ITAT ruling provides respite to off-shore debt funds in India

The judgement would benefit several FPIs who have made investments in OCDs and CCDs in India from the period between 2013 to 2023.

A recent ruling by the Delhi bench of the Income Tax Appellate Tribunal (ITAT) has come as a huge relief to offshore investors who bought Indian debt instruments before 2024, affirming their eligibility for a lower tax rate on interest income earned from various types of debentures.

The tribunal held that foreign portfolio investors (FPIs) are entitled to the concessional 5 percent tax rate on all categories of debentures, not just non-convertible debentures.

The tribunal’s June 25 verdict was on an appeal filed by Amplus Energy Solutions, a Singapore-based FPI which held Indian debt instruments.

The decision contradicts a 2017 internal guidance of the tax department that limited the benefit to interest earned on non-convertible debentures (NCDs) only, under Section 194LD of the Income Tax Act.

According to the department’s guidance, other instruments such as compulsorily convertible debentures (CCDs) and optionally convertible debentures (OCDs) are to be taxed at treaty rates —typically around 15 percent.

The department argued that their convertibility feature disqualified these instruments from the concessional rate, as they were not pure debt instruments.

“The ITAT’s ruling affirming concessional tax on CCDs and OCDs under Section 194LD is a welcome step. It provides much-needed clarity and strengthens India’s position as a predictable and investor-friendly jurisdiction for FPIs,” said Suresh Swamy, partner, Price Waterhouse & Co LLP.

According to tax department, only those debentures that come with no conditions upon maturity should eligible for the beneficial tax rate. But in the case of CCDs and OCDs there are conditions, namely they are convertible into shares, making them ineligible for the 5 percent rate.

The tribunal rejected this contention and held that debentures are debt instruments and what happens after their maturity is “inconsequential” while determining the tax rate.

“The distinction between OCD/CCD with NCD is of no consequence and they are debt instrument only like the bonds… To treat CCD and OCD as shares inpraesentia would be extending too far the principles of interpretation…” said a two-member bench of ITAT comprising judicial member Anubhav Sharma and  account member Manish Agarwal.

“Thus, we are of the considered view that ld. Tax Authorities have fallen in error to not give the assessee the benefit of Section 194LD in regard to OCD/ CCDs also,” it added.

The judgment would benefit several FPIs who invested in OCDs and CCDs between 2013 and 2023.

The discontinued the concessional tax rate in FY24. At present, only investments from IFSC, Gift City, Gandhinagar, are eligible for tax sops. However, many FPIs face tax notices on their legacy debt instruments due to the 2017 communication.

“The tribunal has unequivocally held that you must tax the transaction, not the eventual transformation. A convertible debenture is effectively a bond when you're paid interest on it. Any debate about it being future equity is irrelevant until conversion is complete. This should cut through the tax disputes over the past concessional tax regime for rupee bonds," said Abhay Sharma, head of tax, Bombay Law Chambers.

“The ITAT has ruled that the fundamental intent of section 194LD is to attract long-term foreign capital into Indian debt markets while shielding Indian companies from foreign exchange volatility. The key requirement is that the debt instrument be rupee-denominated, irrespective of its convertibility feature. It upheld the principle of substance over form,” said Punit Shah, partner, Dhruva Advisors.