Bench desired that both the Assessee and the Revenue file Notes on Arguments. It was desired that the Notes on Arguments by the Revenue be filed by the 4th July' 2019 and the Assessee's Notes on Arguments be filed by the 9th July' 2019 after incorporating response to the arguments of the Revenue. 1.3. As such, this Notes on Arguments of the Assessee emanates from the above backdrop and is in compliance with the desires of the Honbl. Bench. Scope of the appeals and encompassing arguments from both sides are dealt with hence forth. 2.1. The prime and fundamental issue revolves around the determination of the arm's length price (under the relevant provisions of Chapter - X of the Income Tax Act) of international transactions involving interest payments to certain associated enterprises in respect of related Compulsorily Convertible Debentures issued to them. 2.2. Facts and points in question are pellucid from the Assessment Order for the lead Assessment Year 2009-10. The Assessee paid interest at the rate of 15% upon issue of Compulsory Convertible Debenture to its three respective associated enterprises namely, Flight Training Mauritius, Emirates Dubai and CAE Hungary. These three international transactions, in respect of such interests paid, were referred by the Assessing Officer to the Transfer Pricing Officer for mere determination of their respective arm's length prices within the

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 24 of 48 meaning, scope and purpose specific provisions of Chapter - X of the Income Tax Act. (Kindly refer to Paras- 1 & 2 on Pages- 1 & 2 of the Transfer Pricing Order for AY: 2009-10). 2.3. Upon reference, the Transfer Pricing Officer first rejected the Assessee's adoption of the comparables selected under Comparable Uncontrolled Price (CUP) method. The argument of the Transfer Pricing Officer for this rejection was that the comparables selected by the Assessee were for dissimilar periods and were in the context of Non-convertible Debentures whereas the Assessee's international transactions were in the nature of Compulsory Convertible Debentures. (Kindly refer, Para- 5 on Page- 3 of the Transfer Pricing Order for AY: 2009- 10). 2.4. The Transfer Pricing Officer did not dispute adoption of CUP method by the Assessee as the correct method. The only aspect the Transfer Pricing Officer disputed and rejected was adoption of certain comparables by the Assessee under CUP method. The Transfer Pricing Officer also did not suggest or adopt any other prescribed method to be the most appropriate method under the Income Tax Act or under the Income Tax Rules. Besides these, in spite of having accepted the Assessee's selection of CUP method as the most appropriate method and having rejected only the comparables selected by the Assessee, the Transfer Pricing Officer did not undertake the exercise of determining the arm's length price of the involved international transactions under the CUP method. (Kindly refer, Para- 5 on Page- 3 & 4 of the Transfer Pricing Order for AY: 2009-10). 3.1. Transfer Pricing Officer has a limited fiduciary role and jurisdiction confined to determination of arm's length price (Section - 92 of the Income Tax Act) of an international transaction (Section - 92B of the Income Tax Act) with an associated enterprise (section - 92A of the Income Tax Act) within the confines of methods prescribed for computation (section -92C of the Income Tax Act) upon reference from the Assessing officer (Section - 92CA of the Income Tax Act). Deviation from confines of any of the above constituent elements under the law pulverizes the role and jurisdiction of a Transfer Pricing Officer. Impliedly it is not the role and jurisdiction of the Transfer Pricing Officer to transgress in to the realm of an Assessing Officer. 3.2. By not determining the Arm's Length Price, of the international transactions in the form of interest payments on

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 25 of 48 Compulsory Convertible Debentures to the respective associated enterprises in the instant case, within the confines of the methods prescribed for its computation in terms of Section 92C of the Income Tax Act, the Transfer Pricing officer has abdicated his statutorily prescribed function as depicted above. That being the case, the value of the international transaction adopted by the Assessee should be accepted to be at arm's length. 4.1. Having abdicated the statutorily prescribed methods for computation of arm's length price under section 92C of the Income Tax Act the Transfer Pricing Officer, while dealing with the matter further, has gone beyond the limits and boundaries set in Indian Tax Jurisprudence. 4.2. The Transfer Pricing Officer has misdirected the process completely by invoking the concept of Thin Capitalization which has not yet seen the light of the day in the Indian Tax Laws and Jurisprudence. The Transfer Pricing Officer has drawn all strengths from the Tax Laws of other foreign countries like United Kingdom and conceptualizations of OECD in the context of Thin Capitalization. There is no reference or reliance on any Indian Tax Law because obviously there is none. (Kindly refer, Sub-para- 2.2 of Para- 7 to Sub-para- 3.0 of Para- 7on Page- 5 to & of the Transfer Pricing Order for AY: 2009-10). 5.1. Further justification in this regard has been sought by saying that under section 36(iii) of the Income Tax Act interest is payable and deductible only in respect of a debt and in the subjective opinion of the Transfer Pricing Officer the status of the Assessee was such that no third party would have provided credit to it as a borrower (Kindly refer, Para- 6 on Page- 4, Sub- para- I. 1. to 1.3 of Para- 7 on Page- 4 and Sub-para- 3.1. of Para- 7 on Page- 10 of the Transfer Pricing Order for AY: 2009-10). 5.2. According to the Transfer Pricing Officer this subjective understanding was sufficient enough to decide that matter on hand is that of equity and not debt. Little did the Transfer Pricing officer realize that conjectures, surmises and commercial expediency determination are not permissible for the Revenue Authorities under Indian Tax jurisprudence. Only objective analysis based on facts and evidence within the parameters of law can enable a judicially sustainable proposition. 6.1. In a misplaced pursuit of justifying invocation of non-

