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ARTICLE 11
INTEREST
(1) Interest arising in a Contracting State and paid to a
resident of the other Contracting State may be taxed in that other State.
(2) However, such interest may also be taxed in the Contracting State in which it arises
and according to the laws of that State, but if the recipient is the beneficial owner of
the interest the tax so charged shall not exceed... per cent (the percentage is to be
established through bilateral negotiations) of the gross amount of the interest. The
competent authorities of the Contracting States shall by mutual agreement settle the mode
of application of this limitation.
(3) The term "interest" as used in this Article 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 debtor's profits, and in particular, income from government securities
and income from bonds or debentures, including premiums and prizes attaching to such
securities, bonds or debentures. Penalty charges for late payment shall not be regarded as
interest for the purpose of this Article.
(4) The provisions of Paragraphs (1) and (2) shall not apply if the beneficial owner of
the interest, being a resident of a Contracting State, carries on business in the other
Contracting State in which the interest arises through a permanent establishment situated
therein, or performs in that other State independent personal services from a fixed base
situated therein and the debt-claim in respect of which the interest is paid is
effectivity connected with (a) such permanent establishment or fixed base, or with (b)
business activities referred to under (c) of Paragraph (1) of Article 7. In such cases the
provisions of Article 7 or Article 14, as the case may be, shall 'apply.
(5) Interest shall be deemed. to arise in a Contracting State when the payer is that State
itself, a political sub-division, a local authority or a resident of that State. Where,
however, the person paying the interest, whether he is a resident of a Contracting State
or not, has in a Contracting State a permanent establishment or a connection with which
the indebtedness on which the fixed base in interest is paid was recurred, and such
.interest is borne by such permanent establishment or fixed base, then such interest shall
be deemed to arise in the State in which the permanent establishment or fixed base is
situated.
(6) Where by reason of a special relationship between the payer and the beneficial owner
or between both of them and some other person, the amount of the interest, having regard
to the debt-claim for which it is paid, exceeds the amount which would have been agreed
upon by 'the payer and the beneficial owner in the absence of such relationship, the
provisions of this Article .shall apply only to the last-mentioned amount. In such case,
the excess part of the payments shall remain taxable according to the laws of each
Contracting State due regard being had to the other provisions of this Convention.
62. Scope
The Article deals with interest arising in a Contracting State and paid to a resident
of the other Contracting State. It does not apply to interest arising in a third State or
to interest arising in a Contracting State which is attributable to a permanent
establishment which an enterprise of the State has in the other Contracting State.
Interest is taxed in the State in which it arises and also in the State of residence of
the recipient when paid. It, therefore, suffers tax doubly. The unilateral relief from
double taxation, in the absence of agreement, may be inadequate and not enough to match
the one which could be negotiated bilaterally. Relief from double taxation helps fostering
development of international credit.
Interest may be payable (i) on investments, such as bonds or other negotiable loans or on
loans granted by savers; or (ii) to banks and other financial institutions; or (iii) on
purchase of goods or services on credit. In case of (i) the amount of interest represents
net income of the recipient; in case of (ii) the gross amount of interest has to be
reduced by the amount of interest paid by the recipient in raising the capital and the
other expenses incurred on management, etc., before the recipient's net taxable income is
worked out; and in case (iii) interest charge is normally passed off to the purchaser in
the form of an increase in the sale price. Thus, the taxation of interest involves
questions, which country has the right to tax interest, should it be on gross or net
basis; how much relief should be given by the country of residence of the lender; what
should be the rate for taxation of interest on credit sales of machinery or goods, if such
interest is not treated part of the sale.
The OECD Model provides that interest may be taxed in the Contracting State in which it
arises, but puts a limit on the rate of tax not to exceed 10 per cent of the amount of
interest. Interest charged by banks or financial institutions or payable on money borrowed
for purchase of either machinery or goods or raw materials abroad, are not taxable in many
developing countries. Exemption is provided to encourage industrial development.
What is subject to charge in the source State is the interest which arises in that State
and is taxed according to the laws of that State.
63. Taxability of interest
Paragraph (1) provides that the interest may be taxed in the State of residence. It
does not, however, stipulate the exclusive right to the State of residence.
State of source has also been given right to impose a tax if its laws so provide
(paragraph (2) of Article 11). The taxability of the income by State of residence of the
recipient will take place only if it has arisen in the other Contracting State and has
also been paid to the resident of the former State. Unless interest has not been paid, the
question of taxability would not arise.
The word 'paid' should be given a wider meaning and should not be confined to the actual
payment but also where the amount is unconditionally made available to another person. An amount can be said to be paid if the giver
discharges his liability and makes the amount unconditionally available to the person
entitled thereto. Thus, a credit balance, without
more, only represents a debt and a mere book entry in the debtor's own books does not
constitute payment which will secure a discharge from the debt. However, when a creditor desires that the debtor should open an
account in its (creditor's) name in the debtor's book of account and deal with these
accounts according to its instructions, the money could be said to have been paid and the
money after having been credited to the creditor's account belongs to
creditor.
