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Accrual of deemed income
February, 03rd 2007
The taxable events in the execution of a contract may arise at several stages in several years. Mere execution of the contract in India will not make the entire income taxable in India.

Non-resident companies entering into business deals in India have to negotiate a difficult and curvaceous path to escape tax. Section 9 of the Income-Tax Act, 1961 deems any income accruing/arising, whether directly or indirectly, through/from any business connection in India as accruing/arising in India. This section has come in handy for the Revenue, to rope in all types of transactions in India entered into by non-resident companies for taxation.

The other option open to the Revenue is to look into the Double Taxation Avoidance Agreement (DTAA) to see if the non-resident company is having a permanent establishment (PE) in India. If income arises without any activity of the PE, even under the DTAA the tax liability in respect of overseas services would not arise in India. Section 9 has a direct territorial nexus.

Relief under the DTAA, having regard to Section 90(2) of the Act, would arise only in the event of the taxable income arising to the non-resident company in one contracting State on the basis of accrual of income in another contracting State on the basis of residence.

As far as accrual of income in India is concerned, taxability must be seen in terms of Section 4(2) read with Section 9, whereupon the question of seeking assessment of such income in India on the basis of the DTAA would arise. While the legal provisions are cumbersome, applying the facts of the case to suit the relevant law is a Herculean task.

Offshore services

Take, for instance, the Shikawajima-Harima Heavy Industries (288 ITR 408) case. This Japanese resident company pays taxes in Japan. It is engaged in the business of construction of storage tanks and other engineering works.

It formed a consortium with four other companies and entered into an agreement with Petronet of India in January 2001 for setting up a Liquefied Natural Gas project in Gujarat. This was a turnkey project.

The role and responsibility of each member of the consortium were specified separately. The Japanese company was to develop, design, engineer and procure equipment and supplies to erect and construct storage tanks. Apart from construction and erection, the contract involved supply of equipment/materials and services, both offshore and onshore. The price was payable for offshore supply and services in dollars. The company approached the Authority for Advance Ruling (AAR) for advice regarding probable tax liabilities. The AAR ruled that the company was liable to be taxed in India in respect of the amounts received/receivable from Petronet for offshore supply of equipment and materials both under the I-T Act and the India-Japan DTAA. The same view was taken about offshore services.

The company took up the matter in appeal before the Supreme Court, which took a radically different view. The court said that the mere fact that the contract was turnkey by itself would not mean that even for the purpose of taxability the entire contract must be considered to be an integrated one so as to make the Japanese company pay tax in India.

Execution in stages

The taxable events in the execution of a contract may arise at several stages in several years. Mere execution of the contract in India will not make the entire income taxable in India. The territorial nexus doctrine plays an important part in assessment of tax. Operations which give rise to income may take place partly in one territory and partly in another. Apportionment will have to be considered.

The contract with Petronet clearly demarcated the payment for the offshore and onshore supply of goods and services.

This is also recognised by clause (a) of Explanation 1 under Section 9(1). Mere existence of business connection may not result in income of the non-resident company from transaction with such a business connection accruing or arising in India.

The concepts of profits of business connection and PE should not be mixed up. Business connection is relevant for applying Section 9; PE for assessing the income under the DTAA. There may be overlapping of income. The entire transactions between Petronet and the Japanese company were completed on the high seas. Profits on sale, therefore, did not arise in India.

Two conditions

The question of applying DTAA does not arise. Two conditions are required to be met simultaneously for applying Section 9(1) (vii)(c) of the Act with regard to the supply of services.

First, the services, which are the source of the income that is sought to be taxed, must be rendered in India. Second, those services should also be utilised in India. Both these conditions must be satisfied simultaneously. The location of the source of income within India would not render sufficient nexus to tax the income from that source. The services rendered in this case were outside India and had nothing to do with the PE.

The Supreme Court has clarified difficult provisions of the law in this landmark ruling (288 ITR 408).

T. C. A. Ramanujam
(The author is a former Chief Commissioner of Income-Tax.)

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