The Assessee is a company incorporated in Japan.  It is engaged, inter alia, in the business of construction of storage tanks as also engineering etc.  It formed a consortium with various parties and entered into an Agreement with Petronet LNG Limited (“LNG Petronet”) on 19-1-2001 for setting up a Liquefied Natural Gas (LNG) receiving, storage and degasification facility at Dahej, Gujarat.  The contract envisaged a turnkey project. Role and responsibility of each member of the consortium was specified separately. Each of the member of the consortium was also to receive separate payments.  The Assessee was to develop, design, engineer and procure equipment, materials and supplies, to erect and construct storage tanks.

The contract involved the following:

Nature of SupplyNature of workPrice Payable
(i) offshore supply,Price of Equipment and Material (including cost of engineering, if any, involved in the manufacture of such Equipment and Material) supplied from outside India on CFR basis, and the property therein shall pass on to the Owner on high seas for permanent incorporation in the Works, in accordance with the provisions of the Contract.US dollars
(ii) offshore services,Price of design and engineering including detail engineering in relation to supplies, services and construction and erection and cost of any other services to be rendered from outside India.US Dollars
(iii) onshore supply,Price of Equipment and Material supplied from within India for direct delivery at Site and permanent incorporation in the Works.partly in US dollars and partly in Indian rupees
(iv) onshore servicesPrice of design engineering, detail engineering, customs clearance, inland transportation, procurement services, supervision services, project management, testing and commissioning and any such service in relation to the Works rendered in Indiapartly in US dollars and partly in Indian rupees
(v) construction and erectionConstruction and erection activitypartly in US dollars and partly in Indian rupees

Proceedings before Authority for Advance Ruling (“AAR”)

The taxpayer filed an application before AAR raising question on taxability of offshore supply and offshore services.  Before the AAR, no issue was raised as regards taxability of onshore supply, onshore services and construction and erection. The dispute centered around taxability of ‘offshore supply’ and ‘offshore services’.

With respect to taxability of offshore supply, the AAR held that as per provisions of Article 7(1) of the India Japan DTAA read with para 6 of the protocol[i], profits from supply of equipment of machinery (sale of which was completed abroad, having placed the order directly overseas office of the enterprise) shall be covered within the meaning of the phrase directly or indirectly attributable to that permanent establishment.

As regards taxability of the amounts ‘received’ and ‘receivable’ by the Assessee from Petronet for offshore services, the AAR held that both section 115A(1)(b)(B) and Article 12(2) of the India-Japan DTAA clearly indicate that the whole of technical fee without any deduction is chargeable to tax.  The AAR further held that the tax so charged shall not exceed 20 per cent of the gross amount of the royalty or fee for technical services.

The Taxpayer filed an appeal before Supreme Court.

SC Decision

SC Observation on Importance of Agreement

The SC made following important observation on how to construe a contract from a tax perspective[ii]:

“In construing a contract, the terms and conditions thereof are to be read as a whole. A contract must be construed keeping in view the intention of the parties. No doubt, the applicability of the tax laws would depend upon the nature of the contract, but the same should not be construed keeping in view the taxing provisions.”

The SC observed that project is a turnkey project and the contract may also be a turnkey contract, but the same by itself would not mean that even for the purpose of taxability the entire contract must be considered to be an integrated one so as to make the appellant to pay tax in India.  The taxable events in execution of a contract may arise at several stages in several years.  The liability of the parties may also arise at several stages.  The SC observed Supply obligation is distinct from service obligation. Similarly, offshore supply and offshore services have separately been dealt with.  Price for each of the component of the contract is separate. 

The SC held that the very fact that in the contract, the supply segment and service segment have been specified in different parts of the contract is a pointer to show that the liability of the taxpayer thereunder would also be different.

The SC further observed that the contract indisputably was executed in India.  Entering into a contact in India will not make the entire income derived by the contractor to be taxable in India since parts thereof will have to be carried out outside India.

SC Observation on Territorial Nexus

The SC judgment highlights the importance of doctrine of territorial nexus.  The SC made the following important observations on this issue[iii]:

“26. Territorial nexus doctrine, thus, plays an important part in assessment of tax.  Tax is levied on one transaction where the operations which may give rise to income make take place partly in one territory and partly in another.  The question which would fall for consideration is as to whether the income that arises out of the said transaction would be required to be apportioned to each of the territories or not.

27. Income arising out of operation in more than one jurisdiction would have territorial nexus with each of the jurisdiction on actual basis.  If that be so, it may not be correct to contend that the entire income “accrues or arises” in each of the jurisdiction.”

The SC observed that in case of composite contract performed in different places, the principle of apportionment can be applied to determine the taxability of different components.  The relevant observations are as follows[iv]:

“In cases such as this, where different severable parts of the composite contract is performed in different places, the principle of apportionment can be applied, to determine which fiscal jurisdiction can tax that particular part of the transaction. This principle helps determine, where the territorial jurisdiction of a particular state lies, to determine its capacity to tax an event. Applying it to composite transactions which have some operations in one territory and some in others, is essential to determine the taxability of various operations.”

