The Income-tax Appellate Tribunal (ITAT), Mumbai has held that the interest received by branches in India from their overseas headquarters will be taxable in India.

ITAT Mumbai gave this verdict in an order late last month on an appeal filed by Dresdner Bank, Germany. The bank contended that that the interest on its nostro account received from its headquarters abroad was a result of an intra-organisation transaction and hence a revenue-neutral activity.

This argument was not accepted by ITAT bench comprising judicial member P Madhavi Devi and accountant member Pramod Kumar. The ITAT concluded that taxability of the transaction should be determined on the basis of the profits accruing in India. Neutrality of revenue can be considered only when examining the operations of the enterprise as a whole. In this case, ITAT observed, the Indian branch should be construed an independent entity to which the income has accrued.

The ITAT held that cross-border dealings within an enterprise, which invariably relate to two tax jurisdictions, need to be examined closely to ascertain the taxability in each jurisdictions. In the contemporary business situation when economic activities of an organisation are spread over several tax jurisdictions, and the right of each such jurisdiction is restricted to the profits accruing to the PE in that jurisdiction, it is necessary that profits accruing or arising in such jurisdictions are computed correctly.

The ITAT decision in the Dresdner Bank case need to be read with another decision by the Kolkata ITAT in the case of ABN Amro Bank. In this case, interest was paid by the Indian branch to the foreign branch. The issue in ABN Amro Bank is this: Whether the interest paid by the Indian branch is eligible for deduction.

The banks will face a double jeopardy. In ABN Amro Banks decision, the Kolkata bench of tribunal had held that deduction of interest paid to foreign branches or head office cannot be allowed as it is a transaction from self to self.

However, when it came to taxation of interest income received from the foreign head office and branches, the Dresdner Bank decision says that income is to be taxed as the branch is to be treated as hypothetically independent. The tribunal noted that the ABN Amro decision will have no impact on this decision, as it was dealing with an income situation and the ABN Amro was dealing with an expense situation.

However, it is clear that the issue of intra-organisation transactions requires to be considered by a larger bench and in a holistic manner. The tribunal itself has observed that it is alive to the fact that this judgement can possibly result in an incongruity, inasmuch while a foreign bank operating in India will be taxable in India in respect of the interest it earns from its head office and branches abroad, no deduction will be available, but the tribunal stated that it was dealing only with the scope of income accruing or arising in India under section 5(2)(b) and it should be treated as a precedent only on this question.

In Dresdner Banks case, the interest income involved was only Rs 5 crores for one year, but since all foreign bank branches will be affected by this decision, the revenue impact could be substantial.