Revenue may attribute higher income to non-resident's India connection- Withdraws important circular 23 of 1969
Adding further uncertainty to India’s tax environment, the Indian Central Board of Direct Taxes (“CBDT”) has recently withdrawn Circular 23 of 1969 (“Circular 23”) which laid down limitations on the taxability of non-resident business income in India. The withdrawal of the Circular could be particularly relevant for non-residents who require the presence of agents in India if the respective non-resident is situated in a jurisdiction which has not entered into tax treaty with India.
Taxation of non-residents in India
Taxation in India is governed by the provisions of the Indian Income Tax Act, 1961 (the “ITA”). Under section 5, Indian residents are taxable on their worldwide income whereas non-residents are taxable on income that accrues or arises, is deemed to accrue or arise in India or which is received in India. Section 9 of the ITA deems certain non-resident income to accrue or arise in India. As per section 9(1) of the ITA, the business income of a non-resident is deemed to arise in India if attributable to a business connection of the non-resident in India. Business connection is a broad concept, similar to the concept of “Effectively Connected Income” in the United States. The Supreme Court of India (“SC”) has defined it as meaning a “real and intimate connection between a trading activity carried on outside India and a trading activity carried on within India”, which contributes to the earning of income by the non-resident.1 Thus, this concept is wider in ambit and not as specific as the “permanent establishment” (“PE”) concept contained in Article 5 of Indian tax treaties, which require the satisfaction of defined criteria such as a fixed place of business, period of presence etc. As a consequence, theoretically there could be a situation where a non-resident has a business connection in India but does not have a PE under the relevant tax treaty. In this context it is pertinent to note that section 90(2) of the ITA allows the taxpayer to take refuge under the domestic laws or Indian tax treaties, whichever is more beneficial.
Circular 23, which was binding on tax authorities, contained rules with respect to the tax liability of non-residents entering into various kinds of business arrangements for eg. non-resident company selling goods to its Indian subsidiary, non-resident purchasing goods in India, non-resident selling plant and machinery to an Indian importer on installment basis etc. In the context of agents of a non-resident, Circular 23 mitigated the impact of the broad definition of business connection specifying the extent of income attributable to such a business connection. As per Circular 23, if the commission received by the Indian agent was fully representative of the value of profit attributable to his service, no further income was assessable in the hands of the non-resident. This rule was similar to the position laid down by Indian courts in a treaty context (see below), as per which payment of arm’s length remuneration to a PE extinguishes any further liability in the hands of the non-resident.
Although the issue of attribution is not statutorily settled, Indian courts have tended to follow the single entity approach to attribution in the treaty context. On the issue of income attributable to a PE, the SC held in the landmark case of DIT (International Taxation), Mumbai v. Morgan Stanley and Co. Inc.2, that arm’s length payment to the PE of a foreign entity extinguished any further tax liability of the foreign entity in India. This was also reiterated by the Bombay High Court in the case of SET Satellite 3, wherein the court overruled a tribunal judgment which favoured the dual entity approach to attribution of income.
Under domestic law, the withdrawal of Circular 23 leaves no indication to the taxpayer or tax authorities with regard to method of determining attributable income. Circulars issued by the CBDT are binding on the revenue authorities and it is possible that this withdrawal will result in a litigious position for non-resident taxpayers, especially at lower levels of revenue authorities. What makes it more problematic is that the CBDT has given little justification for this move and has merely indicated that the withdrawal of Circular 23 is due to the fact that it was being “misused”. Considering that Circular 23 merely enunciated internationally accepted principles with regard to source of business income, it is unclear what nature of “misuse” is being referred to by the revenue authorities.
As such the withdrawal of Circular should not lead to a change in the legal position. In the absence of Circular 23 and attribution rules specific to ‘business connection’, it should still be possible for us to rely on rulings such as Morgan Stanley which have dealt with the issue of attribution in the context of ‘permanent establishment’. Further, India has a wide network of tax treaties and non-residents who enjoy the benefits of a treaty would continue to be protected by operation of section 90(2) of the ITA, as discussed above.
However, one hopes that the revenue authorities realize that such departures from well established positions are not the wisest way towards tax reform.