In a recent ruling in ITA no 4896/Mumbai /03, Hon’ble Income Tax Appellate Tribunal ( ITAT Mumbai / The ITAT ) has delivered a land mark decision, in the case of Linklaters LLP Vs Income Tax Officer – International Taxation. In the ruling The ITAT Mumbai has analyzed in great detail various issues involved in the facet of International Taxation. Apart from the issues which arose before the Mumbai ITAT in cross appeals filed by the assessee and the revenue, Mumbai ITAT took cognizance of the powers of ITAT on the issue of admission of a new issue at this stage of appeal which has not been taken up by the lower authorities during proceedings before them. Through this article an attempt has been made to summaries the observation of the Mumbai ITAT and its impact on the taxation in India on fee for professional Services rendered in India through a PE in or from outside India.
Back Ground
· The assessee is a United Kingdom (U K) based partnership law firm headquartered in London, a fiscally transparent entity (An entity which is not taxable in its own hand) in UK not having any branch, office or any other form of presence in India.
· The assessee firm rendered professional services (Services) to clients in India both within India as at times it’s personnel visited India for provision of services as well from outside India.
· The assessee filed its return of income in India for AY 1995-96 disclosing NIL income claiming that since assessee does not have a Permanent Establishment [PE] in India within the meaning of Article 5(1) of Double taxation Avoidance Agreement between India and UK [The Treaty], thus not liable to tax in India for income earned from such Services either under The Income Tax Act 1961 (the Act) or under Article 7 of or Article 15 of The Treaty.
· Without prejudice to this assessee filed an income computation statement of the PE taking a notional per hour rate which a lawyer in India is likely to earn from rendering of similar services. Further for this quantification the assessee considered the charges for services rendered in India Only.
· The Assessing officer ruled that permanent establishment of assessee exits in India within the meaning of Article 5(2)(k) of The Treaty, thus the income of the PE is taxable in India as per article 7 of the said Treaty under domestic laws as “Business profits”
· He did not accept the notional quantification of the profits of the PE by assessee and quantified the profits on actual charge basis including services provided by PE from outside India as well.
· On Appeal, the Learned CIT(A) allowed the appeal against the assessee on the issue of PE creation and quantification of Income of the PE. However the CIT(A) ruled in favour of the assessee on the issue of attribution of profits to PE and concluded that only services rendered by the PE in India are taxable in India.
As a result of the order of CIT(A), cross appeals came up before the Mumbai ITAT raising the following issues for consideration by the Hon,ble ITAT
1 Whether the total income of the appellant be determined at Rs. Nil as returned.
2. Whether the appellant had a permanent establishment in India under Article 5(2)(k) of the Tax Treaty between India and the U.K.
3. Whether the income of PE computed by the appellant at the notional rate per hours charged at appropriate rates for an Indian lawyer be accepted.
4 Whether the assessee was taxable in respect of only that portion of income that was related to services performed in India.
5 Whether the “force of attraction” principle in Article 7 of the Indo UK DTAA.” has been correctly appreciated.
Apart from the above issues raised by the aggrieved parties, another issue came up before the Mumbai ITAT during the course of proceedings -
6 Whether the assessee being a fiscal transparent entity in U K. is eligible for benefits under The Treaty
7 Whether ITAT, at the proceeding before it, has powers to examine an issue which has not been examined by the lower authorities.
The Mumbai ITAT considered the rival submissions carefully and analyzed the issues before it in the light of prevailing provisions of The Income Tax Act 1961, various judicial pronouncements on the subject available domestically and globally, expert opinions, commentary on model tax convention and delivered the decision on various issues as following -
Taxability under the domestic law
Assessee’s case
· Following the ratio decidndi by Mumbai High Court in the case of Clifford Chance (318 ITR 237), income of the assessee provided from outside India can not be taxed in India.
· Since the provisions of The Treaty are more beneficial they have the overriding effect over the provisions of The Indian Income Tax Act, 1961, hence income from service provided in India also can not be taxed in the absence of a PE.
Revenue’s Case
· The assessee has a business connection in India with in the meaning of section 9 of The Act as it has a PE in India within the meaning of Article 5(2)(K) of The Treaty. Thus the income of the assessee is taxable in India as business profits under Article 7 of the treaty.
· The assessee being a fiscal transparent entity, is not eligible for the benefit under The Treaty, it’s Income is taxable in India under Article 15 of The Treaty.
