Tax Hotline August 12, 2010

Branch of US educational institute required to apply 75% income in India

Bombay High Court (“High Court”) has held that requiring a branch office to apply certain percentage of its income in India, is a valid condition for income tax exemption.

Background of parties

In 1993, American Hotel and Lodging Educational Institute (“AHLEI”), a Florida1 non-profit corporation, signed a memorandum of understanding (“MoU”) with National Council for Hotel Management and Catering Technology (“NCHMCT”). Under the MoU, AHLEI agreed to provide certain courses and expertise in order to improve the quality of hospitality education and training in India. Accordingly, AHLEI provides hospitality education programs and an accreditation system to permit NCHMCT to recognize other hospitality schools.

Judicial precedent in this matter

Authority of Advance Ruling (“AAR”)2 ruled under an application that AHLEI fulfills eligibility criteria for a grant of exemption under S. 10 (22) Income Tax Act, 1961 (“ITA”) as replaced by S. 10 (23C)(vi)3. This subsection of ITA provides that a university or educational institution existing solely for educational purposes and not for purposes of profit and which is duly approved may apply for its income to be exempted from tax. Central Board of Direct Taxes (“CBDT”) however rejected AHLEI’s application for exemption under ITA of its income for years 1999-2002. The application was rejected on the grounds that AHLEI is not an educational institute established in India and that it has a surplus of funds on its balance sheets4.

The Supreme Court of India, in appeal, ruled that AHLEI fulfills the eligibility criteria of an educational institute under ITA and directed the CBDT to not refuse AHLEI’s application. Amongst other reasons for ruling in favor of AHLEI, the Supreme Court held that the location of university is not relevant and the test is whether education is imparted in India. It further held that if after meeting the expenditure, a surplus remains incidentally from the activity carried on by the educational institution, the institution will not cease to be one which exists solely for educational purposes.

Demand of tax

In February 2009, Income Tax Department (“Revenue”) made a tax demand against AHLEI for Rs.104.8 million for assessment years 2001-2007. AHLEI challenged this tax demand at relevant forum stating that its application for tax exemption made to the CBDT is still pending. In November 2009 CBDT approved AHLEI’s application for assessment years 1999-2002 with the condition that "the assesse (AHLEI) will apply 75 per cent of its accounting income for educational purposes in India".

Arguments at High Court

Counsel for AHLEI held that stipulation for spending 75% of accounting income for years 1999-2002 were impossible of compliance since the accounting years in question had already passed. Further, it was contended that the said stipulations are against Supreme Court directions which require CBDT to provide sufficient notice to AHLEI for compliance.

Revenue contended that appeals against assessment for relevant years are pending before Commissioner of Income Tax/ Tribunal.

High Court’s view

High Court quoted the Supreme Court’s earlier judgment in AHLEI’s matter: “prescribed authority can grant approval subject to such terms and conditions as it deems fit provided they are not in conflict with the provisions of the 1961 Act (including the above mentioned monitoring conditions). While imposing stipulations subject to which approval is granted, the prescribed authority may insist on certain percentage of accounting income to be utilized / applied for imparting education in India”.

High Court further held the purpose of giving exemption of income under S 10 (23c) (vi) is for providing education in India. CBDT, which is the ‘prescribed authority’ for granting exemption under this section, has the power to ensure the meeting of purpose for which exemption is granted. The imposition that certain percentage of accounting income be applied in India is therefore valid under law.

It further directed CBDT to allow AHLEI a reasonable period and opportunity to comply with the conditions of income exemption and for recovery of any tax claim.

Our analysis

High Court’s judgment would have a critical impact on several foreign non-profits operating as a branch in India. The CBDT exercises wide latitude in its discretion for allowing exemption of income for branches of foreign entities. While applications are considered on a case to case basis, CBDT may prescribe varying income application condition.

Branches of foreign entities exempt from income tax under provisions of ITA are also subject to the application and accumulation of income as applicable to domestic entities and listed under S. 115 of ITA.

This judgment may also have a significant impact on foreign universities proposing to set up their India presence under the ensuing Foreign Educational Institutions Regulation of Entry and Operations, (Maintenance of Quality and Prevention of Commercialization) Bill 2010 (“Bill”)6. The Bill in its current form provides for setting up of India operations of foreign universities. If this judgment is strictly interpreted, it may discourage foreign universities from applying for income tax exemption. In turn, it may overall discourage foreign universities from entering India under the ensuing Bill.

Status of a branch office in India is qua the status of its head office. Branch office’s exposure to liability (whether legal liability or tax demand) in India directly exposes the head office to same liability. Similarly, a condition for tax exemption or requirement to apply certain percentage of income in India may become applicable to head office by the virtue of branch office not having a separate legal existence of its own.

A possible solution to avoid foreign non-profit corporation’s exposure is to set up a subsidiary in form of Section 25 Company (“S 25 Co.”), organized under the Companies Act, 1956. S 25 Co. is like any other corporate entity, with two critical exceptions: a) It can only be organized for promoting commerce, art, science, religion, charity or any other useful object; and b) it cannot distribute dividends to its shareholder.

The current ruling may subsequently not have an impact in case of S 25 Co. model, and would be governed by the specific provisions of the ITA.

Kabeer ShrivastavaParul Jain & Vivek Kathpalia




2 Non-resident or certain categories of resident can obtain binding rulings from the AAR on question of law or fact arising out of any transaction/proposed transactions which are relevant for the determination of tax liability.

3 “[(vi) any university or educational institution existing solely for educational purposes and not for purposes of profit, other than those mentioned in sub-clause (iiiab) or sub-clause (iiiad) and which may be approved by the prescribed authority94; or]

4 ITA provides that tax-exempt entities have to apply their income for the purposes for which they are organized and have received tax exemption. Accumulations of funds are allowed only for specific purposes and for limited period of time.

5 Section 11 provides how an entity whose income is tax exempt would have to apply at least 85% of its income on its objects. S 11 further prescribes conditions regarding accumulation and future application of the income and investment of funds similar to those applicable to charitable trusts.

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