ALFANAR ENERGY PRIVATE LIMITED,GURUGRAM, HARYANA, INDIA vs. THE DEPUTY OR ASSISTANT COMMISSIONER OF INCOME TAX, CIRCLE 1(1), GURUGRAM, GURUGRAM, HARYANA, INDIA

This appeal is preferred by the assessee against the final assessment order dated 29.07.2024 of the Dy. Commissioner of Income-tax, Circle 1(1), Gurugram (hereinafter referred as ‘the Ld. AO’) for Assessment Year 2020-21 passed u/s 143(3) r.w.s. 144C(13) r.w.s. 144B of the Income Tax Act, 1961 (hereinafter referred as ‘the Act’).

The assessee is part of the multinational group, Arabian Trading Group which is based out of Kingdom of Saudi Arabia and is engaged in generating, developing, accumulating, distributing and supplying electricity by setting Renewable Energy Power Plants. This is the first year of the assessment of the assessee. During the year, the assessee has undertaken the following international transactions:- International Transactions Transfer Pricing method Total Value of International Transactions (in INR) Issue of compulsorily Other method 2,44,77,26,400 convertible debentures (CCDs) Interest on CCDs Comparable Uncontrolled 46,52,90,098 Price (CUP) Method Issue of equity shares Other Method 45,04,31,700

We have heard both the sides and gone through the material on record. At outset it is pertinent to mention that the assessee has submitted that the ground No.1 is general and ground No.2 is not pressed. The ground No.3 arises out of the fact of AO/TPO holding the interest charged on CCD issue by the assessee as international transaction and subsequent ground No.4 to 11 are with regard to transfer pricing adjustments proposed on this alleged international transaction relating to payment of interest on CCDs.

Now with regard to these ground numbers 1 to 6, which are interrelated the same pertain to the proposed TP adjustment of Rs. 46,52,90,098/- on account of the interest on CCDs issued by the assessee to its AEs as a fact, during FY 2019-20, AEPL issued INR denominated CCDs to Alfanar Company and Alfaran Power Limited. The said CCDs are issued for a period of 15 years. Further, during FY 2018-19, AEPL had issued INR denominated CCDs to Alfanar for a period of 15 years. All the CCDs were issued between 26.08.2015 and 26.08.2019 and carried a fixed interest rate 13% per annum and are unsecured in nature. The assessee benchmarked the transactions of interest on CCDs with other debt instruments. However, the AO observed that the CCDs issued by the assesse cannot be compare to a debt instrument and accordingly, rejected the benchmarking analysis of the assessee. The AO has further observed that the CCDs issued by the assessee are more akin to equity rather than debt and the reasons put forth by the TPO are contained in para 5.1 as under: “The instrument used to raise funds in the case was a Compulsorily Convertible Debenture (CCD) The CCD is a hybrid instrument which is in the nature of both debt and equity depending on the date of conversion. However, in the instant case, there is no sanctity for the date of conversion in the agreements where in the CCD can be converted to equity at the option of both the issuer and subscriber. Therefore, the CCDs issued by the assessee are more akin to equity in this case rather than debt. The arguments for the same were already provided in the show cause notice and are reproduced here again for clarity. i. When there is no moratorium on the conversion date, as in the instant case, the differentiation between debt and equity disappears as the same instrument can be debt one day and equity the next day depending on the discretion of the issuer and the subscriber ii. In such a scenario, CCDs cease to maintain the character of pure debt even before the date of conversion iii. This is because, for the CCD subscriber, there is no surety of receipt of interest, as the instrument may as well become equity the next day iv. For the CCD issuer too, the instrument ceases to remain debt because the debt holder may become shareholder and be eligible to vote with just a resolution. Therefore, the instrument itself is akin to an equity instrument, based on the agreements entered into by the assessee"

Accordingly, the TPO has concluded that the CCDs issued by the assessee are in the nature of equity. Since there is no interest payment associated with equity instruments, the ALP of interest payment is determined to be NIL, by using the CUP method.

The assessee filed detailed submissions vided Form 35A before the DRP and the primary arguments of the assessee was against re-characterization of the CCDs issued by AEPL into equity as well as rejection of benchmarking analysis undertaken using Bloomberg database and NSDL database. The Panel considered the submissions and the fact that the Ld. TPO has mentioned that: "5.2 The assessee has submitted that it has "no intention" of converting the CCD into equity and it should therefore it should be considered as a debt instrument only. However, this "intention" fades before the formal written agreements that were entered between the assessee and its AEs, in which it is clearly written that the CCDs can he converted at will by both the issuers and subscribers. If the assessee indeed had the intention of not converting the CCDs, then there would not be an option to do so in the agreement itself. Therefore, this argument cannot be accepted. 5.3 The assessee has provided a list of differences between CCDs and Equity. The undersigned is in agreement with these differences in so far as the nature of CCDs remains debt. However, in this case, the CCDs do not have the character of debt, having no moratorium on conversion and being freely convertible into equity at the will of the issuer and subscriber.

