EY Tax Alert. Executive summary. Kolkata Tribunal rules on taxability of online advertisement revenues. 18 April mber 2012

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1 18 April mber 2012 EY Tax Alert Kolkata Tribunal rules on taxability of online advertisement revenues Executive summary 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 Ernst & Young advisor. This Tax Alert summarizes a recent ruling [1] by the Kolkata Income Tax Appellate Tribunal (Tribunal) in the case of Right Florists Pvt. Ltd. (Taxpayer) on taxability of amounts paid to search engines such as Google and Yahoo for online advertising services. The Tribunal ruled that the payments would not be considered as royalty or fees for technical services (FTS) under the Indian Tax Laws (ITL), as well as under the relevant Double Taxation Avoidance Agreement (DTAA). Furthermore, the Tribunal also held that a website, per se, would not constitute a Permanent Establishment (PE) in India under the basic fixed place PE rule. This conclusion was based on the Commentary to the OECD Model Convention (OECD MC). In the course of the ruling, the Tribunal also commented on the relevance of India s reservations on the OECD MC and its Commentary. [1] ITA No. 1336/Kol/2011

2 Background and facts The Taxpayer, a florist and an Indian company, used the search engines of Google/Yahoo for advertising its business. Payments were made to search engine companies, Google Ireland (Google) and Yahoo US (Yahoo), for displaying the Taxpayer's advertisement when certain key terms were used on such search engines. The Taxpayer was of the view that the payment was not taxable in India in the hands of the search engine companies and, hence, no taxes were withheld on such payments. The payments were disallowed by the Tax Authority on the ground that the taxes ought to have been withheld at source. Furthermore, the Taxpayer should have approached the Tax Authority to determine the appropriate withholding tax rate before making a foreign remittance. models and it was time to find an alternative to the PE concept. The Tribunal concluded that a website, per se, could not constitute a PE in India under the ITL for the search engine companies. This was also the view of the HPC. The Tribunal also held that there was nothing on record to demonstrate or suggest that the receipts by Google and Yahoo were on account of business connection in India. Reliance was placed on the OECD MC to conclude that a search engine, which has a presence through its website, cannot have a PE in India under the DTAA unless its web servers are also located in India. This was not the situation in this case; the servers of the search engines were not located in India. Hence, Google and Yahoo did not have sufficient presence in India so as to be taxable on its business profits in India. Whether the payments constituted royalty On appeal, the First Appellate Authority deleted the disallowance and ruled in favor of the Taxpayer. Aggrieved by this decision, the Tax Authority appealed before the Tribunal. Tribunal s ruling Whether Google/Yahoo have a taxable presence in India Under the relevant DTAAs, business profits earned by a nonresident (NR) cannot be brought to tax in India unless the NR carries on its business in India through a PE. Traditional commerce required physical presence in a country and, hence, the PE concept had developed at a time when e- commerce was non-existent. Under the ITL, payments for use or right to use industrial, commercial or scientific equipment is considered as royalty when made by a payer resident in India. The Tribunal examined in detail earlier decisions [2] of the Mumbai Tribunal which dealt with the payments made by an Indian entity to a foreign search engine portal for online advertising services. In these decisions, the payments were not considered as royalty under the ITL as there was no use or right to use any industrial, commercial or scientific equipment by the payer. Based on these decisions, the Tribunal concluded that the payments to Google/Yahoo were not in the nature of royalty. Reference was made to the report of the High Powered Committee (HPC) constituted by India to look into tax issues surrounding e-commerce, which had indicated that traditional PE tests failed when it came to e-commerce [2] Yahoo India Pvt. Ltd. [140 TTJ 195] and Pinstorm Technologies Pvt. Ltd. [TS 536 ITAT (2012) Mum]

3 On reservations by India on the OECD MC India, in its role as an observer, has expressed certain reservations on the OECD MC as a non-member, which were included in the non-member countries positions section of the 2008 update. The Tribunal noted India s reservations on the OECD MC that a website may constitute a PE in certain circumstances. The Tribunal observed that this can be treated as contemporanea expositio in respect of DTAAs entered into by India after so expressing its reservations (i.e., DTAA signed after 2008). Beyond this, the reservations have no role to play in judicial analysis. In any event, the Tribunal also observed that the reservations expressed by India merely state that the website may constitute a PE in certain circumstances but it does not specify what those circumstances are in which, according to the Tax Authority, a website could constitute a PE. As regards payments to Yahoo (US entity), the DTAA additionally required that the service should make available technical knowledge, skill etc. to the payer for it to be taxed as fees for included services. This was not satisfied in the present case. For this purpose, reliance was placed on the decisions of the Delhi High Court in Guy Carpenter & Co. Ltd [4]. and Karnataka High Court in De Beers India Pvt. Ltd [5]. No withholding tax obligation in absence of primary tax liability The SC, in the case of GE India Technology [6], had held that, in the absence of primary tax liability on the income recipient, there cannot be a vicarious liability upon the payer to withhold taxes. Based on the above and relying on the GE India ruling, the Tribunal held that there was no liability to withhold taxes for the Taxpayer on its payments made to Google and Yahoo. Therefore, as of now, even on merits, the reservations expressed by India can be said to have no practical consequence. Whether the payments are in the nature of FTS Under the ITL, payments for technical, managerial or consultancy services are considered as FTS. The Supreme Court ruling in the case of Bharti Cellular [3] had held that, as long as there was no human intervention, the service cannot be characterized as FTS. As the whole process of online advertising was automated in which there was no human element, the same cannot constitute FTS. [4] [2012-TII-14-HC-DEL-INTL] [5] [TS-312-HC-2012]. Refer Ernst & Young Tax Alert dated 14 May 2012 [6] [327 ITR 456] [3] [330 ITR 239]

4 Comments This Tribunal ruling addresses the question of taxability of revenues arising to an NR from e-commerce transactions and how the traditional rules of taxation, as contained in domestic tax laws and the DTAA, impact fundamental cross-border taxation issues such as characterization of income and creation of nexus for the purpose of taxation. The Tribunal s observations on India s reservations to the OECD MC and its Commentary provide some guidance on its role in tax treaty interpretation. Also of significance is the view expressed by the Tribunal that a website, per se, does not constitute a PE of a foreign enterprise under the fixed place PE rule. This decision should help ease concerns of taxpayers engaged in similar e-commerce transactions.

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