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 26 of 48 existing Thin Capitalization concept in Indian Tax Laws, the Transfer Pricing Officer has further transgressed the legal boundaries, by re-characterizing the debt in terms of Compulsory Convertible Debentures under reference as Equity when it still bore the character of a debenture. Interestingly, even the First Appellate Authority recognizes the fact that the Transfer Pricing Officer has treated the matter to be that of Thin Capitalization though the debt equity ratio has never been discussed. (Kindly refer, Point- ii on Page- 5 of the First Appellate Order for AY: 2009-10). 6.2. Certainly re-characterization of a transaction cannot be done unless there is an intention of the parties or there is any arrangement, understanding or action in concert. In the instant case there is an issue of Compulsory Convertible Debenture, which has been a legally accepted and duly approved instrument by RBI. The inherent character of a Compulsory Convertible Debenture is that it remains a debenture till such time it is converted in to equity at a future appointed date. There is nothing to suggest that a Compulsory Convertible Debenture is an equity right at the date of its issuance. The Transfer Pricing Officer in the instant case has travelled beyond his statutorily prescribed role and jurisdiction, whereby a conclusion has also been reached by way of re-characterizing debenture as equity on the basis of non-existent presumed theory of Thin Capitalization. Such a presumption cannot change the character of a transaction. 6.3. The entire exercise of determining the arm's length price is only to arrive at the real income earned i.e. the correct price of the transaction which is the interest paid to the associated enterprises on Compulsory Convertible Debenture in the instant case, shorn of the price arrived at between the parties on account of their relationship, viz. associated enterprises. The Transfer Pricing Officer has confused this measure with a charge and has tried to notionally tax the interest that the Assessee paid to its associated enterprises. This has been tried to be achieved by way of treating its value at Nil and thus by denying its claim as expense. This impermissible predetermined objective has been attempted to be accomplished in the instant case by way of another impermissible act of re-characterization of debenture as equity based on presumption of Thin Capitalization concept. 6.4. Finance Act 2017 introduced Section 94B in the Income Tax Act w.e.f. 01.04.2018. This provision was introduced with the sole purpose of limiting interest deduction in certain cases.

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 27 of 48 Indian statute thus for the first time addressed the concerns thrown up in Thin Capitalization concepts abroad. Here too the Indian statute confined itself to only limit the extent alone of the interest paid to the associated enterprise upon issue of a debt. In any case even this newly introduced provision is not relevant for any of the Assessment Years involved in the present set of appeals. This fact is being mentioned here just to emphasize that even here the statute did not permit re- characterization of a transaction in order to deny an interest payment outgo. This new provision also acts just as a limitation simpliciter on an interest deduction. 7.1. Core theme and arguments of the Transfer Pricing Officer is nonexistent Thin Capitalization concept in Indian context. Towards this objective the Transfer Pricing Officer has re- characterized the Compulsory Convertible Debentures (debt) in to equity as has been seen in discussion above. For this the Transfer Pricing Officer also makes reference to the Foreign Direct Investment (FDI) Policy and the Reserve Bank of India (RBI) Policy in respect of fund infusion from foreign sources in to Indian economy. Misplaced understanding of the Government Policy and its purpose has only created a smokescreen of confusion hiding the truth and reality of the matter. (Kindly refer, Para- 3.1. to 3.6. on Page- 10 to 12 of the Transfer Pricing Order for AY: 2009-10). 7.2. Even though statutorily the Transfer Pricing Officer was not entitled to delve in to anything else other than determination of arm's length price of the given transactions, it should have been understood that the needs requirements and purpose under the Income Tax Act and those of the FDI and RBI Policies do not stand opposite to each other or contradict each other. However, they just need to be understood in their respective contexts. 7.3. The purposes of the FDI and RBI Policies are aimed at controlling fund inflow from abroad in the form of debt. They have no problem if the infusions of funds are in the form of equity. In order to ensure this, these policies just declared that Optionally or Partially Convertible Debentures and other Hybrid Instruments, because their conversion in to equity at a future appointed date remains an uncertainty being non compulsive in nature, shall be treated as debt and not equity. This was just to prevent such non compulsive instruments to be used for fund infusion that the Government brought in clarity in this regard.

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7.4. As far as Compulsory Convertible Debentures are concerned, the Government Policy accepted and allowed it to be used for fund inflow from abroad even as a debt, as at a later appointed date it will compulsorily and unambiguously be converted in to equity. Therefore the Government clarified that till such time its conversion in to equity happens and till such time it continues its identity as a debenture, it shall continue to be a valid form of fund infusion from abroad. The Government Policy only defined non-admissibility and non-validity of Optionally or Partially Convertible Debentures and other Hybrid Instruments as means of fund infusion vis a vis admissibility and validity of Compulsory Convertible Debentures as an instrument and means of fund infusion from abroad. This was the need and requirement in a Regulatory environment and for Regulatory purposes. Nowhere did the Government Policy redefined or re- characterized the nature of a Compulsory Convertible Debenture as equity. 7.5. As far as need and requirement under the Income Tax Act is concerned it is enough to understand that the Government nowhere said in the given situation that a Compulsory Convertible Debenture is equity even at the time of its inception and during its continuity as a debenture prior to its compulsory and actual conversion in to equity at the appointed date. That being the case, purposes of Income Tax Act just requires to determine the nature of receipt and expense and decide the taxability of the resultant income. Thus, in the case of a Compulsory Convertible Debenture the nature of its value is that of a debt and once it is converted in to equity at the appointed date, its value is that of an equity. The resultant expense therefore correspondingly will be that of an interest and a dividend, in that sequence. Reading anything more in to the Government's Policy through RBI and FDI Policies is not only misleading but also purposive. 7.6. Moreover, in the instant case of the Assessee, RBI itself has not only allowed and approved the issue of Compulsory Convertible Debentures but has also allowed and approved remittances to respective associated enterprises in the form of interest on these Compulsory Convertible Debentures at various points of time. Also, these Compulsory Convertible Debentures have already been converted in to equity on respective appointed dates and there is no frustration of RBI's expectations in this regard. The documentary evidences to support these contentions are available in the shape of Form - FC-GPR, Form

