Interest Tax Rate Between India and Israel Under DTAA

Interest Tax Rate Between India and Israel

The India-Israel Double Taxation Avoidance Agreement (DTAA), signed on 29 January 1996 and amended by the 2015 Protocol, establishes a reduced withholding tax rate on cross-border interest payments. Under Article 11(2) of the treaty, interest arising in one Contracting State and paid to a beneficial owner who is a resident of the other Contracting State may be taxed, but the tax so charged shall not exceed 10% of the gross amount of the interest. This represents a significant reduction from India's domestic withholding rate of 20% under Section 195 read with Section 115A of the Income Tax Act, 1961.

The India-Israel DTAA applies a single flat rate of 10% on all categories of interest income, without differentiating between bank interest, corporate bond interest, or government securities. This uniform approach simplifies compliance for both Israeli lenders and Indian borrowers.

Treaty Rate vs Domestic Rate: Detailed Comparison

The difference between the DTAA rate and India's domestic withholding rate on interest represents a substantial tax saving for Israeli creditors:

Under Section 115A of the Income Tax Act, the standard domestic withholding rate on interest paid to non-residents on foreign currency borrowings is 20%. However, certain categories of interest enjoy concessional domestic rates — for instance, interest from infrastructure debt funds is taxed at 5% under Section 194LB, and interest on Masala bonds and foreign-currency borrowings made before 1 July 2023 at 5% under Section 194LC. In such cases, the taxpayer should apply the lower of the DTAA rate or the domestic rate, as per Section 90(2) of the Income Tax Act.

With surcharge and health and education cess, the effective domestic rate on general interest works out to approximately 21.2%-21.8% for a foreign company, making the DTAA rate of 10% even more beneficial.

Who Qualifies for the Reduced Rate

The reduced 10% withholding rate on interest under the India-Israel DTAA is available only to recipients who meet specific eligibility criteria:

Beneficial Ownership

Article 11(2) explicitly requires that the recipient be the beneficial owner of the interest income. This means the Israeli entity must have the genuine right to use and enjoy the interest and must not be acting as an agent, nominee, or conduit. Indian tax authorities scrutinize back-to-back loan arrangements where an Israeli intermediary receives interest but is obligated to pass it on to a third-country entity.

Tax Residency in Israel

The recipient must be a tax resident of Israel as determined under Article 4 of the DTAA. A valid Tax Residency Certificate (TRC) from the Israeli Tax Authority (Rashut HaMisim) is the essential document for establishing treaty eligibility. For individuals, Israeli tax residency is generally based on the centre of life test, while for companies, it is based on the place of incorporation or effective management.

Anti-Avoidance Provisions

The MLI's Principal Purpose Test (PPT), applicable to the India-Israel treaty following India's MLI entry into force on 1 October 2019, allows denial of the reduced rate if one of the principal purposes of a financing arrangement was to obtain treaty benefits. India's GAAR provisions under Chapter X-A of the Income Tax Act provide an additional layer of anti-avoidance scrutiny.

Permanent Establishment Exception

Under Article 11(5), the 10% cap does not apply if the beneficial owner carries on business in India through a Permanent Establishment (PE) situated in India and the debt-claim generating the interest is effectively connected with that PE. In such cases, the interest is taxed as business profits under Article 7, potentially at higher rates.

Interest-Specific Treaty Provisions

Article 11 of the India-Israel DTAA contains several important provisions specific to interest income:

Exemption for Government and Central Bank Interest

Under Article 11(3), interest arising in India is taxable only in Israel (exempt from Indian withholding) where it is paid on bonds or similar obligations of the Government or a political sub-division or local authority, or on loans made, guaranteed or insured by the Reserve Bank of India or the Bank of Israel, or by other governmental agencies agreed between the two States.

Definition of Interest

The term "interest" under Article 11(4) is defined broadly to include income from debt-claims of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtor's profits. It specifically includes income from government securities, bonds, and debentures, including premiums and prizes attaching to such securities, bonds, or debentures.

Source Rule

Interest is deemed to arise in a Contracting State when the payer is a resident of that State. Where the person paying the interest has a PE in a State and the interest is borne by that PE, the interest is deemed to arise in the State where the PE is situated, regardless of the payer's residence.

