The Hindu Business Line : Re-structuring hampered

A major amendment has been made by the Finance Act, 2006 with regard to the claim for deduction of interest paid on monies borrowed for business. The income-tax law normally encourages the accrual system of accounting. In fact, the company law all but insists on following the mercantile system of accounting. An exception to assessing income on accrual basis was made with the insertion of Section 43B by the Finance Act, 1983 with effect from April 1, 1984.

It was found that corporate houses were claiming deduction of expenses by way of sales tax, cess or fee, contribution to provident or other funds or interest on term loans without making actual payment. While deduction was claimed on accrual basis in the income-tax assessments, actual payment was not made, thereby depriving the government of legitimate revenues and, at the same time, taking the benefit of not paying the dues as long as possible. Section 43B allowed deduction towards interest on borrowals on the basis of actual payment. Mere accrual of liability towards interest will not be sufficient to claim deduction.

New Explanations

The Finance Act, 2006 has amended the concept of actual payment by adding two new Explanations — 3C and 3D — to Section 43D to clarify that if any sum payable by the assessee as interest on any loan, borrowing or advance is converted into a loan, borrowing or advance, the interest so converted, not "actually paid", shall not be deemed as actual payment and will not be allowed as deduction in the computation of income under Section 43B.

Explanation 3C declares that conversion of interest into loan in the case of borrowing from a public financial institution will bar deduction of interest. Explanation 3D declares that conversion of term loan from scheduled banks will suffer a similar fate and result in denial of deduction. Explanation 3C takes retrospective effect from April 1, 1989. This was the date from which interest on loans or borrowings from public financial institutions were considered for deduction on actual-payment basis by the amendment made by the Finance Act, 1988.

Explanation 3D relating to interest on loans or advance from a scheduled bank takes effect retrospectively from April 1, 1997. This was the date from which such interest on bank loans was considered for deduction on actual payment basis by the Finance No. (2) Act, 1996. When a company turns sick, it negotiates with lending institution for postponement of repayment obligations. Quite often, interest not paid is converted into a loan. It does not mean that interest has either been foregone or is not likely to be paid back. When the converted loan is repaid in full at a later date, the entire amount would have been paid, although the nomenclature will change from interest to loan. Is there a guarantee that on such later occasion, the Department will allow the interest portion as deduction even though it may be termed `converted loan'?

Rocking the boat

The amendment has stirred the hornet's nest. It violates a principle accepted by the Central Board of Direct Taxes on the amount covered under the sales tax deferral scheme of State governments. Notwithstanding Section 43B, Circular No. 674 of December 29, 1993, permitted deduction of sales tax liability converted into loan under the deferral scheme.

The Supreme Court, in J. B Boda & Co., P Ltd vs CBDT (223 ITR 271), ruled that the law does not require `a two-way traffic' of first making the payment and then receiving it back. That was a case concerning deduction of commission to a foreign reinsurance company under Section 80(0). Notwithstanding the present amendment, it may be open to the parties to negotiate with financial institutions or scheduled banks in such a way that first the institution gives a cheque to the company and the company returns the same towards interest. A new loan agreement can be negotiated later for the higher amount, including the interest component. Does the Government want corporates to circumvent the amendment this way? Tribunals have held that the term `actual payment' has to be construed in a liberal manner, taking into account conversion of interest into loan.There are rulings favouring the other view. Sick companies opt for one-time settlement for conversion of interest into loan. The denial of release will hamper financial restructuring of corporate houses and there is no rationale for the retrospective amendment.

In respect of public financial institutions, the amendment takes effect from 1989-90. As regards scheduled banks, it takes effect from assessment year 1997-98. Are officers to reopen completed assessments and disallow interest on converted portion of the loan? Will such reassessments stand the test of judicial scrutiny?

Probably, officers are not aware of the Macniven (HM Inspector of taxes) vs Westmoreland Investments Ltd (2002 255 ITR 612 HL) ruling, wherein the House of Lords held that conversion of interest liability into a term loan would not amount to tax evasion and the Revenue cannot ignore the claim for deduction of interest.

(The author is a Chief Commissioner of Income-Tax.)

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