Thus, the concept of ‘payment' signifies satisfaction of a claim and means fulfillment of the obligation to place funds at
the disposal of the creditor in the manner as required by the terms of contract or in
their absence by custom.
Though, in principle, the right to tax interest income belongs to the State of residence
of the creditor right has also be given to the source State where it arises, provided its
domestic laws so provide.
63.1. Arising or deemed arising of income - The residence
country is entitled to tax interest when it is paid to its resident, though it has arisen
in another Contracting State. The source State has also right to tax it at the stage of
its arising. Income assessable in the source State is of two kinds, viz., (i) arising, and
(ii) deemed arising in that country. The concept of arising in that country although not
dependent upon its receipt, is quite distinct and apart from the notion of deemed arising
of the income. The word 'arises' indicates something whose origin is in the country than
something brought into it. It is defined as to
spring up, to come into existence. It, therefore,
means coming into existence or presenting itself and connotes the idea of the growth or
accumulation with a tangible shape so as to be receivable. It does not mean actual receipt. It is used in contradistinction to
the word 'received’ or 'paid'. It only indicates a right to receive and represents a stage anterior to the point of time when income
becomes receivable and connotes a character of the income which is more or less inchoate. 'Arising' is anonymous with 'accruing' in the
sense of springing as a natural growth or result.
63.1-1 Deemed arising - The right of the source State to tax
is extended to the income even if it is deemed to arise in terms of paragraph (5) or also
according to the laws of that State. If the payer of the interest is the State itself, or
its resident, the interest is deemed to arise in that State irrespective of wherever it
has otherwise arisen or has it's source. It accords with section 12(3)(a) & (b) of the
Ordinance, which narrates circumstances when interest. income is deemed to accrue or arise
in Pakistan. Similarly, interest on account of
indebtedness having connection with the permanent establishment or a fixed base is deemed
to arise in the State where it is situated, notwithstanding of what the residential status
of the payee is, whether he is or he is not the resident of that State. Paragraph (5)
corresponds with section 12(2)(a) of the Ordinance which provides, inter alia, that
income arising whether 'directly' or 'indirectly' through or from any business connection
in Pakistan or any source in Pakistan is deemed to arise in Pakistan.
The term 'deemed' brings within the net of chargeability the income not actually arising
but which is supposed notionally to have arisen. By statutory fiction income which in no
sense be said to arise at all may be considered as so arising. Similarly, the fiction may
relate to the place, the person or the year of taxability.
In some agreements the expression used is 'derived' in place of 'arising' and 'deemed
derived' in place of 'deemed arising'. The word 'derived' demands an enquiry into the
genealogy of income earned as interest which stops as soon as an effective source is
disclosed. If the source of interest is in
Pakistan, the income is taxable in Pakistan, though it might accrue or arise elsewhere.
63.2. Arising of income - Location of the place - The place
where income accrues or arises is determined from locating the originating cause namely,
the source. If the originating cause is situated in Pakistan, income becomes taxable in
Pakistan, Irrespective of the residential status
of the person, or the currency in which the loan is denominated or the place where the
capital is employed. The place of derivation of the interest is the place where the credit
is provided, i.e., the place where the funds in respect of which interest is receivable
are made available to the borrower. Whilst the emphasis is on the provision of credit,
there are circumstances under which such credit is not of much relevance. For instance, in
some cases charging of interest stems from trading transactions, when the goods are sold
on deferred payment basis or on extended credit terms and interest is charged for the
period of trading profits, arises in Pakistan if the trading transactions take place in
Pakistan. In the case of mortgage, the originating cause for interest is the mortgage and,
therefore, the transaction of mortgage would be decisive in establishing the place of
arising of interest. The basis of charge to tax is the receipt or accrual of income, as
interest. When the amount of interest is credited to a party's account, so as to make it
available to him unconditionally, it could be said to have been paid to him. But merely
crediting the account without making it available to the creditor does not tantamount to
payment.
