[By Chairman]

1. The applicant is a non-banking financial company incorporated in India. It makes investments in various businesses in India and abroad in the form of securities including shares, stocks and debentures. For the purpose of funding its business activities in India, the applicant proposes to borrow money from GECC Corporation of USA by issuing fully convertible Bonds under the foreign direct investments schemes. A Bond Subscription Agreement was, therefore, entered into between the applicant and GECC (referred to as investor). As per the Agreement, the Bonds (with the face value of Rs.10/- each) are convertible into equity shares at the end of 5 years from the date of the issue unless extended for a further period of 5 years in which case the conversion would take place at the end of 10 years. Applicant submits that by virtue of conversion there will be constructive payment of borrowed money to the Bondholder. The interest on the bonds is payable by the applicant in rupee currency in cash on half yearly basis irrespective of the fact that the applicant makes profits or not. The rate of interest is specified in the amended Agreement. The applicant further submits that as per the Agreement, the Bonds are treated as debt instruments till their conversion into equity shares. Until conversion the bonds will rank in priority to equity shares in the event of a winding up or liquidation of the applicant company. Moreover, upon conversion of bonds, the equity shares issued will rank pari passu with the existing equity shares. The applicant further submits that GECC does not have a permanent establishment or fixed base in India.

2. These are broadly the facts. The applicant seeks advance ruling to ascertain the precise nature of interest payments under the Income-tax Act and to know whether the applicant is obliged to deduct tax at source. The following questions were formulated for consideration * ; * vide orders dt 13/3/08 and 25/4/08 Question (1) Whether the interest paid/payable to General Electric Capital Corporation upto the date of conversion of bonds into equity shares has to be treated as interest on money borrowed or debt incurred within the meaning of Section 2(28A) of the Act and under Article 11 of the India-USA DTAA and accordingly, liable to be taxed as income under the Income-tax Act, 1961. Question(2) Whether such payment constitutes expenditure incurred by the applicant in connection with raising capital or any other payment being compensation to General Electric Capital Corporation during the pre- conversion period, which would be business income/receipts not attracting tax under the provisions of the DTAA between India and USA. Question (3) Whether the aforesaid payments should be treated as dividend income of GEC Corporation and such income is exempt under section 10(34) of the Act Question (4) Whether the applicant is liable to deduct tax at source under the Act in respect of the above transactions and if so, at what rate

3. Both the applicant as well as the Department have taken the stand that the interest paid / payable to GECC up to the date of conversion of Bonds into equity shares falls within the definition of interest as per Section 2 (28A) of the Income Tax Act, 1961 (hereafter referred to as Act) read with Article 11 of the DTAA * between India and USA (for short Treaty). Section 2 (28A) defines interest as follows:-

Interest means interest payable in any manner in respect of any moneys 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 moneys borrowed or debt incurred or in respect of any credit facility which has not been utilized;

Article 11 of the Treaty defines interest as follows :- (4) The term interest as used in this Convention means income from debt-claims of every kind, whether or not secured by mortgage, and whether or not carrying a right to participate in the debtors profits, and in particular, income from government securities, and income from bonds or debentures, including premiums or prizes attaching to such securities, bonds, or debentures..

3.1. Both the definitions are substantially similar. However, Article 11(4) specifically includes income from bonds or debentures within the ambit of interest.

4. We shall now refer to the relevant clauses in the Bond Subscription Agreement. In the recital, it is stated that the company is in need of working capital / funds for the purposes of its business in India and the investor (GECC) has expressed its willingness to extend financial assistance by subscribing to Bonds in the nature of * Double Taxation Avoidance Agreement promissory notes of the face value of Rs.10/- each. The maximum amount of investors subscription to the Bonds is stated to be Rs.8,000 crores.

4.1. The definition of Bonds and Conversion may be noticed. Bonds shall mean

Series A fully convertible Bonds issued by the company (applicant) of the face value of Rs.10, carrying interest as mutually agreed per tranche, however, not exceeding @ one year G-Sec plus 255 basis points per annum, payable half yearly, each fully convertible in its entirety into equity shares at the conversion price on the conversion date

. Bondholders mean the investor or any third party to whom the Bonds are transferred by the investor and whose name stands registered as such. Conversion is defined as follows: Conversion means the conversion of each Bond by the company into fully paid up equity shares on the conversion date at the conversion price as provided in this Agreement, and the term Converted shall be construed accordingly; For the purpose of clarification, such Conversion shall be deemed to be- - the payment of redemption value by the company to the Bondholder towards redemption of the Bonds; - receipt of the redemption value of the Bonds by the Bondholder by way of receiving the subscription shares; - payment by the Bondholder and receipt by the company of subscription amount towards issuance and allotment of the subscription shares. Conversion Date means the 5 th anniversary of the issue date on which conversion takes place (of all the Bonds into fully paid up equity shares at the conversion price), unless extended by mutual consent by another 5 years.

