Tribunal rings alarm bells for entertainment industry

DIRECT TAX

'Heads I win, tails you lose' seems to be the message India is communicating to the media and entertainment industry.

In an unprecedented ruling that could have far-reaching ramifications, the Mumbai tax tribunal, in a case involving Sony Entertainment Television's Singapore-based company (SET Satellite), ruled that the revenues in respect of broadcasting advertisement are taxable in India, even if the foreign broadcaster operates through a local (dependent) agent who is adequately rewarded.

SET Satellite, which is engaged in the business of broadcasting television channels from Singapore, appointed an India agent to market airtime slots to Indian advertisers.

SET took a plea that it did not have an office or fixed place of business, commonly referred to as Permanent Establishment (PE) in India, and hence was not liable to tax under the India-Singapore Tax Treaty. Further, it contended that since SET remunerated its dependent agent on an arm's length basis, there was no further income attributable to India. SET's position was based on established principles of international law, Indian judicial precedents, administrative guidelines issued by the revenue department and, more specifically, decision of the Authority of Advance Ruling in the case of Morgan Stanley, though currently awaiting Supreme Court adjudication.

The tribunal rejected the plea and ruled that dependent agent and dependent agent PE are two distinct taxable units. The order is well reasoned and articulated based on its interpretation of the terms of the India-Singapore treaty. Of course, it has placed heavy reliance on OECD's report on 'The attribution of profits to PE' and the Australian tax office report.

The basis of this ruling is applicability of strict "force of attraction" rule, a subject matter of intense debate amongst the world's most developed 25 nations, collectively called the OECD. Under the force of attraction rule, it is propounded that irrespective of whether a business is carried out directly or through a dependent agent, the profit attributable to such business would be taxable in the source country. Further, the OECD in its report suggests that the host country's taxing rights (India in this case) are not necessarily exhausted by ensuring an arm's length compensation to the dependent agent.

The present ruling is contrary and transgresses well established principles of international tax, besides being based on theoretical interpretation of OECD's paper on attribution and disregard to the nature of the chain of an entertainment business in general and SET's business model in particular.

When a treaty clearly lays down conditions to be fulfilled for a PE (in India) and its taxability, the tribunal has limited basis to go beyond the terms of the treaty and import grounds and external aids to come to a conclusion on an important principle. The theory propounded by the tribunal on Functions-Assets-Risks (FAR) analysis in addition to the dependent agent's taxability for arm's length remuneration is not borne out from the terms of the treaty. Though the FAR principles are well recognised for cross-border transactions and transfer pricing purposes, they can not apply to SET's case since the present decision is in the context of years when India did not have a transfer pricing legislation.

India had recently acquired an observer status in the OECD and hence the tribunal should have stayed more focused on the facts of the case. Besides, OECD, of its own admission, has suggested that the report's implementation would require amendments to the treaty network amongst the OECD nations. In conclusion, OECD's report and findings merely seek to establish on what the law should be and not what the law is.

Interestingly, the Madras High Court in VRSRM's case, while expressing reservation on placing reliance on the OECD commentaries, has observed that the commentaries relied upon are of limited use and utility and cannot afford a safe or reliable guide to interpretation.

The OECD guidelines are with specific reference to "global trading operations" and in situations where the key entrepreneurial risk taking (KERT) functions are undertaken by the dependent agent, besides dealing with the complexity of taxability of a global trading enterprise. The tribunal has not given any finding to support that SET's dependent agent was indeed undertaking KERT functions. How can an agent selling advertisement airtime slot be classified as undertaking KERT function in a broadcasting entertainment business supply chain of a media giant such as Sony?

The tribunal chose to disregard the principle of liberal interpretation of tax treaties articulated by the Supreme Court in Azadi Bachoo Andolan and Padmasundara Rao's case wherein it is established that literal or legalistic interpretation must be avoided as the basic object of the treaty may be defeated or frustrated. Further, the rule of interpretation should subserve the purpose of the terms of the treaty, which have been expressly agreed between the countries, such agreements themselves having been assimilated as part of domestic law.

The CBDT in September 2004 clarified and reiterated the principle of attribution of profits of a PE on the 'arm's length' basis, following a period of uncertainty the BPO players were subject to. Relying on the terms of the circular, the Authority of Advance Rulings (AAR) in one of the most celebrated decision upheld the principle that the payment of the arm's length remuneration by a foreign enterprise to its dependent agent extinguishes the tax liability of the foreign enterprise in India.

While the Morgan Stanley matter is subjudice, since the revenue department decided to appeal to the Supreme Court, the tribunal could have awaited the decision of the apex court, instead of rushing to deliver judgement on an important principle of international tax law. While the decision would be certainly challenged, one would have to wait and see who will have the last laugh.

(The author is a partner with BMR and views are personal)