Extend Transfer Pricing Laws to Domestic Transactions: Suggests the SC

In CIT v. Glaxo Smithkline, the Supreme Court has suggested/recommended the Ministry of Finance and the CBDT to look into the prospect of extending the transfer pricing laws to "domestic transactions" involving "related parties". The Judgement and a summary is available here.

I shall explore this possibility in a later post.

GAAR and Canada

In an earlier post I had discussed the GAAR provisions under the Direct tax code 2009. In this post I shall look into the GAAR provisions of Canada which is incorporated under S. 245 of the Canadian Income Tax Act (“Act). S. 245 of the Act was introduced with effect from 13 Sep 1988 as a response to the decision of the Canadian Supreme Court in Stubart Investments Limited v. The Queen ( [1984] CTC 294). In Stubart although the court rejected the traditional “strict interpretation” approach to the interpretation of tax statutes, it re affirmed the traditional approach adopted in C.I.R. v. Duke of Westminster ( [1936] AC 1 (HC)) that tax consequences should be based on the legal character of transactions and relationship regardless of their economic or commercial substance.

The relevant provisions of S. 245 of the Act read as under:


(2) [General anti-avoidance provision] Where a transaction is an

avoidance transaction, the tax consequences to a person shall be

determined as is reasonable in the circumstances in order to deny a tax

benefit that, but for this section, would result, directly or indirectly, from

that transaction or from a series of transactions that includes that

transaction.


(3) [Avoidance transaction] An avoidance transaction means any

transaction


(a) that, but for this section, would result, directly or indirectly, in a

tax benefit, unless the transaction may reasonably be considered to

have been undertaken or arranged primarily for bona fide purposes

other than to obtain the tax benefit; or


(b) that is part of a series of transactions, which series, but for this

section, would result, directly or indirectly, in a tax benefit, unless

the transaction may reasonably be considered to have been

undertaken or arranged primarily for bona fide purposes other than to

obtain the tax benefit.


(4) [Where s. (2) does not apply] For greater certainty, subsection (2)

does not apply to a transaction where it may reasonably be considered that

the transaction would not result directly or indirectly in a misuse of the

provisions of this Act or an abuse having regard to the provisions of this

Act, other than this section, read as a whole.


S. 245(3) stipulates the transactions which are deemed to be avoidance transactions for which consequences would follow as u/s S. 254(2) read with 245(5) [ S. 245(5) is not quoted above]. A Conjunctive reading of 245(3)(a) and 245(3)(b) suggests that an anti- avoidance transaction is one which is made “only” to obtain a tax benefit. More importantly, a literal interpretation of S. 245(4) would suggest that the other provisions of the Act have to be looked into before the GAAR provisions are invoked. In contrast S. 113(14), DTC, 2009 categorizes any transaction whose ‘main purpose’ is to obtain tax benefit as impermissible avoidance arrangement. Evidently, in this regard the GAAR provisions under the DTC are of wider import than S. 245 of the Canadian Income Tax Act. Further, S. 113 (14) (c) of the DTC stipulates that a transaction which “lacks commercial substance” in any manner may be deemed as impermissible avoidance arrangement. If one peruses S. 113 (17) of the DTC which defines the term “lacks Commercial substance” it would leave no iota of doubt that GAAR provisions under the DTC are far more wider than its Canadian counterpart. It is also worth noticing that the Canadian IT Act does not presume any transaction to be for the “main purpose” of obtaining a tax benefit unlike S. 114(1) in the DTC. However, all these points will need consideration at the backdrop of some leading cases.

In my next post I shall discuss some leading Canadian cases on this point and examine the practical application of S. 245 of the Canadian IT Act.

Amiantit International Holding Limited: No capital gains on transfer of shares without consideration

In another interesting decision favouring the Assessee, the AAR concluded that there was to be no tax deducted as Capital gains on the transfer of shares held of an Indian Company by two or more non-resident companies without any consideration or without any such consideration which could not be valued at money’s worth. The AAR in the case Amiantit International Holding Limited, elaborated that since no profit could be accounted for by such a transfer of shares, the revenue could not make such a transaction liable to tax. The Tribunal based its decision on the settled law (CIT vs B.C. Srinivasa Setty) that s.45, the charging section and s.48, the computation section of the Income Tax Act, 1961 have to be read in conjunction. Therefore based on its findings, it concluded that since no profit or gain could have accrued or arisen in such a transaction and since the same could not be quantified, it was not taxable in nature.

In the instant case the Applicant, an investment company owned shares in several Indian as well as European and Latin American Companies. Subsequently the Applicant decided on a restructuring process to improve its economic and business holdings. As part of the restructuring process it decided to transfer all international investments in Pipe 2 manufacturing to its Wholly Owned Subsidiary in Cyprus. All shares held by the Applicant in the three Indian Companies proposed to be contributed to the Cyprus WOS without receiving any consideration for the same by an agreement signed outside India. The revenue raised the contention that such a transfer was not without consideration as it was for gaining business advantage through transactions in the future. It is pertinent to note that the fundamental question before the tribunal was whether there was any accrual of income within the ambit of such a transaction which was subsequently answered in the negative.

