Interest paid to foreign co on convertible debentures taxable

In a move that could set a precedence for numerous court cases on tax deduction in interest payments on foreign currency denominated loans, the Authority for Advance Rulings (AAR) has ruled that the interest paid to a foreign company on convertible debentures constitutes the foreign company’s income and is liable to be taxed in India.

Indian companies raise foreign currency denominated funds in the form of external commercial borrowings (ECBs) or foreign currency convertible bonds (FCCBs). While ECBs are pure loans, FCCBs have an in-built option for the lender to convert them into equity of the companies on maturity. Both in ECB and FCCB, till maturity, the borrower is expected to make interest payments on the amount borrowed.

Incidentally, the AAR ruling of October 10 had been sought by a non-banking finance company (NBFC). Till October 31, NBFCs were not allowed to borrow funds from overseas in foreign currency.

Tax officials say the tax on such interest payments has always been a contentious issue. While some Indian companies seek relief under the double taxation avoidance treaties, others feel it is unnecessary since the amount is borrowed for overseas acquisitions or projects.

Indian companies are expected to redeem around $45 billion of foreign debt by December 2009, which they had borrowed for domestic expansion and overseas acquisitions.

According to the AAR ruling, payment to the foreign company up to the date of conversion of bonds into equity is equivalent to interest paid on borrowed money, under Section 2(28A) of the Income Tax Act, 1961. This section defines “interest” as interest payable in any manner in respect of any money borrowed or debt incurred (including a deposit, claim or other similar right or obligation) and includes any service fee or other charge in respect of the money borrowed or debt incurred or in respect of any credit facility which has not been utilised.

Allaying the confusion as to whether interest on FCCB is similar to interest on any other loan, the authority has stated that the conversion of debt into equity is an option and not a mandatory ruling in the instrument. Therefore, under Section 195 (1), any person paying interest to a non- resident Indian or a foreign company is liable to deduct taxes.

Further, the ruling is of the view that interest payments on convertible debt cannot be interpreted as dividend income since dividend presupposes that the payee, or borrower in this case, holds shares in the company. On the other hand, the bond holder will become a shareholder only upon the conversion of bonds into equity shares.