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 29 of 48 - A2 (Filed with the RBI through the Authorized Dealer Bank) and, Form - 15CA and Form - CBR. These documents substantiate that during the course of inward and outward remittances also, the transactions have been categorized as Compulsory Convertible Debentures and interest on Compulsory Convertible Debentures. Thus these facts are borne on RBI documents also for these purposes. If RBI does not have an issue with its own documentation describing these as Compulsory Convertible Debentures and consequent remittance of interest thereon, there is no reason why the Transfer Pricing Officer should have an issue and misread the meaning of the transaction for suitability purposes. 8.1. Also, it is not the case of the Assessing Officer that the Agreements between the Assessee and the respective associated enterprises for Compulsory Convertible Debentures were sham and bogus and therefore consequent payments of interests were also sham and bogus that could lead to disallowance of the amount of the interests claimed to have been paid under Sections 36(1)(iii) and 37 of the Income Tax Act. 8.2. It is also not the case of the Assessing Officer that nature of the transaction was something different than what has been shown by the Assessee and the same has been done to defraud the revenue or avoid due payment of tax. The Assessing Officer did not feel the need to re-characterize the nature of the transaction though it is legally not permissible otherwise. 8.3. Obviously, the Assessing Officer was satisfied with the genuineness and nature of the transaction and therefore was satisfied with the admissibility of the interest paid on Compulsory Convertible Debentures as genuine expense. The Assessing Officer referred the matter to the Transfer Pricing Officer only to determine the genuine extent of the claimable interest by way of arm's length determination exercise as prescribed under law and rules. The transactions were not referred to the Transfer Pricing Officer to determine the genuineness and nature of the transaction and to re-characterize it. The Transfer Price Officer exceeded his statutorily prescribed role and jurisdiction. 9.1. Hon'ble ITAT, Mum bai, in the case of Besix Kier Dabhol, SA vs. DOT (ITA No.- 4249/Mum/2007) has very categorically identified that the issue on hand in this case is that of Thin Capitalization requiring re-characterization of debt as equity (Kindly refer Paras - 18 and 23 on Pages 16 and 21 of this ITAT

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 30 of 48 order). The Hon'ble Tribunal then very categorically concludes in this case that the international consensus, which the Assessing Officer has referred to, is for the need of Thin Capitalization Rules. But then just because it is desirable, the Assessing Officer can not disallow the interest paid on debt, payable in the cases of thinly capitalized companies. The Honbl. ITAT In this case candidly observed that the Assessing Officer was clearly ahead of his times in disallowing the expenses based on his notions of Thin Capitalization rules when such rules have not even reached the drawing board stage in India (Kindly refer to Para - 29 and 30 on Pages - 26 and 27 of this /TAT order). 9.2. The Hon'ble Mumbai Bench in this case also concludes that once the interest has been paid for business purposes, it is to be allowed under Sec 37 and therefore the RBI guidelines do not play a role in allowability Of these deductions (Kindly refer to Para -30 on Pages - 27 of this ITAT order). 9.3. The Learned Departmental Representative (DR) has attempted to distinguish this case law of Besix Kier Dabhol, SA vs. DCIT, by saying that it has different facts. It has been contended by him that in this case borrowing was the loan simpliciter where as in the case of the Assessee funds were raised by way of floating Compulsory Convertible Debentures. Reasonably speaking, subject matters being loan simpliciter, as learned DR says, and debenture before conversion in to equity in the case of Compulsory Convertible Debenture, as in the case of the Assessee, are theoretically one and the same thing. They cannot be distinguished. Interestingly, the Learned DR has based his observation only on the basis of Paras - 2 and 3 of the Besix Kier Dabhol, SA vs. DCIT ITAT Order and has clearly camouflaged the real issue of Thin Capitalization involved in this case that has been decided by Hon' ble ITAT. That this case law applies clearly on the facts of the case of the Assessee on hand, has been detailed in the just preceding paragraphs 9.1. and 9.2. above. The contention of the Learned DR stands negated. 9.4. It is important to mention that this order of Hon'ble ITAT 'L' Bench, Mumbai in the case of Besix Kier Dabhol, SA vs. DCIT (ITA No.-4249/M um/2007) has been confirmed by Hon'ble Bombay High Court in the Director of Income - Tax vs Besix Kier Dabhol in ITA No.- 776 of 2011. The Hon'ble Bombay High Court in this case decided the questions of law directly applicable on the facts and circumstances of the present set of appeals under consideration.

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10.1. The revenue placed reliance on two case laws namely Ashima Syntex Ltd. in ITA No.- 831 (AHD) of 1998 by Hon'ble ITAT Ahmedabad 'B' Special Bench and Narendra Kumar Maheshwari vs Union of India and others (1989 AIR 2138) of Hon'ble Supreme Court. This was to emphasize the point that in the case of convertible debentures it is nothing but raising capital by way of equity shares increasing the capital base, via media being, issue of convertible debentures. 10.2. Reliance placed on these two case laws by the Revenue are misplaced as they do not lay down good law and they stand in isolation amidst various other case laws that hold the issue differently. First of all the Revenue has missed the point that the case of Ashima Syntex was in the context of allowance of expenditure incurred by the Assessee on the issuance of convertible debenture as a revenue expenditure when they were basically pre-issuance expenditures. Allowance of interest expense on loan under Section 36 (1) (iii) of the IT Act was never the issue under consideration. Similarly, the case of Narendra Kumar Maheshwari was also in the context of role of the Controller of Capital Issues (CCI) in giving sanction for the issue of debentures and on the larger issue of principles of comity of courts administering the laws throughout the country. Therefore, any observation made by the courts in these cases, while dealing with entirely different issues, cannot be imported into the situations of present set of appeals and be made applicable. 10.3. That the decision in the case of Ashima Syntex stands in isolation is very much evident from the following decisions - i. In the case of CWT vs Spencer and Co. (88 1TR 429) the Honbl. Supreme Court concluded that under certain circumstances the Assessee, instead of paying back debt in cash, could discharge the same by transfer of shares, provided in the resolution, and does not change the character of liability. The mode of discharging liability does not change its true character. It simply means that in the case of Compulsory Convertible Debentures, if the discharge of the debt is in terms of equity instead of cash, the character of the debt still remains as that of debt on which interest is payable; ii. In the case of Eastern Investment Ltd. vs CIT West Bengal (201TR 1) Honbl. Supreme Court concluded that there is no difference if instead of paying in cash the payment of price is in the shape of giving over the shares of the company, where the