63.3. Arising of income in Pakistan - A question arises whether
interest paid on the outstanding amount due to be payable abroad in respect of the supply
of an Article or thing to be manufactured and delivered abroad in pursuance of an
agreement transacted and signed abroad, could be said to be the income of the foreign
party having arisen in Pakistan. Under the Income Tax Ordinance income as interest is
deemed to accrue or arise in Pakistan if it is payable as interest by (a) the Government,
or (b) a person except where interest is payable in respect of any debt incurred, or
moneys borrowed and used, for the purposes of a business or profession carried on by such
person outside Pakistan (in the case of resident) and inside Pakistan (in the case of
non-residents). The law is clear, it does not speak of the activity of the recipient but
of the 'source', i.e., the payer. The Government's right to levy and collect income tax on
the interest paid or payable to a foreign corporation is not premised upon the condition
that its activity or the sale from which the (interest) income flows has situs in
Pakistan. Section 12(3) does not speak anything about the act or activity of a
non-resident in Pakistan or place where the contract is signed. The residence of the
obliger who pays the interest, rather than the act or activity of the recipient,
determines the source of the interest income. If the obliger is Government or a resident
in Pakistan, the interest paid by him can have no other source than Pakistan. Interest
becomes payable or is paid not by the interest-bearing obligation, but by the obliger.
Exception is, however, made, in case of obliger being a resident of Pakistan, that the
debt or the money is borrowed and used outside Pakistan for the purpose of
business/profession carried outside Pakistan and in case the obliger is non-resident, for
the purpose of business/profession carried on in Pakistan. Thus, interest paid by the
Government or any person under the circumstances as mentioned in section 12(3)(a) &
(b) is the interest derived by the recipient from sources within Pakistan subject to
income-tax. It is not the Government or that person which is to be taxed on such income,
but the foreign recipient.
63.4. Arising of income in a country where elements of contracts
are most densely grouped -- In the case of CIT v. Saurashtra Cement & Chemical
Industries Ltd., the assessee entered into a
contract with an Italian company for the import of certain plant and machinery, under the
terms, inter alia, that 30 per cent of the price was to be paid against bills of
exchange to be drawn by the non-resident company on the assessee and to 'be
accepted by the assessee. The assessee was to pay 6 per cent interest on the three bills
on the expiry of six months from the date of issue of the bills till their maturity. It
was also agreed that the price was to be paid in pounds sterling. The Income-tax Officer
was of the opinion that in respect of interest payable on bills of exchange the assessee
would be liable under section 9(1)(i) [parallel to section 12(3)(a) of Income Tax
Ordinance, 1979], as an agent of the non-resident company, and made an assessment
accordingly. The Appellate Assistant Commissioner held that section 9(1)(i) did not apply.
The Appellate Tribunal agreed with that view. The Department appealed to the High Court.
The High Court observed that the test to be applied, as laid down by the Indian Supreme
Court in Delhi Cloth & General Mills Co. Ltd v. Harnam Singh is the law of the country in which the elements of contract are most
densely grouped and with which factually the contract is most closely connected. The High
Court observed that the non-resident company came nowhere near shores of India or
territories of India, as regards performance of contract was concerned. It put the goods
on board the ship concerned at a port in Europe. It received all the price in Europe in
terms of foreign currency. The plant was not to be put up or erected by the nonresident
company. Even the instalments were to be paid in foreign currency. So far as the unpaid
price was concerned the amount was to be paid by bills of exchange drawn in a foreign
country and accepted by the assessee in India. Thus, most of the elements of the contract
are found to be most densely grouped with the country, namely, Italy, where the
non-resident company was carrying on the business of supplying plant and machinery and
hence the debt which the assessee-company owed was not an asset held by the non-resident
company in India. Therefore, the interest which was payable in respect of this debt was
not income arising from or through an asset held by the non-resident company in India. The
ratio of this case is fully applicable in Pakistan as provisions of law in both the
countries are identical.
63.5. Rates of withholding tax of agreements - The right of the
source State to tax interest income according to its laws is not absolute. It is limited
by which its tax cannot exceed. Usually the Contracting States agree to a lower rate of
taxation. The benefit of this ceiling or of the lower rate is available if the recipient
of interest income is its beneficial owner. Agreements with Pakistan are divided into two
categories according to whether right to tax has been given to (1) the source State alone;
or (2) both the residence State and source State, to the former when the interest is paid
to its resident and to the latter when it arises or is deemed to arise within its
territories.
Since income in the latter category of cases has to be shared, the rates of withholding
tax should be at a reasonably low rate. The reasonableness has to be arrived at with
reference to the resulting tax effect which should not go beyond what could have been the
tax result with the application of the regular rates on net income. The rates of
withholding tax are normally two: one, with reference to interest payable to banks or
financial institutions, and the other with reference to others. The former is lower than
the latter, reason being obvious. In international field interest may be paid to banks and
other financial institutions. They in turn have to raise funds and loans from other
investors and have, therefore, to incur expenditure on servicing those debts, besides
incurring other expenditure on administration and management. The payment of interest and
incurring of such expenditure result in reduction of income and the effective receipt is
far less than what it could be in the hands of individual investor. The sameness of the
rates of withholding tax for banks and for others causes to the former more tax suffering
than what is experienced by the latter. To prevent happening of such a situation and with
a view to encouraging international credit, two sets of rates have been maintained; one,
in the relation to banks and financial institutions and the other in case of individual
investors, the former is lower than the latter. For example, agreements with FGR, Great
Britain, Korea provide two rates, 10 per cent and 15 per cent. Agreement with Mauritius
exempts income of bank earned as interest from taxation.
