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Direct Tax Alert - Apex Court treats convertible debentures issued in lieu of outstanding interest on loan as actual payment of interest

19 August 2021

BACKGROUND

With a view to allow certain deduction (most statutory dues) only on actual payment, Finance Act, 1983 introduced Section 43B of the Income-tax Act, 1961 (IT Act). Over the years, the subsequent Finance Acts have enlarged the scope of Section 43B of the IT Act. Finance Act, 1989 inserted clause (d) in section 43B to bring interest on loan or borrowing from any public financial institution or State Financial Corporation or a State Industrial investment corporation within the ambit of section 43B of the IT Act. With this amendment, such interest is now allowed only on payment basis irrespective of the year of accrual of the expenditure. Subsequently, the Finance Act, 2006 retrospectively introduced Explanation 3C in section 43B of the IT Act to provide that the conversion of such interest into loan will not be regarded as payment and hence, deduction will not to be granted on such conversion of interest into loan.

Often, due to the loan restructuring negotiated by the borrower with the financial institutions, an arrangement may be worked out wherein the borrower would issue debentures / other securities towards settlement of outstanding interest or loan. In such situation, a question generally arises as to whether such interest can be regarded as paid and thereby deductible under section 43B of the IT Act or not. In this regard, recently, the Supreme Court1 had an occasion to examine the applicability of Explanation 3C to Section 43B of the IT Act where debentures were issued to settle the outstanding interest liability. We, at BDO in India, have summarised the ruling of the Supreme Court and provided our comments on the impact of this decision hereunder.

FACTS OF THE CASE

Taxpayer, an Indian Company, filed a loss tax return for fiscal year (FY) 1995-96. In FY 1995-96, as the taxpayer was unable to discharge interest liability due to its financial hardship, in terms of restructuring agreed with the financial institution, convertible debentures of INR 100 each were issued towards discharge of such interest liability. The taxpayer treated such issue of debentures as discharge of interest liability and thereby claimed deduction under section 43B of the IT Act. However, the tax officer opined that the debentures issued were not as per the original terms and conditions on which the loans were granted, and that the interest would not be considered as discharged. The tax officer further stated that a subsequent change in the terms of the agreement, as they stood, would be contrary to Section 43B(d) of the IT Act and would render such amount ineligible for deduction. Hence, the tax officer disallowed such deduction. Aggrieved, the taxpayer filed an appeal before the First Appellate Authority who granted the relief by observing that the Financial Institutions had accepted the debentures as effective discharge of the liability for the outstanding interest. Thus, the same was no longer payable by the taxpayer as it would tantamount to actual payment for the purpose of Section 43B of the IT Act. The Delhi bench of the Tax Tribunal affirmed the First Appellate Authority’s order. However, the Delhi High Court held that Explanation 3C to section 43B of the IT Act, having retrospective effect w.e.f. 1 April 1989 would be applicable. The review petition filed by the taxpayer was dismissed by the Delhi High Court. Thereafter, the taxpayer filed an appeal before the Apex Court.

APEX COURT RULING

The Apex Court while setting aside High Court’s ruling held that interest was “actually paid” by means of issuance of debentures when it extinguished the liability to pay interest. It also held that Explanation 3C of Section 43B of the IT Act is not clarificatory in nature and does not purport to add new conditions retrospectively. While coming to this conclusion, it made the following observations:

On convertible debentures issued in lieu of outstanding interest

  • Both the First Appellate Authority and Tax Tribunal found, as a matter of fact, that as per a rehabilitation plan agreed between the lender and the taxpayer, debentures were accepted by the financial institution in discharge of the debt on account of outstanding interest. This is also clear from the expression “in lieu of” used in the judgement of the learned First Appellate Authority, the accounts produced by the taxpayer, and the fact that in the assessment of lender bank for the relevant FY, the accounts of the bank reflected the amount received by way of debentures as its business income. This being the fact, it becomes clear that interest was “actually paid” by means of issuance of debentures, which extinguished the liability to pay interest.
  • Explanation 3C of Section 43B of the IT Act was introduced for “removal of doubts” which only clarified that interest that remained unpaid and has been converted into a loan or borrowing shall not be deemed to have been actually paid.
  • Basis the facts of the present case, the issue of debentures by the taxpayer was, under a rehabilitation plan, to extinguish the liability of interest altogether.

On retrospective applicability of Explanation 3C of Section 43B of the IT Act:

  • Section 43B of the IT Act is not misused by not actually paying interest but by converting interest into a fresh loan and thus, bonafide transactions of actual payments are not meant to be affected. For this purpose, the Apex Court relied on its decision in the case of K.P. Varghese2.
  • A retrospective provision which is “for the removal of doubts” cannot be presumed to be retrospective even where such language is used if it alters or changes the law as it earlier stood. For this purpose, the Apex Court relied on its decision in the case of Sedco Forex International Drill. Inc3.
  • Any ambiguity in the language of Explanation 3C shall be resolved in the favour of the taxpayer. For this purpose, the Apex Court relied on its decision in the case of Vodafone International Holdings BV4.
  • The Supreme Court factually distinguished the decision in the case of Gujarat Cypromet Ltd.4. In that case, the Supreme Court observed that Explanation 3C was squarely attracted as outstanding interest had not actually been paid, but instead a new credit entry of loan appeared, thereby Explanation 3C of section 43B of the IT Act became operational.

BDO COMMENTS

Hitherto, the issue of conversion of outstanding interest into debenture or a loan and treatment of the same as tantamounting to actual payment has been a vexed one.  The prevailing view has been that if outstanding interest was replaced by another debt, it would not be tantamount to discharge if interest liability as Explanation 3C to section 43B would get attracted. However, the taxpayers have been successful when the discharge of liability has been by way of a non-debt instrument. The Delhi High Court in the case of Rathi Graphics6 has held that the conversion of interest amount into equity shares shall be taken as actual payment within the meaning of Sec 43B of the Act. A similar view has been taken by the Mumbai ITAT in the case of Garware Chemicals7. With the COVID-19 pandemic playing havoc, many businesses have entered into negotiation with their lenders to restructure their loans. This Ruling will be helpful where the borrowers have either issued shares or debentures or any other security in settlement of its outstanding interest amount. However, the language of the agreement has to be suitably worded to take advantage of this Ruling. In such circumstances, the taxpayer could treat the issuance of security as actual payment of interest and thereby claim deduction under section 43B of the IT Act.


1M.M. Aqua Technologies Ltd vs. CIT, Delhi III., Civil Appeal No. 4742-4743 of 2021 (Supreme Court)

2K.P. Varghese v. ITO [1981] 4 SCC 173 (Supreme Court)

3Sedco Forex International Drill. Inc v. CIT [2005] 12 SCC 717 (Supreme Court)

4Vodafone International Holdings BV v. Union of India [2012] 6 SCC 613 (Supreme Court)

5CIT v. Gujarat Cypromet Ltd. [2020] 15 SCC 460 (Supreme Court)

6CIT -vs.- Rathi Graphics Technologies Ltd [2015] 64 taxmann.com 65 (Delhi)

7Garware Chemicals Ltd -vs.-CIT [2015] 54 taxmann.com 86 (Mumbai - Trib.)