Arm's Length Limitation

Article 11(7) contains an important safeguard: where the amount of interest exceeds the arm's length amount (due to a special relationship between the payer and beneficial owner), the treaty provisions apply only to the arm's length portion. The excess is taxable according to the domestic laws of each State, with due regard to the other provisions of the DTAA.

2015 Protocol Changes

The Protocol signed on 14 October 2015 (in force from 19 December 2016) deleted paragraphs 3 and 4 of Article 24, which contained the treaty's tax sparing (deemed tax credit) provisions under which Israel could credit Indian tax spared under Indian tax incentives. The Protocol also deleted the most-favoured-nation clause that formed part of the treaty's protocol. Israeli lenders can therefore claim credit in Israel only for Indian tax actually paid.

Documentation Required

Israeli entities receiving interest from Indian sources must furnish the following documents to claim the reduced 10% rate:

Tax Residency Certificate (TRC)

A valid TRC issued by the Israeli Tax Authority for the relevant financial year, as required under Section 90(4) of the Indian Income Tax Act. The TRC must confirm that the entity is a tax resident of Israel for the period during which the interest is received.

Form 10F

Form 10F is a self-declaration providing the taxpayer's details including status, nationality, Israeli tax identification number, period of residential status, and address in Israel. Since 2022, Form 10F must be filed electronically on the Indian income tax e-filing portal.

No Permanent Establishment Declaration

A declaration confirming that the Israeli recipient does not have a PE in India, or that the debt-claim giving rise to the interest is not effectively connected with any PE in India.

Beneficial Ownership Declaration

A self-declaration confirming that the Israeli entity is the beneficial owner of the interest and is not acting as a nominee, agent, or conduit for any third party.

Withholding Procedure for Indian Payers

Indian entities making interest payments to Israeli residents must comply with the following procedures:

Section 195 Compliance

Under Section 195 of the Income Tax Act, any person responsible for paying interest to a non-resident must deduct tax at source. Where the DTAA rate is lower than the domestic rate and the recipient has provided valid documentation (TRC, Form 10F, and declarations), the payer may deduct tax at the treaty rate of 10%.

Form 15CA and Form 15CB

Before making any cross-border remittance of interest, the Indian payer must:

• Obtain a Form 15CB certificate from a Chartered Accountant, which certifies the nature of the payment, applicable DTAA provisions, and rate of tax deducted
• File Form 15CA electronically on the Income Tax portal, which serves as a declaration to the authorized dealer bank

These forms must be completed before the remittance is processed through the banking channel. Failure to comply can result in penalties and the bank may refuse to process the remittance.

Application for Lower Withholding (Section 197)

Where the Israeli recipient's total Indian income will attract a lower tax liability than the applicable withholding rate, the recipient (the payee) may apply to the Assessing Officer under Section 197 for a certificate authorizing lower or nil withholding. Section 197 is a payee-side application: the Indian payer cannot use it, and the payer's own route is an application under Section 195(2) for a determination of the proportion of the remittance chargeable to tax. The Section 197 certificate is particularly useful for Israeli banks that receive large volumes of interest from Indian borrowers.

Common Disputes and Judicial Precedents

Several issues frequently arise in the taxation of cross-border interest under the India-Israel DTAA:

Interest vs. Royalties Classification

A recurring dispute involves the classification of payments. Indian tax authorities sometimes attempt to reclassify certain payments as royalties or fees for technical services (which may attract different treaty provisions) rather than interest. Royalties are taxed under Article 12 of the India-Israel DTAA, while fees for technical services fall under a separate Article 13; this royalty/FTS boundary has been the subject of litigation, notably in cases involving software licensing fees and equipment leasing payments.

Beneficial Ownership in Back-to-Back Loans

Where an Israeli bank receives interest from an Indian borrower but the funds were originally sourced from a third-country institution, Indian tax authorities may challenge the Israeli bank's beneficial ownership status. The key test is whether the Israeli entity has the genuine right to use and enjoy the interest or is merely a conduit.

Interest on Delayed Payments and Compensation

Questions arise about whether interest awarded by courts or tribunals on delayed payments, or compensatory interest under commercial contracts, qualifies as "interest" under Article 11. Indian tribunals have generally held that such payments fall within the broad definition of interest under the treaty.

Transfer Pricing on Intercompany Loans

Where interest is paid between associated enterprises (e.g., an Indian subsidiary paying interest to its Israeli parent), transfer pricing provisions under Chapter X of the Income Tax Act and Article 9 of the DTAA apply. The interest rate must be at arm's length, and any excess interest may be denied the treaty benefit under Article 11(7).