To encourage industrial development, the developing countries generally exempt interest
payable to industrial companies, apart from borrowings by Government and other public
financial institutions, on money borrowed for purchase of machinery or raw materials
abroad. In Pakistan, interest payable by the Government, or a local authority, National
Development Financial Corporation of Pakistan, Industrial Development Bank of Pakistan, on
the moneys borrowed outside Pakistan is not taxable. Interest is also not taxable if
payable by an industrial undertaking on the amount borrowed outside India for purchase of
plant and machinery, or by any financial institution for advancing loan for that purpose,
or by a public company on moneys borrowed for providing long-term finances for
construction or purchase of houses in India, or by the public sector company on bonds and
debenture.
Such or similar exemption has been provided in some of its agreements with other
countries, as with Canada, Hungary, FGR, Indonesia, Italy, Mauritius, Norway, Sri Lanka,
etc. Even without such provision, when income is not taxable in Pakistan, it cannot be
made taxable by virtue of the absence of a provision in an agreement relating to
exemption.
As regards the general rate, the OECD Model Convention provides for the rate of
withholding tax at ten per cent of interest. The UN Model is specific that whatever be the
rate, it is to be applied to the gross amount. It is done for administrative convenience
and for substantive reasons. But while negotiating the rate, the countries do not
disregard the fact that the gross figure does not necessarily correspond to net income and
that expenses have to be incurred in earning of interest. The rate negotiated approximates
the usual tax rate on the net income so that the tax result by its application on the
gross amount is almost the same as it would have been by the application of the usual and
regular rate on the net income. The other consideration is the rate of tax in the country
of the lender at which credit is to be allowed which, if it is different from the
withholding tax rate, may not grant relief to the extent tax paid in the source country.
The disparity in the tax rates is taken into account in establishing the final rate of
withholding tax.
64. Interest- Definition of
Definition of expression ‘interest’ as contained in paragraph (3) of the
Article is exhaustive, as it goes on to define it with the help of the expression 'means'.
It is defined to mean income from debt-claims. The income which originates from any
debt-claim is taken to be interest income. By defining it exhaustively without reference
to domestic law, the Model Convention has avoided the possible dispute. The definition,
however, encompasses all kinds of income to mean interest income, which the domestic laws
could otherwise define it to so mean. Absence of the reference to domestic law has removed
uncertainty about the import of ‘interest’ which could have been affected with
the change in the domestic laws.
Interest means income from debt-claims of every kind, whether or not secured by mortgage
and whether or not carrying a right to participate in profits. In defining what
constitutes ‘interest’, the Model Convention relies on a general wide definition
coupled with specific inclusion and exclusion. The general definition gives expression to
ordinary conceptions of interest while specific exclusion is designed to deal with
penalties and compensation for belated payments and also interest derived from the active
conduct of trade or business.
64.1. Debt-claims of every kind - The expression 'debt-claims
of every kind' is of the widest import so as to take in every possible kind of claim
arising out of an obligation which could be termed a debt. The word 'claims' means the
common law action for the recovery of the money held to be due, i.e., something
recoverable by an action for debt. It does not really add to the meaning of the word debt
as the concept of 'debt' carries with it the creditor's right to enforce the recovery of
the amount by an action. The expression 'debt-claims of every kind' embraces every kind of
liability of a person owing to another whether in cash or kind, secured-or unsecured,
whether ascertained or ascertainable arising out of an obligation, express implied.
64.2. Debt - Meaning of- The law relating to interest arising
out of 'indebtedness ness' is well settled. Indebtedness means a debt owing. Bonds,
securities notes, etc., are the various forms of acknowledgment of indebtedness or in a
way are certificates of such indebtedness. A debt is a sum of' money which is now payable
or will become payable in future by reason of the presser obligation; debiturn in
praesenti, solvendum in futuro. There
must be a existing obligation to pay a sum of money now or in future. An obligation to pay arises from a promise from the debtor and such a
promise must be supported by consideration. A debt
is, therefore, that one owes to another It may be money lent or the price of goods
sold and delivered or the service rendered, or the payment of rent reserved for lease,
which one is bound to pay to another; a pecuniary due; a liquidated demand; a sum of money
due by certain and express agreement, and includes any claim or demand upto which the
payment of money or directing the payment of money can be recovered in an action. Debt
denotes not only an obligation of the debtor to pay but also the right of the creditor to
receive and enforce payment. To constitute a valid debt, money must have been advanced
with a reasonable belief at the time of advance that it would be paid. Evidence of an
obligation to repay is the first important factor to be singled out of the surrounding
facts and circumstances.