4.2. The nature and essence of the transaction is also discernible from certain other terms of the Agreement, which we would like to refer to. Article 3.1.1. speaks of obligation of the investor to subscribe to the Bonds by making payment of the subscription amount subject to the compliance by the applicant of the various conditions set out therein. Sub-clause (d) of the same Article speaks of

constructive repayment of the investment in the Bonds, by way of subscription to the Equity Shares on conversion in accordance with the applicable provisions.

Article 4.1.2 specifically states that the Bonds which are agreed to be issued as bonds in the nature of promissory notes, shall be negotiable instruments. It is also made clear that the conversion date shall not in any case get extended beyond 10 years from the issue date. Clause

4.1.3 states that unless separately agreed, interest payable to the Bondholder will be payable half yearly in cash in rupee currency in India irrespective of the Company (applicant) earning profits or not. All payments of interest shall be subject to withholding tax at the applicable rate. While Art. 4.2.1 stipulates that the Bonds maintained in physical form shall be transferable by the investor to any third party purchaser for value by endorsement and delivery and the transfer becomes effective when the applicant passes an appropriate resolution. Art. 4.2.2 states that only the Bondholders as are registered in the register of Bond holders/ register of beneficial holders shall be entitled to payment of interest in their name. Article 5.1 specifies that the Bond holder shall apply the amount receivable on redemption of Bonds by subscribing to fully paid up equity shares of the company in the specified manner. Article 6 says that until conversion, the Bondholders shall be entitled to the rights of the secured/unsecured creditors of the company as provided under the Companies Act, including the right to receive interest on due date and the right to receive proceeds on redemption of Bonds on the due date. Prior to conversion, the Bondholders shall not be entitled to any of the rights of the holders of equity shares such as voting rights (Art.6.2).

5. In our view, the payment made to the investor by the applicant by way of interest, is nothing other than what the parties treated it to be so. It clearly answers the definition of interest in section 2(28A) of the Act as well as Article 11 of the Treaty.

6. First, let us see, what is meant by the term debenture. Debenture is not a term of art and has no precise meaning. In Blacks Law Dictionary, the following meanings are given: Debenture: 1. A debt secured only by the debtors earning power, not by a lien on any specific asset. 2. An instrument acknowledging such a debt. 3. A Bond that is backed only by the general credit and financial reputation of the corporate issuer, not by a lien on corporate assets. - Also termed debenture bond;

Convertible debenture: a debenture that the holder may change or convert into some other security, such as stock

In Halsburys Laws of England, 4 th edition, 7 th volume, at paragraph 813, the meaning of debenture is given as under:

No precise definition of the word debenture can be found, but various forms of instruments are called debentures. A debenture is a document which either creates or acknowledges a debt. A document may be a debenture although under its terms, the debt is only to be repaid out of a part of the profits.

In SEBI (Disclosure and Investor Protection) Guidelines, 2000, a debt instrument is defined to mean

an instrument which creates or acknowledges indebtedness and includes debenture, stock, bonds and such other securities of a body Corporate, whether constituting a charge on the assets of body Corporate or not. [emphasis supplied] The Companies Act, 1956 has an inclusive definition of debenture. Debenture includes debenture stock, bonds and any other security of a company whether constituting a charge on the assets of the company or not

. The Company Law Committee gave the meaning of debenture as a document which either creates or acknowledges a debt. # # vide A. Ramaiyas Guide to the Companies Act (16 th Edition, Part-I, page 38). In the case of Shree Rajasthan Syntex Ltd vs. CIT ^ , a division bench of the Rajasthan High Court quoted the following observations of Chitty J. in Edmonds vs. Blaina Furnaces Co. ^^ :

The term itself imports a debt an acknowledgement of a debt and speaking of the numerous and various forms of instrument which have been called debentures without anyone being able to say the term is incorrectly used, I find that generally, if not always, the instrument imports an obligation or covenant to pay. This obligation or covenant is in most cases at the present day accompanied by some charge or security.