In order to understand the deductions made by the tribunal it is necessary to review the two provisions governing Capital gains. s.45 states “Any profits or gains arising from the transfer of a capital asset effected...be chargeable to income-tax under the head “Capital gains”. Further s.48 states “the income chargeable under the head “Capital gains” shall be computed, by deducting from the full value of the consideration received or accruing as a result of the transfer of the capital asset…”.When these two sections are read in conjunction it becomes apparent that there can be no computation of tax unless there is an accrual income in the form of profits or gains. Based on this deduction the Tribunal went on to further elaborate the necessity of accrual of profits and gains as being a quantifiable part of the term income within the ambit of a business transaction. It disregarded the contentions of the Revenue stating that there was no possible means of calculating a real income based on a hypothetical presumption of benefits which could arise by the restructuring process. Such an accrual of income is necessarily to be determined on the day the transaction took place. Since there existed no consideration in money’s worth, no capital gains could be charged. The Tribunal went on to reiterate the principle laid down in the Dana Corporation case that the provisions of Transfer Pricing under s. 92 were not applicable in the present instance as there was no income had arisen, there could be no computation of the same. Therefore the second contention of the Revenue was also rejected by the AAR.

Pursuant to the above, it is interesting to note that this case has successfully managed to put forth certain decisive principles encompassing all such transactions. In my view, a correct interpretation of the taxing provisions has been taken by the AAR as it prevents the Revenue from taxing innocent Companies entering into such transactions for restructuring purposes. The Tribunal has been correct in holding that if during the time of the transaction there was no consideration which could be quantified; it would be unfair for the Revenue to levy taxes based on presumptions of business gain in the future. Not only would such Companies be at a disadvantage but it would also deter foreign investors as every time such a transaction for restructuring were to take place, non-resident companies would have to pay Capital gains on an undetermined hypothetical amount irrespective of any gains. In another interesting perspective, this judgment also concurs with the view taken by the Supreme Court in the Azadi Bachao Andolan case thereby reiterating that if a transaction is“commercially”justifiable, any incidence of tax exemption would not render it being an evasion of tax.

Pertinent to note is the Finance Bill 2010 which through its amendment vide s.56(2) (viiA) states that in any such transfer without any consideration, tax will be imposed on the recepient as Income from Other Sources.

Event: Conference on GST

SCHOOL OF LAW, CHRIST UNIVERSITY, BANGALORE


in collaboration with

LAKSHMI KUMARAN & SRIDHARAN, BANGALORE

invite you to the

CONFERENCE ON GST

on

SATURDAY, 26 JUNE 2010



Dear Sir / Madam:


Greetings from School of Law, Christ University and Lakshmi Kumaran & Sridharan.

The replacement of the state taxes by the Value Added Tax in 2005 marked a significant step forward in the reform of domestic trade taxes in India. Buoyed by the success of the State VAT, the Centre and the States have now embarked on the design and implementation of the perfect solution alluded to in the Bagchi Report. As announced by the Empowered Committee of State Finance Ministers in November 2007, the solution is to take the form of a ‘Dual’ Goods and Services Tax (GST), to be levied concurrently by both levels of Government. The Conference is an endeavor to discuss the political, social and economic character of GST and its impact on different sectors of the economy, and households in different social and economic strata of the nation.

The objective of this Conference is to bring about a multidisciplinary discussion on the subject so as to explore the implications of GST in India. Broadly the Conference has been divided into two themes – the Interplay between the State Tax Laws and GST and the Interplay between the Central Tax Laws and GST.

The themes will be discussed in two sessions. Each session will constitute of a Tax practitioner, a Senior Chartered Accountant, a Government Official (Commissioner / Additional commissioner of Sales Tax) and a representative from the Industry (Consulting firms / Manufacturers).


The confirmed speakers include:

Mr. B.T. Manohar, FKCCI Chairman

Mr.S. Venkataramani, Tax practitioner

Mr. Pradeep Singh Kharola, I.A.S, Commissioner of Commercial Taxes

Mr. V. Raghuraman, Advocate, Partner, Raghuraman & Chythanya, Advocates

Mr. G. Shivadass, Partner, Lakshmi Kumaran & Sridharan, Bangalore

Mr. Nagendra Kumar, LTU Commissioner


The Conference will be held at Christ University Auditorium between 9:30am and 6pm on Saturday, 26 June 2010. Kindly confirm your participation by indicating the number of heads attending latest by Tuesday, 22 June 2010 by emailing at the below mentioned addresses. A nominal registration fee is being charged based on the following table. The registration fee is payable in cash on the Registration Desk between 8:30am and 9:30am on the Conference Day.

Category Amount

Professionals / CA’s Rs. 1500 per delegate

Academicians and Research Scholars Rs. 1000 per delegate

Students Rs. 250 per delegate


For registration or any further queries, please feel free to write back or contact the Student Coordinators at:
Prarthna Kedia Shambhavi

+91 99868 92464 +91 99457 85819
prarthana.kedia@law.christuniversity.in
shambhavi@law.christuniversity.in

Income from Sale of Shares: Business Income or Capital Gains?