The expression 'debt' may take colour from the provisions of the Ordinance [see section
2(29)]. It may have different shades of meaning. If
money is due to a person and is not paid for but has been withheld from him after the
time when the payment is to have been made, in a breach of his legal rights, it is a
compensation whether it is liquidated under agreement or statute. The compensation is
properly described as interest. It may
be regarded either representing the profit a person might have made if he has had the use
of the money, or conversely the loss he suffers because he has not that use. The general
idea is that he is entitled to compensation for deprivation. From that point of view it
would seem immaterial whether the money is due to him under a contract express or implied
or a statute or whether the money is due for any other reason in law. In either case money
is due to him and is not paid or in other words is withheld from him when the payment
should have been made.
64.3. Debt is a chose-in-action, a property - Debt is a
property. It is a chose in-action and is heritable and assignable and it is treated as
property under the Transfer of Property Act which calls it 'actionable claim’.
Chose-in-action arising out of contract has two aspects (i) as property, and (ii) as
involving a contractual
obligation for performance. The property aspect is relevant for purposes of assignment,
administration, and taxation and the like; the contractual aspect for performance. The
debt being intangible, cannot have location unless except notionally and in order to give
it notional position rules have to be framed along arbitrary lines. In the case of a debt
due to a foreigner, the proper law of the contract is to be applied, i.e., the law of the
country in which elements of the contract are most densely grouped and with which
factually the contract is most closely connected.
64.4. Amount paid as compensation or damages is not interest -
Interest is of two kinds; that is when it is payable as compensation. for the non-payment
of debt on the proper day and that is which is agreed to be paid on a loan. The former
seems to have been allowed in equity as damages in all cases where there is a wrongful
detention of money which ought to have been paid; and the latter is allowed where the debt
is secured by a bill of exchange or where promise to pay. interest is implied upon a usage
of trade or the like. The distinction between the two is made clear by the Indian Supreme
Court. Thus, when interest has been allowed
under statute or under contract the same is income exigible to tax and where it is not
attributable to either statute or contract but has been awarded on ex gratia basis, it
would partake the character of compensation.
Interest which is merely in name but constitutes part of compensation or part of the
damages, is not 'interest' chargeable to income-tax. As an integral part of such
compensation it may be either slumped up with the other elements in the gross sum or may
be separately stated but treated as a part of the gross sum. Mere description of the amount as interest which in fact is a part of
compensation does not have the effect on altering the true character of the compensation. In Ballantine’s case the
liability to pay interest arose under the award of the arbitrator and in Executors of Bonner
Maurice's case, under the Mixed Arbitral Tribunal. That, in fact, is also the position
with regard to unpaid purchase money coupled with a liability to pay interest together
with each of the instalment.
64.5. Unpaid purchase money - Liability to pay interest is
compensation and not interest - Where parties enter into an agreement to accept a portion
of the purchase money immediately and the balance to be paid in certain instalments along
with interest on the instalment of purchase money, the agreement though it vested the
property agreed to be sold in the purchaser, does not have the effect of converting the
price due into loan. The intrinsic nature of the money due to the vendor is an unpaid
purchase money and not as debt. The parties may, however, agree to convert the unpaid
purchase money as debt. An agreement to pay the
balance consideration due by the purchaser does not give rise to a loan.
When, therefore, there is no agreement initially or any novation
between the parties to treat the unpaid purchase price as a debt repayable with interest,
even if the purchaser incurs the obligation of paying the sale proceeds to the seller, he
does not become in any sense a debtor of the seller. If there is no agreement initially or
by way of novation to treat the balance of sale consideration as paid off in full and no
novation to treat the balance of consideration as a loan, the amount received by the
seller cannot be regarded as interest on money lent.
Detention of purchase consideration by the vendor fastens a liability upon him, in terms
of section 61 of the Sale of Goods Act of 1930, to pay interest, even if he has not
utilised the money. The interest in such case is
received as part of the purchase price itself, that is to say, as part of the
consideration for sale of goods on deferred payment basis and not as a separate source. The nomenclature assigned to such payment is
irrelevant. Payment of interest if it is a part and parcel of the agreement to pay the
unpaid purchase money' on a deferred payment basis, there is no indebtedness, and cannot,
therefore, be treated as arising from an independent source of income. Such amount bears
the character of the consideration for sale.
