Recent Decisions - Pranav Sayta

1. Global Tax Advisory Services Recent Decisions- Pranav Sayta

2. Contents • Ishikawajima-Harima Heavy Industries Co Ltd - Turnkey Contracts • Sony India Private Ltd – Transfer Pricing • Dresdner Bank – Payments to Head Office • Fidelity Northstar Fund – Foreign Institutional Investors

3. Ishikawajima-Harima Heavy Industries Co Ltd – Turnkey contracts

4. Facts • IHI along with consortium members, entered into a contract with Petronet LNG Limited (‘PLL’) in 2001 • Contract was for setting up of a LNG terminal at Dahej, Gujarat • Role/ responsibility and consideration of each consortium member provided separately • Separate consideration also identified for specific scopes of work (for each member) • Scope of work for IHI was categorised into the following categories: • Onshore supply • Onshore services • Construction and erection • Offshore supply • Offshore services • IHI established a Project Office in India for execution of project

5. Facts • The contract was signed in India • IHI had a Permanent Establishment (‘PE’) under Article 5(3) of the India-Japan tax treaty • The property in goods which were the subject matter of offshore supply passed outside India • The offshore services were also rendered outside India IHI filed an application before the Authority for Advance Ruling (‘AAR’) to determine the taxability of offshore supply and offshore services

6. AAR Ruling… • AAR’s view on offshore supplies • Taxability under the Income-tax Act, 1961 (‘Act’) • Sale takes place outside India – property in goods passes outside India • However, certain operations – signing of contract, receiving, unloading, storing and transporting, paying demurrage charges, etc. carried in India • Price (for offshore supply) includes price for such operations • As such, income deemed to accrue or arise in India • Taxability under the India-Japan tax treaty • Supply of equipment directly or indirectly attributable to PE in India. As such profits from offshore supplies taxable in India No indication on profit attribution

7. AAR Ruling • AAR’s view on offshore services • Taxability under the Act & the India-Japan tax treaty • Offshore services – Fees for technical services (‘FTS’) under the Act as well as under the India-Japan tax treaty • Offshore services were not effectively connected to PE • Offshore services taxable at the rate of 20 percent on a gross basis as per Article 12 of the India-Japan tax treaty IHI filed a Special Leave Petition (‘SLP’) with the Honourable Supreme Court of India (‘Supreme Court’) against the ruling issued by the AAR

8. SLP – IHI’s contentions • The title to goods (which were a subject matter of offshore supply) passed outside India - payment made outside India – income from offshore supply not taxable in India • Signing of contract in India was of no consequence as the converse would not have made an assessee not taxable • All operations in connection with offshore supply carried out outside India – No question of any portion of consideration being regarded as deemed to accrue or arise in India • Performing of certain activities in India (loading, unloading, inland transportation) would not render IHI exigible to tax in India • Income from offshore supply not taxable also under the India-Japan tax treaty as all operations carried out outside India • Fees for offshore services were effectively connected with the PE; however the same was not attributable to the PE

9. SLP – Department’s contentions • Each component of the contract was directly relatable to the overall performance • Contract was indivisible; breach of any of the terms would impact the entire contract • The turnkey project constituted a PE under the India-Japan tax treaty • Turnkey project was executed in India in its entirety • Offshore supply and offshore services were interlinked with the entire project • Entire income attributable to the project and deemed to arise in India by virtue of section 9(1)(i) of the Act • Income from offshore supply and services taxable in India

10. SLP – Supreme Court Ruling… • Key observations made by the Supreme Court • Turnkey contract • The mere fact that contract is a turnkey contract would not itself mean that for the purpose of taxability the entire contract must be considered to be an integrated one • The very fact that supply and service segments were specified separately indicates that the liability of the assessee would also be different • The payment for offshore supply and services was clearly demarcated – cannot be held to be a complete contract that has to read as a whole • Income arising from business connection • Although section 9 of the Act raises a legal fiction, it must be construed having regard to the object it seeks to achieve • There is a distinction between existence of a business connection and income accruing or arising from such business connection • Mere existence of a business connection may not result in income accruing or arising in India • Where severable parts of a composite contract are performed, the principle of apportionment should be applied

