The Legal 500

Income-tax (Dispute Resolution Panel) Rules, 2009

In cases involving transfer pricing adjustments or cases involving income adjustments to be made on the foreign companies, which are prejudicial to the taxpayer, the tax officer is required to forward a draft order to the taxpayer, who can file objections against the draft order to the Dispute Resolution Panel (“DRP”).

 

Certain important and recent legal developments and case laws in this area are set out below:

 

Income-tax (Dispute Resolution Panel) Rules, 2009

 

In cases involving transfer pricing adjustments or cases involving income adjustments to be made on the foreign companies, which are prejudicial to the taxpayer, the tax officer is required to forward a draft order to the taxpayer, who can file objections against the draft order to the Dispute Resolution Panel (“DRP”).

 

 The rules to regulate the procedure of the DRP constituted under section 144C of the Income Tax Act, 1961(“ITA”) have been notified. The rules come into effect from November 20, 2009. Under the said rules, DRPs will be constituted at eight cities in India, namely Delhi, Mumbai, Ahmedabad, Kolkata, Chennai, Hyderabad, Bengaluru and Pune. DRP will be a collegium comprising of three Commissioners of Income Tax. The mechanism is investor-friendly and is also expected to reduce taxpayer grievance and litigation.

 

Perquisites Valuation Rules, 2009

 

Various perquisites including fringe benefits are taxable in the hands of employees after the GOI discontinued the erstwhile fringe benefit tax regime under Finance Act, 2009, where under fringe benefits were taxable in the hands of employer like corporate tax. The various fringe benefits which would be taxable as perquisites and the valuation mechanism of various perquisites have been notified now. The rules shall be deemed to come into force with effect from April 01, 2009.

 

The Finance Act, 2009 inter alia brought into the purview of the definition of ‘perquisites’, shares issued or allotted to employees under Employees Stock Options Schemes (“ESOPs”). As a result of this amendment, the benefit from shares acquired under ESOPs by employees is now regarded as salary income for the employees. As a result of this amendment, the employers are required to withhold taxes on salary income due to benefit from ESOPs at the time of allotment / transfer of shares to the employees. The benefit from ESOPs would be the difference between fair market value of shares on the date of exercise of the option and the amount paid by the employee for such shares.

 

Income Tax (Thirteenth Amendment) Rules, 2009 inter alia provide for the valuation of the ESOPs. For shares of a company listed on a recognized stock exchange, fair market value shall be the average of the opening price and closing price of the share on that date on the said stock exchange. For shares of a company listed on more than one recognized stock exchange, fair market value shall be the average of opening price and closing price of the share on the recognized stock exchange which records the highest volume of trading in the share. If on the date of exercise, there is no trading on any recognized stock exchange-

 

 (i) Closing price of the share on a date closest to the date of exercise and immediately preceding such date; or

 

(ii) Closing price of the share on a recognized stock exchange, which records the highest volume of trading in such share, if the closing price, as on the date closest to the date of exercise and immediately preceding such date, is recorded on more than one recognized stock exchange.

 

For unlisted companies, fair market value shall be such value of the share in the company as determined by a merchant banker (category I) registered with Security and Exchange Board of India on the specified date.

 

 Valuation of other perquisites is similar to earlier perquisite valuation rules, except for some change in valuation in case of perquisite by way of motor car, where the values of perquisite have been increased marginally.

 

Withdrawal of Circular no. 23

 

 The Central Board of Direct Taxes has withdrawn Circular no. 23 dated July 23, 1969, and consequently Circulars no. 163 dated May 29, 1975, and no. 786 dated February 07, 2000, which provided certain further clarifications with respect to Circular no. 23. These circulars clarified various issues in relation to the concept of income accruing or arising from India through or from business connections in India to a non-resident, under section 9 of the ITA. The circular has been withdrawn on the ground that the taxpayers were interpreting it to claim relief, which was not in accordance with the provisions of section 9 of the ITA. Though the concept of business connection and attribution of income therefrom is well established by various courts, the withdrawal of circular would lead to many tax disputes and tax department may even argue that various case laws pronounced on the basis of the said circular would no longer apply.

 

Case Laws

 

IT Act

 

Commissioner of Income Tax v. Maggronic Devices Pvt. Ltd.

