Delhi High Court holds on the taxability of offshore and onshore supply and services under the composite contract

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1 KPMG FLASH NEWS KPMG IN INDIA Delhi High Court holds on the taxability of offshore and onshore supply and services under the composite contract 29 April 2014 Background Recently, the Delhi High Court in the case of Linde AG, Linde Engineering Division and Anr. 1 (the taxpayer) dealt with issues relating to the taxability of offshore and onshore supply and services under the composite contract and consortium vis-a-vis Association of Person (AOP). The High Court held that the consortium between the taxpayer and Samsung was not forming an AOP. Further, the contract between them was divisible. Offshore supply was not taxable in India since the property was transferred outside India and the contract was not providing business connection in India. In relation to the taxability of offshore services under the Income-tax Act, 1961 (the Act), it was held that if such services linked with the manufacture and fabrication of the material and equipment to be supplied overseas and form an integral part of the said supplies then such services would not be taxable in India. 1 Linde AG, Linde Engineering Division and Anr. (W.P. (C) No. 3914/2012 & CM No. 8187/2012) Further under the India-Germany tax treaty (tax treaty) if taxpayer had a Permanent Establishment (PE) in India at the time when offshore services were being rendered by it which were attributable to the PE, the same would be considered as business profits and taxed accordingly. Accordingly, the matter was remanded back to the AAR to deal with this issues afresh. Facts of the case ONGC Petro Additions Limited (OPAL), an Indian company, floated a tender notice inviting bids executing the work (including undertaking all activities and rendering all services) for the design, engineering, procurement, construction, installation, commissioning and handing over of the plant. The project was to be executed on turnkey basis. The taxpayer and Samsung Engineering Company Ltd. (Samsung) entered into a Memorandum of Understanding (MOU) whereby both the parties agreed to form a consortium, for jointly submitting a bid to secure the contract for execution of the aforesaid project.

2 OPAL awarded the contract to the taxpayer and Samsung for carrying on work of all activities and services required. The taxpayer filed an application before the Assessing Officer (AO) under Section 197 of the Act claiming that no portion of the amount payable was liable to withholding of tax under Section 195 of the Act. It was contended that the said transactions were performed and completed outside India and payments for the said transaction were also received outside India. Therefore such payment was not chargeable to tax in India. The AO did not accept the same and directed OPAL to withhold tax on amounts paid to the taxpayer in terms of the contract. The taxpayer filed an application before the AAR under Section 245Q of the Act. The AAR held that consortium of the taxpayer and Samsung constitutes an AOP. The contract was an indivisible contract and was incapable of being split up into different components/parts. Accordingly, income received/ receivable by the taxpayer for offshore supply of equipment, materials and spares and for offshore supply of drawings and designs relating thereto was taxable in India. Aggrieved by the AAR s ruling, the taxpayer filed a writ petition before the High Court. High Court s ruling Whether consortium constitutes an AOP Relying on various decisions 2 the High Court observed that AOP is one in which two or more persons join together for a common purpose or common action and there is a joint management or joint action by the said two or more persons. A mere cooperation of one person with another in serving one s business objective would not be sufficient to constitute an AOP merely because the business interests are common. A common enterprise, which is managed through some degree of joint participation, is an essential condition for constituting an AOP. The MOU between the taxpayer and Samsung specified that each consortium member would be responsible for its share of work and would also provide the information, data and material required for performance of work by the other member. Neither of the members had any role to play with respect to the scope of work which was allocated to the other member. The equipment/material to be supplied and the works to be executed by each member under the MOU as well as under the contract entered into with OPAL was well defined and the members were to act separately and in accordance with the respective work allocated to them. 2 CIT v. Indira Balkrishna [1960] 39 ITR 546 (SC), G. Murugesan and Brothers v. CIT (1973) 4 SCC 211, N.V. Shanmugham and Co. v. CIT (1970) 2 SCC 139 The internal consortium agreement was also explicit with regard to risk to be borne by the members. The taxpayer and Samsung agreed to bear the risk for the work falling within their scope of work including on account of non-payment or default by OPAL. Neither of the members would be liable to each other on account of any loss or damages incurred by the other member on account of non-payment by OPAL. Insofar as cooperation between the taxpayer and Samsung towards project management was concerned, it was expressly agreed between the said parties that each shall be responsible for the management and control of work falling within their own scope. However, for the purposes of representing the Consortium to OPAL, it was agreed that Project Directors would be nominated by the taxpayer and Samsung who would have the authority to direct the project execution in accordance with the provisions of the contract entered into between the parties with OPAL and in conformity with their internal agreements. It was expressly agreed that the Project Directors would remain responsible to their respective sponsors. The payments to be made for separate items of work were also specified. The currency in which the payments were to be made was also separately indicated. Thus, insofar as execution of the work was concerned, even OPAL recognised that different items constituting the contract would be performed independently by the taxpayer and Samsung. The consideration for the work performed was to be made directly to the concerned member of the consortium in accordance with the work performed by him. The fact that a third party is desirous to deal with the members as one consortium cannot be the determinative factor in considering whether the members constitute an AOP for the purposes of being assessed for taxation. Accordingly the High Court held that the facts of this case do not indicate a sufficient degree of joint action between the taxpayer and Samsung either in execution or management of the project to justify a conclusion that they had formed an AOP. The CBDT Instruction No relied by the taxpayer does not apply to the facts of the present case, however, the said instruction does indicate the correct understanding in law. 3 Instruction No.1829, dated 21 September 1989