11. SLP – Supreme Court Ruling… • Supreme Court’s view on offshore supplies • Taxability under the Act • Only such part of the income as is attributable to the operations carried out in India can be taxed in India • The mere fact that contract is a turnkey contract would not itself mean that for the purpose of taxability the entire contract must be considered to be an integrated one • Sale takes place outside India – property in goods passes outside India and payment outside India • The fact that the contract was signed in India is of no material consequence • Income from offshore supply not taxable in India • Taxability under the India-Japan tax treaty • Paragraph 6 of the Protocol to the India-Japan tax treaty not fulfilled • Supply of equipment not directly/ indirectly attributable to PE in India – PE not involved in operations in connection with offshore supply • Income from offshore supplies not taxable in India

12. SLP – Supreme Court Ruling… • Supreme Court’s view on offshore services • Taxability under the Act • Sufficient territorial nexus between the rendition of services and territorial limits of India necessary to make the income from offshore services taxable • Location of source of income in India would not render sufficient nexus to tax the income from that source • Entire contract would not be attributable to the operations in India assuming the offshore elements form an integral part of the contract • Entire services rendered outside India – not deemed to accrue or arise in India • Section 9(1)(vii)(c) requires two conditions to be met – the Services ought to be rendered in India as well as utilised in India – in order to be taxable in India

13. SLP – Supreme Court Ruling • Taxability under the India-Japan tax treaty • Article 7 of the India-Japan tax treaty applicable – profits directly or indirectly attributable to its PE taxable in India • Offshore services were rendered outside India – PE did not have any role to play in such services – therefore not attributable and hence not taxable in India • The term “effectively connected” & “attributable to” are to be construed differently – even if offshore services & the PE are “connected” • Offshore services inextricably linked to the offshore supply – must be considered in the same manner

14. Sony India Private Ltd – Transfer Pricing

15. Facts • CBDT has issued instruction no 3 of 2003 (‘Instruction’) under s. 119 • “Where aggregate value of international transaction exceeds Rs 5 crores, case to be picked up for scrutiny and reference under section 92CA to be made to the Transfer Pricing Officer (‘TPO’)” • Sony imported high end equipments from its associated enterprises for sale in India • Resorting to the Instruction, AO referred the case to TPO, who determined the ‘arms length price’ (‘ALP’) • After affording an opportunity of being heard, the AO passed the assessment order assessing income based on the ALP determined by TPO • Appeal against AO’s order filed with CIT(A). Parallelly, writ petition filed with Delhi High Court

16. Questions • Whether a writ of Certiorari can be granted quashing the Instruction, to the extent it requires compulsory reference to the TPO to determine ALP where aggregate value of international transactions exceeds Rs 5 crores? • Whether a writ of Certiorari can be granted to direct the AO to exercise his powers ignoring the Instruction?

17. Sony’s contentions • Classification of international transactions into two categories (ie value > Rs 5 crores and < = Rs 5 crores) is suspect and violative of Article 14 of the Constitution • The Act itself does not make such a classification – doing so by an Instruction is ultra vires the Act • Judicial discretion of the AO to refer the case to a TPO has been fettered/ taken away by the Instruction in cases where value of international transactions > Rs 5 crores • In effect, executive instructions cannot control the law and set at naught the statutory framework for the exercise of discretionary powers by quasi judicial authorities • Ultimate decision on computation of ALP is with the AO, who is bound to follow the steps outlined in s. 92C(1) to (3), while determining the ALP as against the TPO – who is not bound to follow such steps • In absence of any specific provision permitting this, an Instruction cannot bring about such change

18. Department’s contentions… • Act envisages a role for the CBDT in relation to both the method to be applied and the manner of its application for the computation of ALP • There are adequate safeguards built into s. 92C to ensure that the determination of the ALP by the AO is not a mechanical exercise: • the assessee is given an opportunity of being heard before the AO proceeds to determine the ALP • acceptance of the ALP declared by the assessee is the rule and its rejection is an exception • AO needs to refer only if he considers ‘necessary or expedient’ to do so, but a prima facie opinion to do so will suffice, as the TPO is also bound to follow provisions of s. 92C(1) to (3) • AO is not bound to accept the ALP arrived at by the TPO • In effect, the assessee gets two opportunities to demonstrate that the price declared requires acceptance

