Offshore services caught in the Indian tax net : the death of territorial nexus doctrine
A recent ruling by the Mumbai Income Tax Tribunal (the “Tribunal’), in Linklaters LLP v.ITO1, has completely changed the rules of the game for offshore service providers providing services to Indian residents or services with respect to Indian projects. The Tribunal has dealt with a number of significant issues, such as the requirement of territorial nexus for taxation, eligibility of treaty benefits to a fiscally transparent entity, constitution of service PE and attribution of profits. We discuss some of the important aspects of the ruling here and briefly analyse the effect of this ruling.
Linklaters (the “Assessee”), a UK based law firm, had during the relevant fiscal year (1994-95), rendered legal advice and services to clients with respect to projects in India. In order to render such services, the partners and employees of the Assessee visited India for varying periods of time. The revenue sought to tax the Assessee on grounds of having a permanent establishment in India as per Article 5(2)(k) of the India-UK Treaty.
The Tribunal delivered a detailed ruling, analyzing a number of judicial precedents delivered by the judiciary in India and those by foreign courts and commentaries by experts, including the OECD Commentary. The significant issues dealt with by the Tribunal are discussed hereinbelow:
· Territorial Nexus: Starting from the ruling delivered by the Hon’ble Supreme Court in Ishikawajima Harima Heavy Industries Ltd. v. DIT 2 and which was later followed by the Bombay High Court in Clifford Chance v. DCIT 3, offshore services were considered taxable in India only when such services were rendered in India and utilized in India. However, the amendments introduced by the Finance Act, 2010 had, with retroactive effect dating back to 1977, done away with the requirement of rendition of services in India. The Tribunal in this ruling applied the amendment and held that, the rule laid down in Ishikawajma and Clifford Chance were now bad in law and that mere utilization of the services in India was now sufficient to attract taxability in India.
· Application of treaty benefits to a partnership: A significant aspect of the ruling was that the Tribunal has recognized that even an offshore partnership, being fiscally transparent, would be eligible for benefits under the India-UK Treaty as long as either the partnership or the partners are taxed in the country of residence. A twin pronged approach was adopted by the Tribunal to arrive at this result.
Firstly, it held that the partnership itself should qualify as a person since a partnership which is treated as a taxable unit under the Indian Income Tax Act was regarded as a person under the India-UK Treaty. It then went on to discuss the objective of the Treaty and held that a Treaty should not be subjected to a strict interpretation and should be interpreted in good faith. In light of the same, it held that it is the taxability of the entire income of the person in the state of residence rather than the mode of taxability that should govern the entitlement to treaty benefits. Therefore as long as the partnership or the partners are taxable in the residence state, treaty benefits should be extended.
The other approach that it also took was that as long as the residence state has a right to tax the partnership, the condition that the person has to be ‘liable to tax’ for the treaty benefits to apply would be satisfied. To this extent, there is no requirement that tax actually has to be imposed. Further, the Tribunal was also disinclined to rely on the OECD Commentary which provides that when a partnership firm is not taxable in the country of residence in its own right, the treaty entitlement to a partnership firm are to be denied’ in light of India’s reservation with respect to the same.
· Service PE and Independent Personal Services under the India-UK Treaty: The Assessee raised the argument that the Service PE in the India-UK Treaty was inapplicable as the primary condition of a fixed place, was not fulfilled in the present case. However, the Tribunal observed that the Service PE provision was not an illustration of instances whereby a PE could be constituted, but was an extension of the basic rule relating to fixed place. Hence, there was no requirement of a permanence test to be satisfied. Additionally, the Tribunal ruled that the partnership will have a PE in India rather than considering the more specific provision relating to Independent Professional Services in Article 15 of the India-UK Treaty on the grounds that Article 15 only covered individuals.
· Attribution of profits: On the point of attribution of profits, the Tribunal held that the quantum of profits attributable to the PE must be assessed by taking the value of services rendered by the PE at the price at which the Assessee actually billed its’ clients. The flexibility to apply hypothetical values for the purpose of attribution was confined to a PE’s transactions with its head office and branches and does not extend to transactions with third parties.
