INTERNATIONAL TAX & FINANCE CONFERENCE 2013 Material/ITF2013... · 8 INTERNATIONAL TAX & FINANCE CONFERENCE 2011 ... classes of ICAI teaching Income Tax for CA final students; (c)

8 INTERNATIONAL TAX & FINANCE CONFERENCE 2011

Bombay Chartered Accountants' Society

ITC Rajputana, Jaipur

Cross border outsourcing- Tax aspects including Transfer Pricing

– Mr. H. Padamchand Khincha, Chartered Accountant

INTERNATIONAL TAX & FINANCE CONFERENCE 2013



Mr. H. Padamchand Khincha, Chartered Accountant

Shri H. Padamchand Khincha, B.Com, LLB, FCA, 5th Rank in B.Com, Bangalore University 25th Rank in CA Final (November 1982). Presently partner in M/s. H. C. Khincha & Co.

Other Activities:

TEACHING:

(a) Visiting Faculty at IIM, Bangalore; (b) Was a Faculty at the intensive coaching classes of ICAI teaching Income Tax for CA final students; (c) Visiting faculty at the Direct Taxes Training Institute of the Income Tax Department.

PROFESSIONAL:

(a) Was writing a monthly column on ‘Tax Patrika’ – a magazine in Hindi devoted to Direct & Indirect Taxes; (b) Presented papers at various Seminars, Conferences all over the country; (c) Was a panel member for answering queries at the ‘NRI Taxation – on line’ of the Economic Times; (d) Was on the advisory board for answering queries of Lex Site.Com a legal portal; (e) Convenor of the Study Group formed to prepare the approach paper on the “Transfer Pricing Guidance Note”.

AUTHORSHIP:

(a) Co-author of “Tax Holiday u/ss.10A and 10B – An analysys; (b) Author of Comparative Analysis of Indian Tax Treaties published by BCAS; (c) Author of three booklets: (i) Capital Gains of Non-Residents; (ii) Tax Deduction at Source; (iii) Concept of Indexation under Capital Gains; (d) Articles published in Current Tax Reporter, BCAJ, Taxwatch, Journal of CA Institute, etc.

SPORTS ACHIEVEMENTS:

(a) Was a keen cricket player. Was selected to represent All India Colts vs the Visiting West Indies team at Pune in 1978; (b) Won prizes in middle distance running in St. Joseph’s College Athletic Meet.

OTHERS:

Adjudged the ‘Best Outgoing Student’ of St Joseph’s College of Commerce in 1979.

Cross Border outsourcing - Tax aspects including Transfer Pricing

International Tax & Finance Conference, 2013 1

Cross Border outsourcing — Tax Aspects including Transfer Pricing

Mr. H. Padamchand Khincha, Chartered Accountant

1. INTRODUCTION1.1. Outsourcing connotes sourcing out. The “sourcing out” could be of ‘functions’,

‘activities’ or ‘people’. It has a history spanning centuries. It is today all pervasive. Historically, Kings lent their army to their neighbouring kingdoms in the hour of need. The concept of outsourcing which began then has today culminated into ‘deputation and secondment of employees’ and ‘sub-contracting of businesses’.

1.2. Servant maids are a classic example of an application of ‘outsourcing model’ domestically. Commercially, outsourcing has become inevitable for any business house. Globally, outsourcing facilitates business being carried out in a borderless earth. Every person is in some or the other way outsourcing – for some it is a convenience and for others it is a necessity.

1.3. Practically, the concept of outsourcing has led to a situation of ‘placelessness’. Innovative technology and the smart-sourcing (ie, outsourcing in the smartest manner) has made the activity of business ‘nomadic’. Because of technology pervasiveness, a work can be done at any place. If it can be done at any place, it also means, it can be done by anybody with the necessary capability. Technology has thus imparted mobility to the situs or locale of work [or activity].

1.4. Some have defined outsourcing to mean a process of “lift and shift” – meaning an existing process is ‘lifted’ out of its current locale and ‘shifted’ over to another. Such exercise of ‘lift and shift’ is advancing towards ‘Virtual outsourcing’. The Information Technology sector is re-discovering itself with the advent of cloud computing, virtualisation and automation. The etymology of the word ‘outsourcing’ has changed to represent the ever emerging and changing practices.

1.5. The reasons for, and kinds of outsourcing, have increased with the efflux of time. The multitude of outsourcing service providers today handle almost all aspects of a project, from product or service designing, development, testing including marketing and sales.

1.6. The process of outsourcing generally entails three stages: (i) Initial strategy – to firm-up and visualise the role of outsourcing in the organisation; (ii) Preliminary evaluation – to decide on the appropriate outsourcing projects and the service providers; and (iii) Selection – to work out the legal, pricing and service level terms.

1.7. The objective of outsourcing may be to achieve economies of scope and scale through shared services, technology or international wage arbitrage. Outsourcing is today a de rigueur for every business house. Such outsourcing emanating out of compulsion or comfort has not been easy. It is prone to various inherent problems such as possible loss of control over the organisation’s business processes; shortcomings in performance vis-à-vis expectations; gap between expected and realised benefits/results, etc. The


2 International Tax & Finance Conference, 2013

process of outsourcing (especially across the borders) is subjected to intricate income-tax implications.

1.8. The objective of this write-up is to collate and deliberate some of the important income-tax ramifications of cross border outsourcing in service sector. India has attained a distinctive status among the developing countries for its fast-growing service sector. This rapid growth has had significant impact on the macro-economics of the country. This acceleration in service sector has come at the cost displacement of manufacturing segment. India is making efforts towards achieving a balance between the two. Currently, the manufacturing sector however has lost its pre-eminence to the service sector. Keeping this hard fact in the hindsight, this write-up strives to address some income-tax issues arising in the outsourcing regime in the service sector [being more relevant in the Indian context].

1.9. This write-up only addresses generic issues arising in the outsourcing era. It does not address any industry-specific issues (for instance, Pharma, Scientific research, automobile, etc). It seeks to provide a tertiary view of the income-tax issues relating to the two-way outsourcing (inbound and outbound). The write-up however deals largely with outbound outsourcing due to the length constraints and the principles in outbound transactions can be applied in the inbound context by applying the corollary logic. For ease of discussion, the issues have been captured under various headings/ segments.

Some outsourcing models1.10. The strength of the services sector has helped India secure significant business. Cost

arbitrage coupled with availability of skilled personnel has resulted in many overseas companies setting up captive development centres. Concepts and design of the work are formulated overseas. Translating these into reality is outsourced to India. Strategic and key functions remain outside. Hardcore execution happens in India.

1.11. Looked at this potential, Indian companies have been offering similar services. Having secured the contracts, certain on site functions are pushed down to their subsidiaries or group companies overseas. Cost arbitrage is not entirely lost, as the work at overseas locations is by the affiliates of Indian companies; the remuneration for which is benchmarked not against overseas standards but the Indian ethos.

1.12. It is therefore not just a story of ‘inbound’ outsourcing. ‘Out-bound’ outsourcing is increasing in evidence.

2. TAXABILITY OF NON-RESIDENTS IN INDIA (ON OUTBOUND OUTSOURCING)2.1. The scope of income chargeable to tax in India in case of non-residents is dealt in

section 5(2) of the Act. As per the said subsection, a non-resident is chargeable to tax in respect of the following.

��

��

��

��



2.2. Income accruing and received outside India is not taxable in the case of a non-resident. Receipt of income in India is a fiscal fact and cannot be disputed. Instances of deemed receipt are enlisted in sections 7 and 198. It is income accruing or arising in India or income deemed to accrue or arise in India, that has remained the focus deliberation and discussion (and is so in this write-up also).

Income accruing or arising in India 2.3. In the case of a non-resident, the scope of total income taxable in India is limited, by

not including incomes accruing or arising outside the taxable territories. Section 5(2)(b) provides that income ‘accruing or arising’ or ‘deemed to accrue or arise’ in India shall be chargeable to tax [in India]. The situs of income has to be in India. The situs may actually be in India. The statute may also deem the situs to be in India in particular cases/situations.

2.4. Section 5, thus proceeds on the assumption that income has a situs; though there is no indication as to how the situs is to be determined. Income, that is the subject matter of taxation, should have an originating cause. This, in legal parlance, is the source of income. The source of income either may be an asset, an activity, a service, decree etc. Dealings – commercial, financial or otherwise are the cause from which the income sprouts [parentage]. The dealings may stipulate that the place where the consideration is paid/satisfied is different from the place of the originating cause of income. The right to receive may, territorially, be thus separated from the cause of receipt. The right to receive in legal parlance is “accrual’. It can therefore be discerned that the place of accrual is different from the place of its source.