Mumbai ITAT ruling
· The ruling of Hon,ble Mumbai High Court in the case of Clifford Chance and the decision of Apex Court in the case of Ishikawajima Harima Heavy Industries [2007] 288 ITR 408 relate to a period before the amendment in Section 9(1)(vii) of The Income Tax Act 1961 by Finance Act 2010.
· The legal premise of the above rulings
o That Income from services sought to be taxed in India must be provided and utilized in India and
o “Territorial nexus of taxation”
· are no longer good law after the amendment in the Act. Now there is no need for such services to be rendered in India for taxability in India. The amendment in Section 9 (1)(vii) has rendered both the above rulings redundant.
· The territorial tax system is prevalent in very few countries, that too with riders, hence can not be termed as an internationally accepted systems. The source and residence rule of income is followed worldwide.
· To avoid double taxation of income in more then one tax jurisdiction, the mechanism of DTAA is in place and provision of such treaties have overriding effect on domestic laws to the extant these are more beneficial to the assessee.
The ruling of the ITAT has thrown light and cleared dust around litigative matter of taxation of income of professional services in India. Though this ruling has unsettled position emerged on the issue after the rulings of Mumbai High Court in the case of Clifford Chance and the decision of Apex Court in the case of Ishikawajima Harima Heavy Industries [2007] 288 ITR 408, however this ruling has put rest to the controversy on the issue post amendment in the Act. This ruling once again remind us how venerable are the matter settled by even Apex Court of the land as they can be unsettled by a legislative amendment making mockery of the judicial system.
Existence of assessee’s permanent establishment in India under Article 5(2)(k)
Assessee’s Case
· Article 5(1) of the treaty contains the general condition for creation of a PE and Article 5(2) of The Treaty contains list of examples prima facie constituting a PE. The general conditions of Article 5(1) are to be necessarily satisfied before such examples are considered to be a PE.
· There was no continuity of activities in India and the personnel of the firm visited India only as and when required basis.
· The activities of the assessee were sporadic or isolated and with no infrastructure, no continuity or stability so as to result in a PE.
· The assessee do not involve furnishing of services as envisaged in Article 5(2)(k) of The Treaty but is rendering services directly to its clients.
Revenue’s case
· If permanent establishment under Article 5(2)(k) comes into existence only when provisions of Article 5(1) are to be satisfied, “the provisions contained in Article 5(2)(k) would be rendered redundant. The specific provisions prevail over the General provisions.
· ‘Rendering of services’ is not distinct from ‘furnishing of services’. The expression ‘rendering’ and ‘furnishing’ are synonymous. In the context of PE creation, this question of ‘rendering’ or ‘furnishing’ of services is not relevant.
Mumbai ITAT Ruling -
· The Article 5(1) of The treaty consist of ‘basis rule PE’, however there are three criteria embodied in the definition, one physical location criteria, two right to use that location criteria and carrying out the business from that location criteria.
· Article 5(2) consist of two categories of PE, first Illustrations what constitute PE [ Clause (a) to (i)], second what is extension of basic rule i.e. deemed PE { Clause (j) and (k)}. These two categories are contained in all the major Model Tax Conventions be it UN, OECD or US model.
· The express provisions of OECD Model Tax Convention, that a building or site etc. constitute a PE only if that last for certain period of time, and UN Model commentary, that scope of the of the provisions of Article 5(3)(b) extend beyond the basic rule, imply that the provisions of these clauses are deeming in nature.
· The interpretation of Article 5(1) and 5(2) as given by the assessee is contrary to well established principle of statutory interpretation that an inclusive definition is intended to add to the primary meaning, so as to bring within its scope items which may or may not fall within the scope of primary definition.
· There is no legally sustainable merits in plea that professional services can only be ‘rendered’ and not ‘furnished’, and the connotations of furnishing of services cannot be extended to rendering of services. That connotation of ‘rendering’ also extend to “to give or make available;
· The expression ‘rendering’ and ‘furnishing’ are somewhat interchangeable in normal course of business, and it will be too pedantic and hyper technical an approach to narrow down the meaning of the expression ‘furnishing’ to exclude rendering of professional services.
· A treaty, is to be interpreted in good faith on the basis of general expectations of the parties and in accordance with the ordinary meaning given to the treaty in the context and in the light of its objects and purpose.
Quantification of Taxable Income on the basis of prevailing market prices of
similar services, in view of independence fiction of Article 7 (2)
Asseesse’s case
· Under article 7(2) of The Treaty, the profit attributable to PE are not the actual profit but the hypothetical profits which the PE is expected to make under the similar condition, if PE was wholly independent of its’ General Enterprise (GE).
