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Taxability of Fees from offshore services — post Finance Act, 2010

Subject : Income Tax Law
Month-Year : Mar 2011
Author/s : Ankit Virendra Sudha Shah
Chartered Accountant
Topic : Taxability of Fees from offshore services — post Finance Act, 2010
Article Details :

By the time you read this Article, the Finance Bill, 2011 will be presented by the Hon’ble Finance Minister in the Parliament and probably with minimum changes expected in the direct tax provisions in this year’s budget on account of onset of the Direct Tax Code in the financial year 2012-2013, it is then time to introspect on one of the most discussed and publicised amendment of Finance Act, 2010 in section 9 of the Income-tax Act, 1961 (‘the Act’).

By the Finance Act, 2010; the Legislature retrospectively amended the Explanation to section 9 of the Act (which was inserted retrospectively only vide the Finance Act, 2007) to reiterate the taxability of income by way of interest, royalty and Fees for Technical Services (‘FTS’), under the principle of ‘source rule of taxation’. This was done with a view to reverse the findings of the Apex Court in the cases of Ishikawajima-Harima Heavy Industries Ltd. v. DIT, (288 ITR 408) and the Karnataka High Court in the case of Jindal Thermal Power Company Ltd. v. DCIT (TDS), (321 ITR 31) on the issue of taxability of FTS in India u/s.9 of the Act. The Legislature amended the language of the Explanation to provide that situs of rendering of services was not relevant in determining the taxability of the aforesaid income u/s.9 of the Act. The Memorandum explaining the Finance Bill, 2010 specifically stated the intention of the Legislature to tax the fees from technical services which are provided from outside India as long as they are utilised in India (services rendered from outside India are for brevity referred to as ‘offshore services’). The aforesaid intention further got judicial recognition in the decisions of the Income-tax Appellate Tribunal (‘the Tribunal’) of Ashapura Minechem Limited v. ADIT, (2010) (40 DTR 42) (Tri.) and Linklaters LLP v. ITO, (42 DTR 233) (Tri).

However, on a careful reading of section 9(1)(vii) along with the aforesaid Explanation, a question that arises for consideration is whether the plain words of the statute in their present form support the intention of the Legislature of ‘situs of utilisation of services’ as being condition of paramount importance to determine the tax jurisdiction of income from offshore services u/s.9 of the Act.

The issue has been dealt only from the perspective of provisions of the Act and not from the perspective of Double Taxation Avoidance Agreements entered by India with other countries.

Section 4, section 5, r.w.s. 9(1)(vii) of the Act provide for taxability of FTS in India. Section 9(1)(vii) of the Act by deeming fiction prescribes three rules qua the category of the payer for determination of the tax jurisdiction of FTS in India in the form of sub-clauses (a), (b) and (c). The concept of ‘source rule’ of taxation was introduced in section 9 of the Act to address the difficulties faced in taxing income in the nature of interest, royalty and FTS by the Finance Act, 1976. Section 9(1)(vii)(b) which deals with taxation of FTS along with an Explanation to Section 9, in its present form, is reproduced below for ready reference :

“(vii) income by way of fees for technical services payable by :

(a) ..................

(b) a person who is a resident, except where the fees are payable in respect of services utilised in a business or profession carried on by such person outside India or for the purposes of making or earning any income from any source outside India; or

(c) ..................

Explanation — For the removal of doubts, it is hereby declared that for the purposes of this section, 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) and shall be included in the total income of the non-resident, whether or not, :

(i) the non-resident has a residence or place of business or business connection in India; or

(ii) the non-resident has rendered services in India.”

From the aforesaid provision, one would appreciate that in its present form, the condition of ‘utilisation of services in India’ as determining the tax jurisdiction of fees from offshore services cannot be found in the plain words of the statute. The condition of ‘utilisation of services’ may be of relevance in order to test the exception as provided in section 9(1)(vii)(b) of the Act, but cannot be read to determine the taxability of offshore services. In other words, the ‘situs of service utilised’ can be relevant only to fall under the exception of section 9(1)(vii)(b) and not the main part of section 9(1)(vii)(b). Further, if the said condition was to be read even in the main part of section 9(1)(vii)(b), then there was no requirement to separately classify the provision in clauses (a), (b) and (c) and the language of the provision would have been different. The condition on the touchstone of ‘source rule of taxation’ which then determines the tax jurisdiction of fees from offshore services is discussed below.

The concept as well as the expression ‘source of income’ is not new to the Income-tax Act, 1961. In fact, this concept even existed under the Incometax Act, 1922 (‘the 1922 Act’). The provisions of section 42(1) of the 1922 Act analogous to the present provisions of section 9(1)(i) considered ‘source of income in India’ as one of the basis for determining whether income was deemed to accrue or arise in India.