Where, however, the payment of interest on the unpaid sale price is not a part and parcel
of the transaction of sale, but is on account of an agreement to treat the unpaid price as
loan, such payment arises from a transaction independent of the transaction of sale. A
person carrying on business may agree with a company floated by him that the assets
belonging to him shall be transferred to the company for a certain money consideration and
that in satisfaction of the liability to pay that money consideration, shares of certain
face value shall be allotted to the transferor. In that case there are in truth two
transactions--one a transaction of sale and the other a contract under which shares are
accepted in satisfaction of the liability to pay the price. Instead, in satisfaction of the liability the redeemable loan stock
is to be issued, the matter would not be different. The transaction in respect of the loan
stock is transaction separate from the original transaction of sale, and, therefore, the
source which is responsible for yielding interest is the transaction of loan, independent
of the transaction of sale.
64.6. Amount received in exercise of a right severed from principal
debt is not interest - A question may arise whether when a person assigns to another
person his right to receive loan and interest after a certain period from an enterprise,
the amount received by him as a consideration in excess of the principal amount would
represent interest or business profit. A receipt may constitute income if it arises from
an isolated business operation or commercial transaction entered into otherwise than in
the course of the carrying on of the business, such operation or transaction being treated
as an adventure in the nature of trade because the motive for the institution of the
operation or transaction is profit-making. A contractual right to interest is not the
source of interest and a contractual right severed from the principal debt is not the
structure which produces interest. A sale by lender of his mere right to interest for a
lump sum converts future income into present income. Many instances may be given of the
sale of a capital asset for a consideration which is the income in the hands of the
seller. For most part these are instances of sale of capital. asset for periodic, regular
or recurrent receipts, with periodicity, regularity or recurrence being characteristics of
an income. Such a receipt is usually termed annuity. But there is no reason for holding
conversion of capital asset into an income receipt confined to such cases.
The source of the income is the right to receive income in future. Income will bear the
character of interest, if its effective source is the principal debt. A right severed from
the principal debt if brings about income, that income cannot be called as interest. The
event which is responsible for the arising of income is the assignment or alienation of
the right in praesenti The amount received in excess of the principal debt,
therefore, does not represent interest, as its effective and immediate source is the
transfer of a capital asset.
64.7. Amount of discount - Whether represents interest - A
question arises as to whether the amount of discount charged on discounting a bill or any
other instrument before its maturity or whether the difference between the sale proceeds
of certificates of deposits or bill of exchange and the initial amount invested in the
acquisition of such certificates or bill would represent interest ? In principle, the
amount representing difference between the face value of an instrument and its maturity
proceeds cannot be taken interest. Discount is not interest. Likewise the amount received
in excess of initial investment in certificate deposits or before their maturity on
account of the accumulation of interest over a number of years for which these
certificates have been in the run, does not bear the characteristic of interest. This
amount could be taken as gains of investment, though in the hands of eventual holders of
such certificates or bill of exchange at the time of their maturity, the sum representing
the amount of investment by him and the amount actual due or received on maturity bears
the characteristic of interest.
64.8. Amount paid as interest by a thinly capitalised corporation
is not
taken interest but.is deemed dividend - In a thinly capitalised corporation, the loan
of money made by a shareholder may be treated as a part of the capital of the corporation.
This is because where the corporate device has been used to defraud creditors to evade
existing obligation, to circumvent statutes, to achieve a monopoly the courts should look
upon the shareholders who have been providing necessary finances in the form of debt
rather than as equity. An attempt to do business through the agency of a corporate entity
without providing any sufficient basis of financial responsibility to creditors is an
abuse of the separate entity and the court will foil that attempt by ignoring the
corporate facade. The parent company becomes responsible for the debts of the subsidiary
if the subsidiary has been operating for the account of its parent. If the capital of the
subsidiary is trifling compared with the business to be done and the risks of loss, and
the unity of interest and ownership suggest that the separate personalities of the
subsidiary and the principal do not exist, the debt of the latter is treated as equity. In
such a situation the claims of the controlling shareholder (usually the holding company)
may be subordinated to claims of other creditors, including the claims of the preferred
shareholders in certain circumstances. Debt or
corporation is simply a part of the creditor's own enterprise.
64.9. Debt even if secured by mortgage may yield interest -
After having defined interest in the widest possible import the Article as a matter of
caution uses the clarificatory clauses, whether or not secured by mortgage and whether or
not carrying a right to participate in the debtor's profits, and 'in particular, income
from government securities and incomes from bonds or debentures' The necessity of such a
caution is felt because income from such indebtedness under the domestic laws of country,
or otherwise may not be taken as arising from movable property: Though the debts, as held
by Lord Atkin, exist as movable property and do not, if secured, become identified with
the security or transformed into land in the one case or merchandise in the other and that
separation between debt and security is well established, yet the domestic laws of certain countries hold it to be income from
immovable property. A mortgage is a transfer of interest in specific immovable property
for the purpose of securing the payment of money advanced or to be advanced by way of
loan, an existing or future debt. If the purpose of the mortgage is to ensure recovery of
amount, the amount received as interest cannot be taken as arising from the immovable
property in case the subject-matter of the mortgage is the immovable property itself. But
a mortgage with possession is an 'interest in land'. The mortgagee has a right to
possession and to enjoy the benefits arising out of the land until it is redeemed. In such
a case, the mortgagee rights therein are immovable property. A mortgage is a transfer of an interest in
specific immovable property and what the mortgagee acquires under the transaction is the
mortgagee's interest in specific. immovable property which can even in the case of
usufructuary mortgage, only be immovable property and not movable property. Income arising as a result of usufructuary mortgage is
subject-matter of Article 6.