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 32 of 48 transaction is not challenged on the ground of fraud and is approved by the court; iii. In the case of Secure Meter Ltd. (CC 10548/2009) under order Dt the 11 th August' 2011 the Hon 'foie Supreme Court while confirming the order of Honbl. High Court of Rajasthan confirmed the position that Compulsory Convertible Bonds represent the loan funds and thus represent the debts. The issue of bonds gives rise to a debt loan and not share capital and the expenditure incurred towards bonds should be considered as revenue in nature; iv. In the case of India Cements Ltd. vs CIT (1966 AIR 1053) Honbl. Supreme Court has clearly given the ruling that it is irrelevant to consider the object with which the loan was obtained. Admittedly, the debentures when issued is a loan, and therefore, whether it is convertible, or non-convertible, does not militate against the nature of the debenture, being loan and therefore the expenditure thus incurred would be admissible as revenue expenditure. v. In the case of CIT vs. ITC Hotels Limited (190 Taxmann 430), the Honble. Karnataka High Court has also concluded that even if the debentures were to be converted into shares at a later date the expenditure incurred on such convertible debentures has to be treated as revenue expenditure. vi. In the case of DCIT vs. Modern Syntex India Limited (95 TTJ JP 161), the Honble ITAT Jaipur, has also very clearly held that debenture is nothing but just another form of loan on which interest is payable. The debentures cannot be equated with shares. As regards convertible debentures, the company may also issue other debentures in which case the option is given to the debenture holders to convert them into equity or preferential shares at stated rate of exchange after certain period. Thus, debenture conversion is also another form of loan for a specified period till they are converted into shares. Interest is payable on convertible debentures till they are converted into shares when dividend becomes payable. vii. In the case of GE Strategic Investments India in AAR No.- 769 of 2007, the Hon'ble Authority for Advance Rulings, New Delhi concluded that payment made in the form of interest up to the date of conversion of bonds into equity shares is nothing other than interest paid on money advanced or the debt incurred. The Hon'ble Authority also concluded that the interest payments

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 33 of 48 cannot be construed as dividend as a dividend presupposes that the payee holds shares in a company and the bond holder would become share holder only upon conversion of the bonds into equity shares. It was observed that mode of discharge of the debt created by debentures is not relevant. (Kindly refer Page - 3, 10, 12, 14, 17, 18 and 19 of the order of the Authority). 11.1. On the issue of legality and validity of re-characterization of an instrument and transaction also, the Courts are very direct. In the case of Vodafone India Services Private Limited vs. Union of India ( 368 ITR I ), the Honble Bombay High Court very clearly has ordered that the TPO/AO cannot disregard any apparent transaction and substitute it by re-characterizing the said transaction without any material or exceptional circumstances indicating that the Assessee has tried to conceal the real transaction. 11.2. Honbl. Delhi High Court in case of CIT vs M/S Cotton Naturals (India) Pvt. Ltd [ITA 233/2014] observed that the Revenue Authorities cannot question the commercial wisdom and expediency behind a business decision. The relevant excerpt from the order is given below: "17. Chapter X and Transfer Pricing rules do not permit the Revenue authorities to step into the shoes of the Assessee and decide whether or not a transaction should have been entered. It is for the assessed to take commercial decisions and decide how to conduct and carry on its business. Actual business transactions that are legitimate cannot be restructured." 11.3. Likewise, in the following cases also the Honble Courts have held against re-characterization of a transaction like that done in the instant cases of appeals- i. Order of Honble ITAT Delhi in the case of First Blue Home Finance Limited vs. DCIT in ITA No. 3072/DEL/2013; ii. Order of the Honble ITAT Mumbai in the case of Aegis Limited vs. ACTT in ITA No. 1213/Mum/2014; iii. Order of the Honble ITAT Delhi in the case of Bharati Airtel Limited vs. ALIT (161 TTJ 428); iv. Order of the Honble ITAT Delhi in the case of Unitech Limited vs. DCIT in ITA No. 6585/Del/2015. 12. Thus, all the positions taken by the Revenue have been met both on facts and law and the Honble Bench may kindly consider them favorably, both in terms of the arguments made during hearing and in this Notes on Arguments.

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 34 of 48 13. Besides the above, there is an issue emanating from the applicability of LIBOR vs. PLR rate, to determine the rate of interest to be paid to the associated enterprises. In the instant cases, debentures have been raised in INR, therefore the interest benchmarking has to be done in PLR and not in LIBOR. This is a very well settled issue for which copies of case laws have been submitted before the Honble Bench before the commencement of the hearing. Some of the case laws for ready reference are as below - i. CIT Vs. Cotton Naturals India Private Limited, High Court of Delhi in ITA No. 233/2014; ii. Siva Industries and Holdings Limited (ITA No. 2148/Mds/2010); iii. BT (India) Private Limited ((TA No. 5953/De1/2012); iv. lndegene Lifesystems Private Limited [IT(TP) No.1504 / Bang / 2012)]. 14. A fresh Case Law Compendium with fresh indexing containing the case laws finding specific mention in this Notes on Arguments is being filed simultaneously just to facilitate quick and easy reference for this Notes on Arguments. Submitted for kind consideration of the Honbl. Bench with the prayer to kindly consider the same favourably.”

