Section 5 of the Income-Tax (I-T) Act taxes the global income of resident companies in India.

It gets modified when the company has global operations and profits abroad are taxed in the source countries. Tax credit is given in the Indian assessments for taxes paid abroad on foreign profits.

Courts have held that in case of conflict between the Indian income tax law and the Double Taxation Avoidance Agreement (DTAA) provisions, the latter will prevail. This principle has been enshrined in Section 90(2) of the I-T Act. The company is entitled to claim that the assessment must be governed by either the I-T Act or the DTAA, whichever is beneficial.

The Patni case

In this case, Patni Computer Ltd, engaged in the business of development of computer software, had set up a trading office in Japan. For assessment year 2001-02, it claimed Rs 53,98,000 as loss incurred in the Japanese outfit, in the Indian assessment. The assessing officer (AO) disallowed the claim. He pointed out that under the Indo-Japanese DTAA, the profit earned in Japan is taxable only there and not in India.

By the same logic, he held that any loss incurred by the company in respect of its Japanese trading office is not allowable as deduction from the income which is taxable in India. He disallowed the loss and computed book profits under Section 115JB. In the first appeal, the company was successful in its claim for allowance of losses.

The department went on appeal before the Income Tax Appellate Tribunal (ITAT). It was pointed out that the Japanese permanent establishment (PE) of an Indian company is subject to taxation in Japan only as per the principle enshrined in Article 7 of the DTAA. The profits arising in Japan are excluded from the total income of the Indian company in the Indian tax assessment.

A natural corollary to the above principle will be that the losses incurred by the PE should be assessed to tax and set off against future profits in Japan. It cannot be set off against the income assessable in India. This will be contrary to the treaty provisions. The company had not given up its claim to avail itself of the treaty benefits at any stage or even in the future.

The acceptance of the claim for allowance of losses in the Indian assessments, it was argued, will result in an absurdity. It will mean that the profits of the companys PE in Japan will be taxed in Japan but the losses incurred in Japan will be set off against the Indian incomes. It was also pointed out that in all the other years the company had utilised the provisions of the treaty. It is not therefore open to the company to disregard the treaty provisions in the year of loss.

The company argued that under the Indian law, all profits and losses of an Indian resident would be taxed in India, irrespective of wherever they arise.

The Pune Bench of the ITAT examined the issue at some length. It pointed out that in the case of an Indian company, its global income is assessable under the Indian income-tax as per Section 5(1). It referred to the Supreme Court Ruling in the Azadi Bachao (263 ITR 706) case and held that it is open to the company to go by either the I-T Act or the treaty provisions, whichever is more favourable.

The option is with the company to get taxed either under the Indian tax law or under the Japanese code. The DTAA provision cannot be thrust upon the company. If it is to the advantage to the company to be taxed in India on its world income, which included losses suffered abroad, it is not open to the Revenue to contend that the company should be barred from utilising treaty benefits.

The Implications

This ruling has serious implications. If the company makes profits abroad in a subsequent year, it can claim the benefit of set-off of the prior years losses against such future profits in the Japanese tax assessment.

This means a double benefit, claiming the loss in one year under the Indian law and claiming the same loss in Japan against the future profits. This is referred to as double dip. The Pune Bench of the ITAT considered the same as plausible but pleaded helplessness in the face of the law as it stands today. The remedy, said the Bench, does not lie with us.

Obviously, the lawmakers have to take a closer look at the double taxation law in the light of the Tribunal order of June 29, 2007.