The High Court then observed that

in the ordinary business sense, a debenture is generally understood to be a document., acknowledging a debt and securing repayment thereof by mortgage or charge on the Companys property and providing that until repayment, interest will be paid thereon at a fixed rate usually either half-yearly or on fixed dates

. The High Court further clarified that redemption is a method by which the Company obliterates its obligation to repay its debt to the debenture-holders or debenture stockers or by itself repurchasing the debentures. In Laxman Bharmaji vs. Emperor ** , a division Bench of Bombay High Court pointed out that notwithstanding the fact that the bonds are not styled as debentures, the substance of the instrument has to be looked into. The test of creation or acknowledgment of debt was applied. ^ 269 ITR 461 ^^ [1887] 36 Ch. D. 215 ** AIR 1946, Bombay, 18 In Narendra Kumar Maheswari vs. UOI @ , the Supreme Court observed that debenture is essentially an acknowledgement of a debt with commitment to repay the principal with interest. The Supreme Court further observed that a compulsorily convertible debenture does not postulate any repayment of the principal. Therefore,

it does not constitute a debenture in its classic sense

. The expression repayment of principal has been used obviously in the sense of repayment in cash. In Strouds Judicial Dictionary of Words & Phrases (5 th Edition, Volume 2), while stating that the term debenture has no definite meaning, referred to the observations of Charles J. in Brown v. Inland Revenue Commissioners (64 L.J.M.C. 211), which are quite apposite. The learned Judge said:

A debenture, though never, I believe, legally defined, is included under one or other of the three descriptions laid down by Bowen L.J., in English & Scottish Trust v. Brunton [1892] 2 Q.B. 700, as: (1) a simple acknowledgement under seal of the debt; (2) an instrument acknowledging the debt and charging the property of the company with repayment; (3) an instrument acknowledging the debt, charging the property of the company with repayment, and further restricting the company from giving any prior charge.

6.1. The common thread running through the various definitions referred to above is the inseverable relation between debenture and @ AIR, 1989 SC, 2138 at 2178 debt. An acknowledgement of indebtedness is inherent in it. That apart, the Agreement itself refers to execution of bonds in the nature of promissory notes. Acknowledgement of debt and an undertaking to discharge it is the usual feature of such promissory notes. A format of the Bond/Bond certificate has been placed before us. It contains the following stipulation :

For value received, the Company hereby promises to pay the person who appears at the relevant time on the register of Bondholders as holder of the Bonds in respect of which this Certificate is issued, such amount or amounts as shall become due in respect of such Bonds in accordance with the terms and conditions mentioned under the Agreement, and further promises to comply with the same in all respects.

(emphasis supplied)

7. The payment of interest pre-supposes the borrowal of money or the incurring of a debt. That is what the definition of interest in specific terms states. The question to be asked and answered is whether the money has been borrowed by the applicant and the amount paid by way of interest is directly related to that money The allied and integral question is whether by reason of execution of debenture bonds for the moneys advanced to it, the applicant incurred a debt It admits of no doubt that these questions should be answered in the affirmative. Issuance of debentures is a mode of borrowing money. The raising of funds by means of fully convertible debentures is a well known commercial and business practice. Debenture, as already noted, creates or recognizes the existence of a debt which remains to be so till it is repaid or discharged. The interest relates to the debt which the applicant incurred by getting the funds requisite for its business from GECC. Does it cease to be a debt merely because the bonds are redeemed not by returning the money but by getting shares of the equivalent value Does convertibility of debentures affect the characteristic of debt and transform it into something else We do not think so. If the mode of discharging the debenture debt is by issuing equity shares in lieu of payment in cash, it does not in any way detract from its legal character as debt. The legal position has been succinctly stated by the Supreme Court in CWT vs. Spencer & Co $ . The Supreme Court observed thus:

In respect of the assets purchased by the assessee from Kellners the assessee had not paid a part of the consideration, i.e. Rs.31,26,000. Prima facie that part of the consideration is a debt due from the assessee to the kellners. The fact that under certain circumstances the assessee, instead of paying back the debt in cash, could discharge the same by transfer of shares, as provided in the resolution quoted above, does not change the character of the liability. The mode of discharging a liability does not change its true character.

