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When the going gets tough for foreign taxpayers
September, 08th 2008

Globalisation has brought in not just newer methods of conducting business but also controversies, in the taxation space. Of late, one has seen a spurt in the number of taxation-related decisions by various tribunals and courts.

An expert in the field of international taxation, S. P. Singh, Senior Director with Deloitte Haskins & Sells, India, has been closely associated with the development of transfer pricing and international taxation in India.

In this email interview with Business Line, Singh raises a note of caution for foreign companies entering into a contractual arrangement relating to high investment turnkey projects and says that high incidence of tax may not make these projects economically viable. He is of the view that unexpected tax provisions, which are not in line with the internationally accepted norms, make it tough for the foreign taxpayers.

Singh also brings to light issues relating to capital gains arising from transfer of a foreign enterprise's `trademarks' registered in India and a recent ruling clarifying this.

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Excerpts from the interview:

Is there clarity on the taxability of bandwidth charges, which is one of the major expense items for IT companies in India?

To facilitate transmission of huge amount of data and voice, dedicated bandwidth is being provided by several companies.

A question that recently came before the Authority for Advance Ruling (AAR) in the Dell International Services India Pvt. Ltd (AAR No. 735 of 2006) case and the Delhi High Court in the Estel Communication P. Ltd. (ITA 527/2007) case was whether a payment against this facility is liable to taxation in India or not, particularly when the service provider is outside India.

While the Revenue authorities were of the view that this is taxable as royalty, fees for technical services or business income, the AAR, in its decision dated July 18, 2008, held that such payment cannot be characterised as royalty or fees for technical services. However, in the absence of sufficient information, it did not decide whether the service provider constitutes a permanent establishment (PE) in India or not.

In the Estel case, the question before High Court was whether the services provided can be said to be technical services or not. In its order of March 7, 2008, the court held that Internet bandwidth does not amount to providing technical services.

These two decisions would have far-reaching implications, as most of the outsourced units in India depend on such services for their smooth functioning.

In the past, telecom service providers have also been under the microscope of not only the income-tax authorities but also under other taxes.

In the BSNL vs Union of India (Writ Petition (Civil) 183 of 2003) case, the question that came up before the Supreme Court was whether the facility of mobile phone connections amounted to sale or service. In the landmark ruling dated March 2, 2006, the court held that there was no delivery of goods and the subscriber to a telephone service could not have intended to purchase or obtain any right to use electromagnetic waves.

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What are the tax implications of foreign companies undertaking turnkey projects in India?

There has been a substantial rise in the number of large turnkey projects, which require a lot of investment and a variety of technical expertise. It is not possible for any one company - whether domestic or foreign - to provide all of them.

Consequently, companies partner with a public sector undertaking (PSU) to carry out the work. The question is whether this amounts to creation of an Association of Persons (AoP), in which case there would be heavy tax incidence (taxable on a net basis at 41 per cent).

This was the issue before the AAR in the Geoconsult ST GmbH case. The applicant (Geoconsult) formed a joint venture (JV) with two Indian companies to provide consultancy services to a PSU of Himachal Pradesh.

It was provided that the JV parties were jointly and severally liable for the satisfactory execution and completion of the assignment. Share of the fee of each JV partner was predefined. Based on these facts, the AAR held that these companies constitute an AoP.

Interestingly in this case, though initially the question posed before the AAR by the applicant was that its share of income from the contact is taxable as FTS (fees for technical services) under the India-Austria treaty and, hence, taxable on gross basis at 10 per cent; it ended with a tax liability on net basis at 41 per cent.

Given this scenario, any company entering into a contractual arrangement of the nature discussed above needs to be careful as the high incidence of tax may not make the project economically viable.

What is the current situation on the issue of attribution of profits to a permanent establishment (PE) in India and the taxability of foreign taxpayer?

Interpretation of various tax provisions always poses a dilemma, more so in the case of foreign taxpayers who are new entrants to the Indian shores and too aware of the Indian tax laws. Unexpected tax provisions which are not in line with internationally accepted norms make the going all the more tough for the foreign taxpayers.

For example, it is generally accepted internationally that if a non-resident carries on its business through a PE, then only so much profit may be taxed in that country which is attributable to the business activities being carried on by that PE.

The controversy lies in the attribution of profits, wherein the taxman is always eager to attribute as much profits as possible to the operations of the PE. This controversy came to the forefront after the Mumbai Tribunal decision in the SET Satellite (Singapore) Pte Ltd case, wherein it was decided that the foreign taxpayer's liability does not extinguish even if the PE is remunerated at arm's length price (ALP). It was ruled that the foreign company is additionally taxable in India on the basis of Functions performed, Assets employed and Risks taken (FAR analysis).

The Supreme Court had also pronounced a path-breaking decision in the Morgan Stanley & Co. Inc case, wherein it was emphasised that determination of income of a PE would depend on proper functional analysis. Given this, it is possible that a foreign company may not have any tax liability in India if the Indian PE was remunerated at ALP. Based on this decision, the Mumbai High Court recently reversed the earlier mentioned Mumbai Tribunal decision in the SET Satellite case.

It is relevant to point out here that the approach suggested by the Organisation for Economic Co-operation and Development (OECD) is totally different from that of the Mumbai High Court.

Given the conflicting approaches and the court decisions, it is important that the Government takes steps to settle the issue taking into account the views of the courts in India and internationally accepted norms.

What is your view on the tax department's claim on capital gains arising out of transfer of foreign enterprises' `trademarks' registered in India?

The capital gains arising from transfer of `trademarks' registered in India has always been a bone of contention between taxpayers and the Department. The basic issue is whether the capital gains on intangibles are taxable on the basis of its situs or the residential status of the taxpayer. A related question is where does an intangible arise - where the IPR holder is located or where the business is carried on?

Trademarks may be created either by publicity and advertisements or by continuous R&D. The issue is if both of these should be taxed as significant business carried out here or if there should be a difference in treatment for the two types of trademark.

These issues have been discussed in the recent ruling by the AAR in the Foster's Australia Ltd case. The AAR ruled that the registration of trademark has no bearing on the ownership. It has been observed that the commercial exploitation of the trademarks and brand, aided by the marketing and advertising efforts, would result in creation of valuable intangible asset in the place of business, which happens to be India in this case.

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It is immaterial that the trademarks and names originated in another country and was initially registered there. However, the AAR is of the view that intangibles which involve R&D would be located in the place where such activities are carried out.

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