Revenue’s Case
· For computation of PE profits, there is no justification for disregarding the actual incomes attributable to PE and adopting hypothetical amounts. The place of accrual of income is not the place where these services are rendered but where the services are utilized.
· It is only elementary that what to be charged to tax is real income and not the notional income which the assessee could have earned under an imaginary state of affairs.
Mumbai ITAT Ruling
· PE is nothing but a part of the General Enterprise itself. Fiction of hypothetical independence in Article 7(2) is confined to a PE’s transactions with its GE. The fictional independence under Article 7(2) does not travel beyond the transactions with entities other than the GE, and the other PEs belonging to the same GE.
· The principle set out in Article 7(2), helps ascertainment of taxable profits in each of the tax jurisdiction involving more than one tax jurisdictions transaction and the transaction values in case of such intra organization transactions are taken at an arms length price.
· The plea that arms length price adjustment can be made in respect of the transactions with the clients of the assessee is not acceptable. The revenues earned by the assessee are to be taken at actual figures with no adjustments.
A detailed analysis of the treaty provision, on the issues of PE creation and fiction of hypothetical independence in Article 7(2), and application in the context has been brought out by this ruling and is land mark in interpretation of the treaty provisions clearly setting a path for the assessee’s and the tax authorities to follow in the future.
Assessee’s entitlement to the benefits of India UK tax treaty
Assessee’s case
· The expression “liable to tax” must include the person who is under an obligation to file the income tax return, in whose hands the income is determined and from whom taxes are recovered.
· The Partnership firms, including a foreign partnership are treated a taxable Under Income Tax Act, thus making it “liable to tax” in India, thus a partnership firm is entitled to the treaty benefits.
Revenue’s Case -
· The Treaty benefits apply only to a person who is resident of both or one of the contracting states as per article 1(1).
· The definition of term ‘resident of a contracting state’ as per Article 4 (1) of the treaty means any person who, under the law of that state, is liable to taxation therein by reason of his domicile, residence, place of management, or any other criterion of similar nature.
· The assessee firm was a fiscally transparent entity not liable to tax in UK in its own right, it does not confirm the conditions laid down in article 4 (1), hence is not entitled to treaty benefit in India.
Mumbai ITAT Ruling -
· A partnership firm is a person under article 3(2) of The Treaty as it is treated taxable under The Income Tax Act 1961.
· The expression ‘liable to tax by reasons of his domicile, residence, place of management or any other criterion of similar nature’ refers to a situation in which a person is liable to tax in a tax jurisdiction by the virtue of a locality related attachment which leads to residence type taxation.
· Whether the partnership is liable to tax, depends how the amount of tax payable on the partnership income is determined, whether in relation to the personal characteristics of the partners or not. If yes, then the partnership itself would not be considered liable to tax. If the income is computed at the level of partnership, before being allocated to the partners, but the tax is technically paid by the partnership or that it is assessed on partnership will not change that result”.
· “Taxability of entire income” in the residence state, rather than the “mode of taxability there”, should govern the Treaty benefit entitlement. When a partnership firm is taxable in respect of its profits not in its own right but in the hands of the partners, as long as entire income of the partnership firm is taxed in the residence country, it is entitled for treaty benefits.
While ruling so the ITAT has analyzed and confirmed the judgment of ADIT Vs Green Emirates Shipping & Travels (100 ITD 203), which deals with the issue of entitlement of India UAE tax treaty benefits to UAE resident who are not actually liable to pay any personal income tax in UAE. ITAT observed that the actual payment of tax in one state is not a condition precedent to avail the benefits of DTAA in the other Contracting State. The tax treaty prevents not only 'current' taxation but also ‘potential' double taxation. The right to tax residents vests only with principal State under a tax treaty, that right, whether that right exercised or not, continues to remain exclusive right of that state.
This ruling of ITAT on this issue has far reaching implication on this contentious issue of treaty benefit to a fiscally transparent entities no direct Indian judicial pronouncement was available.
Application of force of attraction principle in computation of profits attributable to the PE.
The ITAT approved ruling by the Hon’ble Authority for Advance Ruling in the case of Steffen, Robertson & Kirsten Consulting Engineers & Scientists, In Re (230 ITR 206), where the AAR ruled that the statutory test for determining the place of accrual of income is not the place where these services are rendered but where those services are utilized”. Whether the accrual of income is in respect of fees for technical services or in respect of professional fees, that does not alter the nature of deeming fiction under Section 9(1) of the Income Tax Act. This position is further fortified by the retrospective amendment to Section 9(1) by insertion of new Explanation thereto.