The Mumbai Bench of the ITAT in a recent decision, Management Structure & Systems v. ITO, has elaborately discussed the law on when income from sale of shares is to be treated as business income and when it is to be treated as capital gains. The assessee was a private company engaged in “management consultancy, investment advisory and equity reserve research services”. It filed returns showing certain income from sale of shares as capital gains. The Assessing Officer on the other hand categorised the income as business income, as he concluded that the assessee’s activity in trading of shares was a business activity and the shares were not held as a capital asset but as stock-in-trade. It was not disputed that the assessee was not registered as a broker or sub-broker with any stock exchange – in the view of the AO, this was immaterial, while in the view of the assessee, this non-registration was urged to be conclusive of the fact that that the shares were not traded by the assessee as a business activity.

Allowing the assessee’s appeal, the Tribunal held that whether the activity of buying and selling of the shares is in the nature of trade or investment is a mixed question of law and fact; and importance has to be given to how the assessee’s books treat the shares. Following the decisions of the Supreme Court in Associated Industrial Development Co., 82 ITR 586, and H. Holck Larzsen, 160 ITR 67, as well as CBDT Circular No. 4/2007, the Tribunal approved a set of principles which could be applied in this regard. The same principles have also been reached by a co-ordinate Bench of the Tribunal in Gopal Purohit, 122 TTJ (Bom).

Accordingly, the position of law is that in determining whether the income arising from sale of shares is to be treated as business income or as capital gains, the following factors are relevant:

(1) What is the intention of the assessee at the time of purchase of the shares? The answer to this can be found out from the treatment given to the purchase in the assessee’s books of account.

(2) Has the assessee borrowed money to purchase the shares, and paid interest thereon? As per the Tribunal, money is generally borrowed to purchase goods for the purposes of trade and not for investing in an asset for retaining.

(3) What is the frequency of the purchases and disposals? As per the Tribunal, “If purchase and sale are frequent, or there are substantial transactions in that item, it would indicate trade. Habitual dealing in that particular item is indicative of intention of trade. Similarly, ratio between the purchases and sales and the holdings may show whether the assessee is trading or investing (high transactions and low holdings indicate trade whereas low transactions and high holdings indicate investment).”

(4) Is the purchase and sale made for realizing profit, or for retention and appreciation in its value? The former is indicative of the purchases being part of trade; and the latter is indicative of the purchases being an investment. Furthermore, it would be relevant to ask whether the intention behind the purchase was to enjoy dividend, or merely to earn profit on sale of shares. Importantly, a commercial motive is an essential ingredient of trade in this context.

(5) The Tribunal also considered that if the items in question were valued at cost, it would indicate that they were investments. Where they were valued at cost or market value or net realizable value, whichever is less, it will indicate that items were treated as stock-in-trade.

(6) Finally, it would be relevant to consider how the assessee is authorized in its Memorandum / Articles.

Taxability of FIIs in India: Part 2

In an earlier post I had made an assertion that the law relating to taxability of FIIs remains largely unsettled. In this post I shall attempt to provide evidences/reasoning for the aforementioned assertion. It is to be noted that this post does not deal with the taxation of derivative transactions by FIIs. The same has been dealt by Ravichandra S. Hegde of J. Sagar Associates here. This post deals with the taxability of FIIs relating to the purchase and sale of equity shares.


As a starting point it is first essential to understand the business activity of a FII. Conventionally, a FII is used to denote an investor who is in the form of an entity engaged in investing money in a foreign financial market. Legally clause 2(f) of the SEBI (Foreign Institutional Investors) Regulation, 1995 defines FII to be “an institution established or incorporated outside India which proposes to make investment in India in securities.” The legal definition of a FII is functional in nature i.e. the definition signifies the principal business activity of a FII (investment in securities).

The fundamental dispute relating to taxability of FIIs in regard to purchase and sale of securities revolves around the question of characterization of Income. Simply put, the question is whether the income generated at the hands of the FII through transactions relating to purchase and sale of equity shares or other securities are in the nature of “business income” or “capital gains”. The revenue in various cases has contended that the income generated at the hands of a FII should be characterized as “capital gains”. Per contra, the FIIs have contended that the income generated through purchase and sale of equity shares is in the nature of “business income”. The rationale for this is not far to seek; if the FIIs are successful in their contention then it would necessarily mean that they can only be taxed in India if the department is able to show a permanent establishment of a given FII in India.

Prior to 2007 the AAR in various cases namely XYZ/ABC, Equity Fund, Fidelity Advisor Series, VIII, USA and Morgan Stanley had concluded that the income generated by the FIIs was in the nature of “business income”. It would not be entirely correct to apply Morgan Stanley to the present issue as the question in Morgan Stanley was regarding the taxability of derivative transaction by FIIs. However in 2007 the AAR in Fidelity Northstar Fund (hereinafter “fidelity”) held that the income generated by the FIIs through purchase and sale of equity shares was in the nature of “capital gains”. In fidelity the question before the AAR was whether securities which were the subject matter of purchases and sales by the applicant were held by the applicant by way of stock in trade so as o give rise to “business income” or investment in capital assets so as to yield “capital gains”. The AAR came to the latter view i.e. the profit arising to the applicant was in the nature of “capital gains” and not “business income”. The conclusion drawn by the AAR in fidelity was based on two grounds (i) SEBI regulations (ii) sec. 115AD of the IT Act, 1961.