19. Department’s contentions • Determination of ALP by TPO also minimizes the possibility of the AO acting arbitrarily • ALP determined by TPO serves as a guideline to exercise the discretion conferred upon him, without making the TPO the final authority

20. High Court Ruling • Instruction classifying transactions is • Straightforward • does not leave any room for confusion, and also • bears a nexus to the objective sought to be achieved • Not suspect classification – Not violative of article 14 • Instruction is • consistent with the statutory objective • neither arbitrary nor unreasonable and • not ultra vires the Act • Instruction does not interfere with the discretion of the AO, rather serves as a guideline for the AO in the exercise of his discretion • Instruction is for a limited period – CBDT is expected to review the impact of the Instruction periodically

21. High Court Ruling • AO not required to form a considered opinion u/s 92C(3) before he can make a reference to the TPO - Only Prima facie opinion of AO sufficient to make a reference to the TPO • AO mandatorily required to give an opportunity to the assessee after receiving the report of TPO • AO not bound to accept the ALP determined by the TPO • In effect the assessee gets two opportunities to demonstrate that the price declared requires acceptance – first before TPO & second before the AO

22. Dresdner Bank AG – Interest received by branch

23. Facts • Dresdner AG a non-resident banking company incorporated in Germany and operating in India through its branch office • Branch had obtained funds only through deposits and borrowings in India • The funds were typically deployed for lending in India • Funds of the branch were placed temporarily in the NOSTRO account of Dresdner AG ie HO and later brought into India for lending • Interest in relation to the funds placed in NOSTRO account were credited to the P&L account of the branch

24. Question • Whether interest earned by branch from HO (& other overseas branches) is taxable in India?

25. Dresdner’s contentions • Transactions between branch and HO are transactions with oneself cannot lead to any income – these transactions are self-cancelling & tax neutral • Reliance placed on the decision of Betts Hartly Huett - Cal HC • Dresdner made the following submissions during the course of hearing before ITAT: • That it does not seek treaty protection and the matter should be adjudicated under the provisions of the Act • That the ratio in ABN AMRO ruling would not be applicable

26. Department’s contentions • Dresdner would be taxable u/s 9(1) • Income ‘accruing of arising’ in India should be taxable in India • Interest in NOSTRO a/c emanated from operations in India and therefore, accrues or arises in India • If the branch and HO operations were to be considered as one, then there would be no requirement to file a ‘return in respect of India operations’ • The articles of DTAA with Germany were also clear on the aspect that the income of PE is quite independent of its HO • As per the notes to computation, the income of Indian branch is computed as per the DTAA. Therefore, the income of the PE is independent of its HO • The interest on NOSTRO a/c maintained with the HO is therefore taxable in the hands of the Indian branch

27. Tribunal’s Ruling… • The interest earned by branch from its HO would be taxable in India as per the provisions of s. 5(2)(b) of the Act • Under the provisions of the Act, it is the foreign company which is taxable and not its branch or PE in India. • The taxability of such foreign company is confined, inter alia, to income which accrues or arises in India • The Act does not define the expression ‘income accruing or arising in India’ nor any special mechanism has been provided for taxation of PE of foreign enterprise – therefore, recourse to be had to general provisions of Act and accounting principles

28. Tribunal’s Ruling… • Ascertainment of Dresdner’s taxable business profits in India would involve an artificial division of overall profits of Dresdner – between profits earned in India and profits earned outside India. • This can be achieved only by treating the Indian PE as a fictionally separate profit center vis-à-vis its HO. • Intra-organisation interest will therefore, have to be taken into account to arrive at ‘income accruing or arising in India’ • Treatment right as per transfer pricing provisions which regard PE as distinct enterprise and treat payment of interest by HO to branch in India as international transaction resulting in a taxable event • Income is to be taxed in the same Jurisdiction in which corresponding expense deduction is to be allowed

29. Tribunal’s Ruling Basis…. • Intra organisation transactions are to be ignored only when profits of the organisation as a whole are to be computed, or when these transactions are domestic transactions within one single enterprise and within one tax jurisdiction. • When profits of a PE are to be computed (as distinguished from profits of the organisation as a whole) intra-organisation transactions are NOT profit neutral • Substance over Form – choice of legal form should not lead to different tax results • Hon’ble Calcutta HC decision in the case of Betts Hartley Huett was distinguished on the fact that the said decision was rendered in the context of taxation of the HO and not in the context of taxation of its Indian PE and dealt with s. 9(1) of the Act, and not with s. 5 of the Act

