June 17, 2009

Tax Authorities Shed Light On Taxation Of Composite Contracts Having Separate Identifiable Segments

In a case involving a composite contract between entities in India and China, the Income Tax Appellate Tribunal, Hyderabad Bench (“ITAT”) in Andhra Pradesh Power Generation Corporation Ltd.,¹ held that if there are two separate identifiable segments of the composite contract, only income arising from that part of the composite contract under which services are provided in India is subject to tax in India.

Facts

Andhra Pradesh Power Generation Corporation Ltd. (“Assessee”) entered into an agreement with National Machinery And Equipment Import And Export Corporation China (“CMEC”) for design, manufacture, supply, erection and commissioning of hydro electric generators on a turnkey contract basis for a fixed consideration. Assessee approached the Income Tax Department (“Department”) through two letters for permission u/s 195 of the Income Tax Act, 1961 (“ITA”). Under the first letter, Assessee requested the Department to issue a certificate to permit remittance of 90% of the total consideration to CMEC for supply of generators without deduction of tax. In the second letter, Assessee requested the Department to assess the balance 10% to be remitted to CMEC for erection and commissioning works and communicate the rate of tax to be applied for tax deduction at source. The present case is an appeal resulting from the CIT (A)’s order dismissing the case of the Assessing Officer (“AO”) for taxing the entire income earned under the contract as business income.

The AO observed that CMEC continued to exercise control over the equipment which resulted in CMEC having a business connection in India. The AO also observed that CMEC had taken warehouses on hire and a residential colony was constructed for CMEC employees working in India. Therefore, CMEC had a permanent establishment (“PE”) in India. Hence the income attributable to the entire composite contract is subject to tax in India as business income.

Judgment

The ITAT agreed with AO’s primary finding that it was one composite contract which has been split into two separate identifiable contracts, one relating to supply of equipment which had taken place outside India and the other one relating to erection, testing and other related services which took place in India. As regards the contention regarding the PE in India, it is pertinent to note that the Double Taxation Avoidance Agreement between India and China spells out under Article 7(1) that no business profit would arise in India if an enterprise proves that the business activities have no relation with the permanent establishment in India. Since the equipments were not manufactured in India and the portion of the composite contract relating to supply of equipments have no relation with the activities carried out by the PE, the ITAT held that the consideration paid towards supply of equipment cannot be taxed in India.

ITAT also observed that if parties have contracted that it is a free on board (FOB) contract and title in the goods shall pass outside India, the AO cannot change the intention of the parties. Further, ITAT was satisfied with the division of the consideration as intended by the parties to the contract and stated that the Assessee has rightly offered to pay tax on the second part of the contract for providing erection and commissioning services.

Analysis

Surprisingly, the ITAT in this judgment has not made a reference to the landmark Ishikawajma case although it is substantially in consonance with the principle followed by the Supreme Court in that case. Ishikawajma² which had similar facts as the present case ruled that only such part of the income in a composite contract as is attributable to operations carried out in India can be taxed in India. Further, inter alia it also clarified that the location of the source of income within India or the fact that the agreement was signed in India would not render sufficient nexus to tax the income from that source.

The Worley Parsons Ruling³ which created some concerns a few months back, questioned the very basis of the doctrine of territorial nexus which had been laid down by the Supreme Court in its ruling of Ishikawajma and developed by the recent ruling of Clifford Chance⁴. However, considering the facts of this case, it may not be possible to compare this judgment with the Worley Parsons Ruling as unlike the facts involved in Worley Parsons, the supply of equipment which forms 90% of the contract consideration is not a pre-requisite for the services provided under the contract in India. The ITAT in the present case has not delved upon these issues at all. Since this judgment was given before the Worley Parsons Ruling came out, it would be interesting to see if the courts continue to apply the rationale of Ishikawajma to future cases.

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