2.5. The charge under section 5 is on accrual of income in India. If parties could contractually ensure accrual outside India, non residents could limit/eliminate the tax exposure in India. Section 9 attempts to protect the “tax base”, by deeming certain incomes to accrue or arise in India. In this process, it also excludes certain incomes from the clutches of the fiction. The determination of place of accrual is thus important. The Madras High Court in the case of C.G. Krishnaswami Naidu v. CIT (1966) 62 ITR 686 (Mad) held that the situs of accrual has to be determined according to the general principles of law and in light of the particular facts.

2.6. The statute does not provide any guidance on the process or methodology of determining the place of accrual of income. It is a fact-based exercise. There cannot be a single yardstick to reckon the locale of income. The learned authors Kanga & Palkhivala in their treatise ‘The Law and Practice of Income Tax’ [8th edition - page 225] observe –

“It would be nearly impossible and wholly unwise to lay down any general test to determine the place where profits or gains of business or employment accrue. In some cases it may be the place of the formation of the contract, but other factors, e.g. the place where the contract is carried out or acts are done under the contract, may be decisive in certain circumstances. The question should be decided on the facts of each case in the light of common sense and plain thinking, and too much importance should not be attached to, or emphasis laid upon the niceties of verbal definitions.”

2.7. One is generally compelled to refer and rely upon judicial precedents to throw light on the aspect of ‘place of accrual/arisal’. This write-up is restricted to cross-border



outsourcing in service sector. Keeping this in mind, the judicial precedents which have deliberated on the ‘place of accrual’ in the context of services rendered or performed are only discussed.

2.8. In the light of the various judicial precedents, it becomes relevant to deliberate on some of the questions in the context of outsourcing. A typical outsourcing can pictorially depicted as under:

Figure 1

2.9. In the aforesaid diagram, there is an Indian company [“India Co”] which outsources certain services to one of its group companies [“Group Co”] outside India. The services are to be ultimately rendered to an overseas client. The client would make a payment to the India Co for the overall contract. India Co would in turn remunerate the Group Co for its efforts in the outsourced task.

2.10. It has been held that income from work done or services performed or rendered accrues at the place where the work is done or services are performed [Shoorji Vallabhdas and Co. v. CIT [1960] 39 ITR 775 (SC), Performing Right Society Ltd. v. CIT [1977] 106 ITR 11 (SC), CIT v Anamallais Timber Trust Ltd [1950] 18 ITR 333 (Mad), CIT v. Madras and Southern Mahratta Railway Co., Ltd. [1940] 8 ITR 280 (Mad), In re V. G. Every [1937] 5 ITR 216 (Cal) etc.]. Accrual is thus linked to the place of activity or performance. The person who pays for it or the place where it is utilized does not determine normally, the locale of accrual. Clauses (v), (vi) and (vii) of section 9(1), introduced from 1976 have modified this understanding. Under these sections, a ‘payer’ if a resident, could be the reason of accrual in India. If the payer is a non-resident, the place of utilization if in India is deemed as the locale of accrual.

2.11. In an outsourcing scenario and in such multitude of alternatives, various questions arise, in the context of determining the place of accrual of income.

(a) Is the place where services are performed (outside India in the illustration above) the only test to reckon the place of accrual?



(b) Can place of consumption be a place of accrual? – Is it in India (since India Co utilises the services of Group Co) or is it outside India (since the ultimate beneficiary or the overseas customer is outside India)?

(c) Can payer [India Co] be a place of accrual?

(d) Will the place of delivery of the outsourced deliverable matter? In other words, does it matter whether the Group Co has handed over the deliverable to the overseas client directly outside India or was it brought into India [to India Co] to be handed over ultimately to the overseas client?

(e) Whether place of receipt of monies by Group Co would be a determining factor?

(f) Should a person examine the situs of the contract between the parties having regard to the following:

(i) Is it a tripartite agreement between the parties or are these independent contracts between parties (i.e., main contract and sub-contract)?

(ii) Where are the agreements signed?

(iii) Where are they executed?

(iv) Under which law are they governed – Indian or overseas?

2.12. Some tests of deemed accrual, do not fit with the economic notions of accrual and its locale. The fallouts of a deemed accrual are also many. Resolving them has been a continual battle. Definitive rationale is still eluding us. Consequently, the debate persists. To have consistent and logically sustaining propositions is not easy. Whether a payment by a person who is not ordinarily resident [but yet a subset of resident] making a payment overseas could result in an income deemed to accrue or arise in India? Whether the proviso to section 5(1) exempting certain overseas income of a not ordinarily resident could help the prevention of accrual in India? Whether a source of income in India, of a payer [dependent agent PE] could expose the payee to tax obligations in India? Whether utilisation of services/ property/ right in India by a non-resident payer without the knowledge of the payee, expose the latter to tax obligations in India? Will the answer be different, if such utilisation happens in a subsequent year after the contract for usage of right or property is entered into?

2.13. Understanding the role of section 9 is therefore of utmost importance. The significance of this section can be appreciated in the light of some fundamental questions that could arise. For instance:

(a) If the charge of tax is established under section 5, is there a necessity to enter the precincts of section 9?

(b) Can section 9 expand the scope of section 5? Or is it subservient to it?

(c) Can section 9 function as an exemption section? Can section 9 exclude any income from chargeability despite it being chargeable under section 5 (on actual accrual basis)?

2.14. These doubts emanate primarily due to the complex interplay between section 5 and 9. Some facets of this intricate relationship between the two sections could be as under.



Interplay of sections 5 & 92.15. Sections 4 and 5 impose a ‘general’ charge. Section 9 ‘applies’ such general charge.

Section 9 is an operative section which effectuates the broad framework outlined by section 5. Sections 5 and 9 are not independent provisions. The genesis of section 9 is found in section 5.

2.16. Section 5(2)(b) mandates that income accruing or arising in India or deemed to accrue or arise in India is chargeable to tax in India. Section 9 enumerates incomes deemed to accrue or arise in India. Section 5 determines the boundary of incomes within which the legislature can levy tax. It is thus the outer-limit or boundary for charge of income-tax in India.

2.17. Section 5(2)(b) has two limbs – (i) actual accrual or arisal in India and (ii) deemed accrual or arisal in India. The latter is governed by section 9. Section 9 has been enacted for various reasons. It is a multi-faceted provision which (i) enlists incomes deemed to accrue or arise in India; (ii) clarifies the place of accrual or locale of income; (iii) exempts the charge created under actual accrual.

2.18. Section 9 ‘complements’, ‘supplements’ and sometimes ‘interferes’ with the scope of actual accrual in section 5 and as such, assumes the role of a special regime. Being special and specific, it should override the generic charge of section 5. That section 5 yields to section “9” is indicated in the opening portion of section 5 which reads ‘Subject to the provisions of this Act …’.

2.19. Section 9 being a “lex specialis”, in the event of any contradiction between the actual accrual and deemed accrual, the dictum of section 9 [deemed accrual] should prevail. To the extent that section 9 covers a subject matter, it would superimpose on section 5. In such circumstances, the resolution of an issue would be on the mandate of section 9. Section 9 may limit the reach or clarify the actual accrual in section 5. If section 9 curtails section 5, the general charge in the latter would be rendered ineffective. Participants may deliberate upon the all the above.

Section 9 – Clarificatory in nature2.20. As per section 9(1)(i), all income accruing or arising, whether directly or indirectly,

through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situated in India is deemed to accrue or arise in India.

2.21. The opening portion of section 9(1)(i) reads - ‘all income accruing or arising’. It thus deals with those incomes which have been concluded to be accruing or arising. Clause (i) thus deals with incomes whose ‘factum of accrual or arisal’ is crystallized and ‘cause’ of accrual is known. The cause of accrual could be ‘business connection’, property, asset or source. Clause (i) clarifies the place of accrual of such income. Similarly, clause (iv) clarifies that payment of dividend by an Indian company outside India is deemed to accrue or arise in India. Although, dividend paid by an Indian company to its shareholders would actually accrue in India, clause (iv) clarifies that the place of payment of such dividend does not matter.



Section 9 – Overriding effect of deemed accrual/arisal 2.22. If the income accrues or arises due to the causes enlisted in clause (i), the place of

accrual is compulsorily and forcibly dragged into India irrespective of where the actual place of accrual or arisal was. To this extent, the actual accrual or arisal have to pave way for deemed accrual/arisal.

2.23. Section 9(1)(ii) deals with place of accrual of salary. It provides that the place of accrual is the place where services are rendered. Thus the locale of income follows the activity of employment. The factum of rendering services in India suffices the charge of tax on salary income irrespective of the residential status of the employee, locale of the employer or receipt of salary. Clauses (v), (vi) and (vii) also could result in altering the place of accrual [more of all these later].