Practical Examples and Calculations

Example 1: Israeli Bank Lending to an Indian Company

An Israeli bank provides a foreign currency loan of USD 5 million to an Indian manufacturing company at 6% annual interest. Annual interest payment = USD 300,000 (approximately INR 2,50,00,000).

• Without DTAA: Tax at domestic rate = 20% + 2% surcharge + 4% cess ≈ 21.22% = INR 53,04,000 (approx. USD 63,650)
• With DTAA: Tax at treaty rate = 10% = INR 25,00,000 (approx. USD 30,000)
• Net saving: INR 28,04,000 (approx. USD 33,650) per year

Example 2: Israeli Individual Earning Fixed Deposit Interest from India

An Israeli tax resident (NRI who moved to Israel) has fixed deposits worth INR 50,00,000 in an Indian bank earning 7% annual interest = INR 3,50,000.

• Without DTAA: TDS on NRO deposit interest at 30% plus 4% cess (31.2%) ≈ INR 1,09,200
• With DTAA: Tax at treaty rate = 10% = INR 35,000
• Net saving: INR 74,200

Example 3: Interest on External Commercial Borrowing (ECB)

An Indian infrastructure company raises an ECB of USD 20 million from an Israeli institutional lender. Interest rate: 5.5% p.a. Annual interest = USD 1,100,000.

• Domestic rate for ECBs: 5% under Section 194LC (for loan agreements executed before 1 July 2023; later borrowings attract the standard 20% rate)
• DTAA rate: 10%
• Applicable rate: 5% for such grandfathered borrowings (lower of domestic and DTAA rate under Section 90(2))

In this scenario, the domestic concessional rate is more beneficial than the DTAA rate, illustrating why taxpayers must always compare both rates.

Frequently Asked Questions

What is the interest withholding tax rate under the India-Israel DTAA?

Under Article 11(2) of the India-Israel DTAA, the maximum withholding tax rate on interest is 10% of the gross amount, provided the recipient is the beneficial owner and a tax resident of Israel. The domestic Indian rate on interest to non-residents is generally 20% plus surcharge and cess.

Does the 10% DTAA rate apply to all types of interest income?

The treaty rate of 10% applies to interest from all categories of debt-claims, including bank loans, corporate bonds, government securities, and fixed deposits. However, for certain types of interest (such as infrastructure debt fund interest under Section 194LB, or Masala bonds and ECBs issued before 1 July 2023 under Section 194LC), the domestic rate of 5% is lower, in which case the domestic rate applies under Section 90(2).

Can an Israeli bank claim the reduced interest rate under the DTAA?

Yes, Israeli banks can claim the 10% treaty rate on interest received from Indian borrowers, provided the bank is the beneficial owner of the interest and furnishes a valid TRC from the Israeli Tax Authority. The bank must not have a PE in India to which the loan is effectively connected.

What is the impact of the 2015 Protocol on interest taxation?

The Protocol signed on 14 October 2015, in force from 19 December 2016, deleted the tax sparing (deemed tax credit) provisions in Article 24 of the treaty, under which Israel could credit Indian tax spared under Indian tax incentives. It also deleted the protocol's most-favoured-nation clause. Israeli lenders can now claim credit in Israel only for the Indian tax actually paid.

How do transfer pricing rules affect intercompany interest under the DTAA?

When interest is paid between associated enterprises (e.g., Indian subsidiary to Israeli parent), the interest rate must be at arm's length under India's transfer pricing rules and Article 9 of the DTAA. Any excess interest beyond the arm's length amount may be denied treaty benefits under Article 11(7).

What documents must an Israeli lender provide to claim the 10% DTAA rate?

The Israeli lender must provide a valid Tax Residency Certificate from the Israeli Tax Authority, Form 10F (filed electronically), a beneficial ownership declaration, and a no-PE declaration. The Indian payer must also file Form 15CA and obtain Form 15CB before making the remittance.

Is interest on delayed payments covered by the India-Israel DTAA?

Interest awarded by courts or tribunals on delayed payments, or compensatory interest under commercial contracts, generally qualifies as interest under the broad definition in Article 11(4). Indian tribunals have typically upheld this interpretation, though specific facts and circumstances may vary.