The word ‘source of income’ is not defined under the provisions of the Act. However, the CBDT in Circular No. 3 of 2008 on Explanatory Notes on provisions relating to Direct Taxes of the Finance Act, 2007 explained the principle of ‘source rule of taxation’ for determining tax jurisdiction of FTS in S. 9 as to be the country where the income is earned. The word ‘earned’, though not defined under the provisions of the Act, has received judicial interpretation in various decisions.

The Gujarat High Court, in the case of CIT v. S. G. Pgnatale, (124 ITR 391) explained the concept of ‘income earned’ for the purpose of section 9(1)(ii) of the Act. The Court, after considering the ratio of the relevant legal precedents at that point of time, explained the meaning of the word ‘earned’ in the narrower sense and in the wider sense. In the narrower sense, the word ‘earned’ refers to a place of rendering or performance of services as an ingredient to determine the ‘source of income’ and in the wider sense equated it with ‘accrued’, meaning that not only the assessee under consideration should have rendered services or otherwise, but also should have created a debt in his favour i.e., a right to receive. Thus, the wider meaning of the word ‘earned’ indicates something which is due and entitlement to a sum of money consideration for which services have been rendered or otherwise by the assessee.

Further, the principle of ‘source of income’ juxtaposed with the words ‘income earned’ has been aptly explained in the following decisions, which hold the field of taxation on ‘source of income’, even today :

  • E. D. Sassoon & Co. Ltd. v. CIT, (26 ITR 27) (SC);

  • CIT v. Ahmedbhai Umarbhai & Co., (18 ITR 472) (SC);

  • CIT v. K.R.M.T.T. Thiagaraja Chetty & Co., (24 ITR 525) (SC);

  • CIT of Taxation v. Kirk, (1900) AC 588 (PC);

  • W. S. Try Ltd. v. Johnson (Inspector of Taxes), (1946) 1 ALL ER 532 (CA); and

  • Webb v. Stenton, (1883) (11 QBD 518) (CA).

A question may then arise as to where then the condition of ‘income earned’ as intended by the Legislature can be found in the plain words of section 9(1)(vii) of the Act. The words ‘payable by’ in section 9(1)(vii) express the condition of ‘income earned’.

In the general sense, the word ‘payable’ means that which should be paid. However, the following decisions have held that the word ‘payable’ is somewhat indefinite in import and its meaning must be gathered from the context in which it occurs :

  • New Delhi Municipal Committee v. Kalu Ram, (1976) (3 SCC 407); and

  • Garden Silk Weaving Factory v. CIT, (213 ITR 10) (Guj.)

Further, the decision of Madhya Pradesh High Court in the case of CIT v. The Central India Electricity Supply Co. Ltd., (114 CTR 160) has explained the words ‘due’ and ‘payable’ in context of section 41(2) of the Act. The Court observed that the word ‘due’ has two meanings, and one of the meaning is equivalent to ‘payable’, thereby indicating that the word ‘payable’ can be read to include ‘due’ and expressing that debt or obligation to which applied has by contract or operation of law becomes immediately enforceable, thereby in other words, satisfying the twin condition of ‘income earned’ in the wider sense u/s.9(1)(vii) of the Act. This argument gets support from the fact that Explanation to section 9 of the Act has been specifically amended to provide that situs of rendering of services shall not be relevant in determining the tax jurisdiction of the income from offshore services and thereby conveying the meaning of ‘income earned’ in a wider sense. The findings of the Apex Court in E. D. Sassoon & Co. Ltd. (supra) were relied upon by the Gujarat High Court in the case of CIT v. S. G. Pgnatale, (Guj.) in order to differentiate the meaning of the word ‘earned’ in wider sense from the narrower sense.

The relevant observations of the decision of CIT v. S. G. Pgnatale, (supra) with respect to the word ‘earned’ are reproduced below, duly explaining it in the narrow sense as well as in the wider sense :

“. . . . 17. The word ‘earned’ even though it does not appear in section 4 of the Act has been very often used in the course of the judgments . . . . The concept, however, cannot be divorced from that of the income accruing to the assessee. If the income has accrued to the assessee, it is certainly earned by him, in the sense that he has contributed to its production or the parenthood of the income can be traced to him . . . . The mere expression ‘earned’ in the sense of rendering the services, etc., by itself is of no avail.”