Section 9 – Exclusionary or exempting role2.24. Section 9 can contract or nullify or exempt the charge of tax. The exclusionary role of

section 9 can be understood having regard to the following:

(a) A person engaged in shooting of movies in India2.25. A non-resident engaged in shooting of cinematographic films in India could have been

held to be chargeable to tax in India as the activity of ‘shooting’ (activity test) happens in India. The income from such activity therefore accrues or arises in India. In fact even section 9(1)(i) is widely worded to encapsulate such income within the charge of tax. However, clause (d) in explanation 1 to section 9(1)(i) states that no income shall be deemed to accrue or arise in India through or from operations which are confined to shooting of any cinematographic films.

2.26. The scope of this provision was explained by para 4 circular 394 dated 14-9-1984 under the heading “Exemption of foreign film producers from taxation of income attributable to showing cinematographic films in India” [emphasis supplied]

(b) Purchase of goods in India for export2.27. Clause (i)(b) to section 9 clarifies that no income shall be deemed to accrue or arise in

India for an assessee through or from operations which are confined to the purchase of goods in India for the purpose of export.

2.28. Circular 163 dated 29-5-1975 clarified that clause (i)(b) of section 9 seeks to ‘exempt’ certain portion of profits attributable to purchase of raw materials. The relevant portion of the circular reads —

“The taxability of such portion of profits will, however, be subject to the exemption provided in clause (b) of the Explanation to section 9(1)(i)” [emphasis supplied]

2.29. The Central Board of Direct Taxes in both the aforesaid occasions has acknowledged that section 9 could operate as an ‘exemption’ section under certain circumstances. The learned authors Kanga & Palkhivala in their treatise ‘Law and Practice of Income Tax’ on clause (b) of section 9(1)(i) [Pages 266 & 267 – 8th edition] observe:

“But in the case of non-residents (though not in the case of residents who are not ordinarily resident) the consequent tax liability is negatived by clause (b) of the



Explanation. The effect is that no income is deemed to accrue in India to non-resident through or from operations confined to the purchase of goods in India for export even if the purchases are made through a regular agency established in India for that purpose.” [emphasis supplied]

2.30. The learned authors have acknowledged that section 9 has the power to ‘negate the tax liability’. They concur with the view that section 9 could create exception(s) to the ‘general charge’ created by sections 4 and 5.

2.31. On the interplay between section 5 and 9, the learned author V. S. Sundaram in his treatise ‘The Law of Income Tax in India’ [9th edition - page 314] observes as under:

“The combined effect of sections 5 and 9, with reference to the observations of the Supreme Court is as below. Where the income is received in India, both in the case of resident and in that of a non-resident, the income is taxable without apportionment. If the liability is on the basis of accrual in India, the apportionment should be made if there are several defined stages of accrual, i.e., manufacture, sales or purchase in so far as operations can be defined and apportionment is practicable; otherwise not. If the income is deemed to accrue or arise in India, the Explanations under clause (i) above should be followed. These explanations assume that accrual may be in stages, each stage corresponding to an ‘operation’ and there will be an apportionment in the case. The only difference therefore (apart from receipt under section 5) between section 5 and 9 is that in one case income actually accrues in India while in the other it is deemed to accrue.” [emphasis supplied]

2.32. One can discern from the above that if the taxability is fastened on the basis of ‘accrual in India’, the question of apportionment of income to India will have to be reckoned. The determination as also quantum of apportionment is outlined by section 9 and its explanations. Accordingly, any income which is chargeable to tax on ‘accrual’ basis under section 5 has to pass the litmus test under section 9 to firm-up the final charge of tax. To conclude, section 5 is subject to section 9. Section 9 would uphold, clarify, diminish or negate the charge created under actual accrual/arisal limb of section 5. Participants may deliberate on the above.

Determination of income chargeability if section 9 is considered applicable 2.33. As already detailed, section 9(1)(i) states that all income accruing or arising, whether

directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situated in India is deemed to accrue or arise in India. An outsourcing contract would necessitate an examination of the implications under each of the above. Each of these are dealt with below:

Business connection 2.34. The first limb of the above clause refers to income arising from any business

connection in India. The expression ‘business connection’ under section 9(1)(i) connotes carrying of some business activity in India. Extracts of the various explanations in section 9(1) which are relevant to business connection are as under —



“Explanation 1 – For the purposes of this clause –

(a) in the case of a business of which all the operations are not carried out in India, the income of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India..

Explanation 2 – For the removal of doubts, it is hereby declared that “business connection” shall include any business activity carried out through a person who, acting on behalf of the non-resident,–

(a) has and habitually exercises in India…; or

(b) has no such authority, but habitually maintains in India a stock of goods or merchandise ; or

(c) habitually secures orders in India..

Provided that such business connection shall not include any business activity carried out through a broker, general commission agent or any other agent having an independent status, if such broker, general commission agent or any other agent having an independent status is acting in the ordinary course of his business:

Provided further that where such broker, general commission agent or any other agent works mainly or wholly on behalf of a non-resident (hereafter in this proviso referred to as the principal non-resident) or on behalf of such non-resident and other non-residents which are controlled by the principal non-resident or have a controlling interest in the principal non-resident or are subject to the same common control as the principal non-resident, he shall not be deemed to be a broker, general commission agent or an agent of an independent status.

Explanation 3 – Where a business is carried on in India through a person referred to in clause (a) or clause (b) or clause (c) of Explanation 2, only so much of income as is attributable to the operations carried out in India shall be deemed to accrue or arise in India.

Explanation 4 – For the removal of doubts, it is hereby clarified that the expression “through” shall mean and include and shall be deemed to have always meant and included “by means of”, “in consequence of” or “by reason of”.” (emphasis supplied)

2.35. Explanation 2 to section 9(1)(i) defines ‘business connection’ in an inclusive manner. It reads - “business connection” shall include any business activity carried out through a person who, acting on behalf of the non-resident. It does not define business connection per se. It includes any business activity carried out through a person. Business connection is equated with ‘activity’. Additionally, such activity has to be carried out through a person. This implies that a business connection for explanation 2 visualizes human intervention (and not automated business through machines).

2.36. Further, such ‘person’ must act on behalf of the non-resident. In other words, an agent of non-resident is envisaged in business connection. Such person establishes the ‘connect’ of non-resident with the activity in India. An ‘activity in India’ therefore gets transformed into a ‘business connection in India’. For this transformation the activity



has to recur and repeat. This is evident from clauses (a), (b) and (c) of the definition which use the term ‘habitually’.

2.37. The locale of action has to be in India. The stress is on the action – ‘in India’. Business connection cannot be established if the connection is merely with India.

2.38. A business could have various operations. Some could be carried out in India and some outside India. It is only those incomes attributable to ‘operations’ which are carried out in India that is taxable under the Act. If it can be established that there are no operations carried out in India, then the non-resident would not be taxable in India [Refer CIT v. Toshoku Limited (1980) 125 ITR 525 (SC)]. This is the mandate of Explanations 1 and 3 of section 9(1)(i).

2.39. The concept of ‘business connection’ when applied in the context of outbound outsourcing raises a number of queries. We have enlisted some of them below with the help of a typical outbound outsourcing model (refer Figure 1):

(a) Whether Group Co under the circumstances establishes a business connection in India?

(b) Explanation 1(a) requires ‘reasonable’ attribution of profits. How would the reasonability be measured?

(c) Business connection under explanation 2 is created by an agent’s activity in India. Does this mean physical presence of the agent of the Group Co. in India is required for establishing business connection?

(d) Can India Co be called as an agent of the Group Co to establish business connection in India? Will the answer change, if the India Co is a wholly owned subsidiary of the Group Co?

Existence of agent to establish business connection2.40. An important facet of “business connection” is the existence of an agent. Explanation

2 clarifies that business connection will not include cases where the business activity is carried out through a broker, general commission agent or any other agent having an independent status, if such broker, general commission agent or any other agent having an independent status is acting in the ordinary course of his business.

2.41. The existence or absence of an ‘agent’ would have a substantial bearing on establishing connection in India. The below illustrated case study throws some issues for deliberation:



Figure 2

2.42. In the aforesaid diagram, there is an Indian company [“India Co”] which outsources certain services to one of its group companies [“Group Co”] outside India. The services are to be ultimately rendered to a client in India. The client would make a payment to the India Co for the overall contract. The India Co would in turn remunerate the Group Co for its efforts in the outsourced task. With this fact pattern, if the business connection of Group Co in India is examined; the following questions may arise:

(a) Whether the fact that the contractor (India Co) and the ultimate client/ beneficiary (Client) are in India establishes the business connection in India?

(b) Would the conclusion change if the services are rendered by the Group Co through:

i. Agent in India?

ii. Branch in India?

iii. Subsidiary in India?

