EY Tax Alert. Delhi Tribunal rules guarantee fee income received by foreign parent from Indian subsidiary is taxable in India.

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1 12 December 2017 EY Tax Alert Delhi Tribunal rules guarantee fee income received by foreign parent from Indian subsidiary is taxable in India Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor. Executive summary This Tax Alert summarizes a recent ruling of the Delhi Income Tax Appellate Tribunal (Tribunal), dated 6 December 2017, in the case of Johnson Matthey PLC [1] (Taxpayer), on the issue of taxation of guarantee fee received by a foreign parent company from its Indian subsidiaries. In the present case, the Taxpayer, a foreign company (FCo), had provided a corporate guarantee under a global agreement to a foreign bank on behalf of its two Indian subsidiaries, for which it received guarantee fee from them. While filing its return of income (ROI), FCo offered guarantee fee to tax as interest income at 15% as per Article 12 of the India-UK Double Taxation Avoidance Agreement (DTAA). The Tax Authority disputed the characterization of guarantee fee as interest income and asserted that it is taxable at the full rate of 40% under the Other Income Article 23 of the DTAA. [1] [TS-578-ITAT-2017(DEL)]

2 FCo raised an alternative plea before the Tribunal that guarantee fee income is not taxable in India since it did not accrue or arise in India. At the highest, it is in the nature of business income which, in the absence of a permanent establishment (PE) in India, is not taxable in India. The Tribunal admitted the additional ground. However, the Tribunal upheld the Tax Authority s contention and held that guarantee fee income is taxable in India. Furthermore, it is not in the nature of interest income despite the wide scope of the definition of interest as per the domestic tax laws of India. It is also not interest covered by Article 12(5) of the DTAA. Guarantee fee cannot be characterized as interest since FCo did not have privity with the loan agreement between the foreign lender and the Indian subsidiary. Guarantee fee is also not in the nature of business income since FCo was predominantly engaged in the manufacturing business, and not in the business of providing corporate/bank guarantees to earn income on a regular basis. Hence, guarantee fee income is taxable at the full rate under the Other Income Article of the DTAA. Background The source rules of the Indian Tax Laws (ITL), inter alia, cover income which: (a.) Accrues or arises in India, or (b.) Is deemed to accrue or arise in India. One of the incomes which is deemed to accrue or arise in India is interest income payable to a non-resident by a resident, except where interest is payable in respect of any debt incurred, or moneys borrowed and used, for the purposes of business or profession carried on by such resident outside India or for the purposes of making or earning any income from any source outside India. In other words, interest payable to a non-resident by a resident for the purposes of business carried on in India is taxable in the hands of the non-resident. The ITL defines the term interest in a wide manner to include interest payable in respect of moneys borrowed or debt incurred (which includes deposit, claim or other similar rights or obligations). It also includes any service fee or other charge incurred for such moneys borrowed or debt incurred or in respect of any credit facility which is unutilized. Article 12 of the DTAA deals with taxation of interest income and, inter alia, provides that interest arising in India and paid to a UK resident may be taxed in the UK. However, such interest may also be taxed in India according to the laws of India, but if a UK resident is the beneficial owner of such interest, the tax so charged by India cannot exceed 15% of gross amount of the interest. Article 12 defines interest, inter alia, as income from any debt claim (whether or not secured by mortgage or carrying right to participate in the debtor s profit). Furthermore, Article 23 of the DTAA ( Other Income Article) is a general provision which also grants taxing rights to India for any residual income sourced in India, which is earned by a resident of the UK. Unlike Article 12, since there is no capping of tax rate in India under the Other Income Article, the tax rate applicable to such incomes is the full tax rate of 40% [2] as applicable to foreign companies. Facts FCo, a tax resident of the UK, entered into a global corporate guarantee agreement with certain foreign banks for providing guarantee in respect of loans granted by such banks to its group companies across various countries. Accordingly, the foreign banks also extended the loan facility to two subsidiaries of FCo in India. FCo received guarantee commission from its subsidiaries for provision of corporate guarantee to the foreign banks. FCo offered it to tax at a concessional rate of 15% as interest as per the Other Income Article of the DTAA. In its draft order, the Tax Authority held that the guarantee commission did not fall within the definition of interest under Article 12, but is taxable under the Other Income Article of the DTAA. Since the Other Income Article grants taxing rights to the source country (i.e., India), guarantee fee is chargeable to tax under the ITL at the full tax rate applicable to foreign companies (i.e., 40% [2] ). FCo raised objection before the Dispute Resolution Panel (DRP) on re-characterization of guarantee fee income and levy of higher rate of tax. However, the DRP confirmed the Tax Authority s action and, accordingly, the Tax Authority passed the final order levying higher tax on FCo. Aggrieved by the Tax Authority s order, FCo filed an appeal before the Tribunal. Taxpayer s contentions The definition of interest under the ITL is very wide in scope and, hence, includes payment in nature of guarantee fee. The said definition under the ITL covers an amount which may not be regarded as interest in general parlance and is also applicable even in the absence of a lender-borrower relationship. In this regard, FCo relied on judicial precedents [3]. Hence, guarantee fee income is covered by Article 12 of the DTAA and is liable to tax in India at a rate not exceeding 15% of gross interest. While trying to defend characterization as interest, FCo raised two alternative pleas, without prejudice to its original claim of interest income. [2] As increased by the applicable surcharge and cess [3] CIT v. Vijay Ship Breaking Corporation [(261 ITR 113) (Guj)]; Viswapriya Financial Services and Securities Ltd. [(258 ITR 496)(Mad])