7.1. The same view was taken by the Supreme Court in Eastern Investments Ltd. vs. CIT, West Bengal * . In that case, the assessee - company agreed to reduce its share capital by taking over from the $ 88 ITR 429 * 20 ITR 1 administrator of the estate of a major shareholder 50,000 shares @ Rs.100/- a share. The administrator, on his part, agreed to forego cash payment and instead to receive debentures of the face value of Rs.50 lakhs carrying interest at 5% per annum redeemable at the option of the registered holder at any time. The question arose whether the 5% interest paid to the administrator on the debentures was in the nature of expenditure (not being in the nature of capital expenditure) incurred solely for the purpose of earning income or profits. The Supreme Court held that the interest payment is a permissible deduction under Section 12(2) of I.T.Act, 1922. The following observations of the Supreme Court are quite apposite in the present context :

This being an investment company, if it borrowed money and utilized the same for its investments on which it earned income, the interest paid by it on the loans will clearly be a permissible deduction under Section 12(2) of the Income-tax Act. Whether the loan is taken on an overdraft, or is a fixed deposit or on a debenture makes no difference in law. The only argument urged against allowing this deduction to be made is that the person who took the debentures was the party who sold the ordinary shares. It cannot be disputed that if the debentures were held by a third party, the interest payable on the same would be an allowable deduction in calculating the total income of the assessee company. What difference does it make if the holder of the debentures is a shareholder There appears to be none in principle in view of the fact that no suggestion of fraud is made in respect of the transaction. If the debentures had been paid for in cash by the same party, no objection could have been taken to allowing the interest amount to be deducted. In principle, there appears to us no difference, if instead of paying in cash the payment of the price is in the shape of giving over shares of the company when the transaction is not challenged on the ground of fraud and is approved by the Court

7.2. The underlined portions of the passage extracted above will emphasize that even if the amount covered by debentures is repayable in the shape of giving over the shares of the company, it does not make any difference for allowing deduction of interest paid on the money borrowed by way of debentures.

8. Basically what happens is that the money is advanced to the applicant as a financial package for which the applicant executes the debenture bonds and till they are converted into shares, the applicant keeps paying interest on the amount covered by bonds. Obviously, the interest is paid in respect of a debt. There is no other way of understanding the transaction. True, the obligation to repay the amount is embedded in the concept of debt, but, as stated earlier, the repayment need not be in the form of cash, it could be in kind. Conversion of bonds into fully paid up equity shares at the end of the specified period at the conversion price amounts to constructive repayment of debt and this idea is clearly conveyed by the definition of the term conversion as well as Article 3.1(d). Everyone of the clauses in the Agreement referred to earlier, makes it abundantly clear that the debentures are issued and bonds executed by the applicant in consideration of the moneys advanced to the applicant and that a debt is incurred on that account. The factum of advancing money, the subscription to and execution of bonds carrying interest form part of an integral transaction. If so, there is no escape from the conclusion that there is a debt and what is paid as interest is towards that debt. The debt is extinguished on making over fully paid equity shares at the agreed price and at the agreed time to the debenture holder. In our view, the ingredients of Section 2(28A) are clearly satisfied.

9. Viewed from the angle of the Treaty, the position is more clear. The income from bonds and debentures is specifically treated as interest under Article 11.4. When periodical payments are made by the applicant to GECC by way of interest, undoubtedly it constitutes income in the hands of the recipient i.e. GECC. Therefore, it satisfies the definition under Art. 11.4. Having regard to the language used in Art. 11.4, there is no room for controversy whether the payment is relatable to borrowed capital.

10. There is yet another aspect. Suppose at the end of the stipulated period, the company which has issued debentures is not in a position to convert the bonds into equity shares as per the agreement or the company is wound up. The bond-holders right to claim or recover the debt still survives.

11. The learned counsel for the applicant has cited the decision of Special Bench of IT Appellate Tribunal in the case of Ashima Syntex Ltd. vs. ACIT # to steer clear of the alleged uncertainty brought out by the said decision in addressing the present controversy. The question that arose in Ashima Syntex was whether the expenditure incurred by the assessee for issuing convertible debentures was other than capital expenditure so as to qualify for deduction u/s 37 of the Act. The Tribunal held that the substance of the transaction was that of raising capital base of the Company and therefore it would be capital expenditure even if the capital was meant to be used for business purposes. It was observed that convertible debenture is in the nature of an advance or deposit akin to share application money

as there is no repayment of money but the amount is adjusted towards shares compulsorily and interest is paid on that until shares are allotted