(c) Business connection is not applicable if the agent has an ‘independent’ status. An agent working mainly or wholly for the non-resident or its group companies is not an agent with independent status. Does this mean that independence is measured only in terms of ‘scope of the agent’s work’ or who its beneficiaries are?

(d) If an agent is mainly/wholly financially or economically dependent on the non-resident (Group Co in the present case); can business connection be constituted? Can it be said that the agent is merely a conduit or a mirror image of Group Co in India? What signifies independence?

(e) How would interplay between Explanations 1(a), 2 and 3 to section 9(1) impact the chargeability of income in India?

(f) Finance Act, 2012 inserted Explanation 4 to clarify the expression “through” to mean and include “by means of”, “in consequence of” or “by reason of”. Does this expand the scope of section 9 and business connection?



i. ‘Consequence’ may be felt in a year when the assessee (Group Co) has no territorial nexus at all with India. For instance, Group Co had a dependent agent in India to carry on business in India whereby business connection is established. After certain years, Group Co wraps up business in India. One year later Group Co renders some services to the Indian client directly. Will the services rendered be considered as one in consequence of its business connection in earlier year?

ii. Does “by reason of ” cover every other person (directly, indirectly or remotely) associated with a business connection in India?

Property or asset in India2.43. Income from property or asset in India is covered under section 9(1)(i) of the Act.

Both the terms ‘assets’ and ‘property’ have not been defined in the Act and have to be understood in their normal connotation. In a typical outbound outsourcing model, the services are rendered by the non-resident in or outside India. The question is whether existence of any property or asset in India results in income for the non-resident?

2.44. In the outsourcing context, the non-resident (to whom certain services are outsourced) may perform activities or renders services with the use of ‘asset’ or ‘property’ in India [for instance, a server in India, intellectual property held by the Indian company, infrastructure facility of Indian company - i.e., office & technology]. In such an eventuality, would any part of the income of the non-resident (Group Co in the present case) be deemed to accrue or arise in India? Is the ownership of assets (owned by India Co in the present case) a relevant criterion? Whether mere ‘use’ of assets could satisfy the criterion of ‘income accruing through or from assets in India’? Participants may deliberate on this aspect.

Source of income in India2.45. The term ‘source’ has not been defined in the Act. “Source” is not a legal concept, but

something which a practical man would regard as a real source of income. [Rhodesia v. Comr of Taxes 9 ITR Suppl. 45, 52 (PC); CIT v. Kanchan Bai 77 ITR 123, 126 (SC); Amrit Kunwar v. CIT 14 ITR 561, 582 (FB); Vijaykuverba v. CIT 49 ITR 594, 605; Sterling Foods v. CIT 150 ITR 292, 298; Shiva Prasad v. CIT 84 ITR 15]. In Seth Shiv Prasad v. CIT [1972] 84 ITR 15 (All), it was held:

“A source of income may be described as the spring or fount from which a clearly defined channel of income flows. It is that which by its nature and incidents constitutes a distinct and separate origin of income capable of consideration as such in isolation from other sources of income and which by the manner of dealing adopted by the assessee can be treated so.”

2.46. The source of income has to be in India for section 9(1)(i) to apply. Source of income is thus an important ingredient for triggering section 9(1)(i). Under normal connotation, source implies the starting point or the genesis of something [acknowledged by AAR in Dell International Services India (P) Limited (2008) 305 ITR 37 (AAR)]. The concept of ‘source’ has important ramifications in an outsourcing business. Keeping the importance of the concept of source in mind, the ensuing paragraphs capture the snapshot of some landmark rulings in the context of ‘source’:



Contract is the source2.47. The Apex Court in the case of Vodafone International Holdings B.V. v. Union of India

(2012) 341 ITR 1 (SC) held contract to be the locale of source:

“166. Revenue placed reliance on “Source Test” to contend that the transaction had a deep connection with India, i.e. ultimately to transfer control over HEL and hence the source of the gain to HTIL was India.

167. Source in relation to an income has been construed to be where the transaction of sale takes place and not where the item of value, which was the subject of the transaction, was acquired or derived from. HTIL and Vodafone are offshore companies and since the sale took place outside India, applying the source test, the source is also outside India, unless legislation ropes in such transactions.” (emphasis supplied)

2.48. The Delhi Tribunal in the case Lufthansa Cargo India (P) Ltd. v. DCIT (2009) 91 ITD 133 (Del.) treated the contractual arrangement and payer (referred later) as a source of income.

“The assessee’s ‘source of income’ is the activity of wet-leasing of aircraft to non-resident companies under contract made outside India and the source of income is outside India.”

2.49. One may also refer the Privy Council decision in the case of Raja Bahadur Kamakshya Narain Singh of Ramgarh v. CIT [1943] 11 ITR 513 (PC) which held that source of the royalties may be deemed to be the lessee’s covenants to pay them [Also Hart (Inspector of Taxes) v. Sangster (1958) 34 ITR 303 (CA)].

Payer (Customer) is the source of income2.50. The Bangalore Tribunal in the case of Titan Industries Ltd. v. ITO (2007) 11 SOT 206

(Bangalore) observed -

“9. Source of income is not a legal concept but it must mean something which a practical man regards as a real source of income. When the customer of company i.e. associate company is located outside India then it cannot be said that source of income is not outside India.”

2.51. The Delhi Tribunal in the case Lufthansa Cargo India (P) Ltd. v. DCIT (2009) 91 ITD 133 (Del.) held as under:

“In the context of an international transaction source can be said to be ‘outside India’ if… the payer is a non-resident.”

Payer is not the source but activity is the source2.52. In Asia Satellite Telecommunications Co. Ltd. v. Dy. CIT (2003) 85 ITD 478 (DELHI) the

Tribunal observed:

“We are agreeable that the source does not refer to the person who makes the payment but it refers to the activity which gives rise to the income. In the present context the activity which is resulting into income in the hands of non-resident customers, namely, the TV channels is the ultimate viewership of the programmes transmitted by them through the assessee in the footprint areas including India.”



2.53. In International Hotel Licensing Co., In re (2007) 288 ITR 534 (AAR), the Authority for Advance Ruling observed:

“There can be no gain saying that a person who makes the payment cannot be the source of income for purposes of section 9(1)(i) of the Act; the term therein refers to the activities which give rise to making a payment by the person. For example the employer pays the salary for the activities of the employees or the principal pays commission to the agent for his activities.”

2.54. In South West Mining Limited (2005) 278 ITR 233 (AAR), the AAR observed:

“If the fees is payable in respect of services utilised in a business or profession carried on by such person outside India or for the purpose of making or earning any income from any source outside India, the fees payable to the non-resident consultant in Canada will not be deemed income of the consultant arising or accruing in India.”

2.55. In a recent Delhi High Court decision in CIT v. Havells India Ltd. (2013) 352 ITR 376 (Del) it has been held that the customer cannot be considered as source of the income though he is the source of the monies received.

Other sources of income2.56. In certain cases an asset was held to be the source [Refer Hart v. Sangster (1958) 34

ITR 303; Rhodesia Metals Limited v. CIT (1941) 9 ITR (Supp) 45; Cull v. Cowcher 18 TC 449]; some have held law or statute as source of income [Refer Raja Rameshwara Rao v. CIT (1963) 49 ITR 144]; few have held decree of court to be the source [Refer Princess Maheshwari Devi of Pratapgarh v. CIT (1984) 147 ITR 258 (Mum.)].

2.57. In the typical case of an outbound structuring, the foreign company (to whom the work has been outsourced) carries out its activities outside India. The payer (being the Indian company which outsourced a part of the work) is in India. The contract documenting such outsourcing arrangement could be executed in or outside India. The services rendered by the foreign company (outsourced company) could be ultimately consumed by a company which could be in a third country (which is neither incorporated in the payer’s country or the country in which services are provided). Thus, a single outsourcing transaction could have nexus to various nations. In such an eventuality, the question is:

(a) Which country lay claim to taxing the income on the ground that the source of income is in their jurisdiction?

(b) Whether the source of income is different from the place of its accrual?

Capital assets in India2.58. Outsourcing arrangements often require assets to be transferred between the customer

and the service provider (for example, equipment, intellectual property or real estate), usually on the commencement or termination of such arrangements. This could entail tax issues such as:

(a) Whether any taxable profits or gain (actual or deemed) arise for the transferor (whether or not there is a separate charge for it)? In which country would the same be taxable?



(b) What would be the characterisation of the income - royalty or otherwise?

(c) Can such gains/profits be mitigated [or would they be enlarged] by leasing or licensing the assets, rather than transferring ownership absolutely?

(d) Would there be any challenges around apportionment of consideration between assets transferred and those which are actually utilised by the service provider to ascertain the quantum of income deemed to accrue or arise in India?

