28 April 2014 EY Tax Alert Delhi HC rules on AOP constitution and taxability of offshore supply and services 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 EY advisor. This Tax alert summarizes a recent Delhi High Court (HC) ruling [1] in the case of Linde AG (Taxpayer), wherein the HC was required to rule on (i) whether the consortium formed by the Taxpayer, a German Company and a Korean company (KCo) for the purpose of bidding for a contract floated by an Indian company (ICo) would constitute an Association of Person (AOP) under the provisions of Indian Tax Laws (ITL) and assessable on its global income as a tax resident of India; (ii) whether the income receivable for offshore supply and offshore services under the contract is taxable in India. Based on the facts of the case and having regard to the separate and independent scope of responsibilities of the Taxpayer and K Co, the HC held that the consortium, so formed, cannot be treated as an AOP under the ITL. On taxability of income for offshore supply, the HC, on principle held that, the same is not taxable in India if all the activities in relation to the supply of equipment are carried out overseas. [1] [TS-226-HC-2014(DEL)]
Facts A pictorial representation of the arrangement is given below: not taxable in India as all the activities in relation to the above components were performed outside India and the fee for the contract was also received outside India. However, the Tax Authority did not agree with the Taxpayer s stand and directed ICo to withhold taxes on the amounts paid. Thereafter, the Taxpayer filed an application before the Authority for Advance Rulings (AAR) [2] for determining whether the consortium was taxable in India in the status of AOP and whether fee receivable for offshore supply of equipment and offshore services was liable to tax in India under the ITL and the respective Double Taxation Avoidance Agreement (DTAA). The Taxpayer, a German company, entered into an Memorandum of Understanding (MOU) with KCo to form a consortium, with an objective of submitting a joint bid to secure a turnkey contract for design, engineering, procurement, construction, installation, commissioning and handing over of the plant for the Dual Feed Cracker floated by ICo (Project). Subsequently, the Taxpayer and K Co (collectively members ) also entered into an internal consortium agreement (ICA) to record their understanding. The Project was awarded to the consortium formed by the members pursuant to which a written contract was entered into between ICo and the members (Contract). The work to be performed under the Contract by the members was separately identified and was allocated based on each member s technical expertise. Accordingly, the Taxpayer was responsible for the procurement and offshore supply of equipment, basic and detailed engineering and drawings and onshore services such as pre and post commissioning and training of personnel. Likewise, the scope of responsibility of K Co was clearly defined. The Contract also provided split of consideration for diverse responsibilities of the Taxpayer and K Co separately. The Taxpayer made an application for nil withholding order from the Tax Authority for offshore supply and offshore service component on the basis that the income was Ruling of the AAR In response to application, the AAR ruled as follows: The consortium constituted an AOP under the ITL as: The Contract was awarded in the name of the consortium The liability of the members towards performance of the Contract was joint and several Further, since the Contract with ICo was indivisible, the entire fee receivable under the Contract for both offshore supply of equipment, materials and spares and for offshore supply of drawings and designs was taxable in India in the hands of the consortium as a separate person. Aggrieved, the Taxpayer filed a writ petition with the HC [3]. [2] [TS- 170-AAR-2012 (AAR No. 962 0f 2010)] [3] The SC, in the case of Columbia Sportswear Company (TS- 549-SC-2012), after considering various provisions under the ITL and the constitutional law, held that the AAR is a quasi-judicial authority and is similar to a Tribunal and, accordingly, the ruling of the AAR is appealable not just before the SC, but before the High Court as well.