 

The assessee was engaged in the manufacture of audio magnetic sound heads. The assessee entered into an agreement with a Singapore Company for the purchase of know-how in the form of technical and engineering data, design data, drawings, sketches, photographs etc., and product know-how. This agreement consisted of two parts. One part consisted of the transfer of the plant know-how and the other part consisted of product know-how. The agreement was entered into between the companies in Singapore. Two of the Directors of the assessee-company traveled to Singapore for the purchase of plant know-how pursuant to the resolution of Board of the assessee-company. They collected the technical documents including designs, photographs etc. from the Singapore Company. What was obtained was data including drawings, designs, sketches, photographs, etc. which were handed over by the Singapore Company to the Directors of the assessee.

 

The issue was whether the consideration for transfer of such know-how should not be treated as royalty under the ITA and accordingly allowing remittances without deducting tax at source.

 

 The Himachal Pradesh High Court held that there was an outright transfer of know-how in the form of data, drawings, designs, etc. to the assessee. Thus, there can be no manner of doubt that a plant was purchased and the title in the documents stood transferred to the Indian Assessee and it became the owner. The foreign company has no business in India. It has no plant in India. The transaction took place in Singapore. The agreement was entered into between the parties at Singapore and the documents were handed over to the representative of the Indian company at Singapore. This is a case of outright purchase of plant know how and not a case of transfer of interest. It was held that the amount being paid was on account of purchase of the plant and not as royalty.

 

CIT v. NIIT Ltd.

 

The respondent was a public limited company engaged in the business of providing computer education and training through its own centres and franchisees, to whom the assessee has provided licences to run its business. The assessee was required to provide the infrastructure facilities like computers, furniture, administrative set up, classroom, etc. The franchisees operate and manage the centres. In one of the models, fees collected from the students was deposited in the account of the respondent and then the fees collected was shared with the franchisees in accordance with the terms of the franchisee/licence agreement.

 

The issue involved in this case is whether in the facts and circumstances of the case, the assessee was not liable to withhold tax under section 194I of the ITA in respect of the payments made to the franchisee under the head “infrastructural claims”?

 

 It was stated by the Delhi HC that the agreement was in fact a franchises agreement and it cannot be said that by the agreement, rent was in fact being paid by the assessee company to the licensee. The essence of the agreement was to conduct the business of running education centre jointly. The relationship between the parties in the present case was not of a lessor and lessee even if the charges have been broken up by the assessee under the head of marketing claims and infrastructure claims. In view of these facts, it was held that the broad objective of the agreement between the assessee and the franchisee was to share the revenue and certainly it was not to hire the premises provided by the assessee. The provision of Section 194I of the ITA cannot be read to break up composite contracts and when that is not the intention of the parties themselves. It was held that there was no payment of rent by the assessee to the licencees/franchisees within the meaning of Section 194I of ITA. The assessee was not liable to withhold tax on such payments.

 

Pintsch Bamag, In Re

 

The applicant is a company incorporated in Germany. Through the process of international competitive bidding, it was awarded a contract by Tuticorn Port Trust. The scope of work is “work design, fabrication supply, transportation, delivery, installation and maintenance of mild steel, navigational channel and fairway buoys, mooring gear and solar operated navigational lighting equipments in relation to Sethu Samudram Ship Channel Project being executed in Tamil Nadu. The applicant has sub-contracted most of the work to a third party. Leaving out the sub-contracted work, the following work will be undertaken by the applicant:

 

 i. Study of the technical requirements in relation to the execution of the Contract;

 

ii. Designing of Fairway Buoys, Mooring Gears and Solar Operated Navigational Equipments;

 

iii. Supply of critical components to sub-contractors, if required;

 

iv. Supervision of installation of equipments and other items mentioned in the Main Contract, as and when the installation is carried out by the sub-contractor.

 

Out of the aforesaid four activities, activity (ii) and (iii) would be carried out in Germany. The 4th activity i.e. supervision of installation/commissioning will be in India and for carrying out such supervision, two engineers from Germany will be deputed who will be present at the time of installation of fairway buoys, mooring gears and solar operated lighting equipment in the mid-sea. According to the applicant, this process of supervision will be for less than 60 days. The time schedule for completion of the main contract is 16 months.

 

The applicant contends that it has no permanent establishment (“PE”) in India and that the supervisory operations which it will have to carry out at the time of installation and commissioning by the sub-contractor would be only for 2 months and therefore no PE exists nor can be deemed to exist. Consequentially, it is submitted that under the terms of the Double Taxation Avoidance Agreement (“DTAA”) between India and Germany (“IGDTAA”), business profits received by the applicant cannot be subjected to tax in India.