Specific provisions of section 92.59. Section 9(1)(i) is general in nature. The other limbs of section 9 deal with specific

streams of income. In the context of business outsourcing, sections 9(1)(vi) and 9(1)(vii) dealing with particular nature of income viz., “royalty” or “fees for technical services” are relevant. Once an item falls within the specific category [of sub-clause (vi) or (vii) of section 9(1)], the general category [of sub-clause (i)] would have to yield to the specific category. This was the view held among others in the following decisions.

�� !�"#

�� $�� $�%�&�'��*+� �+*�� /"� �</� �� =� �>�?�"#

�� $�� @+��J�?*Q��U%��&� �� =�� X��"#

�� 'X� �+��&��&� �� /�� Y<=� �Z\�"#

�� ^�+��*�� +��&��&� �� =�� _�<=� ��?�"�

2.60. If the transaction falls within section 9(1)(vi) or 9(1)(vii); whether there is any business connection or not – is of no consequence.

Section 9(1)(vi) – royalty2.61. Outsourcing or Out-Tasking [wherein only specific tasks are outsourced] is an approach

whereby a business utilises an external supplier for the management of processes, products or technologies. It is a tactical approach of sourcing the processes or technologies or technical equipments. This ensures managing fewer processes involving lesser risk by outsourcing processes which are time and resource consuming.

2.62. Business process outsourcing has evidenced licensing of ‘intellectual properties’; development of software through use of technical know-how. Success in off-shoring has encouraged many entities to outsource key business processes and high-end knowledge work. Outsourcing cuts into the traditional “core competencies” of organisations. The historical ‘labour arbitrage’ is advancing towards “intellectual arbitrage”. This wave of movement towards the outsourcing of the key knowledge functions has resulted in payment of royalties towards use of such intellectual properties and consequent income-tax implications.

2.63. Section 9(1)(vi) deals with taxation of royalty payments to non-residents. It states that royalties payable by a resident of India to any non-resident would be deemed to accrue or arise in India. The term ‘royalty’ is defined in Explanation 2 to section 9(1)(vi) in an exhaustive manner [Annexure I].

2.64. ‘Royalty’ in general means consideration for the use of patent, copyright or any other property of similar nature. The word web defines it as payment to the holder



of a patent or copyright or resource for the right to use their property. As per Jowitt’s dictionary of English Law, fifth edition Vol. 2, ‘royalty’ means a payment reserved by the grantor of a patent, lease of a mine or similar right, and payable proportionately to the use made of the right by the grantee [cited from Advanced Law Lexicon, 3rd edition 2005].

2.65. Royalty in general is associated with aspect of use or exploitation of the property. It is a consideration received by the owner for granting/licensing a right to use the said property. Property for this purpose would include intellectual properties such as patents, copyrights and similar properties. The holder or owner of the intellectual properties does not part away with the proprietary rights. He permits others to use the rights, which use otherwise would have constituted a ‘trespass’. A payment for an outright sale of intellectual properties is not generally regarded as ‘royalty’ (Refer CIT v. Ahmedabad Manufacturing & Calico Printing Co. (1983) 139 ITR 806 (Guj); CIT v. Neyveli Lignite Corporation Ltd. 243 ITR 459).

2.66. The definition of ‘royalty’ under the Act is however wider than its meaning in the general context. The explanation under the Act not only includes payments for the use of the properties, but also covers within its ambit, transaction involving transfer of all or any rights in the said properties.

2.67. In the context of business outsourcing, payments made to service providers could include an element of royalty. The income-tax issues that could emanate from this are discussed below with the help of an illustration:

Figure 3

2.68. In the aforesaid diagram, there is an Indian company [“India Co”] which outsources certain services to one of its group companies [“Group Co”] outside India. India Co would remunerate the Group Co for its efforts in the outsourced task. In the course of rendering services, Group Co provides certain confidential, technical know-how which



is niche and critical for the successful execution of outsourced task. With this fact pattern, the following questions may arise:

(a) Can it be argued that the final deliverable handed over by the Group Co to India Co involves transfer of rights (partial or whole) to use the intellectual property Co? Does the payment or part thereof by India Co constitute royalty?

(b) Is the payment made by India Co is for the ‘effort’ or ‘result of the effort’ by Group Co?

(c) Will the conclusion alter if the intellectual property deliverable was incidental to the outsourcing [and not specifically paid for use of IPR(s)]?

(d) Either way (whether separately reckoned or not), can it be held that the payment made by India Co is not only for services rendered by the Group Co but also for the IPR(s) or the copyrights and other incidental rights attaching in the services rendered by the Group Co?

(e) Are these questions to be answered on the basis of documentation (for example, contracts; invoices) or intention of parties?

(f) Explanation 3 to section 9(1)(vi) includes transfer of all or any rights in computer software within the ambit of royalty definition in the Act. Will this amendment impact the IT software outsourcing industry?

(g) Explanation 5 to section 9(1)(vi) states that any consideration in respect of any (i) rights; (ii) property; or (iii) information irrespective of ‘possession’ or ‘usage’ or ‘locale’, is royalty. Would this explanation alter the definition in Explanation 2 or its understanding?

Applicability of section 9(1)(vii) 2.69. As per section 9(1)(vii), income by way of fees for technical services is deemed to

accrue or arise in India. Explanation 2 to section 9(1)(vii) defines the expression ‘fees for technical services’ [Annexure II].

2.70. Rendering of managerial, technical or consultancy services (including the provision of services of technical or other personnel), for a consideration is regarded as ‘fees for technical services’ (“FTS”). The terms ‘managerial, technical and consultancy’ employed in the definition of ‘fees for technical services’ have not been defined in the section 9(1)(vii). In the absence of definition of the terms one needs to understand the meaning thereof in their natural sense.

The Word Web defines these terms as follows:

Managerial = Of or relating to the function or responsibility or activity of management.

Technical = 1. Of or relating to technique, 2. Characterising or showing skill in or specialized knowledge of applied arts and sciences, 3. Of or relating to proficiency in a practical skill, 4. Of or relating to a practical subject that is organised according to scientific principles, 5. Resulting from or dependent on market factors rather than fundamental economic considerations, 6. (of production of chemicals) made for commercial purposes especially on a large scale.



Consultancy = The practice of giving expert advice within a particular field.

The Shorter Oxford English Dictionary defines these terms as follows:

Managerial = of, pertaining to, or characteristic of a manager, esp. a professional manager of or within an organization, business, establishment etc.,

Manager = 1. A person who manages something, 2. ...... 3. A skilled in managing house hold affairs, money etc., ..... 4. A person whose office it is to manage an organization, business establishment, or public institution or part of one; a person with a primarily executive or supervisory function within an organization etc.; a person controlling the activities of a person or team in sports, entertainment, etc; the dictionary has used the term ‘manager’ along with prefix such as “bank manager, factory manager, floor manager, football manager, hotel manager, personnel manager, stage manager, team manager, theatre manager, etc.,”

Technical = 1. having knowledge of or expertise in a particular art, science, or other subject, 2. Pertaining to, involving or characteristic of a particular art, science, profession or occupation or the applied arts and science generally; 3. using or dealing with terms that belong to a particular subject or field; requiring specialist knowledge to be understood; treating a subject in a specialist way;

Consultancy = the work or position of a consultant; a department of consultants;

Consultant = A person who gives professional advice or services in a specialist field; the dictionary has used the term ‘consulting’ along with prefix such as “consulting architect, consulting engineer, consulting physician”.

2.71. ‘Outsourcing’ or the use of third-party service providers is a business strategy increasingly in evidence as it enhances the capability to respond to an increasingly competitive market. A host of activities are currently being outsourced. Some are administrative or ancillary; some supportive; and some integral to the functioning of the organisation. Irrespective of the role they play in the overall functioning of the organisation, they create dependencies upon these specialised “service providers”.

2.72. From an income-tax standpoint, the challenge is around categorising the service rendered by these “service providers” as ‘managerial’, ‘technical’ or ‘consultancy’. There are many services which could be excluded from the realm of these three categories. In certain cases, the distinction between the three gets blurred leaving the taxpayer with some sort of a dilemma. Not all treaties include all the three limbs of the definition. Hence, appropriate classification assumes importance. Some of such services which are generally outsourced and the attendant qualification disputes are illustrated below:

(a) Is marketing function a managerial, technical or consultancy services?

(b) Is routine or mechanical repair of plant and machinery a technical service?

(c) Is maintenance of day-to-day books of account and banking functions a consultancy service?

(d) Are commercial functions or routine felicitation services covered within the ambit of section 9(1)(vii)?



(e) Should ‘managerial services’ involve some element of planning of activity to be done? Or mere execution is sufficient?

