2007 (1) TMI 91 - SC - Income Tax

Non-resident foreign company's offshore supply and services income not taxable in India lacking territorial nexus

ISHIKAWAJIMA-HARIMA HEAVY INDUSTRIES LTD. Versus DIRECTOR OF INCOME-TAX

The SC held that a non-resident foreign company's offshore supply income was not taxable in India as goods were supplied and title passed outside India, ... Taxability of Offshore Supply Income - Accrual of income u/s 9 - Offshore supply of equipment and materials - non-resident foreign company - Territorial nexus doctrine - distinction between the existence of a business connection and the income accruing or arising out of such business connection - India-Japan Double Taxation Avoidance Agreement (DTAA) - relationship between the permanent establishment - principle of apportionment - HELD THAT:- Since the appellant carries on business in India through a Permanent Establishment, they clearly fall out of the applicability of Article 12(5) of the DTAA and into the ambit of Article 7. The Protocol to the DTAA, in paragraph 6, discusses the involvement of the permanent establishment in transactions, in order to determine the extent of income that can be taxed. It is stated that the term 'directly or indirectly attributable' indicates the income that shall be regarded on the basis of the extent appropriate to the part played by the permanent establishment in those transactions. The permanent establishment here has had no role to play in the transaction that is sought to be taxed, since the transaction took place abroad. The distinction between the existence of a business connection and the income accruing or arising out of such business connection is clear and explicit. In the present case, the permanent establishment's non-involvement in this transaction excludes it from being a part of the cause of the income itself, and thus there is no business connection. In our opinion, the concepts profits of business connection and permanent establishment should not be mixed up. Whereas business connection is relevant for the purpose of application of Section 9; the concept of permanent establishment is relevant for assessing the income of a non-resident under the DTAA. There, however, may be a case where there can be over-lapping of income; but we are not concerned with such a situation. The entire transaction having been completed on the high seas, the profits on sale did not arise in India, as has been contended by the appellant. Thus, having been excluded from the scope of taxation under the Act, the application of the double taxation treaty would not arise. Double Tax Treaty, however, was taken recourse to by Appellant only by way of an alternate submission on income from services and not in relation to the tax of offshore supply of goods. Having regard to the internationally accepted principle and DTAA, it may not be possible to give an extended meaning to the words 'income deemed to accrue or arise in India' as expressed in Section 9 of the Act. Section 9 incorporated various heads of income on which tax is sought to be levied by the Republic of India. Whatever is payable by a resident to a non-resident by way of fees for technical services, thus, would not always come within the purview of Section 9(1)(vii) of the Act. It must have sufficient territorial nexus with India so as to furnish a basis for imposition of tax. Whereas a resident would come within the purview of Section 9(1)(vii) of the Act, a non resident would not, as services of a non-resident to a resident utilize in India may not have much relevance in determining whether the income of the non-resident accrues or arises in India. It must have a direct live link between the services rendered in India, when such a link is established, the same may again be subjected to any relief under DTAA. A distinction may also be made between rendition of services and utilization thereof. The provisions of Section 9(1)(vii) of the Act are plain and capable of being given a meaning. There, therefore, may not be any reason not to give full effect thereto. However, even in relation to such income, the provisions of Article 7 of the DTAA would be applicable, as services rendered outside India would have nothing to do with permanent establishment in India. Thus, if any services have been rendered by the head office of Appellant outside India, only because they were connected with permanent establishment. Even in relation thereto, principle of apportionment shall apply. The Authority, in our opinion, has committed an error in this behalf, as if services rendered by the head office are considered to be the services rendered by the permanent establishment, the distinction between Indian and foreign operations and the apportionment of the income of the operations shall stand obliterated. It would be contrary to the intent and purport of the Double Taxation Convention which is a part of the scheme under the Income Tax Act. The appeal is allowed in part and to the extent mentioned hereinbefore. 1. ISSUES PRESENTED and CONSIDEREDThe core legal questions considered by the Court were:(a) Whether the amounts received or receivable by the appellant, a non-resident foreign company, from Petronet LNG for offshore supply of equipment and materials are liable to tax in India under the Income Tax Act, 1961 and the India-Japan Double Taxation Avoidance Agreement (DTAA).(b) If such income is taxable, to what extent are the amounts reasonably attributable to operations carried out in India and thus taxable in India.(c) Whether the amounts received or receivable for offshore services rendered by the appellant are chargeable to tax in India under the Act and/or the India-Japan DTAA.(d) If offshore services income is taxable, what portion of such income is chargeable to tax in India and at what rate.(e) Whether the appellant is entitled to claim deductions for expenses incurred in computing income from offshore services under the Act and/or the DTAA.2. ISSUE-WISE DETAILED ANALYSISIssue (a) and (b): Taxability of Offshore Supply IncomeRelevant legal framework and precedents: The Court examined Sections 5(2) and 9(1)(i) of the Income Tax Act, 1961, which provide that income of a non-resident is taxable in India if it is received or deemed to be received in India or accrues or arises or is deemed to accrue or arise in India, including income accruing through or from a business connection in India. Explanation (a) to Section 9(1)(i) and Article 7 of the India-Japan DTAA were also considered, which restrict taxation to profits attributable to a permanent establishment in India. The Court reviewed precedents interpreting business connection and permanent establishment, as well as principles of territorial nexus and apportionment of income.Court's interpretation and reasoning: The Court found that the contract was a turnkey project with distinct components for offshore supply, offshore services, onshore supply, onshore services, and construction/erection, each with separately specified prices and payment terms. The title to goods supplied offshore passed outside India on the high seas, and payments for offshore supply were made in US dollars. The Court emphasized that the contract components were severable and that the offshore supply was completed outside India.The Court held that mere execution of the contract in India or existence of a permanent establishment