HC ruling A. On whether consortium constitutes AOP i. Factors constituting an AOP The term AOP has not been defined under the ITL and, hence, has to be given an ordinary meaning. Relying on various decisions, the HC held that following factors are essentially required to be present for the constitution of an AOP: It must be constituted by two or more persons. They must join together for a common purpose and intention. The association must move by a common action and there must be some scheme of common management. The cooperation and association amongst the constituent members must not be perfunctory and/or merely in form. The association amongst members must be real and substantial, which is sufficient to treat the association as a separate homogenous taxable entity. The intention of the legislature was to treat the combinations of persons, who were engaged together in some joint enterprise, but did not, in law, constitute partnerships, as a separate taxable entity [4]. A mere cooperation of one person with another in serving one s business objective would not be sufficient to constitute an AOP. Neither of the members had any role to play with respect to the scope of work which was allocated to the other member. Therefore, as far as the execution of the project was concerned, each party had to work independent of the other. The only area of cooperation between the members was to share the information, data and material necessary to enable the other member to perform its work as per the work schedule provided in the Contract. This kind of cooperation is important and is generally present in the execution of work wherein multiple agencies are involved. The fees paid for each item of work was separately specified in the Contract with ICo. The fee corresponding to the work of the Taxpayer was directly paid by ICo to the Taxpayer. Also separate invoices were raised by the Taxpayer and KCo. Thus, even ICo recognized that different items constituting the contract would be performed independently by the members. There was no arrangement for sharing of profits and losses between the members. Each of them would earn profits or incur losses based on the prices agreed by them and costs incurred by them in performance of the allocated work under the Contract. Further, none of the members was liable for losses and damages incurred by other member on account of nonpayment by ICo. Thus, the risk to be borne by the members was restricted only to the extent of their allocated responsibility and work. ii. Application of the factors to the present facts iii. Certain specific objections of the Tax Authority The following features of the Contract, MOU as well as the ICA indicated that the arrangement between the members was not an AOP: Each member was separately required to perform a specific part of the Contract which was clearly demarcated and separately identified in the Contract entered into with ICO. The allocation of work among the members of the consortium was such that each member performed the work which was within their respective technical expertise. [4] B.N. Elias [(1939) 3 ITR 408 (Cal HC)] Before the HC, the Tax Authority raised following arguments to support that members constituted an AOP in the facts of the case: a) In terms of the Contract, the members were described as contractor and for the purpose of obligations under the Contract, they were considered as forming consortium. b) As per the Contract with ICo, the members were jointly and severally liable for performance of the Contract. c) ICA provided for certain level of cooperation by way of appointing Project Directors and Manager for the execution of the Project, who would
represent the consortium in interaction with I Co. While holding that the members did not form AOP, above contentions of the Tax Authority were considered as below by the HC. (a)term consortium, used to refer to the members, does not indicate existence of an AOP Although the manner in which a third party deals with the members of a consortium is relevant for determining whether the members constitute an AOP, the same cannot be regarded as conclusive. One will have to evaluate the extent of collaboration as agreed between the members. Both the members had agreed to present themselves as a consortium to bid for the contract, however, the ICA clearly provided that except for providing a common face and complying with the terms of the contract with ICo, they would conduct their business independently with no interference from the other. The ICA clearly stipulated that the members did not intend to form an association. Though, a plain reading of the Contract indicated that the consortium members were treated as a single entity for imposing liability for due performance of the Contract, the annexures to the Contract which provided for the split of the contract work between the members indicated that ICo also recognized that each member would perform the items of work allocated to them separately and independently. common enterprise or an association and are moved by joint action for a common purpose. It is similar to a director of a company who provides personal guarantee for the loan taken by the company. Although the director and the company may become jointly and severally liable to the lender, they continue to be independent of each other, and merely the joint liability does not result in constitution of AOP between the director and the company. One must exhibit features of a partnership in relation to the common enterprise, to constitute an AOP. (c) On joint management of the contract As per the ICA, each of the members was responsible for managing and executing the allocated portion of the Project through their own personnel and their independent resources. The cooperation among the members in the form of sharing information and material was merely to enable each other to perform their respective work. It is akin to the level of cooperation as expected from independent agencies executing a project. Neither of the member had any control over the quality of the work done or equipment supplied by the other member. Although the members worked towards a common contract with a certain level of cooperation, they cannot be considered as AOP, as they do not work as a single cohesive entity but perform their independent allocated works. Their activities do not indicate a sufficient degree of joint action. (b) On jointly and severally liable Impact of earlier ruling of the AAR Although the Contract provides that the members would be jointly and severally liable to ICo for the performance of the Contract, it only means that the members accepted a contractual obligation towards a third party, which cannot lead oneself to state that the same is an AOP. Further as per the ICA, members had clearly agreed that their risks and liability was limited only to the extent of their responsibility and allocated work. Any entity may agree to accept a liability for due performance of an obligation of another for its business purposes. However, that, by itself, cannot lead to a conclusion that parties have formed a The HC also observed that the facts in the present case are similar to the AAR decision in the case of Hyundai Rotem and Mitsubishi Co [5] where it was held that an AOP was not constituted. Based on the Supreme Court (SC) decision in the case of Columbia Sportswear, although the AAR ruling is binding only on the applicant and the Tax Authority in respect of a transaction in relation to which the ruling has been [5] [2010] 323 ITR 277 (AAR)
