NEW DELHI: The Central Board of Direct Tax (CBDT), the apex direct taxes body, has withdrawn a 40-year old circular, which has the potential to India 44 in IT competitiveness

This could impact, for example, foreign companies that engage business process outsourcing (BPO) units in India. There are over 300 foreign IT-BPO companies in India, and they account for about 35% of the $50-billion revenue of the industry.

However, it is not just captives of foreign companies that could be impacted by CBDT's current move. Now, the tax authorities would find it easier to tax a portion of the income of the parent company arising from the activities of the BPO, even if that income is not generated in India.

This flows from Section 9 of the Income-Tax Act, which says, "income accruing or arising directly or indirectly, through or from any business connection in India, shall be deemed to be income accruing or arising in India, and hence, where the person entitled to such income is a non-resident, it will be includable in his total income". A BPO can be treated as a business connection.

The circular No 23 of 1969 offered an escape route from falling within the ambit of Section 9 to non-resident companies with BPO units in India. The circular, which now stands withdrawn, said, among other things, "if the agent's commission fully represents the value of the profits attributable to his service, it should, prima facie, extinguish the assessment".

This portion of the circular had been interpreted to mean that if a foreign company pays for its BPO services as if these services were rendered by a third party, that is, at 'arms-length', then there is no cause for assessment.

With this illustration now being withdrawn, the path is open for the tax authority to lay claim to the income of the parent deemed to arise from the activity of its business connection, that is, the BPO, arms-length transaction or not.

"This would come as a major setback to the IT / ITeS sector which will have to re-evaluate their business model in absence of this circular," said Ernst & Young partner Amitabh Singh.

The CBDT, however, is very clear about the intention behind the withdrawal of the circular. An I-T department official said the circular had opened a can of worms as it was being misused by foreign companies. It was only intended to provide clarity of what the government's intention behind Section 9 of the I-T Act and foreign companies were taking shelter behind it to avoid tax.

Withdrawing the circular, the CBDT said: "It is noticed that interpretation of the circular by some of the taxpayers to claim relief is not in accordance with the provisions of the Section 9 of the Income-Tax Act, 1961, or the intention behind the issuance of the circular".

In fact, even when the circular was in force, the I-T department has argued in appeals, references and petitions that the circular would be interpreted to allow relief to the taxpayer, which is not in accordance with the provisions of Section 9 or the intention behind the issue of the circular.

The CBDT has not just withdrawn the circular 23 of 1969, but also other two related circulars — No. 163 of 1975 and No. 786 of 2000. Withdrawal of circular No. 786 will hit the exporting community hard, as it dealt with taxability of commission that an Indian exporter received/secured outside the country for carrying out the services of an overseas agent.

Withdrawal of the circular No. 23 will also strengthen the hands of the I-T department in the Sony Entertainment Television, Singapore, case. The case is to come up for hearing in the Supreme Court soon. In this case, the Mumbai tribunal had held that even if arms-length remuneration had been paid to the agent, the non-resident would still be assessed in respect of any additional profits attributable to the dependent agent having permanent establishment. The high court, however, reversed it, basing its decision on circular No 23.

"This circular enunciated the correct position of law, which was further affirmed even recently in the SC ruling in Morgan Stanley matter where the Court has said that if the Indian activities are taxed in the hands of the Indian entity there is no further taxation in the hands of foreign company. It is important the circular should have been implemented more rather than withdrawn," said PwC executive director Rahul Garg.

Som Mittal, president, Nasscom, said: "I don't think there's a direct impact on the IT-BPO industry. However, we will study the full implications. For the IT-BPO industry transfer pricing is the main issue and this is being addressed by the government through safe harbour provisions being made. Overall, we have to create an environment which makes it easier to do business with and in India."