(i) SEBI Regulations - The AAR relied on Lord Reid’s observation in J. Harrison Ltd. v. Griffiths ([1962] 40 TC 281 (HL)) which was quoted by the Supreme Court of India in CIT, Bombay v. Holck Larsen as a test to determine in a given situation whether one is a dealer in shares or investor in shares. Lord Reid observed as under:

“In the present case the question is not what (sic) [whether] the transaction of buying

and selling the shares lacks to be trading, but whether the later stages of the whole operation show that the first step- the purchase of the shares- was not taken as, or in the course of, a trading transaction.”

In order to ascertain the above highlighted first step the AAR in fidelity relied on the SEBI regulations pertaining to FIIs especially the 1995 regulation. After the perusal of the same the AAR was of the view that since the SEBI regulations do not allow FIIs to trade in securities in India, it would be legally untenable to conclude that the first step to purchase FIIs would be in contravention of all the SEBI regulations. The following part of the ruling is apposite”

“It cannot be lost sight of that regulation 15A of SEBI Regulations referred to above, permits dealing in offshore derivative instruments only and none other. The words transact business and the transaction of business in Clauses (a) & (c) respectively of Sub-regulation (3) of Regulation 15 postulate transaction of sale and purchase, they do not refer, as such, to the trading activity. It needs no emphasis to point out that transact business is different and distinguishable from carrying on business. Transact business is a general term which refers to carrying on all types of activities whereas business transaction refers to only commercial trading activities. Thus it follows that the aforementioned words and expressions, in the context in which they are used, do not deal with the subject of trading in securities much less do they permit activities of trading in securities by a FII. In no way, the framework of the provisions of the Guidelines, Acts and Regulations, discussed above, can be so interpreted as to lead to the inference that trading in Indian securities is open to the FIIs.”

 

“In our view it will be preposterous to impute an intention to FIIs, who responded to the offer of investment in securities in response to the guidelines, got themselves registered under the SEBI Regulations and undertook to abide by those regulations that they would, in the very first step itself, have intended to violate all the legislative requirements which provided them the opportunity to enter the capital market in India. That the FIIs could not have intended to trade in the first step of purchase of shares, is also strengthened by the fact that in the income tax returns filed by many of them, in consonance with the above legislative provisions, they have shown their income as capital gains”

In 2010 the AAR in Royal Bank of Canada (hereinafter “royal bank”) implied that fidelity may be incorrect inasmuch as holding that the FIIs are prohibited from trading in shares and securities as per the SEBI and FEMA regulations (see para. 15 and 15.1 of the ruling). However, the Royal Bank case may not be an authority on this point as the question in royal bank was with regard to derivative transaction by FIIs similar to the one in Morgan Stanley.



(ii) Sec. 115AD – the AAR in fidelity opined that s. 115AD is a self contained and special provision for charging to tax the income of FIIs from securities and since s. 115AD does not contemplate FIIs deriving income from “business income” there would be no question of classifying the income generated by FIIs through transfer or sale of securities as “business income”. This view has not been subscribed to by the AAR in Royal Bank. The following part of the Royal Bank case is relevant



“It must be noted that the expression “in respect of” is of wide import, more or less synonymous with the expression ‘ in connection with’ or ‘ in relation to’. There is no particular reason why the income on account of trading in securities is excluded from the purview of section 115AD.......................”


“There is no warrant to place a restricted construction on clause(a) of sub-section(1) of section 115AD that only the income on account of holding the securities (like fruits from a tree) is covered by clause(a). If such restricted scope was intended to be given to clause(a), there should have been a more explicit language to that effect especially to counteract the effect of the wide expression ‘ in respect of’. The argument of the learned counsel for the Revenue that clause(a) of sub-section(2) which excludes the deduction admissible to business income a clear pointer that income on account of trading in all types of securities is not contemplated by section 115AD does not appeal to us.”

Concluding the two latest judgements i.e. fidelity and royal bank showcase contrasting opinions on the taxability of FIIs in relation to purchase and sale of equity shares. Though one may argue that royal bank was only concerned with derivative transaction; it cannot be undermined that both royal bank and fidelity provide contrasting interpretations of S. 115AD of the IT act (a key aspect as far as the taxability of FII in relation to purchase and sale of equity shares is concerned). Apart from this fidelity does not follow the ruling in XYZ/ABC Equity Fund  and Fidelity Advisor Series on the rationale that in both the cases the AAR had not applied the test laid down by the Supreme Court in CIT, Bombay and subsequently not taken the SEBI regulations into consideration. At present the law on this point is far from settled as their are contrasting rulings delivered by the same authority. Ultimately, the taxability of FIIs would be a mixed question of law and fact. Nevertheless some uniform and well reasoned answers needs to be found for the questions mentioned as under:

(1) Is it correct to import SEBI regulations in classifying the income generated by FIIs in India?

