- Income from sale of digital capacity treated as business income
- However, Tribunal warns that the characterization is case specific and would depend on whether the transferee exercises the rights of an owner or a licensee
- In this case, the transferee was considered to be an owner as it had the right to lease or on sell the digital capacity, and ability to participate in management decisions
- Limited clarity provided on situs of digital capacity
In a judgment that is particularly relevant for the telecom and broadcasting industries, the Mumbai ITAT has recently held that the sale of digital capacity should be characterized as “sale” (and result in business income) and not the “right to use” (which would result in royalty income).
The taxpayer in this case was Flag Limited (“Flag”), a Bermuda based company which forms part of the Flag Telecom Group. Flag built a submarine fibre optic cable extending from UK to Japan, which could provide capacity to regions along the way, such as the Middle East, South Asia and South East Asia. While a substantial part of the cable was laid undersea, the cable would come onshore in certain countries, where it would connect with the domestic telecommunication system. For this purpose, Flag entered into an agreement with thirteen “landing” companies (mostly national telecommunication companies).
In India, Videsh Sanchar Nigam Limited (“VSNL”) was appointed the landing party. Following are some key features of the commercial agreement between VSNL and Flag:
- Under a cable sales agreement (CSA), Flag sold digital capacity was sold to VSNL for USD 28.9 million for 25 years which was the life of the cable.
- After the 25 year period, the cable system would be sold and the proceeds would be shared amongst the signatories, in proportion to their ownership rights.
- VSNL would share the recurring cost of installation of submarine cable system and segments, and in consideration be provided an indefeasible right to use (IRU) to the extent of 1/3rd of such cost.
- VSNL was allowed to transfer/ assign or on sell the capacity at any point in time, to the exclusion of Flag
- VSNL was allowed to participate in the management decisions in India relating to the management of the global cable and Flag along with all the landing partners who were treated as “co-owners” of the cable.
- As the developer of the technical design of the cable system, Flag agreed to provide maintenance services for twenty five years (for which a separate consideration would be paid) as well as standby maintenance (for which it would be reimbursed on a cost basis, for maintenance of resources).
- The life of the maintenance agreement was stipulated at 25 years, which was the life of the cable.
The agreement between VSNL and Flag was executed outside India, and the payment for sale of capacity was also made outside India.
Key issues examined by the ITAT
Since Flag was situated in Bermuda, with which India does not have a tax treaty, all issues examined by the ITAT were in the context of the Indian Income Tax Act, 1961 (“ITA”). Further, while there were several issues examined in the ruling, we have focused on the key issues relating to digital capacity, which were as follows:
A. Whether digital capacity is capable of being “sold” if the fibre optic cable is not?
The revenue argued that digital capacity was not capable of being “sold” as an asset separate from the cable within which it is contained, since the sole function of setting up the cable is to transmit digital capacity, which makes the digital capacity an “inherent feature” of the cable. The taxpayer argued that the cable is merely in the nature of a sheath within which the good is contained, which is supported by the agreements entered into by the parties. The Tribunal agreed with the taxpayer, particularly on account of the agreements entered into between the taxpayer and VSNL, which demonstrated that the primary intent of the arrangement was sale of digital capacity (and not the cable).
B. How to decide whether digital capacity was sold or licensed?
The revenue argued that since the arrangement entered into between the parties allowed VSNL to use the digital capacity, with the cable continuing to remain in the ownership of Flag, it was essentially a long term license of digital capacity to the relevant parties. The revenue relied on several arguments, including the point that, if the buyer of digital capacity terminated the CSA, the capacity would lapse back to the cable rather than remain with the buyer (to be sold to someone else, as a tangible asset would be).
The taxpayer argued and provided detailed documentation in support of the position that the sale of digital capacity accorded VSNL the rights of an owner rather than a licensee. The Tribunal agreed with the taxpayer and relied on the following factors to hold that the capacity was sold and not licensed:
- The purchaser VSNL was allowed to sell/ lease the capacity to another party, to the exclusion of Flag
- The agreements between Flag and VSNL prescribed detailed provisions allowing VSNL to participate in the management and decision making process in relation to the digital capacity. It was observed that this is typically a right of ownership and not provided to holders of a license.
- As per their accounts, Flag had accounted for the digital capacity as a “good” and the cost of the cable as a “cost of producing the good”. VSNL on the other hand had recorded its expense as expense towards purchase of a capital asset.
- The proceeds on future dispositions of the cable system were to be shared equally amongst the signatories in proportion to their ownership rights, thus indicating that the cable was merely a means of purchasing digital capacity.