2.73. The provisions of sections 9(1)(vi) and (vii) are subject to certain inbuilt exclusions. A transaction which is covered by these exclusions cannot be deemed to accrue or arise in India and thereby escapes the levy of tax.

Exclusions from section 9(1)(vi)/(vii)2.74. Clauses (vi) and (vii) of section 9(1) articulate the circumstances in which income

from royalties and FTS would be deemed to accrue or arise in India respectively. In an outbound outsourcing context, the payment would be normally made by an Indian company/resident. Clause (b) of sections 9(1)(vi) and (vii) deal with payments made by residents. The same is as under:

9(1)(vi)(b) a person who is a resident, except where the royalty is payable in respect of any right, property or information used or services utilised for the purposes of a business or profession carried on by such person outside India or for the purposes of making or earning any income from any source outside India

9(1)(vii)(b) a person who is a resident, except where the fees are payable in respect of services utilised in a business or profession carried on by such person outside India or for the purposes of making or earning any income from any source outside India

2.75. Both clauses include twin exclusions. The wordings of the exclusions are almost identical. Accordingly, the exclusions in clauses (vi)(b) and (vii)(b) are addressed together.

2.76. It is manifest from the above that if – technical services/royalties are utilised (i) in a [or for the purposes of – as in royalty] business or profession carried on by a resident outside India; or (ii) for the purposes of making or earning any income from any source outside India, then the payment even though covered under the definition of “royalty” or “FTS” would be outside the scope of section 9(1)(vi)/ (vii).

2.77. The conjunction between these two exceptions is ‘or’; indicating them to be ‘alternate’ exceptions. In the event any of the exception is satisfied, the royalties/ fees payable cannot be deemed to accrue or arise in India under section 9(1)(vi)/(vii).

2.78. The former exception deals with fee/amount payable ‘in respect of’ royalties/ technical services utilised in/for ‘business carried on outside India’. The latter deals with royalties/ fee payable and utilised for ‘the purpose of’ making or earning any income from any ‘source’ outside India.

2.79. The element of ‘utilisation’ is common to both these exceptions. The term ‘utilise’ has not been defined in the Act. The term ‘utilize’ as per Word Web means ‘Put into service; make work or employ for a particular purpose or for its inherent or natural purpose’. As per Shorter Oxford English Dictionary, ‘utilise’ means ‘make practical use of’, ‘use effectively’, ‘turn to account’.



2.80. The legislature does not prescribe the ‘extent’ to which such services have to be utilised in the business carried outside India or for purpose of making or earning a source of income outside India. If the services are utilised, the exception to section 9(1)(vi)/(vii) is satisfied. There is no stipulation that such services must be ‘wholly or only or exclusively utilized’ for business carried on outside India/ making or earning source of income outside India. It is also not necessary that for the exception to apply, the whole of the business of the Indian company should be carried on outside India. The exception is limited to the extent of utilisation for the business.

2.81. Interestingly, section 9(1)(vii)(b) uses the phrase ‘utilized in’ whereas 9(1)(vi)(b) uses ‘utilized for’. The word “in” used as a preposition after the term “utilised” in section 9(1)(vii). It has a narrow meaning and signifies inclusion or position within limits of space, time or circumstance. Contrastingly, the phrase ‘utilised for’ is wider in its scope and ambit. This difference in terminologies could have consequent tax implications while determining the chargeability of royalty/ FTS in India. Participants may deliberate.

2.82. Although the extent of utilisation could possibly vary (depending upon whether the language is ‘utilised in’ or ‘utilised for’), the existence of ‘utilisation’ element is a must. This indicates the importance of utilisation to satisfy either of the exceptions mentioned above. They were inserted into the statute by Finance Act, 1976. Interestingly, the term ‘utilisation’ is absent in circular no. 202 dated 5-7-1976 [which explained the insertion of these provisions into the statute]. The relevant portion of the circular is as under:

“The Finance Act, 1976 has inserted a new clause (vi) in section 9(1) clearly specifying the circumstances in which the royalty income will be deemed to accrue or arise in India and also defining the term “royalty”.

15.3 Under the new provision, royalty income of the following types will be deemed to accrue or arise in India:

(a) royalty payable by the Central Government or any State Government;

(b) royalty payable by a resident, except where the payment is relatable to a business or profession carried on by him outside India or to any other source of his income outside India ; and

(c) royalty payable by a non-resident if the payment is relatable to a business or profession carried on by him in India or to any other source of his income in India.

…..

16.1 As in the case of royalty, the Finance Act, 1976 has amended the Income-tax Act clearly specifying the circumstances in which income by way of “fees for technical services” will be deemed to accrue or arise in India and also defining the expression “fees for technical services”. For this purpose, a new clause (vii) has been inserted in section 9(1).

16.2 Under the new provision, income by way of “fees for technical services” of the following types will be deemed to accrue or arise in India:



(a) fees for technical services payable by the Central Government or any State Government;

(b) fees for technical services payable by a resident, except where the payment is relatable to a business or profession carried on by him outside India or to any other source of his income outside India; and

(c) fees for technical services payable by a non-resident if the payment is relatable to a business or profession carried on by him in India or to any other source of his income in India.”(emphasis supplied)

‘Utilised’ v. ‘Relatable to’2.83. The circular uses the phrase ‘is relatable to’ as compared to or contrasted with

‘utilized’ in the Act. Similarly, circular 229 dated 9-8-1977 [which explained the amendments made by Finance Act 1977] also uses the phrase ‘relatable to’. Whether the import and impact of the statutory language has been diluted by the above referred circulars? Whether in the view of the language in the circulars, is it arguable that a lesser intensity of relationship with business carried on outside India would help the non-resident in escaping the deeming fiction in 9(1)(vi) and (vii)? On the other hand, whether such ‘lesser intensity’ relationship make payments made by non-residents to deemed to accrue or arise in India? In other words, would the difference in terminology between the Act and circular have a bearing on interpretation of this provision?

2.84. The interpretation adopted [by applying the phrase ‘relatable to’ instead of ‘utilised’] could have equal and opposite implications under clauses (b) and (c) of sections 9(1)(vi) and 9(1)(vii). In the context of the present write-up wherein the taxation of non-resident is examined, the application of the phrase ‘relatable to’ may be worthwhile - Participants may deliberate.

2.85. Keeping aside the mismatch between the legislative intent [in the board circulars] and the language used in the Act, we proceed to deliberate on the two exceptions by giving primacy (and ignoring concession extended [if any] by the circular) to the Act [ie, utilisation] –

Exception I – Utilisation of services in ‘business carried on outside India’2.86. This exception has certain key words. They form the crux of interpretation of this

exception. Firstly, the term ‘business’ is defined in section 2(13) of the Act. As per the said definition, business includes any trade, commerce or manufacture or any adventure or concern in the nature of trade, commerce or manufacture. The term ‘business’ is of wide and indefinite import. In a fiscal statute, it must be construed in a broad rather than a restricted sense - Mazgaon Dock Ltd. v. CIT/CEPT [1958] 34 ITR 368 (SC), CIT v. Calcutta National Bank Ltd. [1959] 37 ITR 171 (SC), Sole Trustee, Loka Shikshana Trust v. CIT [1975] 101 ITR 234 (SC), S.G. Mercantile Corpn. (P.) Ltd. v. CIT [1972] 83 ITR 700 (SC); Continental Construction Ltd. v. CIT [1992] 195 ITR 81 (SC)

2.87. The language employed in section 9(1)(vii)(b) is ‘…fees are payable in respect of services utilised in a business’. The phrase ‘in respect of’ means ‘attributable to’ or if it is given a wider meaning, “relating to or with reference to” [Refer see Asher v. Seoford



Court Estates Ltd. [1950 A.C. 508, 5261]; Tolaram Relumal v. State of Bombay [1955] 1 SCR 158 at P. 165: (AIR 1954 466 at p.499); CIT v. Synopsis International Old Ltd. (2012) 212 Taxman 454 (Kar.)].

2.88. The usage of the phrase ‘in respect of’ broadens the scope of the exception. It would exclude payments in respect of services utilised for a business outside India from being deemed to accrue or arise in India.

2.89. The words ‘carried on’ are indicative of continuum, frequency or regularity. According to the Stroud’s Judicial Dictionary, the phrase ‘carried on’ - “implies a repetition or series of acts.” In Smith v. Anderson, 15.CH.D 247, 277-278, the observation of Brett L.J. were as under:—

“The expression ‘carrying on’ implies a repetition of acts, and excludes the case of an association formed for doing one particular act which is never to be repeated”. In Kirkwood v Gadd (1910) AC 422, at page 423, Lord Loveburn also said: “what is carrying on business? It imports a series of repetition of acts”. [Refer Golf in Dubai LLC v. DIT [2008] 306 ITR 374]

2.90. The words “carrying on business” require something more than merely selling or buying, etc. Whether a person “carries on a business” in a particular commodity must depend upon the volume, frequency, continuity and regularity of transactions of purchase and sale in a class of goods and the transactions must ordinarily be entered into with a profit motive (Board of Revenue v. A. M. Ansari [1976] 38 STC 577 (SC); [1976] 3 SCC 512).