· Taxation of related profits: The Tribunal held that in addition to income derived from services rendered by the PE in India, any income in respect of the services rendered to an Indian project would also to be taxed in India in the hands of the Assessee, regardless of whether such services are rendered through the PE or directly by the parent entity.
This ruling by the Tribunal would have wide-spread ramifications for foreign service providers as the tax-net has now been extended even to services that are provided outside India and those services which were similar to services rendered by a PE in India. Not only such provisions are unreasonable and tend to do away with settled jurisprudence related to ‘territorial nexus’, it could also have potential double tax implications for the foreign service providers, especially in a situation where a foreign country refuses to grant its resident a credit for taxes paid in India due to conflicting source rules.
Further, the ruling also fails to have considered many aspects relating to treaty interpretation, some of which are discussed below:
· The requirement of territorial nexus to tax: The Tribunal has stated that the requirement of territorial nexus for purposes of determination of tax liability is relevant only for the purposes of territorial tax systems and not otherwise. Further, the Tribunal while stating that the law laid down in Clifford Chance and Ishikawajima Harima is no longer valid in light of the amendments carried out by Finance Act, 2010. Herein, it must be noted that the Supreme Court in Ishikawajima Harima has specifically clarified that territorial nexus for the purpose of determining the tax liability is an internationally accepted principle and further has held that this requirement would only be satisfied where services are actually rendered in India. While the Tribunal would be bound by the amendment to Section 9, carried out by Finance Act, 2010, it is still bound by the Supreme Court judgment in respect of the obiter relating to territorial nexus and it is not prudent on part of the Tribunal to have passed comments at variance with the Supreme Court on the same.
· Applicability of treaty benefits to partnership entities: At the outset, it must be noted that in the year to which the transactions related to, Linklaters was established as a general partnership and not a Limited Liability Partnership. The UK domestic law provisions define a partnership as a relationship which subsists between persons carrying on business with a view to profit and not as a separate person. The same is the situation under the India-UK Treaty as well and partnerships are specifically not entitled to treaty benefits except for Indian partnerships. Since Indian partnership entities are taxed as a separate unit, a specific inclusion has been provided under the India-UK Treaty for Indian partnerships to avail treaty benefits. Hence, it is surprising the that Tribunal did not consider this aspect at all while making a determination that a UK partnership will qualify as a person under the India-UK Treaty.
· Application of PE provisions to Linklaters: As noted above, Linklaters was constituted as a general partnership for the year in question and has later on changed its constitution to a Limited Liability Partnership. While a LLP is regarded as a separate entity, apart from the partners, such is not the case with a general partnership. In such case, the income of the partners, in respect of legal services, should be categorized under Article 15 of the India-UK Treaty as Independent Personal Services rather than as Business Profits. In this regard, it must be noted that Article 15 of the Treaty itself envisages that income of an individual, whether in his own capacity or as a member of the partnership, in respect of professional services should be categorized as Independent Personal Services under the India-UK Treaty. With respect, it is inconceivable as to why the Tribunal failed to consider this aspect at all.
· Attribution of profits to PE in India: The Tribunal has held that the force of attraction principle would apply in light of the language of the India-UK Treaty. However, it goes on to the extent of stating that all profits relating to services rendered by the assessee, whether in India or outside India, in respect of Indian projects is taxable in India. This would in effect mean that even services rendered solely from UK, in relation to Indian projects would be attributed to the PE in India. The force of attraction rules in the India-UK Treaty can only be extended to other activities that are carried on in India and cannot be extended to activities that are carried out in the UK or any other territory. It is surprising as to the wide interpretation that has been extended by the Tribunal in relation to attribution of profits to bring into the tax net all services rendered in relation to an Indian project.
This judgment marks a complete departure from the law laid down by the Supreme Court of India and is not in line with the international law on the subject. Considering that the matter was before the Tax Tribunal, the constitutionality of the amendments made by Finance Act, 2010 could not be challenged and one can expect a constitutional challenge when the matter is appealed before the High Court.
The judgment requires a reconsideration as elaborated upon above and one hopes that the issues which have been missed out in the Tribunal proceedings are considered in appeal by the High Court.