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 35 of 48 examined whether the 'interest' paid of Rs. 7,68,26,983 was in the nature of `interest' at all. The Assessing officer concluded that the CCDs were actually equity and not debt since it was compulsorily convertible to equity shares and that the Reserve Bank of India also recognised CCDs as equity instruments. Also, the TPO was of the view that the appellant had junk credit rating, having no operating income or source of cash flow to service the interest payable at 15% and that no third party would make investment in CCDs and that the arrangement amounted to this capitalisation. Holding this, the amount of Rs. 7,68,26,983 was held to be not in the nature of 'interest' and ALP of the transaction by CUP method was held as Nil and adjustment of Rs. 7,68,26,983 was determined u/s 92 CA (3) of Income tax Act, 1961. As grounds No. 1 and 2 are general in nature these do not require adjudication. The relevant grounds of appeal raised by the appellant are "3. That on the facts and in the circumstances of the case, the Learned AO/Learned TPO erred in making adjustment to the transfer price of the Appellant’ international transactions with related parties by INR 7,68,26,983 for interest on debentures and considering the same to be nil. 4. That the Learned AO/Learned PO erred in rejection of comparability analysis undertaken in the Transfer Pricing documentation by the Appellant in accordance with the provisions of the Act read with the Income tax Rules, 1962 ((the Rules"). 5. That the Learned AO/Learned TPO erred in reclassifying the debenture issued by the appellant form CCD to equity. The Learned YPO during the course of the hearing had not contended on the nature f the intercompany funding and had queried only on the rate of interest charged. Accordingly, the Learned TPO failed to provide to the appellant adequate opportunity to argue on the proposed classification of CCD as equity. The Learned TPO went beyond the brief of arbitrating only on the arm's Length pricing related to the rate of interest, and proceeded to question the nature of the inter-company funding. 6. That the Learned AO/Learned TPO proceeded to apply the principle of thin capitalisation, as contained in the Legislation from UK and Australia, in contravention to confining the assessment based on the principles provided in the Indian

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 36 of 48 Transfer pricing regulations (as provided in the Act and the Rules). 7. The Learned TPO as part of the TP order did not refer to nor had any dispute on the rate of interest charged, and thereby making the TP order erroneous. These are taken up together in determining whether the TP adjustment made by the TPO is correct. The relevant issues raised in the above grounds are as under: i) Whether TP study has been rightly rejected? The comparisons made by the appellant with transactions of cases of other years and in respect of non-convertible debentures was not correct. The said comparisons in the TP document was therefore rightly rejected by the Transfer Pricing Officer as detailed in the order dated 29.1.2013. ii) Whether borrowing is debt or equity; Whether thin capitalisation rules apply? The Assessing Officer has in effect held that CCDs amount to equity, and that the case is of thin capitalisation as the appellant has shown the funds as debt rather than equity although, the debt equity ratio has not been discussed in the order of the Transfer Pricing Officer. In the case of Besix Kier Dabhol, SA vs DDIT (I Tax),Circle-3(2), Mumbai, ITAT, Mumbai in their order in ITA No.4249/Mum/07 dated 20.11.2010 have held on similar facts that in absence of specific thin capitalisation rules in India, recharacterisation of debt capital as equity capital and accordingly disregarding the interest payments as tax deductables is not in order. Drawing support from the above, I hold that the conclusion of the AO that the CCDs is equity and that interest payment is not allowable cannot be upheld. iii) Whether rate of interest charged is at arm's length? It is on record that the funds which have been raised by the appellant through CCDs and have been utilised for the business of the appellant. The appellant has paid 15% as the rate of interest to its AEs for this purpose. It is been that PLR for A.Y.2008-09 as seen from SBI corporate website varies from 12.25% as on 1.1.2009 to 13.00% as on 10.11.2008. At an average, the same can be taken at 12.6% as against 15% claimed by the appellant. Under such facts, the interest paid of Rs.7,68,26,983/- at @ 15% is certainly not at arm's length and is also evidently in excess of the +/- 5% margin allowable. The AO/TPO is therefore required to rework the ALP taking into account, 12.62% rate of interest as the Arm’s Length rate of interest on the

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 37 of 48 borrowing i.e. CCDs and rework the addition made u/s 92CA accordingly. It is held accordingly.” 22. As per above para, it is noted that it is noted by CIT (A) that as per the tribunal order of Mumbai Bench rendered in the case of Besix Kier Dabhol, SA vs. DDIT as reported in 131 ITD 299 in which the issue was decided in favour of the assessee on this basis that in the absence of specific Thin capitalization Rules in India, recharacterization of Debt Capital as equity Capital and disregarding of interest is not in order. We reproduce the relevant paras of this tribunal order i.e. para 18 to 30.

“18. That takes us to objection of the Revenue authorities to the effect that the borrowings by the assessee, on which interest has been claimed as deduction, are in fact part of the capital of the assessee which is brought in the garb of borrowings purely on tax considerations. Our attention is pointed out to the fact the ratio of debt to the equity is 248 : 1 which is unusually high by any standard and that such a highly geared company only shows that equity is brought in the garb of debt, and it is contended that since what is termed as borrowing by the company is de facto minimum required capital to carry out the business in India, interest cannot be allowed as a deduction on the same. In other words, Revenue’s objection is that the assessee company is so thinly capitalized that its debt capital is required to recharacterized as equity capital for the purpose of examining claim of deduction for interest on such debt capital. 19. Thin capitalization refers to a situation in which capital of a business is made up of greater portion of debt than equity, and its such gearing or leverage ratio i.e. debt equity ratio, is too high. The tax treatment being given to the equity capital and debt capital being fundamentally different, it is often more advantageous in international context to arrange financing of a company by loan rather than by equity. It does affect the legitimate tax revenues of the source country in which business is carried out because while dividends and interest are generally taxable at the same rate in the hands of the recipient in the source country, e.g. under India Belgium tax treaty WHT rate on interest, other than bank interest, as also dividend is at uniform 15 per cent, interest is tax deductible and that results in lower corporate taxes in respect of PE profits. These tax benefits could be further optimized by hybrid financing instruments such as profit participating loans, convertible loans or where instrument is treated as debt in the source country of the income (i.e. resulting in tax deductible interest) and as equity in the residence country of the lender (i.e. where lender

