Sunday, April 5, 2009

AAR doubts Ishikawajima – Territorial Nexus and Royalties

An earlier post discussed the taxability of royalties paid to non-residents for technical services. There has been substantial conflict in decisions on this point. Under Section 9(1)(vi) of the Income Tax Act, 1961, royalties payable by non-residents in respect of a right, property or service utilized for the purpose of making or earning any income for any source in India is deemed to accrue or arise in India. Similarly, s. 9(1)(vii) provides that income by way of fees or technical services payable by a non-resident in respect of services utilized for making or earning any income for any source in India is deemed to accrue or arise in India. In what is a curious omission, the Supreme Court appears not to have noticed that this provision deals with payments by non-residents, and not payments to them. Therefore, it does not appear to be applicable in cases where an Indian company engages the services of a non-resident and pays royalty or fees for technical services.

However, in Ishikawajima Harima, the Supreme Court had held that this provision applied even in cases where payments were made to the non-resident, and went on to hold that a “live link” was required before the deeming fiction in s. 9 takes effect. In other words, the Supreme Court held that unless the service was both rendered and utilized in India, it would not be deemed to accrue or arise in India. Both conditions had to be satisfied simultaneously. Therefore, if an Indian company entered into a contract with an American service provider, but all the service was rendered from the service provider’s establishment in America, s. 9 would not apply. While there was no express limitation to this effect in the provision, the doctrine of territorial nexus lent some support to the Court’s ruling. However, an Explanation was introduced by the 2007 Finance Act which specified that such income will be included in the total income of the non-resident whether or not the non-resident has a residence or place of business or business connection in India. The most natural reading of this provision is that Ishikawajima had been nullified by legislative intervention. As the earlier post points out, this is what the Bombay High Court held in Siemens. However, the Court departed from this position in December 2008, with its decision in Clifford Chance, holding that Ishikawajima was still good law.

On 31 March 2009, the Authority for Advance Rulings (New Delhi) considered this issue afresh, in Re Worley Parsons Pty Ltd. Reliance Petroleum Ltd. had entered into an agreement with the applicant, a company incorporated in Australia. Under the terms of this contract, which consisted of two phases, the applicant was required to provide various services to RPL in connection with procurement, project management, construction etc. Phase I of this contract was completed before the contract was terminated, and RPL paid the applicant a sum of approximately $8 million. The question that arose was whether this was “deemed to accrue or arise in India” and therefore part of the applicant’s total income.

The case itself consisted of two aspects – one involving DTAAs and another involving s. 9(1)(vi) and (vii) of the Income Tax Act. Under the DTAA entered into between India and Australia, royalties arising in one State may be taxed in the other when the beneficiary is a resident of the other contracting State (Art. XII). This provision does not apply, however, if the resident has a fixed base or a permanent establishment in the other State, and if the service in respect of which royalty is paid is effectively connected with that PE or fixed base (Art. XII, paragraph 4). In that eventuality, the profits of the PE or fixed base are taxable in the State in which it is situated, to the extent the income earned is attributable to it (Article VII). In this rather complicated scheme, the applicant argued that there existed an effective connection, but this was rejected on facts, since most of the services were rendered from Perth, Australia. An interesting question that arises at this stage is precise nature of the relationship between Article XII and VII – if there is an effective connection between the service and the PE, that income will almost always be attributable to that PE. The AAR noticed this, and left the question open. Since these provisions are similar across many DTAAs, the question is of some importance.

As far as the second question is concerned, the AAR doubted the correctness of the observations in Ishikawajima that the service had to be both rendered and utilized in India. Noting at several places its inability to disagree with the Supreme Court, the AAR finally distinguished the decision in Ishikawajima, holding that the Court had in that case ‘assumed’ the existence of ‘effective connection’ without considering either that question or that of territorial nexus, and that it had made a finding of fact that none of the services were rendered in India. The AAR then applied the deeming fiction in s. 9(1)(vi), finding that it could do so since its case differed from Ishikawajima on the abovementioned two factual aspects, and that the principle of territorial nexus was therefore not contravened. It is noteworthy that the Explanation introduced by the 2007 Finance Act was not considered by the AAR.

With this decision, and the amendment introduced in 2007, there is thus substantial doubt as to the position of law on this area.

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