3 Firstly, by way of an additional ground of appeal not taken before lower authorities, FCo argued that since the source of guarantee fee was the global corporate guarantee agreement entered into outside India for providing guarantee for its group companies in respect of loans availed from foreign banks, it does not accrue or arise in India. For this proposition, FCo relied on an earlier ruling of the Mumbai Tribunal [4]. Secondly, guarantee fee partakes the nature of business income, but is not chargeable to tax in India as per Article 7 (Business Profits) of the DTAA in the absence of a PE in India. Tax Authority s contentions The charging provisions under the ITL stand triggered in the present case since the Indian subsidiaries had availed a loan from the foreign banks and in this regard had paid guarantee fee to FCo. FCo earned guarantee fee not merely by entering into a global corporate agreement with the foreign banks, but on account of the fact that the Indian subsidiaries had availed loans from such banks. Guarantee fee income is not in the nature of interest, either under the ITL or under the DTAA in the absence of a lender-borrower relationship between FCo and its Indian subsidiaries. Guarantee fee income is covered by the Other Income Article of the DTAA and is, hence, liable to tax at the full rate of 40% as applicable to foreign companies. Tribunal s ruling The Tribunal ruled in favor of the Tax Authority and upheld taxation of guarantee fee income at the full rate by adopting the following reasoning: a. Guarantee fee income accrued/arose in India Guarantee fee income accrued or arose in India since the Indian subsidiary had availed a loan from the foreign banks and the loan transaction took place in India. It is true that FCo entered into a global corporate guarantee agreement with a foreign bank outside India, but no guarantee fee would have accrued from jurisdictions where the subsidiaries did not avail loans from the foreign bank. Hence, it is not the entering into a global corporate guarantee agreement which occasions FCo to charge guarantee fee, but it is the act of the subsidiary in availing the loan that leads to accrual of guarantee fee to FCo. Since the loan transaction took place in India, it cannot be contended by FCo that no income accrued in India. Reliance was placed on the Supreme Court (SC) ruling in the case of Kanchanganga Sea Foods Pvt. Ltd v. CIT [5] for the [4] Capgemini SA v. DCIT [(2016)(160 ITD 13)] [5] [(2010)(325 ITR 540)] proposition that, in cases of receipts created by legal fiction under the source rule of the ITL, there is no escape from the conclusion the nonresident had received the same in India. In view of the SC ruling, guarantee fee in the present case accrued and was received by FCo in India. b. Guarantee fee is not in the nature of interest Definition of interest under the provisions of the ITL and the DTAA needs to be interpreted in the context of the usage and with reference to other words and phrases used in the definition. Although the definition employs the words claims of any kind or service fee or other charges, such terms need to be understood in relation to the transaction or contract of loan. As per the ITL definition of interest, any payment pursuant to a loan transaction qualifies as interest if it is made in the context of a loan and in relation to the privity of contract between the parties, even in the absence of a debtorcreditor relationship. However, payment made to a stranger to the privity of the loan transaction or contract cannot be treated as loan even though such payments are incidental to such loan. If the definition of interest under the ITL or the DTAA is given a wide meaning, it would not only cover payment of interest, but also other payments incurred for pre-loan documentation and payments to third parties (like consultancy fees) within its ambit, even though it is not related to the loan transaction proper. Such interpretation does not reflect the true intention of the Legislature or DTAA-makers. FCo, being a stranger to the loan transaction, and the contract of guarantee being different from the contract of loan, guarantee fee received does not fall within the purview of the definition of interest as per the provisions of the ITL and the DTAA. c. Guarantee fee is not in the nature of business income FCo is admittedly engaged in manufacturing of catalysts and chemical products. The global guarantee agreement is entered into for the limited purpose of enabling its subsidiaries to secure loans and the guarantee income is incidental in nature. FCo was not engaged in the business of providing corporate/bank guarantees to earn income on a regular basis. Hence, it cannot partake the character of business income which, in the absence of a PE in India, is not taxable in India under Article 7 of the DTAA. Hence, guarantee fee, in the present case, is rightly covered under the Other Income Article of the DTAA and, consequently, taxable at the full rate as applicable to foreign companies.

4 Comments It is common for a global parent to enter into global corporate guarantee agreements with a global bank in respect of credit facilities availed by its subsidiaries across various jurisdictions. The parent may also recover guarantee fee from the subsidiaries under an appropriate transfer pricing policy. In the present ruling, the Tribunal has held that such guarantee fee paid by Indian subsidiaries is taxable in India at the full rate. It is neither in the nature of interest liable to tax at a lower rate nor in the nature of business income which, in the absence of a PE, is not taxable in India. Interestingly, the Tribunal did take note of an earlier ruling of the Mumbai Tribunal, which had held that such income is not taxable in India since it did not accrue or arise in India, nor can it be deemed to accrue or arise in India. But, the Tribunal neither distinguished nor dissented from the earlier ruling. Taxpayers would need to factor in the above conflict of views while making tax compliance based on the facts and circumstances of the case.

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