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 38 of 48 may claim the participation exemption of interest income because of its characterization as distribution of profits). That is how tax considerations at times do result in a company being too thinly capitalized, or, to put it differently, financed by a disproportionate ratio of debts. In order to protect themselves against such erosion in their legitimate tax base, several tax jurisdictions enact rules to counter this vulnerability and these rules are termed as ‘thin capitalization rules’. 20. It is for this background that many jurisdictions take several legislative anti-abuse measures including limiting deduction on interest when the company is considered to be too highly geared under applicable tax regulations. India has woken up now to neutralize this kind of manoeuvring and the Direct Taxes Code Bill, 2010, does seek to provide a legislative framework for remedial measures to counter erosion of tax base by thin capitalization. Under s. 123(1)(f) of the proposed Direct Taxes Code Bill, 2010 (Bill No. 11 of 2010 as introduced in the Parliament on 30th Aug., 2010) as a part of the general anti-avoidance rule, "any arrangement entered into by a person may be declared as an impermissible avoidance arrangement and the consequences, under this Code, of the arrangement may be determined by recharacterising any equity into debt or vice versa". That is the first step taken by the India’s tax administration in the direction of having formal thin capitalization rules in India. However, it is not in dispute that as at the material point of time, India did not have any thin capitalization rules, nor does it have any thin capitalization rules even at present. 21. Interestingly, however, thin capitalization rules do exist in Belgium which perhaps explains, for the reasons we shall now set out, the peculiar capital structure may have been adopted by the assessee. As per the Country Survey Report on Belgium, as published by the International Bureau of Fiscal Documentation, Amsterdam (based on information as on 19th Dec., 1995) Belgium applies two sets of thin capitalization rules. Firstly, a 1:1 debt/equity ratio applies to loans granted by individual directors, shareholders and non-resident corporate directors to their company [art. 198(10) IR/WIB]. Interest relating to debt in excess of this ratio is recharacterized into a non- deductible dividend. Furthermore, the interest rate may not exceed the market rate. Secondly, a 7:1 debt/equity ratio applies to debt if the creditor (resident or non-resident) is exempt or taxed at a reduced rate in respect of the interest paid on the debt. Interest relating to debt in excess of this ratio is considered a non-deductible business expense [art. 198(11) IR/WIB]. In a 2008 IBFD publication "International Tax Planning and Prevention of Abuse" (by Dr Luc De Broe : ISBN 978-

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 39 of 48 90-8722-035-08; @ p. 502), these thin capitalization rules are summed up as follows : "Belgium has five domestic law provisions that are relevant for the discussion of thin capitalization, i.e. art. 26 BITC; art. 54 BITC; art. 198, 11° BITC, art. 18, 4° BITC and the Belgian GAAR. Articles 26, 54 and 198 belong to the first group of aforementioned rules. The deduction of interest is denied if the statutory conditions for deductibility are not satisfied. Articles 26 and 54 are not concerned with the question whether the borrower is undercapitalized but only whether the interest charged is at arm’s length. Excessive interest (i.e. interest charged above the prevailing market conditions) is not deductible. Article 198, 11° is concerned with undercapitalized companies. Interest is not deductible if the statutory 7 : 1 debt/equity ratio is exceeded. Article 18, 4° BITC belongs to second group of aforementioned rules; it recharacterizes certain interest payments into dividends both for corporate tax purposes of debtor and for withholding tax purposes, while curiously it does not recharacterize debt into equity (neither for corporate tax, nor for capital duty purposes). In certain circumstances, the Belgian GAAR may have the potential to recharacterize purported debt into equity. In that case, it also belongs to the second set of rules." 22. It is thus only under the Belgian tax laws, which inter alia restrict the interest deductions only to the extent of debt capital ratio of 1:7 in sharp contrast to the debt ratio in the present case which is 1:248, that the mode of borrowings, i.e. via GE or via PE, may have some tax implication even though at somewhat superficial level. That perhaps explains as to why the borrowings are claimed to have been resorted to by the Indian PE and not the Belgian GE directly. If these borrowings were resorted to by the Belgian GE directly, prima facie the thin capitalization rules would have restricted the interest disallowance in excess of borrowings exceeding seven times the equity capital, whereas in the present case borrowings are two hundred forty-eight times the equity capital. As the capital is structured now, and the borrowings having been resorted by the Indian PE directly, it could possibly be said, or at least argued, that there is no debt capital in the assessee company—i.e. the Belgian entity, and this debt capital is confined to borrowings directly by the PE. Be that as it may, it cannot be open to us to apply these thin capitalization rules in the hands of the assessee company while computing its taxable income in India, because so far as taxability in India is concerned, the limitation to be placed on deduction of expenses has to be limitation under the laws of the State in which PE is situated i.e. India. It may be useful to recall that in terms of the provisions of art. 7(3)(b) of Indo-Belgian tax treaty, "In the determination of the profits of a PE, there shall be

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 40 of 48 allowed as deductions expenses which are incurred for the purposes of the business of the PE including executive and general administrative expenses so incurred, whether in the State in which the PE is situated or elsewhere, subject to the limitations of the taxation laws of that State". Admittedly, there are no limitations on deduction of interest expenses on borrowings, which can be attributed to thin capitalization rules, in India. 23. The question then arises whether even in the absence of any specific thin capitalization rules in India, it could be open to the Revenue authorities to recharacterize the debt capital as equity capital and, accordingly, disregard the interest payments as tax deductibles. 24. We find guidance from Hon’ble Supreme Court’s judgment in the case of Union of India & Anr. vs. Azadi Bachao Andolan & Anr. (2003) 184 CTR (SC) 450 : (2003) 263 ITR 706 (SC) wherein their Lordships have, inter alia, observed as follows : "111. In para 3.3.1 after noticing the growing practice amongst certain entities, who are not residents of either of the two Contracting States to try and avail of the beneficial provisions of the DTAAs and indulge in what is popularly known as ‘treaty shopping’, the report says : ‘3.3.1 ..there is a need to incorporate suitable provisions in the chapter on interpretation of DTAAs, to deal with treaty shopping, conduit companies and thin capitalization. These may be based on UN/OECD Model or other best global practices.’ 112. In para 3.3.2 the working group recommended introduction of anti-abuse provisions in the domestic law. 113. Finally, in para 3.3.3 it is stated ‘the working group recommends that in future negotiations, provisions relating to anti-abuse/limitation of benefit may be incorporated in the DTAAs also.’ 114. We are afraid that the weighty recommendations of the working group on non-resident taxation are again about what the law ought to be, and a pointer to the Parliament and the executive for incorporating suitable limitation provisions in the treaty itself or by domestic legislation. This per se does not render an attempt by resident of a third party to take advantage of the existing provisions of the DTAC illegal. (Emphasis, by underlining, italicized in print, supplied by us)

