INSIGHT: India Clarifies on Taxability of Fees Paid for Debt Under India–France Tax Treaty

The AAR concluded that, front-end fee received for loan appraisal application is not regarded as interest payable under the India–France tax treaty (“tax treaty”). However, front-end fee (other than appraisal fee) as commitment fee, cancellation fee, monitoring fee and amendment fee after approval of finance were treated as interest under the India–France tax treaty. The AAR confirmed that front-end fee received for loan appraisal application is not characterized as Fees for Technical Services (“FTS”) but is taxable as business profits subject to the determination of Permanent Establishment (“PE”).

Facts

The applicant is a limited liability company incorporated under the French domestic laws. It is a subsidiary of Agence Francaise de Development, a government owned financial institution. It is engaged in private sector financing in various countries, including in India. The applicant entered into loan facility arrangements with its clients engaged in the business of developing infrastructure projects in India. Pursuant to the financing arrangements, the applicant will earn the front-end fee income like commitment fee; cancellation fee; monitoring fee; amendment fee and reimbursement of out of pocket expenses, in addition to interest on such loans.

In the arrangement, the total front-end fee payable is 1.25 percent of the approved credit facility. The first tranche of front-end is invoiced and payable to the applicant before the due diligence at 0.25 percent of the aggregate amount. The balance fee of 1 percent is invoiced after considering the amount of credit facility approved and recovered after executing the transaction documentation. In this case, the balance front-end fee is payable when the credit facility is approved, agreement between debtor and creditor is drawn, credit facility is invoiced and transaction documentation is signed.

The applicant, in order to obtain certainty arising from the proposed transaction, filed an application before the AAR to seek clarity taxability on the following questions:

•  (i) Would front-end fees earned be characterized as interest or FTS under the India–France tax treaty?
•  (ii) Where the front-end fees are not regarded as interest or FTS, would such fee earned be treated as business income and not liable to tax in the absence of a PE in India?
•  (iii) Whether actual reimbursement of expenses by the clients towards legal, advisory fee and out of pocket expenses initially incurred by the applicant are treated as business income?

AAR Ruling

The revenue argued that, the applicant was not bound to sanction credit facilities, and was entitled to appraise the project to decide whether or not to sanction the credit facilities hence, the payment of front-end fee was mandatory and did not dependent or was connected with the loan advanced but, was obligated to pay the fee even if the loan transaction was not sanctioned or approved. In support of this argument, the revenue relied in the case of Bombay Commonwealth Development Corporation (“BCDC”) of Bombay High Court wherein it was held that, the front-end appraisal fee is not interest in absence of a debt claim in existence when the front-end fee was payable. Since conditions of the Bombay High Court are satisfied, the front-end fee received for appraisal by the applicant is not interest. The AAR recognized the applicant as a tax resident of France for availing the benefits under India–France tax treaty relying on the Supreme Court ruling in the case of Azadi Bachao Andolan.

In evaluating when a debt claim comes into existence and determine if the front-end fee relates to a debt claim the AAR observed that, the BCDC ruling relied by the revenue had direct relevance as front-end fee is paid post approval but prior to actual disbursement of the loan facility. In the present case, the front-end fee other than appraisal fee (balance portion of front-end fee) is payable only after the credit facility is approved, agreement between debtor and creditor has been drawn, credit facility is invoiced and transaction documents are executed. Hence, debt claim is in existence post credit facility is granted/approved becomes connected with the loan that the lender is bound to advance in accordance with the agreement.

Effectively, the amount earned from commitment fee, cancellation fee, amendment fee and monitoring fee is construed as directly related to the debt claim since, such front-end fee are charged after the disbursement of credit facility. It was clarified that the AAR did not conclude that fee relates to debt claim only after the loan is disbursed. However, once the loan is disbursed there is no doubt that debt claim has come into existence. Hence, the front-end fee other than the appraisal fee related to the loan is treated as interest income under the India–France tax treaty. Conversely, the applicant contended that, commitment fee is a percentage of loan not drawn, and thus not related to the loan disbursed.

The AAR observed that, once a debt claim is in existence the fee charged is inextricably linked to the debt claim due to the commitment of debt claim regardless of any method to compute the fee. Similarly, the cancellation fee is for un-availed credit facility withdrawn which is after disbursal of loan connected with the credit facility sanctioned and subsequently cancelled. This makes it directly related to and on account of loan advanced thus, would qualify the fee to be treated as interest. The AAR clarified that, irrespective of whether the amendment fee relates to interest rate or principal amount, such fee is in connection to the debt claim already in existence hence, is regarded as interest under the India–France tax treaty. Further, as the applicant is monitoring the financials and constantly involved in the review of credit arrangement, monitoring fee is also characterized as interest for tax purposes.

The evaluation of whether front-end fee is in the nature of appraisal services under FTS is based on the analysis if the appraisal services satisfy the “make available” clause under India–Portugal tax treaty by applying the Most Favored Nation (“MFN”) provision read into India–France tax treaty without any notification. The AAR relying on the Supreme Court decision in the case of GVK Industries Limited stated that, in absence of ‘make available’ clause in a tax treaty, services would be regarded as FTS. However, if the applicant impart any technical knowledge, experience, skill, know-how to the borrower, “make available” clause is satisfied hence, excluding appraisal services from FTS clause under the India–France tax treaty.

The Delhi High Court ruling of Steria (India) Ltd dealt with this issue to conclude that, the benefit of lower rate or restricted scope of FTS under the India–France tax treaty is not contingent on any action by the respective governments. It was concluded that, beneficial provision or restricted scope of FTS in a tax treaty entered by India with another OECD member country can be applied to India–France tax treaty by invoking the MFN provision from the date on which the India–France tax treaty or such other tax treaty is effective. The AAR following the Delhi High Court ruling concluded that, front-end fees received by the applicant in absence of “make available” conditions is excluded from FTS clause of the India–France tax treaty.

On the question of existence of a PE it was observed that, determination of PE is based on the facts of each case each year that was not a subject matter before the AAR. The applicant through a certificate confirmed that, it does not have a PE in India, to be examined by the revenue. Further, in absence of available facts about the actual nature of reimbursement of expenses, the AAR could not conclude on the true character of the reimbursement expenses.

Practical Points

The subject of income characterization in the comprehensive financial contracts and arrangements has been a subject matter of evaluation from taxability perspective under the tax treaties. Usually, the form of transaction or classification is resolved after analyzing the facts of each case. In the instant case, AAR applied the nexus theory to assess existence of debt claim and conclude that all forms of fee involved in the loan transaction, except for the front-end fee towards appraisal, is taxable as interest owing to the inherent association of the fee post the approval of the financial arrangement.

The concept of MFN clause in the tax treaty is widely explored by the taxpayers to avail the tax treaty benefits. MFN clause is not merely applied to restrict the scope of definition but, is also extended on the exemption clause under the applicable tax treaties. Interestingly, in the case of Production Resource Group, Belgium the AAR held that, by virtue of MFN clause of the India–Belgium tax treaty, a restricted scope of FTS provided under the India–Portugal tax treaty can be imported into the India–Belgium tax treaty to conclude that. the services provided by the applicant is not taxable as FTS. Although, the guidance on classification and MFN can be implemented universally, the AAR ruling are binding on the applicant and has persuasive value on taxability of similar transactions for other taxpayers.

Shailendra Sharma is a chartered accountant with a multinational consulting firm in India.