(2) If (1) is in the affirmative, then does SEBI regulations allow FIIs to trade in Securities?

(3) What is the correct scope and application of S. 115AD of the IT Act, 1961?

Non-Discrimination in International Tax Law

I would like to thank Ankit for inviting me to write a few guest posts for this blog. In this post, I wish to look at some aspects of non-discrimination protection in international tax law.

1. Introduction

Non-discrimination provisions are perhaps among the lesser-used provisions in tax treaties. Under the OECD Model Draft, the principle of non-discrimination is covered under Article 24. A survey of the reported cases will reveal, however, that the provision is hardly ever used. Two questions prominently arise in this regard. First, when will it be said that a provision of law differentiates between two groups in a relevant sense? And secondly, when would that differentiation amount to discrimination?

The first issue essentially turns on the identification of a comparator – treatment against the assessee must be compared vis-à-vis treatment against ‘X’ entity. That ‘X’ entity is the comparator. How is this comparator to be identified? This issue is addressed in a judgment of the Pune Bench of the ITAT, Daimler-Chrysler, about which I have written a two-part post available here and here.

The second question turns on the standards applied in assessing the content of the protection against discrimination. I will concentrate on this second issue, but before that, a slight detour to the rationale of non-discrimination provisions may be relevant.

2. The Broad Object and Rationale

Non-discrimination provisions in tax treaties are in general intended to eliminate tax discrimination in certain precise circumstances. The provisions seek to “balance the need to prevent unjustified discrimination with the need to take account of legitimate distinctions” based on, for example, difference in liability to tax or ability to pay [OECD, Model Tax Convention on Income and on Capital (Commentary) (2008)].

A slight historical tour may be useful in further contextualizing non-discrimination protections in tax treaties. Non-discrimination provisions first made a concrete entrance in the sphere of international economic law in several Treaties of Friendship, Navigation and Commerce. These treaties are the precursors to modern bilateral investment treaties; and were intended to promote, encourage and protect international trade and commerce, and foreign investment. It was from here that the League of Nations borrowed the non-discrimination concept into tax law. The Fiscal Committee of the League, in its Mexico Draft in 1943 and in its London Draft in 1946 specifically included a clause against discriminatory tax treatment of foreigners. [See generally: Kees van Raad, Non-Discrimination in International Tax Law (1986)]

The stated objective of this provision at this juncture was to prevent discriminatory treatment of tax payers having their fiscal domicile in another country and in order to aid the protection of foreign capital in a domestic country [In Re P. No. 6 of 1995, (1998) 234 ITR 371 (AAR)]. This development was reiterated by the OECD in 1958; and then in 1977 [K. van Raad, “Non-Discrimination” (1981) British Tax Review 43].

A separate rationale was subsequently enunciated in the OECD Model in so far as ownership non-discrimination is concerned. This rationale is not in substitution of, but is in addition, to the preceding one. This ‘new’ basis is to ensure equal treatment for tax payers residing in the same State, no matter where the capital supporting the tax payer is coming from. In sum, the ownership provision (as per the OECD Thin Cap study, 1987) “aims broadly at preventing tax protectionism – i.e. the deterrence by tax measures of investment from outside the country.” The principle behind this is that a State ought not to tax local enterprises owned by residents of another State more harshly than it taxes local enterprises owned by residents of the same State. This has in general been “a widely accepted feature of international economic agreement for decades.” [See: M. Bennett, “Non-Discrimination in International Tax Law: A Concept in Search of a Principle” (2006) 59 Tax Law Review 439]. The rational is thus to protect foreign owned capital. This broad rationale of the non-discrimination provision will be useful in resolving more concrete issues, to which this paper will now turn. [See generally: J. Avery-Jones, “The Non-Discrimination Article in Tax Treaties” (1991) British Tax Review 421].

Importantly, a non-discrimination article in the 1977 OECD Model was based purely on this preceding history and rationale. Subsequent OECD Models do not change this basic rationale. Furthermore, in relation to the non-discrimination article, the UN Model specifically referred to and based itself on the 1977 OECD Model. Thus, modern-day non-discrimination clauses can all be traced to broadly the same rationale. Of course, the travaux in individual treaties may suggest otherwise; but broadly, it would be safe to assume a general rationale for all non-discrimination protections in tax treaties.

With this broad objective of the ND clause in contemplation, I move back to the issue of when the non-discrimination articles are said to be breached – what exactly is this discrimination?

3. When the ‘differentiation’ amount to ‘discrimination’?

 Commentaries and commentators are practically unanimous on one point – that all differentiation does not ipso facto result in discrimination. Judicial decisions also echo the same thoughts. In one view, “discrimination means distinguishing between persons adversely on grounds that are unreasonable, irrelevant or arbitrary.” [Arnold and McIntyre, International Tax Primer (2002) 128]. However, whether a particular ground is unreasonable, irrelevant or arbitrary is simply “a matter of judgment” in the sense that it finally depends on what legal test from several available the judiciary chooses to apply [See van Raad, cited above].