64.10. Interest on bonds and debentures- Certain debt-claims
particularly bonds or debentures carry with them
the right to participate in the debtor's profit. Such right, however, does not transform
the contract of loan into the contract for carrying on the business. Participation in
profits as such could be inferred from the nature of the contract. Interest on debenture
or bond is a prior lien on the net income, and is payable before dividends are
distributed. To that extent the holder of bond or debenture could be said possessing right
to participate in the profit. Such bond may sometime be called income bond which means an
obligation on which interest is paid only if earned. Some income bonds resemble preferred
stock so closely that denial of interest thereon as an allowable deduction for tax
purposes has been affirmed by courts. Income on bonds issued by a government utility may
be secured as to principal and interest only by the expectancy of a surplus of the net
operating income of future periods. However,
where the nature of the contract is disguised as loan but in reality it is furnishing
capital for the carrying on the business and the participation in profit rests upon a
provision of funds that is subject to the hazards of the enterprise's business, the
operation is not in the nature of loan. The definition of interest is not considered to
prevent it from being treated as dividend where the lender effectively shares the risks
incurred by the company and where domestic laws in the borrower's country allow for such
treatment. Under certain circumstances because of the close relationship between the
foreign parent company and the domestic subsidiary loan finance to the subsidiary 'may
tantamount to equity finance. But at the same time, however, interest on participating
bonds should not be regarded as dividends, nor that on convertible securities until they
are converted into shares.
64.11. Premium and prizes attached to securities, bonds and
debentures is interest - Income from government securities or income from bonds or
debentures is normally and generally taken as interest income. But the Model Convention
has extended the concept of interest income to premium and prizes attached to such
securities, bonds or debentures. Thus, the interest on these securities, bonds and
debentures is the amount accruing as interest plus the premium paid at redemption or at
issue. Premium is the amount by which the price of a security or other assets exceeds its
nominal, face, par, quoted or market value.
It is a reward or recompense for a particular act; a sum over and above a regular
price paid chiefly as an inducement or incentive.
The effective source of premium or the prize is the acquisition of securities, bond or
debenture which is granted as an inducement or incentive for a person to hold them, in
addition to the normal interest he would be entitled to. The nature of such premium or
prize cannot be different from the nature of interest which accrues because of the
indebtedness. However, the premium received not because of the indebtedness but on account
of some relationship different from such indebtedness, cannot be taken interest. Bond or
debenture is an asset; and if any profit arises on its transfer, such profit constitutes
either a business profit or a capital gain or income falling under Article 21; because the
effective source of the income is transfer of the asset.
64.12. Penalty is not interest - The second sentence of
paragraph (3) excludes penalty charges for late payment from the definition of interest.
The word 'penalty' is a word of wide significance sometimes it means recovery of an amount
as a penal measure even in a civil proceeding. An exaction which is not of a compensatory
character is also termed as penalty. Interest in
a wide sense is the compensation for the use or retention of another's money for the
period its owner has been deprived of its use. Penalty charges for belated payments do not
represent such compensation. Penalty being a punishment or a suffering, it is misnomer to
call it interest. It is punishment annexed by the contract to retain lender's money beyond
the contractual period. The essence of penalty is a payment of money stipulated in terroem
of the 'offending party. The obligation to pay
penalty charges arises not on the basis of the same consideration for the obligation to
pay interest but on account of contracted agreement, or custom or of a judgment on the
happening of the act offending the agreement or custom or-law.
The measure of penalty charges, even if calculated pro rata tirnporis does not done
it with the interest or return on capital, as these are form of compensation different
from interest charges, for the loss suffered by the creditor. The effective source is the
failure of the debtor to meet the contractual or the customary statutory obligation.
65. Debt-claim which forms part of permanent establishment is not
interest but business income
Income from every kind of debt-claims is defined to be interest income for the
purposes of Article 11. But that debt-claim which forms part of the assets of the
permanent establishment of the beneficiary of interest or which is otherwise effectively
connected .with it, is an exception. Interest paid in respect of that debt-claim is taken
to be income from business. Similarly, interest in respect of a debt-claim effectively
connected with the fixed base of the beneficiary established for the purpose of carrying
of independent personal services is taken to be
professional income.