18. Thus, it is clear that according to the Supreme Court in E. D. Sassoon’s case (supra) the word ‘earned’ has two meanings. One meaning is the narrower meaning in the sense of rendering of services, etc., and the wider meaning in the sense of equating it with ‘accrued’ and treating only that income as earned by the assessee to which the assessee has contributed to its accruing or arising by rendering services or otherwise, but he must have created a debt in his favour. . . . . It may be pointed out that these two meanings indicated by the Supreme Court in E. D. Sassoon’s case (supra) have also been indicated in Corpus Juris Secundum, Vol. 28, p. 069 where it has been pointed out that the word ‘earned’ has been construed as meaning entitled to a sum of money under the terms of a contract, implies that wages earned are owing, and may carry the meaning of unpaid, but does not necessarily imply that they are due and payable. The term has been distinguished from ‘due’ and ‘payable’. Thus, the wider meaning of the word ‘earned’ indicates something which is due, owing and entitlement to the sum of money consideration for which services have been rendered by an assessee, is a clear concept indicated by Corpus Juris Secundum. . . . .”

So, based on the aforesaid consideration, it is possible to conclude that the word ‘payable’ in section 9(1)(vii) symbolises the condition of income ‘earned’ in the wider sense and reiterating the principle of ‘source rule of taxation’ u/s.9(1)(vii) of the Act.

In all fairness, before concluding on the condition which determines the tax jurisdiction of fees from offshore services, it would be relevant to consider the finding of the decisions of the Mumbai Tribunal as referred above of Ashapura Minechem Ltd. (supra) and Linklaters LLP v. ITO (supra).

The Tribunal in the case of Ashapura Minechem Limited (supra) relying on the provisions of section 9 of the Act (as amended vide the Finance Act, 2010) held that the technical services of bauxite testing and preparation of reports rendered from outside India by a non-resident company shall be deemed to accrue or arise in India u/s.9(1)(vii) of the Act (and also under Article 12 of India-China tax treaty) on the ground that the impugned services were utilised in India. On a similar analogy, fees from professional services rendered by Linklaters LLP (‘the Appellant’) to residents of India in the case of Linklaters LLP v. ITO (supra) was also held to be taxable in India as FTS under the provisions of section 5(2) r.w.s. 9(1)(vii)(b) of the Act. The Tribunal further opined that ‘situs of utilisation of service’ and ‘situs of payer’ determine the tax jurisdiction of FTS under the source rule of taxation in section 9(1)(vii) of the Act, which also finds support in the respective Memorandum explaining the provisions of the Finance Bill, 2007 and Finance Bill, 2010.

In this regard, it may be relevant to consider the decision of the Gujarat High Court in the case of CIT v. Saurashtra Cement and Chemical Industries Ltd., (101 ITR 502), wherein the Court held that a debt due to a foreigner cannot be treated as an asset or source of income in India and the interest thereon cannot be deemed to accrue or arise in India, merely because the debtor is in India, thereby upholding that situs of the payer itself cannot solely determine the tax jurisdiction of income.

Thus, ‘situs of payer’ and ‘situs of utilisation of service’ may be of relevance for the purpose of determining the applicability of exception u/s. 9(1)(vii)(b) of the Act or satisfaction of additional condition u/s.9(1)(vii)(c).

In addition, the following decisions by various judicial authorities have also upheld the principle of ‘the country where income is earned’ as the basis for determining the tax jurisdiction of income under source rule of taxation :

  • Rajiv Malhotra, in re (284 ITR 564) (AAR);

  • Rupajee Ratanchand and Anr. v. CIT, (28 ITR 282) (AP);

  • Mansinghka Brothers Private Ltd. v. CIT, (147 ITR 361) (Raj.);

  • C. G. Krishnaswami Naidu v. CIT, (62 ITR 686) (Mad.); and

  • SAT Behwaric & Co. v. CIT, (30 ITR 151) (Raj.)

In light of the above, one may conclude that it is the principle condition of ‘income earned’ under the source rule of taxation, which determines tax jurisdiction of FTS u/s.9(1)(vii).

Further, the next important concept which requires simultaneous discussion is of whether India has a ‘territorial tax system’, ‘worldwide tax system’ or ‘mixed tax system’. The reference towards the concept of ‘territorial nexus’ was recently found in the judgments of the Mumbai Tribunal in the case of Ashapura Minechem case (supra), Linklaters LLP v. ITO (supra) and also under Memorandum explaining the provisions to Finance Bill, 2007.

There are essentially three types of tax strategies applied worldwide, which are as under :

  • Territorial tax system;

  • Worldwide tax system; and

  • Mixed tax system

Under ‘territorial tax system’ as rightly explained by the Tribunal in the aforesaid decisions, a taxpayer is responsible for paying taxes only on that part of business which he does within his home country or state. In other words, it relies only on the ‘territorial’ principle for taxing income earned inside the national borders. On the other hand, in ‘worldwide tax system’, a taxpayer is taxed by the home government on all the business that the taxpayer does worldwide. Whereas in the case of mixed tax systems, elements of both territorial and worldwide tax systems are in place.