Unfortunately, the question of what exactly is the standard to be applied has, however, not been considered in great detail by Courts and tribunals. One of the few cases which stands out in this regard is Automated Securities v. ITO, ITA No. 1758/PN/2004. In this case, the Tribunal adopted a test based on the constitutional right to equality – Article 14 of the Constitution of India. Indeed, the Tribunal specifically cited leading constitutional law cases on the point [Kedarnath v. State of West Bengal, AIR 1953 SC 404; State of West Bengal v. Anwar Ali Sarkar, AIR 1952 SC 75]. The other decisions which make a non-discrimination analysis can also be explained on the basis of this test; and no decision specifically leys down a different test. [Reference may be made, in particular, to the following: Chohung Bank v. DCIT, Mumbai Bench, Income Tax Appellate Tribunal; Herbalife v. ACIT, (2006) 103 TTJ (Del) 78; Metchem Canada v. DCIT, (2006) 284 ITR 196 (Mum). Also see: ABN Amro Bank v. JCIT, (2005) 96 TTJ (Kol) 1041]. Consequently, the Indian cases on the point seem to suggest the application of an Article 14 test to the issue.

Thus, one can see from the perspective of the (rather limited) Indian practice of international taxation which considers the issue in detail, that the Article 14 test is applied.

It must be noted at this juncture that it is extremely difficult to sustain an Article 14 challenge to economic and taxation laws [Southern Technologies v. JCIT, Civil Appeal No. 1337/2003, decision dated January 11, 2010]. One issue which needs to be considered is whether this adoption of the Article 14 standard by Indian decisions in interpreting the non-discrimination article in tax treaties is in harmony with the principles of treaty interpretation.

To begin interpreting the non-discrimination article for present purposes, one can briefly outline the principles of interpretation of treaties. The customary international law principles dealing with the interpretation of treaties find themselves codified in the Vienna Convention on the Law of Treaties. Article 31 requires a treaty to be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose. It is implied in this that the principle of effet utile (which suggests that every provision of a treaty must be given some meaning and not be rendered meaningless) applies. Furthermore, the general rule has been extended to imply that interpretation in harmony with surrounding customary international law is to be preferred. Article 32 deals with the supplementary rules of interpretation; used when the meaning under Article 31 is unclear, or used in order to confirm the meaning arrived at under Article 32. [I have avoided heavy citations – but these propositions may be verified by reference to any standard international law textbook].

There is nothing whatsoever in these principles to suggest that the Article 14 test is apposite in the context of interpreting the non-discrimination provision in treaties. Indeed, using an Article 14 test perhaps violates the principle of effet utile – if the test is the same as an Article 14 test, then a separate provision would not be required at all. Both resident and non-resident assesses, both legal and natural persons, are entitled to challenge the vires of a law as violating Article 14. If all assessees in any case have this protection as a matter of constitutional law, why would India and its treaty partners have inserted a non-discrimination article at all into the DTAAs? Furthermore, what is the basis which suggests that the parties to a tax treaty would have intended the domestic constitutional meaning of one party to prevail? Such an assumption does not seem appropriate to begin with, unless the travaux of the particular treaty clearly so indicate. The better approach may be to begin from the principles of treaty interpretation, without being coloured by the fact that non-discrimination provisions exist in Article 14 of the Constitution.

On a purely literal meaning, arguably, discrimination is not easily distinguishable from differentiation. Of course, in law the two are different concepts – but that difference is not easily traceable to the literal meaning of the word. A standard dictionary, for instance, defines ‘discrimination’ as ‘the act of making or recognizing differences and distinctions’ and as ‘a making a difference in favour of or against’ [see van Raad, page 7, citing to several dictionaries]. The verb form ‘discriminate’ is defined as ‘to show or make a difference in treatment’ [For instance, see: World Book Dictionary (1989) 600.].

The legal difference between ‘discriminate’ and ‘differentiate’ arises more from the context in which the non-discrimination protection exists; rather than from the inherent meaning of the words themselves. Thus, in order to appreciate what exactly the difference between the two concepts is, one must refer to the specific context in which the protection exists. Hence, merely borrowing a test from a different area of law may not be appropriate – one must seek to look to that area which most closely approximates the object and purpose of non-discrimination protections in tax treaties. In this view, looking at the literal meaning of the word in light of the object and purpose of non-discrimination protections, the Article 14 test appears to be misleading.

Where else does one look, then? I will try to provide an answer in a subsequent post – meanwhile suggestions from other readers and commentators are most welcome.