Thus the panel observed that the Ld. TPO has held that the CCDs issued by the assessee have attributes of both equity as well as debt, which impacts the arm's length nature of the interest paid by the Assessee. As per the Transfer Pricing Officer, the CCDs issued by the Assessee confer rights that are otherwise available to equity shareholders to debenture holders. The Ld. TPO has further held the concept of thin capitalization 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, ie. its gearing or leverage. is too high. In summary, the Ld. TPO has concluded that since CCDs are hybrid instruments, the benchmarking of CCDs by assessee is not correct as assessee has not 5 adjusted the value of option to convert into equity, and therefore the effective coupon rate is not reliable. Therefore, the ALP of the international transaction of interest on CCDs has been considered as incorrect and adjustment of Rs. 46.52,90,098-has been proposed to the income of the Assessee.

The DRP then considered the Sub-section 92(2) of the Act, which provides that under an arrangement for facility of funding have to be such that “the cost or expense allocated or apportioned to, or, as the case may be, contributed by, any such enterprise shall be determined having regard to the arm's length price of such benefit, service or facility, as the case may be. DRP observed that in this case, the TPO has determined that the Arm's length price of the funding would be "Nil since the funding facility would be an equity infusion arrangement instead of a debt-based one. Thus, the TPO has determined the arm's length price of the funding facility as "Nil". As per the Ld. TPO, the Applicant has not obtained the Funds as debt but equity, and this the funding facility provided had to be in nature of equity infusion, for which the Arm's length payment will be "zero". Hence, leaving aside the re-characterization argument, ALP of the facility is confirmed to be "zero". The Panel held that it is of the opinion that the TPO has to look at the ALF of the facility, instead of nature of funding (Debt/Equity).

The ld. counsel has submitted before us that as the transaction for interest charged on CCDs issued by the assessee to its group entities has not been subjected to deduction/allowance of interest or depreciation in the return, the transaction of interest does not come within the purview of international transaction requiring any adjustments. The ld. counsel has submitted that the interest has been capitalized and made part of work-in-progress. It was submitted that since the interest has been capitalized the same does not result into any increase in the profit or loss of the assessee.

It was contended that he ld. TPO/AO has relied the provisions of section 94B of the Act which is applicable only when interest is deductible. During the year the assessee has not claimed any deduction of the interest paid to AEs. As no interest is claimed as deduction, disallowance as per the provisions of section 94B of the Act is not justified. We find that this aspect was specifically raised as additional ground before the TPO. However, it was not specifically dealt by the DRP and in para 4.9.1 the DRP has observed as follows:- “4.9.1 The spirit of section 94B enshrines the law / rules with regard to thin capitalization so as to consider debt as an equity. The claims of the applicant that due consideration has been given to section 94B is not acceptable. It is a case where the entire sums are due to be treated as equity instead of part of the interest being carried forward as per section 94B. Further, section 94B is only a carry forward provision, but the instant case is that of complete disallowance.

The ld. DR has, however, submitted that as interest has accrued during the year, the same results into an international transaction.

We have given thoughtful consideration to the facts and circumstances of the case and the submissions. On the basis of the material before us, the ld. counsel has sufficiently established that as a financial cost, the interest paid on CCDs has not been actually paid but made part of work-in-progress. Now the issue is if there is at all an international transaction and in this regard having considered Section 92 along with definition of international transaction as provided u/s 92B(1) of the Act and section 94B(1) of the Act we are of considered view that the work-in-progress denotes the ongoing activity which is not ready to be used for generating revenue. Capitalisation of operating costs generally would cease only when all the activities necessary to prepare the use of the qualifying assets are complete and put to use. However, that does not mean that for the mere fact of non-deduction of interest expenses in preset FY, and the capitalization of same in WIP, will not have any bearing in the profits, income, losses or assets of the assesse at any time. The use of words ‘bearing’ in section 92B(1) of the Act when read along with word ‘deductible’ in Section 94B(1) of the Act, indicates that it is not just impact on financials for this year but at any stage also in subsequent years, if the interest component on CCD, shall be deductible then in that point of time it will certainly have a bearing on the profits, income, losses or assets of the assesse. We are of considered view that capitalisation of interest of CCD is a supernumerary but real exercise in the accounting of WIP and but such interest continues to be an expense side item and its allowance in the WIP has to be justified too on scales of business 8 expediency, prudence and being at Arm’s length. The international transaction in case of cost of borrowing has to be seen in context to accrual of cost as ac consequence of borrowing itself. Thus as we are not inclined to accept the contention that no international transaction exists out of accrual of interest becoming payable on CCD if same is capitalized.