On this basis, the Tribunal held that Flag had sold the digital capacity as a stock in trade (and not licensed it) and should be considered to have derived “business income” and not “royalty” from the arrangement.
The Tribunal also went on to make several important observations on the characterization of the capacity sale/ leasing services, which would be relevant in the context of digital capacity, transponder services etc. These are particularly important considering the thin line between the tax treatment of provision of capacity (as a service) versus transfer of capacity (as a sale). Some key observations are as follows:
- Determination of “sale” is a question of fact: Whether or not the transfer is treated as a sale, is always a question of fact that can be only ascertained from the intention of the parties as evidenced by the written agreements in the light of the attending facts and circumstances.
- “Right to use” capacity is characterized by terms and conditions on use: Under such an agreement a transferee generally acquires right to send certain amount of data or information over fibre optic network for a certain period of time under certain terms and conditions. Such an agreement does not hand over the ownership control.
- Sale is characterized by burdens of ownership transferring to the buyer: The key factor in determination of, whether the sale has taken place is to see, whether the benefit and burdens of ownership with all the rights and obligations and risks have been shifted from seller to the buyer or not.
- Three requirements for a “sale”: For the determination as to whether the telecom capacity agreement is for the provision of 'right to use' or 'sale' of a capacity in the cable network, it is required to examine, if the property owner (here cable network owners) has firstly, retained the ownership control and possession of the property; secondly, has retained the risk of loss of the property; and lastly, reserved the right to remove the property from the premise of a purchaser. If the owner of the property has transferred the ownership and control over the property to a purchaser, then such a contractual agreement will be characterize as "sale" and not a contract for 'right to use' the capacity or service contract.
C. Where does the situs/ source of income of digital capacity lie?
As discussed above, the Tribunal held that Flag had earned business income out of the sale of capacity. The Tribunal was required to consider the difficult issue of where the income from such capacity sale should be said to accrue. While the case focuses on “source” in the context of business income, similar issues may apply if the recipient earns capital gains from the sale, and the asset is intangible.
The following possibilities were examined by the Tribunal for allocating source:
- The revenue argued that the landing cable and landing points are situated in India, and that Flag should thus be considered to have a nexus with India and a source of income in India. It therefore examined the revenues of Flag at the India level and the ratio of profits to revenues at the global level, to come to a conclusion on the profits attributable to Indian activities.
The taxpayer argued that most of the segments in the cable system are not connected to or related to India, except for segment S-6 (which runs between Fujairah UAE and Mumbai) and segment S-7 (which runs between Mumbai and Penang Malaysia). Therefore it was argued that it would be inappropriate to tax the entire income merely because a small portion of the cable runs through India.
Without prejudice, it was argued that it would be inappropriate to attribute profits on the basis of the global profit ratio, but that the length of the Indian cable should be examined, in proportion to the global cable, as it is likely that the higher value services of the enterprise would be carried on outside India.
- The Tribunal dismissed the taxpayer’s approach, observing that the asset involved cannot be construed as being a portion of the fibre optic cable alone but the capacity in the cable. It held that it would be inappropriate to examine length of cable given, as the digital capacity is separate from the cable itself. However, it also did not agree with the revenue authorities on a proportion of profits being attributable to India. The ITAT held that there were no activities carried on by the Taxpayer in India to which income could be attributable. The Tribunal supported it’s approach by relying on the fact that VSNL is an independent party to which Flag is selling capacity and not the representative of Flag, and that VSNL is required to own the landing station and related equipment under Indian telecom regulations.
The Tribunal has unfortunately not examined the situs of digital capacity in detail, and the issue is likely to continue being relevant for companies with substantial business activities or a satellite footprint in India.
The revenue placed strong reliance on previous cases in the context of such companies (Dishnet Wireless Ltd., Verizon Communication and Viacom "18" Media Pvt. Ltd.) all of which have ruled on the subject of capacity leasing/ transfer in the past. The Tribunal has differentiated these rulings on the basis that the assesses involved were providing telecommunication services in India and that the judgments were rendered in relaton to the use of equipment. Therefore, it is possible that revenue authorities will continue to rely on rulings such as the Madras High Court ruling in Viacom 18, which characterized payment for bandwidth services as royalty. This ruling however does provide some positive observations on the difference between ownership and right to use, which should be helpful for taxpayers in the future.
What is also unclear, is whether the Tribunal would have ruled differently if the term of the agreement was not for the full duration of the 25 years (constituting the life of the cable). If VSNL had acquired all the traits of ownership for a portion of the cable’s life, would that have made a difference to the characterization. Having said this, this is a positive and well-reasoned judgment overall, which explains the nuances of telecom and broadcasting taxation.