Interest Income and Taxation under Section 9(1)(v) of the Income Tax Act, 1961, and Double Taxation Avoidance Agreements (DTAAs)

Interest income taxation has been a subject of constant refinement in Indian tax law, particularly concerning the taxation of interest paid to both residents and non-residents. The provisions under Section 9(1)(v) of the Income Tax Act, 1961, as amended by the Finance Acts, have established a detailed framework for the taxation of interest income that arises in India. Additionally, the OECD and UN Model Tax Conventions play a crucial role in determining how interest income is taxed in cross-border transactions. This blog aims to break down the relevant provisions, key judicial pronouncements, and international tax treaties affecting the taxation of interest income.

Section 9(1)(v) of the Income Tax Act, 1961: A Key Provision for Taxing Interest Income

Section 9 of the Income Tax Act, 1961, defines the scope of income that is deemed to accrue or arise in India. Under Section 9(1)(v), interest income is specifically categorized to determine whether it is subject to Indian taxation. The provisions in this section identify three major scenarios where interest income shall be considered as having accrued or arisen in India:

1. Interest Paid by the Indian Government

Interest income that is paid by the Indian Government is deemed to accrue or arise in India, regardless of the recipient’s country of residence. This ensures that interest earned on government loans or securities is subject to Indian tax laws.

2. Interest Paid by a Resident Indian Person

If a resident Indian person (whether an individual or entity) pays interest, the income is deemed to have accrued in India, except in the following cases:

• The interest is paid for a debt incurred for the purposes of a business or profession carried on outside India.
• The interest is paid to earn income from any source outside India.

3. Interest Paid by a Non-Resident

Interest income paid by a non-resident is considered to have accrued in India if it pertains to a debt incurred for the purposes of carrying on a business or profession in India. This provision ensures that interest paid for business activities in India by a foreign entity is taxed in India.

Key Case Laws Interpreting Section 9(1)(v)

Several judicial pronouncements have shaped the interpretation of Section 9(1)(v). For example:

• In J.K. Synthetics Ltd. v. Assistant CIT (1990), the Delhi High Court held that the interest payable to a foreign supplier of raw materials fell within the ambit of Section 9(1)(v), making it subject to tax in India.
• In Vijay Ship Breaking Corporation (2003), the Gujarat High Court clarified that interest paid by a resident to a non-resident for business purposes outside India is subject to Indian taxation.
• Similarly, in India Furniture Products Ltd. v. CIT (2020), the Bombay High Court observed that usance charges paid to Indian banks on credit facilities for payments to foreign purchasers are deemed to be interest income and taxable in India.

Impact of the Finance Acts and Amendments

The Finance Act, 1976, brought in significant changes to Section 9 by omitting the fourth limb regarding interest income arising from money lent at interest and brought into India. However, the same Finance Act introduced Section 9(1)(v) to include a broader definition of interest income, ensuring that interest earned from debts connected to business activities in India is taxed under Indian laws.

Further amendments were introduced by the Finance Act, 2007, which expanded the definition of income deemed to accrue in India to include interest income of non-residents, regardless of whether they have a business or permanent establishment (PE) in India. This amendment ensures that non-resident entities, including foreign banks, are taxed on interest received in India.

Double Taxation Avoidance Agreements (DTAA) and Interest Income

India has entered into multiple Double Taxation Avoidance Agreements (DTAAs) with countries worldwide to avoid taxing the same income in more than one jurisdiction. Article 11 of both the OECD Model Tax Convention (2017) and the UN Model Tax Convention (2021) lays down the rules for taxing interest income.

OECD vs. UN Model Tax Convention

Both the OECD and UN models provide a similar framework for taxing interest. The key provisions of Article 11 can be summarized as:

• OECD MTC (2017): Interest arising in one contracting state and paid to a resident of another contracting state may be taxed in the country of the recipient. However, it can also be taxed in the country of origin (source country), subject to a maximum withholding tax of 10% of the gross interest amount.
• UN MTC (2021): The UN Model Tax Convention includes similar provisions as the OECD but with slightly modified tax rates, allowing the tax rate to be negotiated bilaterally.

Both models specify that interest, including government securities, bonds, and debentures, is subject to these rules. In cases where there is a special relationship between the payer and the beneficial owner of the interest (for example, a parent-subsidiary relationship), the provisions may apply only to the arm’s length amount of interest. The excess amount over the arm’s length rate is subject to tax based on the domestic laws of the respective countries.

Special Provisions for Permanent Establishments (PE)

A significant amendment to Section 9(1)(v) was introduced by the Finance Act, 2015, regarding interest paid by the Permanent Establishment (PE) of a foreign bank in India. According to this amendment, interest paid by the PE of a non-resident engaged in the business of banking to its head office or another PE outside India is also deemed to arise in India and is subject to Indian tax laws. This ensures that foreign banks operating in India are taxed appropriately for the interest payments made within India, thereby strengthening the tax framework for foreign entities with a PE in India.