30. Tribunal’s Ruling • Either assessment on the basis of the Treaty, or not – applicability of Treaty vis-à-vis Act cannot be separately considered for each segment • Once the assessee chooses to be assessed as per the provisions of the Act, in preference over the provisions of the Treaty, it cannot be open to the assessee to seek Treaty protection in respect of one of the aspects of the assessment i.e. applicability of MAT • Section 115JA applies to a Foreign company

31. Fidelity Northstar Fund - FIIs

32. Facts… • Applicants - a batch of forty cases, • thirty applications by Fidelity Group of United States of America (‘USA’); • nine by the Fidelity Group of Canada; and • one by the Matthews India Fund • The Applicants are • investment funds organised under the laws of USA and Canada to provide a continuous source of managed investments in securities to its investors • registered with the SEBI as sub-accounts of FIIs

33. Facts • In compliance with the FII Regulations, the Applicants appointed • a global custodian who in turn appointed a domestic custodian; • the global custodian and the domestic custodian were acting in the ordinary course of business and provided such services to several FIIs investing in India • investment managers to manage the funds; • the investment managers are located outside India and do not have any branch office or place of business in India • Applicants did not have any branch or a place of business in India • The purchase and sale of securities in India were made through brokers in India

34. Questions While claiming relief under the Agreements for Avoidance of Double Taxation between India and USA / Canada (‘Treaty’): • Whether the profits arising from the sale of portfolio investments in India will be treated as business income of the Applicant? • Whether the Applicant can be regarded as having a PE in India in terms of Article 5 of the Treaty? • If the income is found to be in the nature of business income, in the absence of a PE in India and in terms of Article 7 read with Article 5 of the Treaty, whether such business income of the Applicant would be taxable in India? • If the income is found to be in the nature of business income and the Applicant were deemed to have a PE in India, whether such income would be taxable in India at the rate of 20% in light of s. 115AD?

35. AAR Ruling… • Profits arising to the applicants from the sale of portfolio investments in India could not be treated as business income of the applicant • As it has been held that transactions of purchases and sales in securities were investment in capital assets leading to realizing of capital gains, remaining questions need not be answered

36. AAR Ruling… • Issue whether • a company was an investment company or a trading company, or, • whether an amount received by a person was a capital receipt or a revenue receipt • was a mixed question of law and facts • Classification of income under the Act has to be done under the law of the land • once it is classified under any of the heads of income, the relevant provisions appropriate to that head of income will apply • To determine whether the conduct was that of a dealer or of an investor, one would need to determine whether the first step, ie the purchase of shares, was taken in the course of a trading transaction • SC in Holck Larsen relied on

37. AAR Ruling… • In case of FIIs, whether the purchase of shares was taken in the course of a trading transaction, the AAR observed that • GOI Guidelines for FIIs issued in 1992 and Modified Guidelines for FIIs (Taxation Aspect) issued in 1994 provided that registered FIIs could buy, sell and realize capital gains on investments • The aforesaid guidelines also provided that registered FIIs will benefit from a concessional tax regime for taxation of income and capital gains • Regulatory framework governing FIIs repeatedly refer to the permission granted to FIIs to ‘invest’ and not ‘trade’ in Indian securities • Reliance was also placed on the FII regulations dealing with maintenance of books of accounts, records, etc • They only discussed maintenance of records relating to buying, selling and realising capital gains on investments

38. AAR Ruling • In view of the various regulations governing FIIs, trading in Indian securities is not open to FIIs • FIIs could not have intended to trade in shares at the time of its purchase • Reliance placed on the treatment of gains from transactions in securities as capital gains in the income tax returns filed by the Applicants in the initial years, pursuant to registration • Dealing with the principles laid down in earlier Fidelity Ruling, the AAR held that, in the absence of books of accounts, it was not possible to verify whether the securities have been held by the Applicants as capital assets or stock-in-trade • Accordingly, in the absence of the accounts and records, the AAR inferred that securities were treated as capital assets by the Applicants

39. Thank you