Computation of the PE "Duration Test" under the India- Mauritius Tax Treaty

In a recent decision in ADIT (Int’l taxation) v. Valentine Maritime (Mauritius) Ltd., ITAT Mumbai has thrown some light on the computation of PE “Duration test” under art. 5(2)(i) of the India-Mauritius tax treaty. In the present dispute the assesse, a Mauritian entity engaged in the business of marine and general engineering and construction had executed three contracts in the India. The duration of these contracts individually were less than “nine months” however if the contracts were taken cumulatively then the entire period would exceed the “nine month” threshold limit under Art. 5(2)(i) of the Indo- Mauritian Tax treaty.
The issue before the tribunal was whether the duration of the projects in the present dispute shall be taken cumulatively or separately. The contention of the revenue was that unlike the India UK DTAA, the India- Mauritius treaty does not specifically incorporate the provision that for the purposes of applying the “Duration test” each project site is to be considered separately. Thus, the revenue contended that under Art. 5(2)(i) of the India Mauritius tax treaty the duration of project sites are to be construed cumulatively and if such a period exceeds nine months then the assesse shall be deemed to be having a permanent establishment in India (PE). As a starting point it is first important to reproduce Art. 5(2)(i) of the India- Mauritius treaty:

Article 5 - Permanent Establishment

1. For the purpose of this Convention, the term 'permanent establishment' means a fixed place of business through which the business of enterprise is wholly or partly carried on.

2. The term 'permanent establishment' shall include:

(i) a building site or construction or assembly project or supervisory activities in connection therewith, where such site, project or supervisory activity continues for a period of more than nine months.

On a plain reading of the above quoted provision it is clear that Art 5(1) lays down a general test of “permanence” for establishing an entity as a PE. On the other hand Art 5(2)(i) lays down a specific “duration test” for establishing a building site, construction or assembly project as a PE. In the present dispute the tribunal has laid down the scope and application of this “duration test”. The tribunal while rejecting the contention of the revenue stated that under art. 5(2)(i) the “duration test” is to be applied to individual projects separately and not cumulatively. The apposite part of the judgment is reproduced as under:

“In other words, each of the building site, construction project, assembly project or supervisory activities in connection therewith is to be viewed on standalone basis. Broadly, the underlying rationale of this approach is that various business activities performed by one and same enterprise, none of which constitutes a PE, cannot lead to a PE, if combined. In our humble understanding, the very conceptual foundation of this approach rests on the assumption that various business activities of the enterprise in different locations are not so inextricably interconnected that these are essentially required to be viewed as a coherent whole. The locations are thus separate places of business, and activities at different locations are, therefore, required to be viewed on standalone basis. In a typical building site, assembly or installation project, or supervisory activities in connection therewith, each of site or project is an independent unit, and the approach to these types of PEs recognize this normal business practice.”- Para. 9

The court also rejected the argument of the revenue that since the India- Mauritius treaty does not specifically exclude (like the India UK treaty) the application of the “duration test” to all projects taken cumulatively, it would necessarily mean that the duration of the projects should be tabulated together inorder to ascertain whether an entity qualifies to be a PE. The court stated as under:

“The provisions set out in protocol to the tax treaties need not necessarily be substantive provisions, and these can also be, and often are, merely clarificatory provisions 'ex abundanti cautela'. What is stated in the said protocol to Indo UK tax treaty is nothing other than what is anyway within the scope of the construction PE clause, as analyzed in the OECD Model Convention Commentary (adopted by the UN Model Convention Commentary as well) - an analysis, with which we are in considered agreement. The protocol provision is merely clarificatory in nature and is apparently set out as a measure of abundant caution. The absence of similar protocol clarification in other tax treaties entered into by India would not, therefore, warrant a different interpretation of the treaty provision.”- Para. 10

The tribunal further lays down two grounds under which the aggregation principle (duration of all the project sites taken together in computing the threshold duration) can be applied. Firstly, where the contracts have been artificially divided inorder to reap the benefits of the tax treaty. The onus of showing such an artificial division would be on the revenue. Secondly, when there is an inextricable interconnection and interdependence between the project sites so that they form a coherent whole. The test of “interconnection and interdependence” is an expanded version of the test laid down in the OECD commentary i.e. “coherent whole- geographically and commercially” test.

BEYOND THE SAMSUNG JUDGEMENT

Beyond the Samsung judgment: An analysis by the Special Bench Tribunal Ruling in the case ITO v. Prasad Production Ltd.