 

Authority for Advance Ruling (“AAR”) observed that it admits of no doubt and in fact it is not disputed that Clause (i) of Article 5.2 of IGDTAA gets attracted to the present case as the contract awarded to the applicant relates to installation and assembly project, and, therefore, the duration test of six months should necessarily be applied even if the applicant at one point of time or the other may set up a fixed place of business for the purpose of monitoring and supervising the installation. The more crucial question that needs to be considered now is whether the work place set up by the sub-contractor to carry out the works entrusted to him by the applicant can be treated as the work place and the PE of the applicant. AAR was of the view that the answer could only be in the negative unless the sub-contractor is treated as a dependent agent of the applicant as distinct from an independent agent. AAR noted that it is not possible to hold that the place of manufacture of the sub- contractor situated far away from the installation site should notionally be regarded as part of the applicant's PE. The language of the opening Para of Article 5 itself furnishes a key to the correct understanding of the concept of PE. The fixed place of business referred to in Para 1 of Article 5 is qualified by the words “through which the business of an enterprise is ... carried on”. In the present case, the enterprise is the "applicant". On a plain reading of the opening Para of Article 5 and the nature of relationship between the applicant and sub-contractor, it cannot be concluded that the business of the applicant is being carried on through the sub-contractor's workshop. The concept of PE conveys the idea that the enterprise's presence has to be “visible” through an establishment in the other country. The objective presence of the foreign enterprise in the other country as reflected in a fixed place of business is the real criterion for determining the existence or otherwise of PE in that country. AAR noted that it is difficult to infer that a fixed place of business existed throughout, with the applicant's personnel making use of the same with frequency and regularity. Occasional or brief visits by some of the employees of the applicant right from the beginning do not give rise to inference of the existence of PE. Taking an overall view, it appears that the need for setting up the PE would arise sometime before the installation and commissioning operations begin.

 

 In the present case there is no conjoint effort of both the contractor and the sub-contractor at the building site. The entirety of work of fabrication and assembly is carried out by the sub-contractor at the workshop set up by him at a place for away from installation site and run by him independent of any control of the applicant. Such a place of business of sub- contractor cannot be regarded as the PE of applicant. It was held that applicant is not liable to be taxed in India, as it has no PE in India.

 

New Skies Satellite and Shin Satellite Public Co. Ltd. v. Assistant Director of Income Tax, International Taxation

 

The assessee, a foreign company, was engaged in operating geostationary telecommunication satellites with transponder capacity which was provided to telecasting companies in India for a fee. Through such transponders installed at the satellite, the assessee was providing facility of data transmission to their customers. The transponders were capable of receiving uplinked data and to amplify the same before down-linking to the foot print area of the satellite. The customers of the assessee were telecasting companies / telecom operators. For such facility, an agreed amount was payable by the customers, as per their respective agreement. Assessee owned, maintained and controlled satellite and operating facility from outside India. The tax officer considered the operation of the assessee of providing transponder capacity as a ‘process’, accordingly, the receipts from customers were treated as royalty and taxed them in India on the ‘source’ basis of taxation.

 

The question arose whether the said fee was “consideration for … the use of any … secret formula or process …” so as to constitute “royalty”.

 

 Tax tribunal noted that the assessee is providing the particular capacity of transponder’s predetermined and pre-guided process. The use of such process is by the customer according to its requirements. The customers use the said process for the purpose of their business in India. Tax tribunal further noted that within the definition of royalty under the ITA and applicable DTAA, the word ‘process’ could not be considered as being qualified by the term ‘secret’. So, the process may be any simple process and need not be secret.

 

It was held that the said consideration received by the assessee is taxable in India as royalty.

 

UCB India (P) Ltd. v. ACIT

 

Assessee is a 100 per cent subsidiary of UCB S.A., Belgium. The assessee is engaged in the business of manufacture and marketing of prescription drugs in the therapeutic areas of allergy and asthma, central nervous system and internal medicine. The assessee manufactured intermediates, bulk drugs and formulations, at its factory. The assessee manufactured some of the active ingredients, while some of the active ingredients were imported by it from associated enterprises.

 

The assessee had undertaken a transfer pricing study, compared its profit margin with those of the identified companies and drew a conclusion that its international transaction have been undertaken at arm’s length price. The assessee adopted the transactional net margin method (“TNMM”) for determination of arm’s length price (“ALP”) in connection with its international transactions. However, the transfer pricing officer (“TPO”) rejected the method adopted and determined the ALP applying the comparable uncontrolled price method (“CUP”). TPO obtained price data from few competitors in India of the assessee.