3 Facts of the present case was similar to decision in the case of Hyundai Rotem 4 in all material aspects where it was held that consortium could not be treated as an AOP. Relying on the Supreme Court s decision in the case of Columbia Sportswear 5, it was held that in absence of any material change in law, the AAR was bound to follow the principle of law as applied in the earlier ruling. Applicability of tax treaty to AOP If in given facts, it is found that a non-resident has formed an association with another entity for conduct of a business venture in India, there is no doubt that the said association would be assessed to tax in India and the same is not proscribed by the provisions of the tax treaty. Whether contract is divisible Relying on the Supreme Court s decision in the case of Ishikawajima-Harima Heavy Industries 6, it was held that it would not be appropriate to consider the contract as a composite one for the purposes of imposition of tax under the Act. The approach as well as the conclusion of the AAR was flawed. The AAR was not correct in proceeding on the basis that the contract as a whole was the subject of taxation. The subject matter of taxation was not the contract between the parties but the income that the taxpayer derived from the contract. The principle of apportionment of income on the basis of territorial nexus is now well accepted. Explanation 1(a) to Section 9(1)(i) of the Act also specifies that only that part of income which is attributable to operations in India would be deemed to accrue or arise in India. The reference of the AAR to the decision of the Supreme Court in the case of Vodafone International Holdings B.V. 7 was not appropriate. The issue in that case was different from issue in this case. Taxability of Offshore supply The contract was on Free on Board (FOB) basis and clearly indicates that the ownership of the material to be supplied by the taxpayer would transfer to OPAL, the moment, the materials were placed for shipment outside India. In the facts of the present case, where the equipment and material was manufactured and procured outside India, the income attributable to the supply thereof could only be brought to tax if it was found that the said income therefrom arises through or from a business connection in India. However, in view of the decision of the Supreme Court in Ishikawajima-Harima Heavy Industries it cannot be concluded that the contract provides a business connection in India. Accordingly, the offshore supplies cannot be brought to tax under the Act. 4 Hyundai Rotem Co. and Mitsubishi Co. [2010] 323 ITR 277 (AAR) 5 Columbia Sportswear Co. v. DIT (2012) 11 SCC Ishikawajima-Harima Heavy Industries v. DIT [2007] 288 ITR 408 (SC) 7 Vodafone International Holdings B.V. v. UOI [2012] 341 ITR 1 (SC) Taxability of Offshore services Under the Income-tax Act If it is accepted that the services provided by the taxpayer relating to design and engineering are inextricably linked with the manufacture and fabrication of the material and equipment to be supplied overseas and form an integral part of the said supplies, then such services would not be taxable under Section 9(1)(vii) of the Act. Consideration for such services would not be considered as Fees for Technical Services (FTS) for the purposes of Section 9(1)(vii) of the Act. This view has also been expressed by the AAR in the case of Rotem Company 8. It was clarified that in order to fall outside the scope of Section 9(1)(vii) of the Act, the link between the supply of equipment and services must be so strong and interlinked that the services in question are not capable of being considered as services on a standalone basis and are therefore subsumed as a part of the supplies. In the taxpayer s case the consideration for the supplies are separately specified, therefore, this aspect would require a closer scrutiny and determination of facts, which we do not propose to do in the present proceedings. Under the tax treaty In this case, the source of FTS was in India and, therefore, by virtue Article 12(1) and (2) of the tax treaty read with Section 9(1)(vii) of the Act, the same would be liable to be taxed in India provided the said fees was not attributable to taxpayer s PE in India. In the event such fees was attributable to PE in India, by virtue of Article 12(5) of the tax treaty, Article 7 of the tax treaty would be applicable and the income arising from provision of services would be liable to tax in India as business profits. Relying on the decision in the case of Ishikawajima Harima Heavy Industries, the High Court held that it would be necessary to determine the income attributable to taxpayer s PE in India. Admittedly, the taxpayer has a PE in India, however, it was contended by the taxpayer that its PE came into existence after it had completed the offshore supplies of equipment and duly provided the offshore services. This was disputed by the tax department and it was contended that the taxpayer had a pre-existing PE in India. 8 Rotem Company [2005] 279 ITR 165 (AAR)

