The assessee was engaged in the business of ship breaking and it acquired old ships for demolition purpose. Credit for 180 days usance period from the date of physical delivery of the ship was agreed and interest was stipulated to be paid for the usance period worked out on the purchase price of the ship. The amounts were to be paid by means of an irrevocable 180 days Usance Letter of Credit (LC). The invoices of the original price and the interest amount were separately prepared. Customs duty was paid on the purchase price excluding the interest amount. The assessee had debited the purchase price of the ships in its books of account and the interest paid was separately claimed as revenue expenditure.
As tax was not deducted at source while making interest payments to the non-resident sellers, the Assessing Officer disallowed the interest paid in terms of the provisions of section 40 (a) (i) of the Income-tax Act, 1961(Act). The assessee contended that in view of the independent contract between the assessee and their bankers for taking out irrevocable LC, the assessee had made paid the amounts to the bank in India and not to the non-residents and therefore was not liable to deduct tax at source under section 195(1). The assessee further argued that the amount in question was not interest within the meaning of section 2 (28A) of the Act or within the meaning of the definition of interest in the article concerning taxation of interest in the Double Taxation Avoidance Agreements (DTAAs). The amount though described as interest was, in fact, part and parcel of the purchase price because it was payable with the purchase price after the usance period of 180 days. It was further submitted that in view of the provision of the DTAAs , the amount in dispute was not chargeable to tax in India . It was part of the business profit which was to be taxed abroad and not in India.
The Court observed that an irrevocable credit constitutes an independent contract between the issuing banker and the seller, and it is not qualified by or subject to the terms of the contract of sale or contact between the issuing banker and the buyer. It is only a banking arrangement to effect payment. The buyer does not get absolved from his contractual liabilities under the contract of sale or from his statutory liabilities, such as, of making deduction of tax at source under section 195(1) of the Act while making payment by the mode of LC.
The DTAAs follow the pattern of the Organisation of Economic Co-operation and Development (OECD) Model Convention. As per OECD commentary the term paid in paragraph 1 of the article concerning taxation of interest has a very wide meaning since the concept of payment means fulfilment of the obligation to put funds at the disposal of the creditor in the manner required by contract or by custom. Payment would therefore mean the fulfilment of the claim to receive interest in whatever form it may actually occur. Thus, payment by way of irrevocable L/C by the buyer will be considered as an interest paid to the seller. The price of the ship became outstanding on the date of its delivery and since it was not being paid cash down against delivery, interest was contractually charged thereon at the specified rate for the usance period. The contractual interest on the debt in the form of the outstanding purchase price of the ship, which revenue was to be recognised as per Memorandum of Agreement and the provisions of the Sale of Goods Act as well as the Accounting Standards, from the date of delivery of the ship, was the amount that would aptly fall in the expression debt claims of every kind. The contention that the interest payable to the non-resident under the MOA was part of the purchase price fails both on facts and in law.
The High Court noted that the provision of section 9(1)(v) (b) read with section 5(2) and section 4(1) and (2) of the Act leave no room for doubt that the income payable by way of interest by a resident to a non-resident, which does not relate to carrying on business outside India or earning of income from outside India, would be deemed to have accrued or arisen to such non-resident in India and will be considered to be part of his total income that would be chargeable to income-tax on which tax shall be deducted at source or paid in advance as per the provisions of the Act. The Court thus held that such interest payable to the non-resident would be deemed to have accrued or arisen to the non-resident in India and income-tax thereon would be deductible at source under section 195(1) of the Act. As a result of this decision importers will have to deduct tax at source on such interest payments or restructure the transactions by paying a consolidated price, which will result in payment of customs duty on the consolidated price. A few interesting facts about this decision are worth noting. This decision runs into 57 pages in which ten counsels argued/ appeared on behalf of the assessee and relied on/cited 48 judgements (numbering a to z and z1 to z22) in support of their arguments and the Department Counsels relied upon 23 judgements (a to v).