 

Tax tribunal noted that CUP method is the direct method for determining arm’s length price; however, CUP is not the most appropriate method in every circumstance. It further noted that determination of the most appropriate method is to be done by the assessee and the TPO. This analysis has not been done by either of them in the present case. If the assessee wanted to adopt a particular method to demonstrate that the international transaction in question was at an arm’s length price, then it was its duty to maintain and furnish the required adequate data. When the burden of proving that a particular method was the most appropriate method was initially in the assessee, it was for the assessee to demonstrate the same by furnishing adequate records and data, irrespective of the fact whether they were statutorily required or not. Similar is the case if the department desires to adopt a particular method.

 

Tax tribunal noted that when in an enterprise, only similar transactions are undertaken, i.e. all the transactions are of the same type, same class, & similar variety, in such a situation, the operating margins of the enterprise would be the TNMM of a class of transactions. In the present case, the assessee manufactured many other drugs than Piracetam and Nutropil. It had also trading activity. What the assessee had tried to do was  to compare the overall operating profit of one entity, with the overall operating margins of the assessee and as the operating margin of the assessee was higher, it asserted that all its international transactions done with its associated enterprises were at ALP. This could not be accepted. The raw material produced and supplied by the originator could not be taken as identical in all aspects with the products supplied by unknown company to other Indian companies. Thus, it was difficult to accept the contention of the TPO that the product in question was identical in all aspects. ALP cannot be determined on preponderance of probabilities or based on objectives sought to be achieved in an enactment or in a policy guideline of the government.

 

Tax tribunal disagreed with the application of TNMM by the assessee and pointed out various deficiencies in the assessee’s analysis. Tax tribunal also disagreed with the application of CUP by the TPO and pointed out various deficiencies in the TPO’s analysis. The case was referred back to TPO to decide the arm’s length price properly.

 

Tax tribunal made various pertinent observations regarding transfer pricing issues, some of which are specified below:

 

 (a)   The basis of determination of TNMM of the assessee and that of the comparable uncontrolled transaction should be the same.

 

(b)   The comparable uncontrolled transaction should be identified on the basis of function, asset and risk analysis.

 

(c)   Under TNMM, net profit margin from an international transaction or a class of international transaction is to be considered and not the operational margin of the enterprise as a whole, particularly when enterprise is engaged in different type of activities.

 

(d)   The transfer pricing study should be sufficiently detailed having relevant information of identification of comparable enterprise and comparable uncontrolled transactions.

 

(e)   Under the CUP, properties of the product and accompanying circumstances require careful evaluation. Even a minor change in product specification, price determinants, nature of enterprise, etc. may have significant effect on price. The comparable uncontrolled price taken by TPO varied significantly and no analysis was done to evaluate the reasons for such variance. The comparable uncontrolled price was not adjusted to take into account various differences in the product, enterprise and circumstances.

 

DCIT, Bangalore v. M/s Jebon Corporation India, Liaison Office

 

The assessee is a South Korea based company and is dealing in trading of semi-conductor components manufactured by various companies across the world. The assessee company opened a LO after getting approval of the Reserve Bank of India. The LO is furthering the work of the company by way of liaising in the area of sale of electronic components such as PCBs (Printed Circuit Boards) and LCDs (Liquid Crystal Displays). The tax authorities carried out survey at the LO and recorded statements of personnel at the LO. On this basis, tax officer concluded that LO is undertaking part of trading activity in India for the head office, including identifying the customer, interacting with the customer, negotiating with the customer, follow-up and after-sales.

 

The issue was whether the LO can be treated as a PE?

 

Tax tribunal observed that LO has freedom in deciding the margin or selling price provided they are not incurring any loss. It is true that a commercial invoice is raised by the HO and the payments are made by Indian customer to the HO through wire transfer. However, this fact will not be a bar to conclude that LO is not involved in a trading activity of the non- resident company. Tax tribunal observed that trading activity consists of various steps and profit can be attributed to each such step.

 

 The case of the assessee would have been covered under Article 5(4)(e) of India-Korea DTAA (which excludes certain activities from the definition of PE) if the LO is maintained solely for the purpose of advertising, supply of information, scientific research or any other activity if it has a preparatory or auxiliary character in the trade or business of the enterprise. In the instant case, the LO is doing something more than that, being involved in securing the order and concluding of the contract. It was held that LO is a PE and therefore, income attributable to LO will be taxable as per Article 7 of the applicable DT AA.

 

Authors:

 

 Atul Dua (atul.dua@sethdua.com) is a Senior Partner, Vikas Aggarwal ( vikas.aggarwal@sethdua.com ) is a Senior Associate with Seth Dua & Associates, Solicitors & Advocate, India

 

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