In another recent judgment which put to rest the ambiguity in the interpretation of Section 195 of the Income Tax Act, 1961, a special bench constituted under section 255(3) of the Income Tax Act, 1961 ruled in favour of the assessee holding that section 195 of the said Act would apply only if the sum received was chargeable in India. Furthermore if the payer had a bona fide belief that he is not liable to tax he is under no obligation to follow the procedure in section 195 of the Act except comply with the RBI manual. The bench further held that section 195(2) was not mandatory in character as the CBDT circular had provided for an alternative procedure.
This case was similar to the recently decided Samsung case of the Karnataka High Court. The bench however after detailed analysis of the Samsung case diverted from the same stating that the Karnataka High Court had sub-silentio disregarded the CBDT Circular of July 2009 which prescribed an alternate procedure for remittance to a foreign entity without applying to the Assessing Officer for a No Objection Certificate. Further it was also per incurium as several precedents of the High courts and Supreme Court had been disregarded by the High Court.
In the present case the assessee company had been awarded a contract by the government of Andhra Pradesh to establish an IMAX theatre at Hyderabad. The assessee company entered into an agreement with IMAX ltd, Canada for the subsequent purchase, of equipment, maintenance and installation for which a certain consideration was remitted without withholding tax. The Assessing Officer concluded that the amount remitted was for the service provided by IMAX, Canada thereby qualifying it under section 9(vii) of the Act. The bench ruled that the sum remitted was auxiliary to the sale of the equipment and not independent services thereby not qualifying it under section 9. Further the Bench relied on a number of precedents and the decision in the Mahindra case whereby the pre-requisite of section 195(2) was held to be the chargeability of the sum remitted.
It is interesting to note that the Special bench debated in detail on the applicability of section 195 in consonance with the most cited Supreme Court judgments like the Transmission case; et al. It further made a detailed analysis of the binding nature of precedents for tribunals to follow keeping in mind the necessity for a thorough reasoning encompassed by different courts of law and their interpretation of the same. The bench systematically interpreted the different judgments in consonance with the principles governing tax law in India. In its considered decision it concluded that the tax payer had the first right to determine the chargeability of the sum of money being remitted, thereby enhancing the power of the tax payer.

Fineprits of The Union Budget: Changes in The Income Tax Act

The finance bill, 2010 as expected has brought about certain changes to the income tax act, 1961. The two important changes vide clause 3 and clause 4 of the finance bill to S.2(15) and S. 9 respectively are discussed in this post.

Definition of “charitable purpose”

S. 2(15) of the IT act defines charitable purpose to include “relief of the poor, education, medical relief, preservation of environment (including watersheds, forests and wildlife) and preservation of monuments or places or objects of artistic or historic interest, and the advancement of any other object of general public utility”. However the proviso to the section stipulates that the “advancement of any other object of general public utility shall not be a charitable purpose, if it involves the carrying on of any activity in the nature of trade, commerce or business, or any activity of rendering any service in relation to any trade, commerce or business, for a cess or fee or any other consideration, irrespective of the nature of use or application, or retention, of the income from such activity”.

Clause 3 of the Finance Bill, 2010 has retrospectively added(applicable from 1st April, 2009) a further proviso stipulating that the first proviso shall not apply if the aggregate value of the receipts from the activities referred to in S. 2(15) is ten lakhs or less in the previous year. The legislative intent seems to be novel as it seeks to remove the hardship on charitable institutions who receive a meager amount for their activities inorder to maintain and provide basic infrastructure. However, clarity needs to sought as to whether the term “receipts” is to understood as per the method of accounting followed by the assesse or whether it is “receipt” in the ordinary sense of the word.

Taxability of Non-Residents

Whereas residents are taxed on their worldwide income as under S 5(1) of the IT act, non –residents are only taxed on income received or deemed to be received or accrues or deemed to accrue in India i.e. the territorial nexus principle as under S. 5(2) of the IT act. Further, S. 9 of the act stipulates income that is deemed to accrue or arise in India. The finance act, 1976 introduced the source rule under S.9 vide the insertion of clause (v), (vi) and (vii) in sub clause 1. The intention of the legislature was to bring to tax interest, royalty and technical fees through a legal fiction created under S.9 of the act, even in cases where the service is provided outside India as long as they are utilized in India. In essence, the source rule stipulates that situs of the rendering of the service is irrelevant. The situs of the payer and the utilization of the service are the relevant ingredients in determining the taxability of the above mentioned services.

However, the supreme court in Ishikawajima-Harima Heavy Industries Ltd., Vs DIT (2007) [158 Taxman 259] held that inspite of the legal fiction created under S. 9 it was decisive to show that there is sufficient territorial nexus between the income and the territory of India. The legislature further attempted to clarify the point on the source rule, hence it introduced an Explanation to sub section (2) of S.9 vide the Finance Act, 2007. However again in a recent decision the Karnataka High Court in Jindal Thermal Power Company Ltd. vs DCIT (TDS), [2009] 182 Taxman 252 held that the Explanation provided as per the Finance Act, 2007 was insufficient in its present form and thereby followed the judgment of the Honorable Supreme Court in Ishikawajima.

Hence, inorder to clarify the legislative intent and overcome the judicial decisions on the point the Finance Bill, 2010 vide clause 4 has introduced a retrospective amendment (w.e.f- 1st June, 1976). The amendment seeks to remove the earlier Explanation as provided by the Finance Act, 2007. Clause 4 of the Finance Bill reads as under:
“ the income of a non-resident shall be deemed to accrue or arise in India under clause (v) or clause (vi) or clause (vii) of sub-section (1) of section 9 and shall be included in his total income, whether or not,
(a) the non-resident has a residence or place of business or business connection in India; or
(b) the non-resident has rendered services in India.”

However the constitutional validity of this clause may be open to challenge as it invalidates the territorial nexus principle.


The author wishes to acknowledge the inputs received from Avantika Govil, 3rd Year Student at School of Law, Christ University.