2.91. It is important to note that for the exception to apply a proactive test of user or utilisation has to be satisfied. The royalty definition may get attracted if the payment is for any right property or utilization out of the various limbs in the definition. The user test finds a mention in only in clauses (iii) and (iva). For the exception to apply, the user/utilization test however is always to be demonstrated.

2.92. It is to be borne in mind that section 9 attempts to charge income to tax in India by enacting a deeming fiction. A deeming section is to be construed and interpreted strictly [CIT v. Amarchand N. Shroff (1963) 48 ITR 59 (SC); CIT v. Mother India Refrigeration Industries (1985) 155 ITR 711 (SC), CIT v. Khimji Menshi (1992) 194 ITR 192 (Mum.) and other cases]. Logically therefore, the exception to the deeming section is to be liberally construed.

Exception II - utilized of services for the purpose of making or earning any income from any source outside India2.93. The term ‘source’ has not been defined. Judicial precedents (as discussed earlier) have

attempted to ascribe a meaning to source as a start point or origin. For the purposes of section 9(1)(vi)/(vii)(b), the source of such income should be outside India.

2.94. The provision does not intend that the payments should be ‘exclusively’ for the purpose of earning any income from source outside India. If the condition of foreign sourced income is satisfied, the second exception is triggered.

2.95. On a perusal of the twin conditions, it is evident that the intention is (i) to carve out those transactions which do not have sufficient territorial nexus with India and (ii)



exclude such transactions from the ambit of taxation in India [Refer International Tire Engineering Resources LLC, In re (2009) 319 ITR 228].

2.96. The “source of income” as a cause of exception is mentioned along with a business carried on outside India. One way of interpreting the same would be to regard the two as mutually exclusive. Proceeding further on these lines of reasoning, a person involved in a business should have no occasion to invoke the rule of “source outside India” in securing an exemption. The wordings of the exemption are “making or earning any income from a source outside India”. The underlined words find a mention in section 57, dealing with “Income from other sources”. Can it be therefore argued that the exception is intended to deal with non-business incomes? Alternatively, can one contend source of income outside India and carrying on business in India can co-exist? [Refer Dell International Services India (P) Ltd. (2008) 305 ITR 37 (AAR)] Participants may deliberate.

2.97. The role of the twin exceptions is significant as they would (for a non-resident payee) withdraw the entire transaction from the charge of tax in India. Appropriate interpretation of the language employed is critical. Participants may deliberate on the following issues enlisted along with illustration below:

Figure 4

2.98. In the aforesaid diagram, there is an Indian company [“India Co”] which outsources certain services to one of its group companies [“Group Co”] outside India. The services are to be ultimately rendered to an overseas client. The client would make a payment to the India Co for the overall contract. The India Co would in turn remunerate the Group Co for its efforts in the outsourced task. In this fact pattern, various questions arise in the context of exceptions to section 9(1)(vi)/(vii).

i. What constitutes carrying on business outside India?

ii. For the exception to be triggered, the utilisation of services should be with reference to a business carried on outside India – Should such business be carried on wholly outside India?



iii. Whether the work carried out by the Group Co can be regarded as a business of India Co carried on outside India? If the Group Co is subject to comprehensive control and detailed direction from India Co, would the exception of 9(1)(vi)/(vii) be attracted/ strengthened?

iv. If the Group Co constitutes a PE of India Co [under dependent agency test] whether the conclusion would alter?

v. If instead of an outbound outsourcing, if there was an inbound outsourcing, whether explanations 1(a) and 3 to 9(1)(i) would have prevented any income of the non-resident from being taxed even though the test of business connection is satisfied?

vi. Whether the client could be regarded as a source of income outside India, to trigger the exception?

3. TREATY PROVISIONS3.1. Having referred the provisions of the Income-tax Act, one needs to examine the

corresponding Treaty provisions.

Relief under Double Taxation Avoidance Agreement 3.2. Double Taxation Avoidance Agreement (“Tax treaty” or “DTAA”) is designed to avoid

double taxation or provide relief in case of double taxation of the same income. Section 90(2) along with relevant circulars confirm that the provisions of the Act would apply to the extent they are beneficial as compared to the Tax treaty.

3.3. As detailed earlier, a non-resident rendering outsourcing services to a resident in India could be chargeable to tax in India under the relevant provisions of the Act. Typically, such income would be categorised as (i) business income; (ii) royalty or (iii) fees for technical services. Correspondingly, one will have to examine the relevant articles of the applicable tax treaty.

3.4. ‘FTS’ or ‘royalty’ income generally is a constituent of business income. It should accordingly be assessed under the head ‘Profits and gains from business or profession’. Many Tax Treaties however provide for technical services and royalty being dealt with under separate articles.

3.5. Under the Tax Treaty therefore, three articles which can have bearing on outsourcing income are – Business Profit article (read with PE article) or FTS article or Royalty article. [We have restricted the discussion to inter-corporate transactions and accordingly not dealt with Independent personal services]. Few implications of these articles in the context of outsourcing are discussed in the ensuing paragraphs keeping the India-US treaty as the basis.

(A) Permanent establishment3.6. Permanent establishment as a concept for levying tax in based on the economic

allegiance between the taxpayer and the taxing state. For cross-border outsourcing arrangements, in particular those involving ‘off shoring’ (the provision of services from one or more offshore jurisdictions), consideration should focus on whether the



arrangements will give rise to a permanent establishment of the payer in the service provider’s jurisdiction.

3.7. In general, a PE is a “fixed place of business” through which the business of a foreign enterprise is wholly or partly carried on in the source country. Even though the basic concept of PE revolves around fixed place of business, it may also extend to certain activities of the foreign enterprise being carried out through a ‘dependent agent’ (agency PE rule) or furnishing of services through employees (service PE rule). Where an outsourcing involves any element of “off-shoring”, there may be a risk of the service provider creating a PE in the relevant off-shore jurisdiction. In practice, this is likely to be an issue where the service provider is economically dependent on the customer or concludes contracts on its behalf.

Fixed place PE3.8. Article 5 of the India-US DTAA defines a PE [Annexure III]. Paragraph 1 emphasises

the fixed place concept. The place of business must be of enduring character. It should reflect durability or permanency. It is not necessary however that the place should be owned by the enterprise. If an enterprise has at its disposal, a particular physical location, the test of ‘fixed place’ of business would be satisfied. This is popularly called as the ‘right of disposal test’. Existence of a ‘fixed place of business’ is a sine qua non for establishing a PE.

3.9. Business connection under the Act lays emphasis on the existence of ‘activity’. This is the mandate of explanation 2 to section 9(1)(i) which defines business connection to include “any business activity carried out through…”. The ‘activity test’ serves as the eligibility criterion to establish a business connection. However, in case of a Permanent Establishment, the eligibility is crystallised by the existence of a fixed place through which the business is carried on. Any business activity carried on without a fixed place of business could establish ‘business connection’ but not a fixed place PE.

3.10. In the context of outbound outsourcing, the income of the non-resident service provider would be chargeable to tax as business income only if (excluding the provisions of other forms of PE) :

i. the non-resident has a business connection in India (through activity in India earning some profits and gains therefrom); and

ii. establishes a PE (through fixed place which carries on business) in India.

3.11. Thus, there is a difference in ‘approach’ between the Act and the tax treaties. In an outsourcing arrangement, when the contract extends over a large time span it is likely that the service provider may routinely have to visit the premises of the party from whom the contract was outsourced. There could consequently arise a situation of some place implicitly being made available to it. Would this create a PE? If it does not cause or result in a fixed place PE, would it give rise to a service PE? What factors are to be evaluated to distinguish the two, particularly in the light of the fact that all treaties do not have service PE, whereas the fixed place PE through ‘right of disposal test’ is universal?



Other forms of PE3.12. Paragraph 2 illustrates particular situations in which a PE is said to exist. The

paragraphs contain illustrations where there is a “statutory” presumption of the existence of a PE. In other words, a PE is deemed to be established even if the basic test of para (1) [fixed place test] is not fulfilled. Paragraph 4 provides for existence of a PE whenever a dependant agent is involved. These paragraphs have to be understood independent of paragraph (1). Two fictional PEs relevant in the context of outbound outsourcing are – Service PE & Agency PE.