The Meaning of “Interest” Under Article 11 of Tax Treaties

Both the OECD and UN Model Tax Conventions define “interest” broadly, covering income from debt claims of every kind, including those secured by mortgages and those carrying a right to participate in the debtor’s profits. The definition also extends to government securities, bonds, and debentures.

A key aspect of interest taxation is that it does not include penalties for late payment, which are classified separately. The term “interest” under these treaties encompasses all forms of remuneration paid for the use of capital, including income received by bondholders and lenders.

FAQs on Interest Income Taxation under Section 9(1)(v) of the Income Tax Act, 1961 and DTAAs

1. What is Section 9(1)(v) of the Income Tax Act, 1961?
Section 9(1)(v) of the Income Tax Act, 1961, deals with the taxation of interest income earned by non-residents. It deems interest to have accrued or arisen in India if it is paid by the Indian government, a resident individual or business, or a non-resident entity for the purpose of carrying on business in India. This provision ensures that interest income tied to Indian business activities is taxed under Indian tax laws.

2. How is interest income taxed in India for non-residents?
Interest income paid to non-residents by an Indian source is subject to tax in India under Section 9(1)(v). The income may also be subject to tax in the non-resident’s home country, but the India tax rate could be reduced under the provisions of the applicable Double Taxation Avoidance Agreement (DTAA).

3. Does India have tax treaties for interest income?
Yes, India has signed Double Taxation Avoidance Agreements (DTAAs) with several countries to avoid taxing the same income twice. These treaties generally provide for reduced withholding tax rates on interest income earned by non-residents, often limiting the tax rate to 10% or 15% of the gross interest amount.

4. How is interest income defined under the OECD and UN Model Tax Conventions?
Under both the OECD and UN Model Tax Conventions, “interest” refers to payments made for the use of money or capital, including income from debt claims of every kind, government securities, bonds, and debentures. It excludes penalties or late payment charges.

5. Can non-residents claim a reduced tax rate on interest income?
Yes, non-residents can claim a reduced tax rate on interest income if India has a Double Taxation Avoidance Agreement (DTAA) with their country of residence. The reduced tax rate typically ranges from 10% to 15% of the gross interest, depending on the specific treaty.

6. Is interest paid by a foreign entity subject to Indian tax?
Yes, interest paid by a foreign entity to a non-resident may be taxed in India under Section 9(1)(v) if the interest is associated with a business or profession carried out in India. However, this depends on the specific terms of the DTAA between India and the foreign entity’s home country.

7. Does the taxation of interest income differ for Permanent Establishments (PEs)?
Yes, the taxation of interest paid by a Permanent Establishment (PE) of a foreign bank in India is subject to Indian tax laws. The Finance Act, 2015, clarified that interest paid by a PE to its head office or another PE outside India is also deemed to arise in India and is taxable under Indian tax provisions.

8. Are there any exemptions on interest income for residents in India?
Indian residents are subject to tax on their global income, including interest earned from both Indian and foreign sources. However, certain exemptions or deductions may be available under specific sections of the Income Tax Act, such as under Section 80TTA for interest earned from savings accounts, which provides a deduction of up to ₹10,000 on interest income.

9. How does the withholding tax on interest income work in India?
Withholding tax is applied by the payer (such as an Indian bank or company) before making the payment of interest. For non-residents, the withholding tax rate is generally 20% under Section 195, but this rate can be reduced under a DTAA, depending on the country of residence of the recipient.

10. What happens if there is no DTAA between India and the foreign country?
If there is no Double Taxation Avoidance Agreement (DTAA) between India and a foreign country, the interest income will be taxed at the higher domestic withholding tax rate of 20% as per Section 195 of the Income Tax Act, 1961. However, the non-resident may be able to claim a tax credit in their home country to offset the tax paid in India.

11. Is there a specific tax rate for interest on government securities?
Interest on government securities is subject to tax in India under the same provisions as other types of interest income. However, in some cases, government securities may enjoy favorable tax treatment, depending on the nature of the securities and the recipient’s residency status.

12. Can interest income received by a non-resident be exempt from tax in India?
Interest income may be exempt from tax under certain conditions specified in the Income Tax Act or relevant tax treaties. For example, interest on bonds issued by the Indian government to foreign investors may be exempt under specific provisions of the tax treaties or domestic laws.

Conclusion

Interest income taxation in India is governed by complex provisions under Section 9(1)(v) of the Income Tax Act, 1961, as well as international treaties such as the OECD and UN Model Tax Conventions. The tax treatment depends on various factors, including the nature of the payer, the use of the borrowed funds, and the tax treaties between India and other countries. It is essential for both residents and non-residents to understand these provisions and how they apply to their interest income to ensure compliance and optimize their tax liabilities.

For businesses and individuals engaging in cross-border transactions or earning interest income from India, seeking professional tax advice is crucial to navigating these intricate rules and making the most of available treaty benefits.