. It is seen that the Tribunal was not concerned with the interest payments and the deduction claimed was not under S.36 (1)(iii) of the Act. There was no occasion to construe and apply the definition of interest as per S.2(28-A) of the Act and Art. 11.4 of DTAA. Hence, strictly speaking, the ratio of the said decision is not applicable to the present case. However, certain observations were made therein that no borrowal of # 100 ITD 247 money was involved in the case of compulsorily convertible debentures and therefore, we consider it appropriate to advert to that aspect. The Special Bench of the Tribunal observed:

We uphold the contention of the Revenue that debentures in this case are fully convertible and there being no liability to repay but retained as capital by conversion into equity shares, it was not a borrowing and consequently the expenditure on issue would not be allowable as deduction

. This conclusion, the Tribunal reached, after referring to and relying on the decision of Punjab and Haryana High Court in the case of Pepsu Road Transport Corporation vs. CIT * . However, we find that the core of the reasoning of the High Court in that case rests on the fact that the RTC Act itself made a distinction between capital provided as per Section 23 and Capital borrowed under Section 26. The capital provided by the Government cannot be equated to capital borrowed and the interest paid on such capital cannot be said to be in respect of capital borrowed within the meaning of Section 36(1)(iii) of the Act.

11.1. Referring to the observation of the Tribunal in Ashima Syntex that in the case of convertible debentures as distinguished from debentures simplicitor, there is no liability to repay and therefore it is not a case of borrowing, the learned counsel for the applicant assailed this observation on the ground that it goes counter to the dicta of the * 138 ITR pg.18 Supreme Court in the cases of Eastern Investments Ltd. & as well as Spencer & Co. && which were apparently not placed before the learned Members of the Tribunal. Relying on these decisions, the Counsel reiterated that the mode of discharge of the debt created by debentures is not relevant. We find considerable force in this contention. However, we are not inclined to express a definite view on the correctness or otherwise of the conclusion reached in Ashima Syntex case having regard to the fact that the question involved and the provisions with which we are concerned are quite different. Suffice it to say that the contention of the applicant, supported by the Revenues stand, cannot be rejected on the basis of the aforementioned observation made by the Tribunal while deciding a different question.

12. In the light of above discussion, the questions set out at page 3 are answered as follows : Question No.1. The payment made to GECC in the form of interest up to the date of conversion of bonds into equity shares is nothing other than interest paid on the money advanced to the applicant or the debt incurred by the applicant and it satisfies the definition of interest under Section 2(28A) of the Act as well as Article 11.4 of the India-US DTAA and it is & 20 ITR 1 && 88 ITR 429 accordingly liable to be taxed as income of GECC under the Act and under Art.11.2 of DTAA. In effect, the question is answered in the affirmative by upholding the contention of the assessee. Question No.2. The first part of the question need not be answered because we are not concerned with the tax liability of the applicant and whether it can claim deduction of interest paid as expenditure under S.37 or S.36(1)(iii) of the Act. We are only concerned with the non-residents liability which has been clarified above. The second part of the question does not really arise for consideration in view of our answer to question no.1. Question No.3. It admits of no doubt that the interest payments cannot be construed as dividend income of GECC. Dividend pre-supposes that the payee holds shares in a Company. The bondholder GECC would become shareholder only upon conversion of the bonds into equity shares. Further, there are express provisions in the Agreement to the effect that the Bondholders will not have any rights as shareholders of the applicant-Company until and unless the conversion takes place. Moreover, dividend can only be paid out of profits (vide Sec.205(1) of Companies Act) whereas in the present case, interest is payable to the bondholder irrespective of whether the applicant makes profit or not. Hence, this question is answered in the negative. Question No.4: Under Section 195(1) of the Act, the applicant is liable to deduct tax at source at the applicable rates inasmuch as the interest paid to GECC is chargeable to income tax in India. As regards the rate of tax, the applicant made it clear in the course of arguments and in the written submissions that the question may be left open so that the assessing authority will decide it in an appropriate proceeding. Hence, no ruling regarding the rate of tax needs to be given. Accordingly, this Ruling is pronounced on this the 10 th day of October, 2008. Sd/- Sd/- Sd/- (A. Sinha) (P.V. Reddi) (Rao Ranvijay Singh) Member Chairman Member F.No. AAR/769/2007 Dated This copy is certified to be a true copy of the Ruling and is sent to:

1. The applicant.

2. The Commissioner of Income-tax-4, Delhi.

3. The JS(FT&TR-I & II), C.B.D.T., New Delhi.

4. Guard file (Batsala Jha Yadav) Addl.Commissioner of Income-tax, AAR(IT)