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 41 of 48 25. It is thus clear that merely because a suitable limitation provision in the treaty or the domestic legislation is considered desirable, and attempts are being made to legislate the anti-abuse provisions subsequently, it would not render the effort to take advantage of existing provisions of the treaty illegal. We are thus unable to accept the plea of the Revenue authorities, and we uphold the claim of deduction of interest in respect of capital borrowed from the shareholders or joint venture partners by the assessee. 26. Even otherwise, it is also important to bear in mind the fact that as the law stands now under s. 90 of the Indian IT Act, the provisions of a tax treaty override the provisions of the Indian IT Act—except to the extent the latter are beneficial to the assessee and this treaty override is unqualified, save and except for clarification that charge of tax in respect of a foreign company at a rate higher than the rate at which domestic company is chargeable, shall not be regarded as less favourable charge or levy in respect of such foreign company. Just in case there were any doubts on this fundamental legal position, the CBDT, vide Circular No. 333, dt. 2nd April, 1982 [(1982) 81 CTR (TLT) 18 : (1982) 137 ITR (St) 1], has set the same at rest. This circular deals with the question as to what the AOs will do when they find that the provisions of the DTAA are not in conformity with the provisions of the IT Act, 1961. Then it was laid down by the Board in the said circular as follows : "The correct legal position is that where a specific provision is made in the DTAA, that provision will prevail over the general provisions contained in the IT Act, 1961. In fact the DTAAs which have been entered into by the Central Government under s. 90 of the IT Act, 1961, also provide that the laws in force in either country will continue to govern the assessment and taxation of income in the respective country except where provisions to the contrary have been made in the agreement." 27. In the case of UCO Bank vs. CIT (1999) 154 CTR (SC) 88 : (1999) 237 ITR 889 (SC), their Lordships of Hon’ble Supreme Court had an occasion to survey the judicial precedents on the question of binding nature of the CBDT circulars. After elaborately dealing with Hon’ble Supreme Court’s judgments in the cases of Navnit Lal C. Jhaveri vs. K.K. Sen, AAC (1965) 56 ITR 198 (SC) and K.P. Varghese vs. ITO & Anr. (1981) 24 CTR (SC) 358 : (1981) 131 ITR 597 (SC), their Lordships concluded that the CBDT circulars inter alia can tone down the rigour of the law and such benevolent circulars are binding on the field authorities. It cannot therefore be open to a Revenue authority to disregard the CBDT circular even if it deviates from the law—as long as it is beneficial to the assessee. Thus, where a DTAA provided for a

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 42 of 48 particular mode of computation of income, the same should be followed, irrespective of the provisions in the IT Act. Where there is no specific provision in the agreement, it is the basic law, i.e., the IT Act, that will govern the taxation of income. When no such limitations on benefits or anti-abuse provisions are set out in the tax treaty, it cannot be open to the Revenue authorities to apply the anti-abuse provisions based on the Judge made law in India—which is essentially to be treated as a part of the IT Act as it is based on the interpretation of provisions under the IT Act and apply the same. As observed by this Tribunal, in the case of Motorola Inc. vs. Dy. CIT (2005) 96 TTJ (Del)(SB) 1 : (2005) 95 ITD 269 (Del)(SB), a tax treaty is an alternative tax regime. It has to be treated as a complete code in itself, in that sense. There are thus no legally sustainable merits in learned Departmental Representative’s passionate plea for invoking principles laid down by Hon’ble Supreme Court in McDowell & Co. Ltd. vs. CTO (1985) 47 CTR (SC) 126 : (1985) 154 ITR 148 (SC), which, inter alia, holds that "colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by restoring to dubious methods" and that "it is the obligation of every citizen to pay the taxes honestly without resorting to subterfuge". It is thus not even necessary to examine whether or not the finance structure in question constituted colourable device or sort of subterfuge. As long as finance structure adopted by the assessee was not specifically prohibited by the applicable tax treaty provisions, and as long as there was no specific anti-abuse provision to deal with the same in the tax treaty itself, the effect of the finance structure could not be ignored. 28. It is interesting to take note of the paradigm shift with regard to the treaty override, as introduced in s. 129(9) of the Direct Taxes Code Bill 2010, which provides that notwithstanding the treaty override provisions in s. 129(8) [which are in pari materia with s. 90(2) of the Indian IT Act, 1961] the provisions of the Direct Taxes Code "relating (a) general anti-avoidance rule under s. 123; (b) levy of branch profit tax under s. 111; or (c) control foreign company rules referred to in the Twentieth Schedule, shall apply to the assessee referred to in sub-s. (8), whether or not such provisions are beneficial to him". The treaty override is thus quite restricted in scope in this new paradigm. Unlike in the proposed code and in sharp contrast to this paradigm, the treaty override in the IT Act, 1961, save and except for the higher tax rate being permitted for the foreign companies, is unqualified. In the scheme of things, as it exists in the Indian IT Act, 1961, the treaty override over domestic law is much wider in scope. We cannot interpret the treaty provisions in such a manner so as to curtail, dilute or otherwise tinker with this comprehensive treaty override over the domestic tax law.