The taxability of interest income in respect of debt-claim effectively connected with the
permanent establishment or the fixed base as the business or professional income depends
upon the debt-claims forming part of the assets of the permanent establishment or fixed
base or-being effectively connected with that establishment or base. It is not based on
what is known as the doctrine of the 'force of attraction'.
The doctrine of 'force of attraction' creates a fiction or presumption in relation to ·
income arising from transactions outside permanent establishment or fixed base as if the
income of the permanent establishment, i.e., if a foreign enterprise has a permanent
establishment in a taxing country, any other income from sources within that country is
automatically regarded as income attributable to the permanent establishment. The
presumption or fiction has no relevance because of the requirement of the effective
connection between the debt-claim and subsequently income arising therefrom and the
permanent establishment. The income is thus taxable as a part of the profit of the
permanent establishment. But, however, if the effective connection is traced to the
activity of the nature as described in (c) of paragraph (1) of Article 7, i.e., the
activities of the same or similar kind as those effected through the permanent
establishment, interest is taxable as business profits. The doctrine of 'force of
attraction' is extended to this extent. In that case also, however, effective relation
between the source of income and the activity has to be established.
The exception as contained in paragraph (4) operates in the following situations:
- The beneficiary owner of the interest carries on business in the other State through a
permanent establishment or performs independent personal services from a fixed base
situated therein
- The debt-claim, the source of interest, is effectively connected with such establishment
or fixed base or the business activities which are same or similar kind as those effected
through the permanent establishment
66. Paragraph (5) and the fiction about arising of income
Paragraph (5) of Article 11 deals with a fiction about where interest income arises
under certain situations. It specifies that the place of residence of the payer is the
source of interest. Interest is deemed to arise in a Contracting State, if the payer is
the State itself; a political sub-division, a local authority or resident of that State.
The second sentence of this paragraph carves out an exception to this rule. The residence
of the payer will not, rather than the place of the permanent establishment or the fixed
base will, be the determinative factor. If the payer of interest has contracted the loan
for the needs of the permanent establishment/fixed base and interest on such loan is borne
by the latter, the source of interest is in the Contracting State in which the permanent
establishment/fixed base is situated irrespective of the place of residence of the owner
of the permanent establishment/fixed base even when he resides in neither of the
Contracting States. The indebtedness on which the interest is paid should have some
connection with the requirements of the permanent establishment/fixed base. The expression
'in connection with' implies some nexus between the two. The existence of the nexus between the indebtedness and the needs of
the permanent establishment/fixed base is the essential requirement for holding the state
of location of permanent establishment/fixed base as the source of interest. The absence
of the nexus will render this rule inapplicable.
67. Interest and the doctrine of arm's length
Paragraph (6) echoes the doctrine of arm's length. It restricts the operation of Article
11 in cases where the amount of interest which would have been agreed upon between the
payer and the beneficial owner of the interest had they stipulated at arm's length. It
provides that where by reasons of special relationship between the payer and the
beneficial owner or between both of them and some person, the amount of the interest
exceeds the amount which would have been agreed upon by the payer and the beneficial owner
in the absence of such relationship, the provisions of Article 11 apply only to the
last-mentioned amount and as for the excess the laws of each Contracting State are
applicable having regard to the other provisions of the convention. The question is
whether such excess be considered as a dividend on the amount of loan representing equity
contribution. For that matter reference to Article 9 is necessary.
Article 9 of the Model stipulates that ‘where conditions are made or imposed between
two enterprises in their commercial or financial relations which differ' from those which
would be made between independent enterprise' then 'any profits which would but for those
connections have accrued to one of the enterprises, but by reasons of those conditions
have not so accrued' should be included in the profile of the enterprise and taxed
accordingly. Whether this clause is 'restrictive’ or is 'illustrative', there has
been difference of opinion. As for the thin capitalisation the rule has been that it
should not normally have the effect of increasing the taxable profits of the domestic
enterprise to any amount greater than the arm's length profit. Article 9 is relevant not
only in adjusting the rate of interest but also in certain circumstances to determining
whether what is presented as loan be considered as contribution to equity capital or the
amount of interest be taxed as profit or be taken as belonging to any other category for
the purposes of applying the provisions of the tax laws of the States concerned and the
provisions of the Convention.
Paragraph (6) is applicable only if the excess payment of interest is the result of a
special relationship between the payer and the beneficial owner or between them and some
other person. Special relationship becomes evident where one of the persons to the
contract is under the influence or control of the other or vice versa. Relationship by
blood or marriage or dictated by mutuality or community of interest as distinct from legal
relationship giving rise to the payment of interest is also covered by the concept special
relationship.
