M J Antony: Taxing non-resident firms

OUT OF COURT

The Supreme Court lays down guidelines for assessing income deemed to accrue in India.

The assessment of tax liability of corporations which do business with their counterparts in different countries with complex contracts and double taxation avoidance agreements is a challenging task. While the global income of a resident company is undoubtedly subject to income tax, the global income of a non-resident firm may not be. It depends upon the nature of the contract and the double taxation avoidance agreement between the two countries. The issue may be complicated by the fact that some of the operations are done offshore as in the recent case decided by the Supreme Court in Ishikawajma-Harima Heavy Industries Ltd vs Director of Income Tax.

In this case, the company was incorporated in Japan. It formed a consortium with four others and entered into an agreement with an Indian firm, Petronet LNG Ltd, for setting up liquefied natural gas receiving and degasification facility in Gujarat. Each member of the consortium was to receive separate payments. The contract involved offshore supply, offshore services, onshore supply, onshore services, construction and erection. The price was payable for offshore supply and services in US dollars, whereas that of onshore supply as also services, construction and erection partly in dollars and partly in rupees.

The dispute arose whether the amounts received by the Japanese corporation from Petronet for offshore supply of equipment and materials were liable to tax under the Indian Income Tax Act and the India-Japan double taxation avoidance treaty. The Authority for Advance Rulings (Income Tax) ruled that the Japanese firm was liable to pay direct tax, even under the treaty. Therefore, the firm moved the Supreme Court.

It argued that the transactions occurred outside the country. The contract was a divisible one and therefore it did not have any liability to pay tax in regard to offshore services and offshore supply. The government, on the other hand, contended that the contract was a composite one. The supply of goods, whether offshore or onshore, and rendition of service were attributable to the turnkey project. The Supreme Court ultimately held that the tribunal was wrong and set aside its order.

While the Japanese firm got relief in the case, the judgement is notable for the principles it has laid down to be followed in such cases. Regarding offshore supply of equipment and materials, the Supreme Court laid down nine guidelines in the context of this case, but have general application. According to it, only such part of the income as attributable to the operations carried out in this country can be taxed here. If all parts of the transfer of goods as well as the payment are carried on outside the country, the transaction cannot be taxed 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 fact that a contract was signed in India is of no material consequence, if the activities in connection with the offshore supply were outside the country and therefore cannot be deemed to accrue or arise in this country. The court further clarified that there was a distinction between a business connection and a permanent establishment. The latter is for the purpose of assessment of income of a non-resident under a double taxation avoidance agreement while the former is for the application of the Income Tax Act.

As far as offshore services are concerned, the court stated that sufficient territorial nexus between the rendition of services and territorial limits of India is necessary to make the income taxable. The entire contract would not be attributable to the operations in India. The test of residence, as applied in the international law also, is that of the tax payer and not that of the recipient of such services.

Regarding Section 9(1)(vii)(c) of the Income Tax Act, dealing with income by way of fees for technical services by a non-resident, the Supreme Court clarified that the services should not only be utilised within India but also be rendered in India or have such a "live link" with India that the entire income became taxable here.

Applying the principle of apportionment to composite transactions which have some operations in one territory and some in others, it is essential to determine the taxability of various operations. The location of the source of income within India would not render sufficient nexus to tax the income from that source. These guidelines are bound to stand in good stead while dealing with the complex international contracts which are increasingly becoming more common due to globalisation.