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Source rule for taxing NRIs
March, 31st 2007

Several judgments of High Courts are proposed to be nullified by the Finance Bill, 2007. For instance, the Executive is looking to annul a judgment delivered in January 2007 concerning interpretation of Section 9 of the Income-Tax Act, 1961 by making amendments to the Finance Bill.

In the Ishikawajima-Harima Heavy Industries Ltd vs Director of Income Tax (288 ITR 408) case, the Supreme Court has held that business connection under the I-T Act is very different from permanent establishment (PE) under the double taxation avoidance law. Remuneration earned by a non-resident company for rendering offshore services will need sufficient territorial nexus with India for it to become taxable in India. The court postulated two conditions for taxability: One, the services must be utilised in India. And, two, such services must be rendered in India.

Narrow interpretation

The facts in the Ishikawajima case show that the Japanese company was executing a turnkey project and carried out offshore services. It also had a PE in India. According to the Supreme Court, the fees for such offshore services will become taxable only if the services are utilised and rendered in India. In an elaborate judgment, the court gave a restricted interpretation of the terms business connection and PE.

According to the apex court, "Section 9 raised a legal fiction deeming income to accrue or arise in India. This fiction must be construed having regard to the object it seeks to achieve." It was of no consequence that the contract was signed in India. All the activities in connection with the offshore supply and services were outside India and, therefore, income could not be deemed to accrue or arise in India. The entire transaction was completed on the high seas.

The Source Rule required both utilisation and execution of the services in India. This was not satisfied in the case of the Japanese turnkey project in India. Mere location of the source of income in India or the mere existence of a PE in India will not be sufficient to attract the Rule.

This ruling was rendered in the context of an appeal against the decision of the Authority for Advanced Ruling.

Explanation introduced

The Finance Bill, 2007 tries to get over this Supreme Court decision by introducing an Explanation in Section 9 to provide that where income in the nature of interest, royalty or fee for technical services is deemed to accrue or arise in India, such income shall be included in the total profits of the non-resident irrespective of the non-resident having a residence, place of business or business connection in India.

The apex court had said that there should be sufficient territorial nexus with India, a direct link. Section 9 is categorical that payment made by a resident to a non-resident is deemed to accrue or arise in India if services are utilised in India. The Supreme Court gave a new interpretation to Section 9. The current amendment in the Finance Bill seeks to annul this interpretation. The Memorandum explaining the provisions of the amendment clarifies that the purpose is to give legal sanctity to the Source Rule. This is recognised in all Double Taxation Avoidance Agreement (DTAA) entered into by India.

The newly inserted Explanation clarifies that where income is deemed to accrue or arise in India under Sections 9 (1)(v) (vi) and (vii) of the Act, such income shall be included regardless of whether the non-resident has a residence, place of business or business connection in India. It is not necessary to establish the territorial nexus between the income deemed to accrue or arise to the non-resident under the said clauses and the territory of India.

The amendment takes effect from June 1, 1976. That was the date when Section 9 was radically altered.

The question arises whether the amendment will achieve the object of overturning the Supreme Court judgment. Section 9(1)(vii) of the Act did not require the establishment of a live link or territorial nexus as a precondition for bringing technical service fees of non-resident to taxation in India. The Supreme Court read this requirement into the Act. Probably, before seeking to amend the section, the Government could have filed a review petition in the Supreme Court.

Difficult to amend

It is difficult to amend an enactment merely to get over an interpretation placed by the Supreme Court and when such interpretation is not entirely based on the words found in the section itself. The apex court had dealt with the case elaborately. It quoted foreign authors in support of its judgment. Appeals against the decisions of the Authority for Advance Rulings are rarely taken up in the Supreme Court.

An unfortunate aspect of the proposed amendment is retrospective by 31 years. It could have been made prospective.

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

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