in India does not render the entire income taxable in India. Taxation requires a territorial nexus between the income and India. The legal fiction under Section 9 must be interpreted in light of the object of the statute and international tax principles. The Court distinguished the concepts of business connection (relevant for Section 9) and permanent establishment (relevant under DTAA). It held that only income attributable to operations carried out in India can be taxed in India, and since the offshore supply was completed outside India, no income from such supply could be deemed to accrue or arise in India.Key evidence and findings: The contract terms, including Clause 22.1 on passing of title, Clause 13.1 on contract price, and Exhibit D detailing prices for offshore supply, were critical. The contract explicitly separated offshore supply and services from onshore activities, with different currencies for payments. The appellant had a permanent establishment in India, but it was not involved in the offshore supply transactions.Application of law to facts: Applying the territorial nexus doctrine and apportionment principles, the Court concluded that offshore supply income was not taxable in India as the supply and transfer of title occurred outside India. The permanent establishment in India was not involved in the offshore supply transactions; hence, profits from offshore supply were not attributable to the permanent establishment and not taxable in India under the DTAA.Treatment of competing arguments: The Revenue argued the contract was composite and integrated, making the entire income taxable in India. The Court rejected this, noting the contract's explicit segregation of components and separate pricing. The appellant contended that offshore supply and services occurred outside India and payments were made abroad, negating tax liability. The Court agreed with the appellant on offshore supply.Conclusion: Only such part of income as is attributable to operations carried out in India is taxable. Offshore supply income, completed outside India with title passing offshore, is not taxable in India.Issue (c) and (d): Taxability of Offshore Services IncomeRelevant legal framework and precedents: Section 9(1)(vii) of the Income Tax Act, which deals with fees for technical services, was examined along with Article 12 of the DTAA. Article 12 provides that royalties and fees for technical services may be taxed in the source state but limits tax to 20% of the gross amount. Article 12(5) excludes taxation if the beneficial owner carries on business through a permanent establishment and the income is effectively connected to that establishment, in which case Article 7 applies.Court's interpretation and reasoning: The Court held that for offshore services income to be taxable in India, the services must be rendered in India and utilized in a business or profession carried on in India. Both conditions must be satisfied simultaneously. In this case, offshore services were rendered outside India and thus lacked sufficient territorial nexus to India for taxation. The permanent establishment in India was not involved in the offshore services, so Article 7 rather than Article 12 applied, limiting taxability to income attributable to the permanent establishment.Key evidence and findings: The contract defined offshore services as design and engineering activities rendered outside India. The appellant received payments in US dollars for offshore services. No evidence was produced to show that offshore services were rendered or utilized in India.Application of law to facts: The Court applied the plain language of Section 9(1)(vii)(c) and Article 12 of the DTAA, concluding that offshore services income was not taxable in India because the services were not rendered in India nor effectively connected to the permanent establishment.Treatment of competing arguments: The Revenue argued that the entire technical fee was taxable in India at 20%. The appellant argued that offshore services were rendered outside India and not attributable to the permanent establishment. The Court accepted the appellant's contentions.Conclusion: Offshore services income is not taxable in India as the services were rendered outside India and not effectively connected to the permanent establishment. Even if taxable, tax would be limited to 20% of gross fees under Article 12.Issue (e): Deductibility of Expenses in Computing Offshore Services IncomeRelevant legal framework and precedents: The Court considered the Income Tax Act provisions and the DTAA, particularly the treatment of fees for technical services and the limitation on deductions.Court's interpretation and reasoning: The Court held that the appellant would not be entitled to claim any deductions in computing income from offshore services under the Act or the DTAA, consistent with the provisions limiting tax on gross receipts.Conclusion: No deduction for expenses is allowable against offshore services income for tax computation purposes.3. SIGNIFICANT HOLDINGS'Only such part of the income, as is attributable to the operations carried out in India can be taxed in India.''Since all parts of the transaction in question, i.e. the transfer of property in goods as well as the payment, were carried on outside the Indian soil, the transaction could not have been taxed in India.''There exists a distinction between a business connection and a permanent establishment. The permanent establishment cannot be said to be involved in the transaction, and therefore the provisions relating to permanent establishment will have no application.''For a non-resident to be taxed on income for services, such a service needs to be rendered within India, and has to be a part of a business or profession carried on by such person in India.''Section 9(1)(vii)(c) clearly states that the fees are taxable only where the services are both rendered and utilized in India. Both conditions must be satisfied simultaneously.''The entire services have been rendered outside India, and have nothing to do with the permanent establishment, and can thus not be attributable to the permanent establishment and therefore not taxable in India.''The principle of apportionment, wherein the territorial jurisdiction of a particular state determines its capacity to tax an event, has to be followed.''The existence of a permanent establishment would not constitute sufficient 'business connection', and the permanent establishment would be the taxable entity. The fiscal jurisdiction of a country would not extend to taxing entire income attributable to the permanent establishment.''The distinction between the existence of a business connection and the income accruing or arising out of such business connection is clear and explicit.''Section 9 incorporated various heads of income on which tax is sought to be levied by the Republic of India. Whatever is payable by a resident to a non-resident by way of fees for technical services, thus, would not always come within the purview of Section 9(1)(vii) of the Act. It must have sufficient territorial nexus with India so as to furnish a basis for imposition of tax.'The Court finally allowed the appeal in part, holding that offshore supply income was not taxable in India, and offshore services income was taxable only to the extent connected with operations in India, which in this case was nil.