4 The stage at which the permanent establishment came into existence is a mixed question of fact and law. The AAR has not considered this question in view of its conclusion that the taxpayer and Samsung had constituted an AOP which was a tax resident entity in India for the purposes of the Act. In the event, it is found that the taxpayer had a PE in India at the material time when taxable services were being rendered by it which were attributable to the PE, the same would have to be considered as business profits and taxed accordingly. The High Court held that it would not propose to examine this question for the first time in this proceeding. Accordingly, the High Court set aside the AAR s order and remanded back the matter to the AAR. Onshore supply and services There can be no dispute that the taxpayer would be liable to pay tax on the component of income included in the amounts received by it on account of onshore supply and services, viz,: supervision during the pre-commissioning construction, post commissioning services and supplies, training and other items of work/activities to be performed in India. Our comments The Delhi High Court in this decision held that the consortium between the foreign companies was not forming an AOP. The contract for offshore and onshore supply and services was divisible. Since the supply was made outside India and the contract for the same was not providing business connection in India, offshore supply was not taxable in India. Regarding the issue related to taxability of offshore services, the matter was sent back to the AAR to determine whether the services were interlinked with manufacture and supply of equipment and forming integral part of the same and the time and stage when the taxpayer s PE came into existence. The issue of taxability of offshore supply and services has been a matter of debate before the Courts. On one hand the AAR in the cases of Alstom Transport SA 9, Roxar Maximum Reservoir Performance WLL 10 and Linde A.G. 11, relying on Vodafone International Holding B.V. applied look at approach and held that composite contract for installation and commissioning of project in India cannot be dissected for the purpose of taxability of the contract. The AAR in some cases also held that the consortium formed by the foreign companies constituted AOP. Accordingly, income from offshore supply and services was taxable in India. On the other hand the Delhi High Court in the case of Nokia Networks OY 12 following the decision of Ishikawajma- Harima Heavy Industries Ltd., has held that in case of one composite contract, supply has to be segregated from the installation and only then the question of apportionment arises under the Act. The High Court held that since the property in goods had passed on to the buyer outside India, said agreement would not be taxable in India. 9 Alstom Transport SA [2012] 208 Taxman 223 (AAR) 10 Roxar Maximum Reservoir Performance WLL [2012] 207 Taxman 293 (AAR) 10 Linde A.G. [2012] 207 Taxman 299 (AAR) 12 DIT v. Nokia Networks OY [2012] 25 taxmann.com 225 (Del)

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