Taxability of Income - Provisions of Income Tax Versus Provisions of DTAA -Business Connection Versus Permanent Establishment "

In a very interesting and landmark question, honorable Apex Court has decided the relation of DTAA with the Income Tax, 1961 for the purpose of taxability of income arising from International Transaction.

In this landmark judgment, honorable Supreme Court has elaborated the scope of ""business connection"" under section 9 and PE under DTAA

Facts and Circumstances of the Case:

""The project work which fell to the share of the applicant involves to develop, design, engineer, procure equipment materials and supplies; to erect, construct storage tanks of a 5 MMTPA capacity with potential expansion to a 10 MMTPA capacity at the specified temperatures (-200 degrees Celsius) including marine facilities (jetty and island break water) for transmission and supply of the LNG to purchasers; to test and commission the facilities relating to receipt and unloading, storage and regasification of LNG and to send out of regasified LNG by means of a turnkey fixed lump-sum price time certain engineering procurement, construction and commission contract. The project is required to be completed in 41 months. The description of the work allotted to the applicant is categorized thus: (1) offshore supply, (2) offshore services, (3) onshore supply, (4) onshore services and (5) construction and erection. The price is payable for offshore supply and offshore services [(1) and (2)] in US dollars, for onshore supply(3) in Indian rupees and for two items [(4) and (5)], namely, onshore services and construction and erection partly in US dollars and partly in Indian rupees. The price of offshore supply of equipment and material (including cost of engineering, if any, involved in the manufacture of such equipment and material), supplied from outside India on CFR basis, was received by the applicant by credit to its bank account in Tokyo and the property in the goods passed to the Petronet on high seas outside India (Ex.D2.1). Though the applicant unloaded the goods, cleared them from Customs and transported them to the site, it was for and on behalf of the Petronet and the expenditure including custom duty was re-imbursed to it. The price of offshore services for design and engineering including detail engineering in relation to supplies, services and construction & erection and the cost of any other services to be rendered from outside India, was also paid in US dollars in Tokyo. The Government of Republic of India concluded a Convention with the Government of Japan for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to taxes on income which was notified on March 1, 1990 (hereinafter referred to as "" Treaty), was given effect to from 29th December, 1989. On these facts, the applicant proposed the following five questions for pronouncement of rulings by the Authority""

Earlier the Authority for Advance Rulings (AAR) [reported in 2008 -TMI - 3470 - AUTHORITY FOR ADVANCE RULINGS] has ruled that,

1  ""The amounts received/ receivable by the applicant from Petronet LNG in respect of offshore supply of equipment and materials is liable to be taxed in India under the provisions of the Act and the Indian-Japan Treaty.""

2  in view of the Explanation (a) to section 9(1)(i) of the Act, and/or Article 7(1) read with the Protocol of the India-Japan Treaty, the amount that would be taxable in India is so much of the profit as is reasonably attributable to the operations carried out in India; we decline to answer the other part of the question in regard to quantification of the amount taxable in India as the parties produced no evidence and did not address in this regard.

3. the amount received/receivable by the applicant from Petronet LNG for offshore services is liable to be taxed in India both under the provisions of the Act as well as under Indo-Japan Treaty.

Not satisfied with the rulings, the appellant has filed an appeal before the Apex Court raising several questions. In this landmark judgment [Reported in 2008 -TMI - 3467 - SUPREME COURT], the apex court has ruled that,

""What is relevant is receipt or accrual of income, as would be evident from a plain reading of Section 5(2) of the Act. The legal fiction created although in a given case may be held to be of wide import, but it is trite that the terms of a contract are required to be construed having regard to the international covenants and conventions.  In a case of this nature,   interpretation with reference to the nexus to tax territories will also assume significance.  Territorial nexus for the purpose of determining the tax liability is an internationally accepted principle.  An endeavour should, thus, be made to construe the taxability of a non-resident in respect of income derived by it.   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.

There exists a distinction between a business connection and a permanent establishment.  As the permanent establishment cannot be said to be involved in the transaction, the aforementioned provision will have no application.  The permanent establishment cannot be equated to a business connection, since the former is for the purpose of assessment of income of a non-resident under a Double Taxation Avoidance Agreement, and the latter is for the application of Section 9 of the Income Tax Act.

Rulings of the AAR have been modified accordingly. 

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For full text of judgments visit: 

2008 -TMI - 3470 - AUTHORITY FOR ADVANCE RULINGS

2008 -TMI - 3467 - SUPREME COURT

Territorial nexus governs taxability of cross border income; DTAA and apportionment limit domestic charging under Section 9. Income from cross-border transactions must have a sufficient territorial nexus with India before being taxed under Section 9; where services or operations are performed outside India or are attributable to a foreign head office, the DTAA and apportionment principles determine taxability and relief.