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No consistency in PE income attribution
July, 10th 2007
There has been a debate on the taxability of turnkey contracts where portion of a contract is executed outside India. In Ishikawajma-Harima Heavy Industries Ltd case, the Supreme Court, in 2006, ruled that mere "business connection" with India may not result in a non-residents income being taxed in India. Further, the court held that operations in taxable territories shall result in taxability of such profits as are "reasonably attributable" to operations undertaken in the taxable territories.
The fact that a contract was signed in India is of no consequence and therefore cannot be the sole determinant. The place from where the services were rendered should determine its taxability, the court said.
But the Finance Act of 2007 partially reversed the order by retrospective amendment from April 1976. The amendment waters down the principle of "territorial nexus" and strengthens the "source rule" in taxing services.
The Supreme Court, in a recent judgment in the case of Hyundai Heavy Industries Co Ltd (HHI) has reiterated the importance of establishing the "economic nexus." HHI is a foreign company incorporated in South Korea. It entered into an agreement with ONGC for designing, fabrication, hook-up and commissioning of South Bassein Field Central Complex Facilities in Bombay High. The contract was divided in two portions, for fabrication of platform and installation & commissioning of the said platform in South Bassein Field.
The question before the court was taxability of the offshore fabrication portion and the quantum of profits attributable to such activities.
HHI contended that it has no PE (permanent establishment) in India as its Indian operations, consisting of installation and commissioning, were completed in less than nine months. It said it was entitled to exemption under the Convention for Avoidance of Double Taxation (DTA). HHI also contended that the contract was divisible into two distinct operations fabrication work undertaken in Korea and installation undertaken in India. It said that any income from fabrication was not taxable in India.
The court, after analysing the scheme of the Act, on the taxation of PEs and after referring to the DTA treaty between India and Korea, reiterated the principle that the taxable unit was a foreign company and not its branch or PE in India.
A non-resident assessees taxability is restricted to income which accrues or arises or are deemed to accrue or arise in India.
The court further held that the scheme of the Indian Income-tax Act was concerned only with the profits earned in India and the only way to do so was by treating the Indian PE as a separate profit centre vis-a-vis the foreign enterprise.
Therefore, unless the PE is treated as a separate profit centre, it is not possible to ascertain the profits of the PE ,which, in turn, constitutes profits arising to the foreign enterprise. It is, therefore, necessary that the profits of a PE is computed as an independent unit, subject to the provisions of the DTA to the extent to which such provisions are more beneficial to the taxpayer.
Further, referring to the force of attraction rule, which implies that where a foreign enterprise constitutes a PE in another country, it brings itself within the fiscal jurisdiction of that country to such a degree that such another country can tax all profits that the foreign enterprise derives from the source countrywhether through PE or otherwise. The court held that it is the act of setting up a PE which triggers the taxability of transactions in the source state. Therefore, unless the PE is set up, the question of taxability does not arise, whether the transactions are direct or through a PE.
The court, distinguishing the activities undertaken by HHI before constituting an installation PE , held that profits earned by the Korean enterprise on supplies of fabricated platforms could be held as attributable to Indian PE as the installation PE came into existence only after the transaction stood materialised, that is, on the conclusion of the transaction between HHI and ONGC. Therefore, the installation PE emerged only after the contract between HHI and ONGC was concluded, that is, after the fabricated platform was delivered in Korea. Further, the profits on supplies of fabricated platforms cannot be said to be attributable to the PE.
The court clarified that even if it is assumed that the supplies were necessary and are integral part of the installation, no portion of profits on such supplies could be attributed to the independent PE, unless the supplies were not at arm's length price. Since in the present case, the sales were directly billed to ONGC, the Indian customer, and there was no service element included in the supplies, the profits that accrued to HHI for Korean operations were not taxable in India.
In conclusion, for turnkey projects, offshore supplies will remain outside the Indian tax net unless the foreign supplier has a PE in India and offshore supplies are attributed to such PE.
The ball is now clearly in the tax administrators court to give a finding that PE and that the principles of attribution is applied taking into consideration appropriate international principles.
Mukesh Butani
The author is a Partner with BMR & Associates and the views here are personal.
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