ITAT Disapproved the decision ITAT Mumbai in case of Clifford Chance and Mumbai High Court Decision in Clifford Chance case with which the ITAT Mumbai decision is merged and held that in the wake of retrospective amendment in section 9(1)(vii), these decision hold no good law.
The Article 7 of The Treaty provides PE, profits of the enterprise may be taxed in the other State but only so much of them as is “directly or indirectly attributable to that permanent establishment”. The inclusion of ‘profits indirectly attributable to the PE’ clearly incorporates a force of attraction principle in the treaty. ITAT further observed tat the basic philosophy underlying the force of attraction rule is that when an enterprise sets up a permanent establishment in another country, it brings itself within the fiscal jurisdiction of that another country to such a degree that such another country can properly tax all profits that the enterprise derives from that country ‐ whether the transactions are routed and performed through the PE or not.
The ITAT observed that the twin conditions to be satisfied for taxability of related profits are (i) the services should be similar or relatable to the services rendered by the PE in India; and (ii) the services should be ‘directly or indirectly attributable to the Indian PE’ i.e. rendered to a project or client in India. In effect thus, entire profits relating to services rendered by the assessee, whether rendered in India or outside India, in respect of Indian projects is taxable in India.
The ruling of the ITAT on the subject of the “force of attraction of rule” is one of the first in the judicial history of Tax treaty. This will set example for assessee and the authorities below for deciding the issues on merit.
On the powers of the ITAT to consider / admit a new issue
Following the Special Bench Of the Tribunal in the case of Tata Telecommunication ltd Vs DCIT (121 ITD SB 384) where dealing with the similar issue the Special Bench has observed as following -
“There is no escape from it’s duty to ensure that the requirement of the section are fully complied and the tribunal can not shun away from its duty to examine all the eligible conditions merely on the ground that some of these conditions are not specifically rejected by the authorities below”.
Taking a cue from the Rule 11 of the Appellate Tribunal Rules 1963, The ITAT observed that there are no restrictions on the Tribunal as to on what grounds the Tribunal decides the appeal. The only rider is, in terms of proviso to Rule 11, that “ the Tribunal shall not rest its decision on any other ground unless the party who may be affected there by has had a sufficient opportunity of being heard on that ground”.
Tribunal further observed that the expressions ‘subject matter of appeal’ and ‘grounds of appeal’ cannot be used interchangeably as they have distinct connotations. While the Tribunal cannot enlarge the scope of ‘subject matter of appeal’ but, within the subject matter of appeal, the Tribunal can examine any aspect of the matter – whether the same has been examined by the authorities below or not.
The decision of ITAT confirms to the earlier judicial pronouncement by authorities and will the appellant in seeking relief from the various issues which has not be adjudicated by the lower authorities.
On Treaty Interpretations
Tribunal held that the fundamental purpose of tax treaties is to ensure that cross border transactions are not taxed twice, ITAT further observed that certain rules should be followed for interpretation of a treaty provisions. Such an observation from the ruling of the ITAT will help in the treaty interpretation and making decision in numerous cases pending before appellate authorities on issue of treaty benefits. Following are principal as suggested by ITAT for treaty interpretation -
ü A tax treaty is an agreement between two countries dealing with taxes, the principles adopted in the interpretation of statutory legislation are not applicable in interpretation of treaties.
ü A tax treaty is to be interpreted in good faith in accordance with the ordinary meaning given to the treaty in the context and in the light of its objects and purpose.
ü A tax treaty is required to be interpreted as a whole, i.e. the provisions of the treaty are required to be construed in harmony with each other.
ü The words employed in the tax treaties not being those of a regular Parliamentary draughtsman, the words need not examined in precise grammatical sense or in literal sense.
ü Departure from plain meaning of the language is permissible whenever context so requires, to avoid the absurdities and to interpret the treaty in such a manner as to make it workable rather than redundant.
ü A literal or legalistic meaning must be avoided when the basic object of the treaty might be defeated or frustrated. Words are to be understood with reference to the subject matter.
ü The words employed in the treaty are to be given a general meaning general to lawyers and general to layman alike.
ü The meaning of the undefined terms in a tax treaty should be determined by reference to all of the relevant information and all on the relevant context. There cannot be any residual presumption in favour of a domestic law meaning of a treaty term.
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