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 43 of 48 29. It is also important to bear in mind that when there are no thin capitalization rules vis-a-vis domestic thin capitalization situations and in the light of the s. 90(2) as it exists at present any attempts to neutralize thin capitalization vis-a-vis PEs of Belgian enterprise will be clearly contrary to the scheme of non-discrimination envisaged by art. 24(5) which provides that, "enterprises of a Contracting State, the capital of which is wholly or partly-owned or controlled, directly or indirectly, by one or more residents of the other Contracting State, shall not be subjected in the first-mentioned Contracting State to any taxation or any requirement connected therewith which is other, or more burdensome, than the taxation and connected requirement to which other similar enterprises of that first-mentioned State are or may be subjected in the same circumstances and under the same conditions". In this view of the matter, it cannot be open to the Revenue authorities to put any limitation on deduction of interest, in respect of funds borrowed by the PE, while computing income in accordance with the provisions of art. 7 of Indo-Belgium tax treaty, when no such limitations are placed on the domestic enterprise. 30. For the reasons set out above, we are of the considered view that the assessee is indeed justified in claiming deduction on account of interest paid on borrowings from its shareholders/joint venture companies. The international consensus that the AO has referred to is for the need of thin capitalization rules, but then just because it is desirable to curb thin capitalization, the AO cannot disallow the interest paid on debt capital in the cases of thinly capitalized companies. The AO was clearly ahead of his times in disallowing the expenses based on his notions of thin capitalization rules, when such rules had not even reached the drawing board stage in India. Learned CIT(A) also did not follow the correct legal position by leaning upon restriction placed in Explanation to s. 37 of the Act, which is not applicable in respect of deduction on interest under s. 36(1)(iii) and in leaning upon restriction placed in art. 7(3)(b) on intra-organization notional payment of interest on capital, whereas the interest payment in the present case did not constitute an intra-organization transaction at all. Even if these interest payments were to be treated as intra-organization transactions by treating the same as payments made to the GE, and not to the joint venture partners, these payments cannot be viewed as notional payments because in such a situation the GE will have corresponding liability to pay the same to the joint venture partners. We have also noted that the interest paid by the assessee may have been contrary to the spirit, if not letter of the RBI guidelines, but then this fact, by itself and particularly in view of Explanation to s. 37 being confined to the amounts admissible as deduction under s. 37, does not render the interest paid by the assessee as not deductible, and it is not even necessary to examine the

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 44 of 48 scope of Explanation to s. 37. It is also quite possible that tax considerations may have played a role in assessee’s planning the capital structure, but an element of planning in structuring capital does not transform a tax-deductible expense of interest into an expense that is non-tax deductible. In view of these discussions, it is clear that the impugned disallowance is indeed contrary to the scheme of the law as it exists; the grievance of the taxpayer deserves to be upheld. We, therefore, direct the AO to delete the impugned disallowance.” 23. As per above paras of this tribunal order, it comes out that even if Thin capitalization Principle is on Statute book of the other country, no disallowance can be made in India by applying this Principle. To this extent, we uphold the finding of CIT (A) by respectfully following this tribunal order. But the issue still remains because, the objections of AO/TPO are not merely on the basis of Thin capitalization Principle. Their basic objection is this that since the interest is paid on CCDs, this is not an interest on debt but on equity and hence, not allowable. On page 11 of his order for A. Y. 2009 – 10, the TPO has reproduced certain comments of RBI in 2007 Policy on convertible debentures in which it is stated that fully and mandatorily convertible debentures into equity within a specified time would be reckoned as equity under FDI policy. In view of this RBI Policy, the TPO concluded that these CCDs are equity and not debt and therefore, interest on it is not allowable u/s 36 (1) (iii). This finding of TPO is not by invoking Thin Capitalisation principle and therefore, it has to be decided independently. We find that the decision of TPO is bases on RBI policy of FDI. We all know that RBI policy of FDI is governed by this that what will be future repayment obligation in convertible foreign currency and since, CCDs does not have any repayment obligation, the same was considered by RBI as equity for FDI policy. Now the question is that such treatment given by RBI for FDI policy can be applied in every aspect of CCDs. Whether the holder of CCDs before ins conversion can have voting rights? Whether dividend can be paid on CCDs before its conversion? In our considered opinion, the reply to these questions is a BIG NO. On the same logic, in our considered opinion,

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 45 of 48 till the date of conversion, for allowability of interest u/s 36 (1) (iii) of Income tax Act also, such CCDs are to be considered as Debt only and interest thereon has to be allowed and it cannot be disallowed by saying that CCDs are equity and not debt. We hold accordingly. This issue is decided.

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 46 of 48 debentures was to be converted into shares on the date of allotment itself and the second part was to be converted after expiry of 15 months from the date of allotment of debenture and therefore it was held that expenses incurred were actually incurred for issue of shares and not issue of debentures. In the present case, the issue is not regarding expenses incurred on issue of shares. In the present case, the dispute is regarding interest on CCDs for a period before conversion. Hence in our considered opinion, this decision of special bench of the Tribunal is not applicable in the facts of present case because the issue in dispute is different. In that case the issue in dispute is regarding expenditure incurred on issue of convertibles whereas in the present case the issue is regarding allowability of interest expenditure on convertible debentures for the pre-conversion period. Hence we hold that the revenue does not find any support from this decision of Special Bench of the Tribunal in that case.

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 47 of 48 convertible debentures cannot be applied in other context such as allowability of interest on such debentures during pre-conversion period or regarding payment of dividend on such convertible debentures during pre- conversion period or regarding granting of voting rights to the holders of such convertible debentures before the date of conversion. 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 share holders 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 allowable u/s. 36(1)(iii) of the IT Act.

ITA No. 2006/Bang/2017, IT(TP)A Nos. 63 & 84/Bang/2015, 599, 2060 & 2178/Bang/2016 & C.O. Nos. 83/Bang/2017 & 09/Bang/2018 Page 48 of 48 27. In the result, Both the C. Os. Of the assessee are dismissed and all three appeals of the assessee for A. Y. 2010 – 11 to 2012 – 13 and all three appeals of the revenue for A. Y. 2009 – 10, 2010 – 11 & 2013 – 14 are partly allowed for statistical purposes. Order pronounced in the open court on the date mentioned on the caption page.

Sd/- Sd/- (BEENA PILLAI) (ARUN KUMAR GARODIA) Judicial Member Accountant Member Bangalore, Dated, the 25th July, 2019. /MS/ Copy to: 1. Appellant 4. CIT (A) 2. Respondent 5. DR, ITAT, Bangalore 3. CIT 6. Guard file By order

Assistant Registrar, Income Tax Appellate Tribunal, Bangalore.