EY Tax Alert. J&K HC rules that contract receipts of a JV result in diversion of income to JV members; receipt not an income of the JV

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1 21 September 2017 EY Tax Alert J&K HC rules that contract receipts of a JV result in diversion of income to JV members; receipt not an income of the JV 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 decision of the Jammu and Kashmir (J&K) High Court (HC) in the case of Soma TRG Joint Venture [1] (Taxpayer). The HC, in this case, was concerned with the issue of whether the contract revenue received by a joint venture (JV) accrues as income in its hands or whether it results in diversion of income at source from the JV to the JV members. The HC noted that the JV was set up merely to enable one of its members to bid for a contract and the entire contract was executed by the JV members at their own cost. The JV did not carry out any activity in relation to the contract. Basis these facts, the HC held that there was diversion of income at source and the contract revenue received by the JV was not an income in its hands. Separately, the HC was also called upon to decide whether payment made by the JV to its members represented expenditure of the JV, which can be disallowed in computing income on the basis that no tax was withheld by the JV. The HC held that the amendment to the Indian Tax Laws (ITL), which provides that there will not be any disallowance of expense in the hands of the payer on failure to withhold taxes if the recipient of income offers such income to tax, applies retrospectively. In the facts of the case, the JV members had offered their share of income from the contract to tax. Hence, the HC held that disallowance of expense is unwarranted in the hands of the JV. [1] [TS-405-HC-2017(J&K)], dated 15 September 2017

2 Background In terms of the provisions of the ITL, in a case where a taxpayer fails to withhold taxes on payments made to a resident, such payment is disallowed as an expense in the hands of the taxpayer (disallowance provisions). The disallowance provisions of the ITL was amended by the Finance Act, 2010, with effect from 1 April 2010, to provide that in a case where the recipient of income files a return of income declaring such income and pays taxes thereon, the payer will be entitled to deduction of expense in the year in which the payee has filed its return of income and offered it to tax. In general, many of the large contracts are executed through a consortium of two or more companies, which could be Indian and/or foreign companies. The consortium may be set up as a JV company to act as the face of the contract. Members may also enter into a separate agreement to define their individual roles and responsibilities. In certain cases, the consortium may be treated as an Association of persons (AOP) under the ITL. While the issue of whether an AOP is constituted or not is in itself litigative, there has been an ongoing litigation on the issue of whether, in a case where there is internal overriding understanding between members, the principles of diversion of income by overriding title apply to the AOP. Furthermore, whether such principles can be drawn by the AOP to contend that income received from the contract is diverted at source in favor of the members which executed the contract and, hence, such receipt should not constitute income in its hands. The judicial precedents on this aspect indicate that the primary test for determining whether there has been a diversion of income is to determine whether the income gets diverted before it accrues to the taxpayer or whether it is applied by the taxpayer after it accrues to it. Facts An Indian company, ICo, wanted to bid for a tender floated by the Indian Railways for construction of tunnels. However, ICo did not satisfy the conditions which were laid out by the Indian Railways in the tender notice. Another Indian company, ICo1, had the necessary experience which would make it eligible to bid for the tenders floated by the Indian Railways. Thus, ICo and ICo1 (JV members) entered into a JV agreement to set up a JV with the intention of filing a joint bid for the tender floated by the Indian Railways. As per the JV agreement, ICo1 would act as the lead party of the JV. Furthermore, both ICo and ICo1 would jointly exercise the authority to incur liabilities on behalf of the JV. It was also agreed that if the contract was awarded to the JV, the JV members would enter into a more detailed JV agreement (new JV agreement), in which case the existing JV agreement would cease to be in force. The bid was filed and the contract was awarded to the JV. As per the terms of the existing JV agreement, the JV members entered into a new JV agreement, as per which, ICo would incur all expenses in relation to the contract, as well as execute the contract. Neither ICo1 nor the JV was required to do any work in relation to the contract. Owing to the limited role of ICo1, the JV members agreed to share the contract revenue in the ratio of 97:3. In terms of the new JV agreement between the JV members, the contract revenue in the relevant financial year (FY) was allocated by the JV to ICo and ICo1 in the ratio of 97:3. The JV filed a return of income in the status of AOP and declared nil income for the relevant FY by contending that the income from the contract was diverted to the JV members at source and there was no accrual of income in its hands. The JV members offered the contract revenue to tax in the agreed ratio. However, the Tax Authority treated the contract revenue as income of the JV. Furthermore, the Tax Authority considered the payment made by the JV to JV members as payment towards sub-contracting charges. Since the JV had failed to withhold taxes on the same, the Tax Authority disallowed the payment made to the JV members under the disallowance provisions. Aggrieved by the order of the Tax Authority, the Taxpayer filed an appeal. Both the First Appellate Authority and the Second Appellate Authority upheld the order of the Tax Authority. Aggrieved, the Taxpayer appealed before the HC. Key contentions of the Taxpayer before the HC The JV agreement was for the limited purpose of participating in the tender and not to execute the same. The contract was executed severally and independently by the JV members. The JV was a mere conduit and no income could be brought to tax in the hands of the JV as it did not carry on any activity or business. The income from the contract cannot be said to be accruing to the JV merely because it was received by the JV. There was diversion of income from the JV to the JV members which had actually executed the contract. Without prejudice, in the absence of a formal contract between the JV and the JV members for subcontracting the project, the provision of tax withholding under the ITL was not applicable to the JV. There should, therefore, be no disallowance in the hands of the JV. Additionally, since the JV members have offered the contract revenue to tax, there should be no disallowance in the hands of the JV. The amendment to the disallowance provisions, being clarificatory in nature, should have retrospective effect and should apply even for the FY under consideration.

