Legislature reinforces source based taxation

DIRECT TAX

Fiscal legislation of nations is not easy to comprehend in situations that entail territorial jurisdiction. Further, where conflict arises, legislation is interpreted inconsistently by interested groups such as the tax administration and tax-payers, leading to judicial intervention. At times, such interpretation is drawn based on differing expectations and perceptions. It is not surprising that cross-border tax matters have become a subject of controversy in the recent past.

One area of recent debate has been taxability of turnkey contracts, where a portion of the contract is executed outside India. In the Ishikawajma-Harima Heavy Industries Ltd case, the Supreme Court ruled that a mere "business connection" with India may not result in a situation where a non-resident's income can be brought to tax in India.

Further, the court held that operations undertaken in taxable territories shall result in taxability of such profits as are "reasonably attributable" to operations undertaken in the taxable territories. The fact that a contract was signed in India is of no consequence and, therefore, cannot be the sole determinant. Finally, the court held that insofar as taxability of services is concerned, the place from where the services are rendered should determine its taxability.

The taxpayers' joy arising from a liberal interpretation given by the Supreme Court was short lived, since the Finance Act of 2007 partially reversed the order by retrospective amendment from April 1976. The amendment waters down the principle of territorial nexus and strengthens "source rule" insofar as services are concerned. The "source rule" is now on a par with tax treaties, besides clarifying the true intent of law "" another instance of the legislature asserting its supremacy over judiciary through constitutionally valid means.

Undoubtedly, the legislature has enormous powers to pass laws, including the power to legislate with retrospective effect. However, the power to enact retrospective law is subject to the parent law, enshrined in the constitution. Article 20 of the Indian constitution restrains the legislature from enacting retrospective amendment in criminal laws.

It is important to assess the implications of retrospective legislation, particularly the ones (in the government's view) that clarify the intent of law, adversely impacting the taxpayer's position. The recent amendment being retrospective in application must pass the test of constitutional validity. Besides the argument on constitutionality, there are softer issues such as certainty of law that need to be borne in mind by policy makers.

Governments, ordinarily, should not resort to retrospective legislation for the simple reason that it shakes the confidence level of the tax-payer, besides eroding the stability of the legislation. In the context of India, which will continue to import significant capital for the next few decades, the government should debate if retrospective amendments will unsettle plans and have a negative impact on investment flows. From the government's standpoint, there is limited principle of estoppel applicable on tax legislation and it can go back on its promise, something India would seldom resort to.

Though the Indian constitution does not deny Parliament the power to make laws with extra-territorial operation, the principle of territorial nexus is an internationally accepted principle of taxation. Countries make fiscal assertions over non-residents if they are physically present within geographical boundaries or if there is a real nexus between the income sought to be taxed and the national frontiers.

However, international law does not provide firm guidelines on how such a close nexus should be established. Based on practice, it can be concluded that economic activity is sufficient nexus for taxation purposes.

Following the aforesaid principles, the Indian judiciary has consistently upheld the principle of territorial nexus, while construing tax laws. Established jurisprudence suggests that there must be sufficient territorial nexus between the income and the geographical limits of the state.

As India's share in cross-border transactions is increasing, tax administrators are anxious that India's tax base should not get eroded. This phenomenon is leading to new enactments and a series of administrative actions, which suggest a narrow interpretation of law, besides lacking pragmatism and a holistic approach. A case in point is the 2007 Budget amendment, which extends Indian territory to 200 nautical miles, seabed and subsoil under water and airspace above territorial waters. Such extensions will merely lead to unnecessary litigation in the years to come.

How complex our tax legislation can be is anybody's guess. While only time will answer the question, the international tax community is left guessing how strict India will get to enforce its source based rules to expand taxation of economic activities.