This conclusion of ours is fortified by the decision of Pune Bench in M/s City Corporation Limited vs. DCIT, order dated 17.08.2021, the same was brought to knowledge of ld. AR by way of seeking a clarification. That was a case where the coordinate Bench was dealing with a situation where the transaction of payment of interest on CCD was in dispute. The assessee had applied Comparable Uncontrolled Price Method to demonstrate that the international transaction were at ALP. The TPO observed that the assessee, in fact, availed funds from its related concerns as share capital, but, wrongly classified as debentures/CCDs for claiming interest deduction. Relying AY 2013-14 decision, the TPO concluded that such financing by the related concerns was a shareholder’s activity and he, thus, recharacterisied the transaction of issue of debentures/CCDs to those of equity shares and held that no interest payment was called for. That is how he determined the ALP of the transaction at Nil and proposed transfer pricing adjustments. The CIT(A) had deleted the same and directed TPO to verify certain facts regarding the ALP determination of the interest on the debentures/CCDs and, accordingly, when both the sides were in appeal before the Tribunal, the coordinate Bench observed in M/s City Corporation Limited (supra) that when the matter came up before the CIT(A), the assessee had contended that the interest cost was taken to work-in-progress and not claimed as deduction. Albeit the CIT(A) approved the ALP determination, but also accepted the assessee’s alternative arguments and he directed the AO that whenever the assessee claimed deduction against this work-in-progress, the interest component for the assessment year 2013-14, whose ALP was determined at nil, should be added back to the total income. Thus, following these directions for the year under consideration which was AY 2015-16, the AO added the interest component to the total income of the assessee representing interest expenditure on debenture/CCDs booked for the assessment year 2013-14. Now, in assessment year 2013-14, the Tribunal had overturned the view of the CIT(A) and had held that recharacterisation of transaction of issue of debentures/CCDs to issue of equity capital was not correct and, accordingly, directed the AO/TPO to re-work out the ALP of the transaction of interest payment. In that view of the matter, the direction given by the ld.CIT(A) for AY 2013-14 stood substituted with that of the Tribunal for re-determining the ALP of the transaction of payment of interest on debentures/CCDs. Thus, while deciding for AY 2015-16, the Tribunal observed that since the assessee has capitalized the interest on debentures/CCDs in its WIP for the AY 2013-14, it is but natural that when work-in-progress is reversed in the subsequent years, at the time when the 10 inventory is finalized, the corresponding amounts of excess interest on debentures/CCDs over and above its ALP, needs to be reversed and added back to the income of that year. In these circumstances, the Tribunal concluded as follows:- “21. ………. To exemplify, if the WIP stood at Rs.1000 as on 31.3.2013 which included interest of Rs.100 paid on debentures/CCDS and pursuant to the directions given by the Tribunal, the ALP of interest payment is re-determined at Rs.75/-. In that case, the differential amount of Rs.25/- (Rs.100 minus Rs.75) is required to be added back proportionately to the total income as and when the corresponding amount of the work-in-progress is reversed on the sale of flats/plots etc. We, therefore, overturn the impugned order on this score and hold that the amount of capitalized interest on debentures/CCDs to the work in progress for the assessment year 2013-14, as is in excess of its ALP freshly determined by the AO/TPO, should be disallowed proportionately in the years in which the work-in-progress containing the amount of such interest standing as on 31-03-2013, is reversed on the sale of flats/plots.”

In the light of the above discussion, we are of the considered view that the re-characterization of CCDs issued by the appellant before us, as equity was not justified and legal. The CCDs as long as they are not converted, continue to be a debt side item in the financials. The mere fact that the CCDs are compulsorily convertible at the end of a particular period like in the present case 15 years, then too, the nature of CCDs continues to be debt instrument. Thus, to the extent of re-charaterisation of CCDs of equity being not permissible, the assessee needs to be benefitted.

However, as the AO has not made any exercise of determining the ALP while the assessee has done a specific benchmarking analysis which has not been disturbed for making the adjustments, we consider it an appropriate case to restore the issue of determination of ALP afresh to the files of TPO/AO. Further, the amount of interest capitalized on CCDs to the work-in-progress for the present AY as is in excess of its ALP freshly determined by the AO/TPO should be disallowed proportionately in the years in which the work-in-progress containing the amount of such interest standing as on 31.03.2020 is reversed.