3 Key contentions of the Tax Authority before the HC Once the JV receives the contract revenue, it becomes its income, irrespective of whether it incurs any expenditure in relation to the contract or not. The JV is an independent entity and it cannot avoid its taxes merely because the JV members have paid their taxes. The contract was awarded to the JV and not to the JV members. Agreement to share profit in a specified manner cannot be a deterrent to levy of tax. Issues before the HC Whether the contract income received by the JV can be treated as being diverted at source to the JV members and, hence, whether the JV was right in contending that such receipts do not qualify as its income. Whether the contract income allocated by the JV to the JV members, which represented expenditure of the JV, is not allowable under the disallowance provisions for default in tax withholding by the JV. Though the definition of income is very wide, in the facts of the case, income from the contract is diverted at source itself before it accrues to the JV. Hence, it cannot be regarded as income of the JV. Applicability of the disallowance provisions The HC referred to the Supreme Court (SC) ruling in the case of R.B. Jodha Mal Kuthiala [3] in support of the proposition that a provision which is inserted in the ITL to rectify an unintended consequence and to make the provision workable, is to be treated as having retrospective application. Basis this, the HC held that the amendment to the disallowance provisions is curative and is retrospective. In the present case, the JV members have paid the taxes on the income received. The case is protected by the amended disallowance provisions. Alternatively, the disallowance provisions will apply only to an amount which remains unpaid at the end of the relevant FY and will not apply to an amount which is already paid during the FY. In the present case, there is no amount payable to the JV members at the end of the relevant FY and, hence, there can be no disallowance in the hands of the JV. HC s ruling On diversion of income at source The genuineness of the new JV agreement between the JV members was not disputed by the Tax Authority. There was no dispute on the fact that the work was exercised by one of the JV members at its own cost and expense. Nothing was brought on record to show that JV members executed the work jointly or that one member had the authority to interfere with the work executed by the other member. The terms of the JV agreement indicate that the JV was formed only for the purpose of submission of the tender bid and once the contract was awarded, work was executed by the JV member. The JV has not performed any work or activity in relation to the contract. The amount received by the JV is, thus, not an income accruing to it. The primary test for determining whether there has been a diversion of income is to determine whether the income gets diverted before it accrues to the taxpayer or whether it is applied by the taxpayer after it accrues to it [2]. [2] Reliance in this regard was placed on the decision of CIT v. Sitaldas Tirathdas [(1961)41 ITR 367] [3] [(1971)82 ITR 570(SC)]

4 Comments This is a welcome ruling by the HC. As stated earlier, there has been litigation on the issue of whether a consortium may constitute an AOP and whether the contract revenue should be taxed in the hands of the members directly. This ruling examines the issue of whether the contract income received by a consortium can be considered as being diverted at source in favour of the JV members such that no income accrues in the hands of the consortium. To that extent, this HC ruling does provide some guidance to taxpayers on the circumstances in which a consortium may claim that the amount received by it is diverted in favor of its members. This HC ruling also clarifies that the amendment to the disallowance provisions is retrospective in nature. However, to the extent that the HC allowed relief on the ground that the disallowance provisions can be applied only to the amount remaining unpaid as at year end, it is contrary to the SC ruling in the case of Palam Gas Service [4] and, with due respect to the Court, does not lay down the law correctly. [4] TS-170-SC Refer EY Tax Alert SC upholds disallowance of expenditure on default in withholding tax, irrespective of whether it is paid or payable dated 5 May 2017

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