sought, the judicial authority is necessarily required to follow the principle of law already accepted by it. Thus in the situation where the facts are similar to its earlier decision, the same law has to be applied. CBDT instruction on non-constitution of AOP The CBDT instruction [6],which supported the view that the foreign companies, forming a consortium for execution of a turnkey contract relating to power projects, will not be treated as an AOP, though withdrawn, represented the correct understanding of the law. B. On taxability of income receivable by the Taxpayer i. Contract was divisible one The Taxpayer was responsible for procurement and offshore supply of equipment, basic and detailed engineering and drawings and onshore services such as pre and post commissioning and training of personnel to be performed in India. The offshore supply was to be performed entirely overseas. Although the Contract provided for a lump sum consideration, annexure to the Contract separately indicated the breakup of the amounts payable for various activities. Hence, such split can be adopted for taxation of various components. The AAR was incorrect in ruling that the Contract is indivisible and, hence, the Contract as a whole was the subject of taxation. Subject matter of taxation is not the contract between the members, but the income that was derived from the contract. The AAR was not correct in placing reliance on the SC ruling in the case of Vodafone International Holdings B.V [7] to arrive at a conclusion that since the liability for performance of the project by members was joint and several, the contract must be read as an indivisible [6] Instruction No. 1829 dated 21 September 1989 [7] [(2012) 6 SCC 613]. See EY tax alert The Vodafone case: SC rules transfer of shares of a foreign company that indirectly held underlying Indian assets not taxable, dated 20 January 2012 one. The SC observations in case of Vodafone are contextual and are required to be read into the facts of the case. Observations on look at vs. look through approach were rendered in context of dealing with tax avoidance scheme and would be incorrect to generalize the same and to apply to every case, regardless of its context. The present case, being that of a genuine commercial transaction, the SC decision in the case of Vodafone is not applicable. To tax income arising from a contract, it will be necessary to evaluate if any income accrued or deemed to accrue or arise in India. Merely because the obligation of the taxpayer is not limited to supply of equipment, but extended to performance of the other components of the contract, it would not mean that the entire income relating to those components of the contract could be deemed to accrue or arise in India. ii. On offshore supply Based on the below reasoning, the HC held that consideration for offshore supply was not taxable in India: The ownership of the equipment was to be transferred by the Taxpayer to the ICo on Free on Board (FOB) shipment, which clearly indicates that the ownership passes to the ICo, the moment the equipment are placed for shipment overseas. Although the members were fully responsible for damage or loss during the transportation of the equipment due to contractual arrangement, the same does not contradict the fact that the ownership therein was passed to the ICo overseas. As per the provisions of the ITL, where all the operations of business are not carried out in India, only that portion of income that is attributable to business connection in India are taxable in India. Mere sale of goods simplicitor outside India does not give rise to any taxable income in India even though the said goods are to be utilized within India. Reliance was placed on the SC decision in the case of Ishikawajima-Harima Heavy Industries [8] wherein it was held that [8] [(2007) 288 ITR 408 (SC)]
execution of a contract in India cannot result in a business connection. iii. On offshore services The Taxpayer was also responsible for preparing drawings and designs for manufacturing and fabricating equipment to be supplied to the ICo, which was performed outside India. Such offshore services, if rendered on standalone basis, can trigger source taxation in India, in terms of special rules applicable to taxation of fees for technical services (FTS). The HC observed that to fall outside the scope of FTS under the ITL, the link between the supply of equipment and the services must be so strong that the services are not capable of being considered as services on a standalone basis. The contention that the offshore services are inextricably linked to offshore supply of equipment was not considered by the Tax Authority. However, in the facts of this case, a separate fee was specified for the supply of equipment. In case the Tax Authority conclude that the services are not an integral/inextricable part of equipment, then it would be treated as FTS under the ITL, in which case it would be relevant to examine if any relief is available to the Taxpayer under the DTAA. Accordingly, matter was remanded back for a close scrutiny of facts by the Tax Authority. Comments The decision provides useful guidance about factors which are relevant for determining AOP under the ITL. Whether or not a particular arrangement triggers AOP assumes significance particularly for foreign companies which participate in execution of projects in India. Under the ITL, an AOP is assessable at an entity level and presence of any part of control and management of AOP in India makes such AOP a tax resident person liable to global taxation. Also, such AOP or its members may find it challenging to access treaty benefits, as, such AOP may not be a treaty resident of other jurisdiction while there is no tax trigger in the hands of the members in India. Certain other tax consequences including deductibility of cost incurred in favor of the members may arise even when such AOP is comprised only of Indian residents. As a consequence, generally, the parties to the consortium arrangement would desire to mitigate the emergence of AOP. The decision is significant as it supports/reiterates a well-accepted proposition that AOP emergence is based on common enterprise, purpose and intention of the parties and reflects an understanding which exhibits features of a partnership. Also, presence of certain cooperation covenants or joint and several liability to the customer are not sufficient to trigger AOP emergence unless the arrangement results in execution of the project as a single cohesive entity. The HC also advocated the principle of consistency in the rulings by the judicial authority, including AAR. It also upheld that in absence of any operations in India, offshore supply would not trigger tax in the hands of the foreign supplier.
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