The established principle of territorial nexus questioned by the AAR
In the recent ruling of Worley Parsons Services Pty. Ltd.1 (“Applicant”) the Authority for Advance Rulings (“AAR”) has revisited the principles of international taxation governing the treatment of royalty payments made for services rendered by a non-resident in India and the well established principles of territorial nexus governing the taxation of such payments.
Facts of the case:
The Applicant in the present case was an Australian Company which had entered into 3 agreements for the provisioning of 3 services being (i) engineering and procurement services (ii) project management services and (iii) construction advisory and commissioning advisory services respectively.
The characteristics feature of the services rendered under the first agreement (agreement for rendering engineering services) were that the majority of these services were performed in Perth and to the extent of 20% were performed in India. As regards the services rendered under the second agreement (agreement for rendering project management services), these were in nature of co-ordination and were partly performed from Perth and partly from India. There were no services which could be rendered under the third agreement (agreement for rendering advisory services) as the project had to be terminated mid way. The Applicant never disputed the fact that it had a permanent establishment (“PE”) in India.
The moot point for consideration before the AAR was whether the services performed under the first agreement were effectively connected to the PE in India. The Applicant stated that in the event such a connection was established the services would be taxable as business profits and thereby making only that part of the profits attributable to the PE to be liable to tax in India.
In the alternative, it was also contended by the Applicant that as per the principle of territorial nexus laid down by the Supreme Court in the case of Ishikawajima Heavy Industries2 only that portion of the services should be taxed which has a territorial nexus with India and therefore only 20% of the services would be taxed in India.
The AAR held that the pre-requisite for making the services liable to be taxed as business profits was that the services in respect of which the royalties are paid should be effectively connected with the permanent establishment. The connection envisaged was a “real and intimate connection” between the royalty generating services and the permanent establishment. It is not enough that there is a permanent establishment of the non-resident in the source country carrying out some activities in connection with the project or the work.
Therefore on the basis of the test laid by the AAR, which is an established principle of international taxation, since the services rendered by the Applicant were not effectively connected with the PE, the services cannot be categorized as being in nature of business profits. Further, the AAR held that the provisions applicable to business profits and royalty payments are mutually exclusive and as the services rendered are not effectively connected, they were liable to be taxed as royalty on the gross amount of services rendered by the Applicant.
As regards the contention raised by the Applicant on the basis of the Apex Court’s ruling in Ishikawajima Heavy Industries that only those services rendered by the Applicant should be liable to be taxed which have a territorial nexus with India, it questioned the logic provided by the Apex Court in the said ruling. The AAR, however, ruled that on account of the binding nature of the Apex Court’s judgment, it had no option but to give effect to Ishikawajima Heavy Industries judgment. However on account of the distinctive feature of the services performed in India under the first agreement, which were the pre requisite for the services which had been performed in Perth, the AAR ruled that services rendered inside and outside India had a territorial nexus with India and were therefore liable to tax in India.
In respect of the service rendered under the 2nd Agreement, the AAR held that since these services were effectively connected with the PE in India, they were governed by the provisions of business profits and liable to be taxed only to the extent of profit attributable to the PE.
The above ruling of the AAR has questioned the very basis of the doctrine of territorial nexus which had been laid down by the Supreme Court in its ruling of Ishikawajima and developed by the recent ruling of Clifford Chance3 The doctrine has till now been regarded as sacrosanct and it is indeed surprising to see the AAR question the same. Though the rulings of the AAR are binding only on the applicant and the tax authorities, its rulings do have a persuasive value and hence developments in this arena would have to be watched carefully. The concept of territorial nexus that has been established so far in India is in line with the international approach and any deviation in approach should be made with caution and circumspection.