The nature of the contract should not be construed through the prism of the taxing provisions
In India, the big strides in economic growth being witnessed are not without their share of tax woes, especially in areas such as service tax, VAT and international taxation. The taxation of offshore supply of equipment and material in a turnkey contract is one such area. On January 4, the Supreme Court delivered a landmark decision on taxation of turnkey contracts in Ishikawajima-Harima Heavy Industries Ltd vs Director of Income Tax, Mumbai (unreported), which will go a long way in settling some of the contentious issues.
Ishikawajma-Harima Heavy Industries Ltd (the appellant) is a tax resident of Japan. It formed a consortium with a few companies in Japan and entered into an agreement for a turnkey project with Petronet LNG for setting up an LNG (liquefied natural gas) receiving, storing and re-gasification unit.
The roles and responsibility of each member of the consortium were well defined with separate consideration. The agreement was for development, designing, engineering and procuring of equipment and to erect and construct storage tanks. Typical of turnkey contracts, the contract involved offshore and onshore supply of equipment as well as offshore and onshore supply of services.
The appellant applied to the Authority for Advance Ruling (AAR) and sought a ruling on its tax positions, for which the authority ruled that the offshore supply of materials and services are taxable in India. The appellant filed a special leave petition (SPL) before the Supreme Court, which was admitted and decided by the apex court.
Divisible or composite?
The appellant contended that the contract is a divisible one and that there can be no tax liability in India for the offshore supply of equipment and services. As per the Double Taxation Avoidance Agreement (DTAA) between India and Japan, business income may be taxed in India only when the non-resident has a permanent establishment (PE) in India and only to the extent that such incomes could be directly or indirectly attributable to the activities of the PE in India.
Therefore, the appellant contended that its PE had nothing to do with the offshore supply of materials and services and that the mere presence of the PE cannot attract tax liability in India, when the PE is not actually connected with the offshore supplies, more so when the DTAA concerned has no `force of attraction clause'.
But the Revenue contended that the contract was a composite and integrated one and that the appellant is liable to pay tax in India for the offshore supplies as well.
It contended that the offshore and onshore elements of the contract are so inextricably linked, that the breach of the offshore element would result in the breach of the whole contract. The dominant object of the contract is the execution of a turnkey project and the question whether the title to the goods supplied passes offshore or within India is secondary to the execution of the contract.
Apex court's view
The Supreme Court held that merely because the contract has been designed as turnkey, it would not mean that the entire contract must be considered as an integrated one for the purpose of taxation as well. The taxable events in execution of a contract may arise at several stages in several years and consequent liability as well may arise at several stages. The contractual obligations are distinct with clear demarcation as supplies and services and as onshore and offshore, with separate consideration for each agreement.
The title in the equipment is transferred outside India on high-sea basis. It held that a contract must be construed based on intention of the contracting parties and the tax laws would depend upon the nature of the contract. But the nature of the contract should not be construed through the prism of the taxing provisions. Since all parts of the transaction in question, namely, the transfer of property in goods and receipt of payment were outside India, the transaction could not have been taxed in India for the mere reason that the appellant has a PE in India. A PE cannot be equated to business connection under Section 9(1)(i) of the Act and the existence of PE would not constitute sufficient business connection.
As far as the offshore services are concerned, the apex court held that the services have to be rendered and utilised in India to be taxable in India. There must be sufficient territorial nexus with India a direct live link with the services rendered. A distinction may also be made between rendition of services and utilisation thereof.
Section 9(1)((vii) deems fees for technical services to accrue or arise in India, when such a fee is paid by a resident, except when such a payment is for services used in a business of the payer outside India or for earning any income from a source outside India. The court held that the deeming sweep of Section 9(1)(vii) cannot be interpreted so widely to bring to tax the income of a non-resident received outside India from a resident for services rendered outside India.
The test of residence is that of the taxpayer and not that of the recipient of such services. For Section 9(1)(vii) to be applicable, it is necessary that the services are not only utilised within India but also 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. Unless the services are rendered and utilised in India, the income cannot be taxed in India.
The Supreme Court has expounded on a wide range of issues, including divisibility of the contract, the trigger point for taxation of the supplies from abroad, the presence of PE and its tax impact, etc. While this is an important decision from the standpoint of a turnkey contract, it is also important from the perspective of the doctrine of territorial nexus for imposing taxes, more so, in the wake of recent issues of levy of service tax on import of services.
Sriram Seshadri (The author is a Chennai-based chartered accountant.)