Findings and Conclusion

With respect to offshore supplies, the Supreme Court concluded that the entire transaction having been completed on the high seas, the profits on sale did not arise in India, as has been contended by the taxpayer.  Thus, having been excluded from the scope of taxation under the Act, the application of the DTAA would not arise.  The SC held that the fact that the contract was signed in India is of no material consequence, since all activities in connection with the offshore supply were outside India, and therefore cannot be deemed to accrue or arise in the country.  With respect to AAR conclusion on Paragraph 6 of the Protocol to the DTAA, the SC held that it is not applicable, because, for the profits to be ‘attributable directly or indirectly’, the permanent establishment must be involved in the activity giving rise to the profits.

With respect to offshore services, the SC observed that Section 9(1)(vii) of the Act must be read with Section 5 thereof and there should be sufficient territorial nexus between the rendition of services and territorial limits of India is necessary to make the income taxable.  

The SC held that for section 9(1)( vii) to be applicable, it is necessary that the services should not only be utilized within India, but also be rendered in India or have such a “live link” with India that the entire income from fees as envisaged in Article 12 of DTAA becomes taxable in India.  The SC concluded that for FTS to be taxable in India the services have to be rendered in India, as well as utilized in India.  Since both these conditions were not been satisfied simultaneously, the SC held that offshore services were not taxable in India.

Amendments Post SC decision

Post SC decision, the Legislature vide Finance Act, 2007 w.r.e.f. 1-6-1976, inserted Explanation under Section 9 and proposed to remove the territorial nexus requirements of business connection in India[v].  The amendment provided that for the purposes of section 9, income is deemed to accrue or arise in India under clauses (v), (vi) and (vii) of section 9(1), whether or not, the non-resident has a residence or place of business or business connection in India.  The Departmental Circular[vi] further clarified that in cases falling under Explanation, there will be no need to establish any territorial nexus between the income deemed to accrue or arise to the non-resident under the said clauses and the territory of India.

However, the amendment still did not completely override the SC decision in Ishikawajima (supra).  The Karnataka HC in the case of Jindal Thermal Power Company Ltd. V DCIT (TDS) [TS-79-HC-2009(KAR)] held that the requirement of rendering of service in India (as held in Ishikawajima) has not been done away with by the Amendment.

Subsequently, the Explanation u/s 9 was again substituted by Finance Act, 2010[vii] where the requirement of rendering services in India was also done away with.

Thus, both the Act and DTAA now envisage territorial nexus (for FTS) based on the criteria that of situs of the payer is in India or the situs of utilization of services is in a business in India.

My Thoughts

The territorial nexus for services is the place where services are actually rendered.  Even in a case where any other actual basis is to be contended with, it at best calls for an apportionment to each of the territories.  In the context of Section 9(1)(ii), the earning of income in India is equated to income payable for rendering of service in India.  Service income is an active income unlike dividend, royalty or interest, which are passive income.  Having similar criteria for both of them may not be appropriate. 

[i] Article 7(1) of India Japan DTAA provides that income attributable to PE shall be so much as is directly or indirectly attributable to that permanent establishment.  This is further explained in Para 6 of Protocol to India Japan DTAA.  Para 6reads as follows: With reference to paragraph 1 of article 7 of the Convention, it is understood that by using the term ‘directly or indirectly attributable to the permanent establishment’, profits arising from transactions in which the permanent establishment has been involved shall be regarded as attributable to the permanent establishment to the extent appropriate to the part played by the permanent establishment in those transactions. It is also understood that profits shall be regarded as attributable to the permanent establishment to the abovementioned extent, even when the contract or order relating to the sale or provision of goods or services in question is made or placed directly with the overseas head office of the enterprise rather than with the permanent establishment.

[ii] Para 60 of SC judgment

[iii] Para 26 and 27 of SC judgment.

[iv] Para 68 of SC judgment.

[v] FA 2007 amendment Explanation.—For the removal of doubts, it is hereby declared that for the purposes of this section, where income is deemed to accrue or arise in India under clauses (v), (vi) and (vii) of sub-section (1), such income shall be included in the total income of the non-resident, whether or not, the non-resident has a residence or place of business or business connection in India

[vi] Circular No. 3 / 2008 dated 12-3-2008

[vii] FA 2010 amendment Explanation.—For the removal of doubts, it is hereby declared that for the purposes of this section, income of a non-resident shall be deemed to accrue or arise in India under clause (v) or clause (vi) or clause (vii) of sub-section (1) and shall be included in the total income of the non-resident, whether or not,—

(i) the non-resident has a residence or place of business or business connection in India; or

(ii) the non-resident has rendered services in India.

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