India follows ‘mixed tax system’. Elements of worldwide tax system are found while taxing residents of India and elements of territorial tax systems are found while taxing non-residents of India. ‘Doctrine of nexus’ is considered in India for the purpose of determining tax jurisdiction of income in case of non-residents.

The ‘doctrine of nexus’ for determination of tax jurisdiction of income of non-residents in India was approved by the Supreme Court in the case of Electronics Corporation of India Ltd. (183 ITR 43) (three-Member Bench decision) as early as in the year 1989 while rejecting the submission of extra-territorial application of the provisions of section 9(1)(vii) of the Act, which are presently being considered. The principle of ‘doctrine of nexus’ was well read down in the provisions of section 9(1)(vii) of the Act by the said judgment. However, the ingredient which shall determine such nexus was referred to the Constitution Bench of the Supreme Court in the Electronics Corporation’s case (supra), since the question was of substantial importance. It would be important to mention here that the decision of the Constitution Bench is still awaited. However, there are reports that before the matter could be placed before the Constitution Bench, the appeal was withdrawn.

Further, the law of nations generally recognises that the ‘doctrine of nexus’ involves consideration of two elements :

  • The connection must be real and not illusory; and

  • The liability sought to be imposed must be pertinent to the connection.

Thus, based on the aforesaid principles, the customary international law that comprehends levy of taxes by a state where there is connection between the state and the taxpayer on either of the following basis :

  • Territorial nexus, based on domicile or residence of the taxpayer in the taxing state; or

  • Economic nexus, based on the economic activity within, or connected with, the taxing state.

If one were to define economic nexus, in common parlance, it is regarded as part of ‘territorial nexus’. A nexus between the person or income sought to be taxed on the one side and the taxing country on the other.

Similarly, one may refer to the following Indian judicial precedents wherein time and again, the judicial authorities have upheld the ‘doctrine of nexus’ between the person or income which is subject to tax and the country imposing the tax as a pre-requisite for the purposes of taxation :

  • CIT v. Eli Lilly and Co. (India) P. Ltd. and Ors., (312 ITR 225) (SC);

  • Hoechst Pharmaceuticals Ltd. v. State of Bihar, (154 ITR 64) (SC);

  • Mahaveer Kumar Jain v. CIT, (277 ITR 166) (Raj.) [decision following the judgment of Electronics Corporation of India Ltd. case (supra)]; and

  • Worley Parsons Services Pty Ltd., In re (312 ITR 273) (AAR);

Based on the aforesaid discussion, one may conclude that the ‘doctrine of nexus’ is well recognised and is an accepted principle for the purpose of determining tax jurisdiction of income, more specifically in cases of taxation of non-residents in India and ‘source of income in India’ is recognised as one of the ‘doctrine of nexus’ to establish territorial nexus in India.

India, therefore, neither follows pure ‘territorial tax system’ nor pure ‘worldwide tax system’, but follows ‘mixed tax system’. So, even after looking at the issue to determine tax jurisdiction of FTS from the point of view of the ‘doctrine of nexus’, the result under this alternative also remains the same that ‘source of income’, being the necessary nexus or connection, must have a relationship with India i.e., of ‘income earned’ in India and therefore, the observations of the Mumbai Tribunal may require reconsideration.

Conclusions :

In the backdrop of the aforesaid discussions, one may conclude as under :

  • Plain words of the statute in section 9(1)(vii) (b) of the Act cannot be read to state that ‘situs of service utilised’ shall be of paramount importance to determine the tax jurisdiction of fees from offshore services;

  • The principle of ‘source rule of taxation’ recognises the country where the income is earned as the basis for determining the tax jurisdiction of fees from offshore services;

  • ‘Situs of payer’ and ‘Situs of services utilised’ are of relevance for the purpose of falling under the exception of section 9(1)(vii)(b) and satisfying the additional condition of section 9(1)(vii)(c) of the Act;

  • Non-relevance of ‘situs of service rendered’, supports the argument that the concept of ‘income earned’ is interpreted in wider sense to determine tax jurisdiction of income from FTS u/s.9(1)(vii) of the Act;

  • India, neither follows pure ‘territorial tax system’ nor pure ‘worldwide tax system’, but follows ‘mixed tax system’; and

  • ‘Source of income’ is recognised under the Act as one of the basis of territorial nexus in determination of tax jurisdiction of income.

Therefore, in light of the aforesaid considerations, the general understanding of fees from offshore services being income deemed to accrue or arise in India and taxable under the domestic provisions of the Act, may require reconsideration.

Editor’s Note: Attention of the readers is invited to the recent decision of the Supreme Court of India (five member Bench) in the case of GVK Industries Ltd vs. ITO (2011-TII-03-SC-CB-INTL) in which the Court has opined on the issue of `territorial nexus’ for taxation in India.

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