The interest payable to a non-resident by an Indian borrower is taxable in the hands of such non-resident in India (except where it is payable in respect of a business / source of income of the Indian payer situated outside India) and accordingly, the Indian borrower is required to withhold the applicable taxes on such interest. This is subject to benefits available to the non-resident, if any, under an applicable tax treaty. The Indian Income-tax Act, 1961 (the “Act”) prescribes specific withholding tax rates for certain interest payments made to non-residents subject to fulfillment of prescribed conditions. These rates vary depending upon the nature and terms of the borrowing. Unless a specific lower rate applies, the default withholding tax rate is 40%[1] for non-resident corporates and 30% for other non-residents. Off late, certain concerns are being expressed about the applicable withholding tax rate on interest payable with respect to INR denominated loans from offshore lenders and this article attempts to address the same.

The Law

Section 194LC of the Act provides for a withholding tax rate of 5% of the gross amount of interest payable to non-residents by an Indian company or a business trust with respect to the following –

(a) Monies borrowed by it in foreign currency from a source outside India under a loan agreement (at any time till June 30, 2020) to the extent the interest does not exceed the amount of interest calculated at the rate approved by the Central Government. This is subject to fulfillment of the prescribed conditions[2].

(b) Monies borrowed by it in foreign currency from a source outside India by way of issue of long-term bonds including long-term infrastructure bonds (at any time till June 30, 2020), to the extent the interest does not exceed the amount of interest calculated at the rate approved by the Central Government. This is subject to fulfillment of the prescribed conditions[3].

(c) Moneys borrowed by it from a source outside India by way of issue of INR denominated bonds (at any time till June 30, 2020) to the extent to which such interest does not exceed the amount of interest calculated at the rate approved by the Central Government[4].

Further, section 115A of the Act provides for a withholding tax rate of 20% of the gross amount of interest payable by the Government or an Indian concern to non-residents on moneys borrowed or debt incurred by it in foreign currency (other than, inter alia, interest covered by the aforesaid section 194LC).

The Controversy

There is a controversy as to whether the interest payable with respect to INR denominated loans would be eligible for the above concessional tax rates of 5% / 20%. The underlying issue behind this doubt is whether INR denominated loans would qualify as “monies borrowed in foreign currency” which is a common expression used in both the above provisions. This is because “monies borrowed in foreign currency” is not a defined expression and a question arises as to whether the said expression is required to be tested having regard to the currency in which the borrowing is denominated in the loan agreement or the fact of remittance of the money in convertible foreign exchange by the lender. As an example, if a US based lender extends a loan of USD 10,000 to an Indian company which receives an INR equivalent of 7,10,000 in its bank account in India (presuming an exchange rate of USD 1 = INR 71), the issue is whether for the loan to qualify as ‘money borrowed in foreign currency’, the loan amount must be expressed in the loan agreement as USD 10,000 and not as INR 7,10,000, though regardless of the currency in which the borrowing is denominated in the loan agreement, the US lender remits the loan amount in convertible foreign exchange and the Indian company receives the money in its bank account in INR. The essential difference between a foreign currency denominated loan and INR denominated loan is that in a foreign currency denominated loan, the currency fluctuation risk is borne by the Indian borrower while in an INR denominated loan, the currency fluctuation risk is borne by the offshore lender.Since the tax withholding obligation lies with the Indian borrowers, and there are adverse tax consequences for any default in complying with the same, they generally tend to adopt a conservative approach while applying the aforesaid concessional tax rates of 5% / 20% on interest payable on INR denominated loans. Therefore, in these cases, unless an applicable tax treaty provides for a preferential tax rate, the borrowers generally tend to apply the default withholding tax rate of 40%/ 30% (as the case may be) which is to be applied on a net income basis.

Discussion and analysis

The withholding tax rate of 5% provided under section 194LC of the Act has an additional peculiarity. The section uses two expressions, viz. ‘monies borrowed in foreign currency’ and ‘INR denominated bonds’. Since section 194LC has a separate clause for INR denominated bonds[5], by implication, one could infer that the expression ‘monies borrowed in foreign currency’ was intended to cover only foreign currency denominated borrowings. This would lead to a further question as to whether the provision relating to ‘INR denominated bonds’ can be extended to INR denominated loans. Based on a plain reading and given the specific reference to the term ‘bonds’, the answer to this question would logically be ‘no’. Considering this ambiguity and in the absence of any clarification, it is difficult to argue that INR denominated loans are covered by the 5% withholding tax rate under the extant provisions of section 194LC of the Act.

This brings us to the 20% rate provided under section 115A of the Act. The tax rate of 20% provided thereunder applies to any monies borrowed or debt incurred in foreign currency and there are no further conditions or any specific stipulation in section 115A regarding the denomination of the borrowing or debt. There is nothing to suggest that the 20% tax rate under section 115A applies only to foreign currency denominated borrowings. Further, it appears that it is not the intention of the legislature that interest incomes of non-residents be taxed on a net basis at the ordinary tax rates given the complexities involved in the determination of income. This is evident from the explanatory notes to the Finance Act, 1994 whereby the gross basis taxation with respect to interest income was extended to all non-resident assessees[6]

“47.1 Prior to the amendment made by the Finance Act, the income by way of dividends, interest and income in respect of units of Unit Trust of India and other specified mutual funds, was taxed at different rates in the case of the non-residents. These items of income were taxed at the rate of twenty-five per cent in the case of foreign companies, on gross basis, i.e., without deduction of any expenditure or allowance while computing the income. In the case of non-resident non-corporate persons, such items of income were taxed at the rates prescribed in the annual Finance Acts applicable to different categories of persons. In their case, the taxation of these items of income was on net basis, i.e., after allowing expenditure or allowances, as per the Income-tax Act, while computing the income. The taxation of these items of income in the case of non-resident non-corporate assessees is also needed to be done on gross basis in order to remove the complexity involved in determining the net income. Further, the tax rate provided on the aforesaid items of income in most of India’s tax treaties with other countries is below twenty per cent. India has tax treaties with as many as forty countries.”

It is also relevant to take note of some specific instances in the past involving similar controversy in different contexts which were taken cognizance of by the government as under–

i. Under the erstwhile section 115A(1)(ia) of the Act, as its existed at the relevant time, income by way of interest received by a foreign company from the Government or an Indian concern on monies borrowed or debt incurred by the Government or the Indian concern in foreign currency, was chargeable to tax at the rate of 25%. There was a doubt whether the said rate of 25% was applicable on the interest income arising from investments, by overseas corporate bodies with specified non-resident Indian shareholders, in Non-resident (External) (NRE) Accounts, Foreign Currency Non-Resident (FCNR) Accounts and deposits of public limited companies.

Author:

Akansha Aggarwal, Partner

Footnotes:

[1] All the tax rates mentioned in this Article are base rates required to be increased by the applicable surcharge and health and education cess.
[2] CBDT Circular No. 7 of 2012, dated 21-9-2012
[3] CBDT Circular No. 15 of 2014 dated 17-10-2014
[4] This was subject to a specific exemption for INR denominated bonds issued outside India during the period September 17, 2018 till March 31, 2019.
5] Inserted by the Finance Act, 2017 w.r.e.f. 1-4-2016
[6] Circular No. 684, Dated 10-6-1994
[7] CBDT Circular No. 473 [F. No. 478/33/86-FTD], dated 29-10-1986