Service PE3.13. Furnishing of services by one enterprise through its employees or other personnel in

the other country for more than specified days constitutes a service PE. The length of duration for which the employees have to be present to create a “service PE” would vary from treaty to treaty.

3.14. Clause (l) of Article 5(2) of the India-USA treaty deals with Service PE. The opening portion reads - the furnishing of services…. Thus, factum of ‘furnishing’ of services is the trigger for establishing a service PE. This is subject to two alternate conditions. Either the activity of ‘furnishing of services’ has to continue within the state for an aggregate period of 90 days; or the services should be performed for a related enterprise (as defined by the treaty).

3.15. Service PE is an illustrative PE and is independent of the fixed place test. The need for a fixed locale is irrelevant. The activities furnished by the employees (or other personnel) constitute the territorial nexus.

‘Furnishing’ v. ‘performed’3.16. The act of ‘furnishing’ of services culminates into a PE if the activity is continued

for the stipulated time frame (‘time test’). Alternatively, the act of ‘furnishing’ of services should culminate into services being ‘performed’ within that state for a related enterprise (‘related party test’). In the latter case, no time test needs to be met for a PE to exist. There is an explicit difference in the verbs used in the operating portion of the time test (‘furnish’) and the related party test (‘performed’). Both these terms are not defined in the Act. Dictionary meaning of the term ‘furnish’ is ‘provision or supply of something’; whereas the term ‘performed’ connotes ‘carry out; fulfil; accomplish’. There is a subtle difference between the two verbs. The term “performed” is indicative of completion. This characteristic is missing in the term ‘furnish’. As regards “furnishing” it is stated that the same must continue for a specified duration.

3.17. If the above meanings were to be applied in the service PE article, one could argue that related party condition is satisfied if the act of furnishing services is performed or completed within that state/country. Can it then be inferred that non-completion of services would not satisfy the condition of constituting service PE or is it only a matter of semantics having no intrinsic difference? Can the term ‘performed’ be interpreted to mean ‘to the extent furnished’ and thereby would part performance also establish a PE? - Participants may deliberate.



Need for human intervention3.18. The furnishing of services is required to be done by the employees or any other

personnel. The phrase “employees or any other personnel” indicates that the services are to be furnished by a body of people. Human intervention is compulsory. To illustrate

Figure 6

3.19. In the aforesaid diagram, there is an Indian company [“India Co”] which outsources onsite software development support to one of its group companies [“Group Co”] outside India. The services are to be ultimately rendered to an overseas client. India Co would remunerate the Group Co for its efforts in onsite software development. Group Co renders these services through employees some of whom are deputed to India Co. If this were to be the fact pattern, various questions arise in the context of creation of Service PE of Group Co in India.

(a) Deputed employees – under what circumstances/criteria, would they be regarded as employees of India Co., or Group Company?

(b) If India Co is an associated enterprise of Group Co whether the presence of employees for a single day would constitute a PE in India? If yes, what would be the impact of the force of attraction rule?

(c) What is the impact of stating that the employees of the Group Co should render service to the related enterprise? [In the treaty language, services are performed for a related party]. Is it possible to design/devise role of employees in not rendering services to India Co. but to its Group Co?

(d) Whether creation of a service PE can be circumvented by sub-contracting the outsourced services to Group 2 Co which would then render the service (with or without its employees)? OR would the presence of employees of Group Co invariably result in a PE for Group 2 Co also?



(e) Whether the term “Other personnel” should necessarily, be understood or referring to individuals exhibiting employee like traits?

Agency PE3.20. Paragraphs (4) & (5) deal with the existence of a PE through or because of an agency.

The test of PE through an agency relationship is an alternative test. An agent may constitute a PE for the person whom it represents, although the test of Article 5(1) is not satisfied.

3.21. An agent is a person who represents another in dealing with third persons. An agent can bind the principal contractually on the basis of the authority that he carries. It is for this reason it is stated that the act of the agent is as good as the act of the principal.

3.22. Not all types of agents result in a PE for the principal. It is only a “dependent agent” who would constitute a PE in the source country.

Qualifications of dependent agent3.23. A dependent agent is one who is legally or economically dependent upon the principal.

Para 37(a) of UN model commentary on article 5 states that an Independent agent means a person who is legally AND economically independent. Therefore in a reverse situation, if a person is legally OR economically dependent, he would be dependent agent. He is a person who is subjected to detailed instructions and comprehensive control. He is a person who has and habitually exercises an authority to conclude contracts. The Authority for Advance Ruling in 237 ITR 230 has held that a dependent agent who has no authority to conclude contacts would not create a PE.

3.24. Treaties may sometimes extend the concept of a dependent agent. A person who habitually maintains and delivers stock regularly for an enterprise may be held to be a dependent agent. A person who secures orders wholly or almost wholly for group enterprise may be held to be a dependent agent.

3.25. For an enterprise to argue that its agent does not constitute a PE, it will have to demonstrate that the person is an independent agent. Further, the independent agent should be acting in the ordinary course of business. Independence here would mean legal and financial independence. Independence could be proved by showing multiple principals, by the extent of risks undertaken, skills exhibited, level of control and supervision. In other words, it should be shown that the agent is not devoted to any one person or enterprise. Such agent has the freedom to price the services rendered.

3.26. The aspect of agency and their independence has been the subject matter of many rulings by the Authority for Advance Ruling. Some of the rulings that may be referred to are: Al Nisr Publishing 239 ITR 879; ABC Equity Fund 250 ITR 194; ABC Equity Fund 233 ITR 416.

3.27. Paragraph 4 of the Article 5 deals with ‘deemed agency PE’. It enlists situations in which an enterprise shall be deemed to have a PE. Each situation or instance deals with a kind of ‘activity’ that the agent should undertake. The various instances enlisted therein use different kind of verbs to explain the activities – namely:

(a) Exercise – An agent who has and habitually exercises an authority to conclude on behalf of the enterprise;



(b) Maintains – An agent who habitually maintains a stock of goods or merchandise;

(c) Conducted – An agent who conducts some additional activities;

(d) Secures – An agent who habitually secures orders.

Is there any specific purpose in using a wide array of verbs? Would the difference in terminology have an impact over the interpretation of such deemed PE(s)? - Participants may deliberate.

The below illustrated case study throws some additional issues for deliberation:

Figure 7

3.28. India Co is a company incorporated in India. It outsources certain functions/tasks (software development) to an overseas company (Group Co). Group Co carries on the software development activity and hands over the blue-print or intellectual property to India Co. In this fact pattern –

(a) If all or majority of the software development activities of India Co are to be carried out through Group Co, a fair degree of quality control needs to be ensured by India Co through controlling the operations and staffing of Group Co. Can India Co then be concluded to have constituted an ‘agency PE’ outside India?

(b) Would the answers change, if Group Co is a wholly owned subsidiary of India Co?

(c) Would India Co be deemed to have an “agency PE” merely for the reason that Group Co earns revenues solely from India Co.?

(d) It is necessary to additionally demonstrate that not only is there a financial dependency of the Group Co but there is also a price manipulation to the detriment of the Group Co?



(e) If the compensation to the Group Co is demonstrated to be at arm’s length, would it negate any profit attribution to the service PE (if any) of the India Co.

(f) Is the term “devoted” in article 5(5) as a disabling factor negating independence indicative of something more than financial or commercial dependency?

(g) A mere “dependency” could be a trigger for a dependent agency PE. However, Article 5(4) demands additional conditions to be fulfilled. In an outsourcing contract, especially in the service industry – which of the prohibited activities could be said to be attracted?

Exclusions from the definition of PE3.29. Para 3 of Article 5 enlists certain exclusions from the ambit of the term “PE”. This

para begins with a non-obstante clause - “Notwithstanding the preceding provisions of this Article, the term “permanent establishment” shall be deemed not to include any one or more of the following..”. It overrides the preceding provisions of the Article [which include fixed place PE, service PE, agency PE]. It is a deeming provision which excludes the enlisted instances from constituting a PE. India-USA treaty has 5 such exceptions. In the context of business outsourcing, clause (e) [or 5th exception] is relevant which reads – the maintenance of a fixed place of business solely for the purpose of advertising, for the supply of information, for scientific research or for other activities which have a preparatory or auxiliary character, for the enterprise.

3.30. This clause excludes ‘maintenance’ of fixed place of business for certain specified purposes – This exclusion raises a number of queries:

(a) Whether the exclusion is of the ‘fixed place’ of business or the ‘activity’ of maintenance or activity simpliciter?

(b) Maintenance of fixed place for the supply of information is excluded from the ambit of PE. What connotes ‘supply of information’? Can it exclude supply of IT blue-prints as well?

(c) Scientific research activity is excluded from the ambit of PE? Are all types of scientific research activities excluded irrespective of their purpose and intensity? Does the phrase ‘which have a preparatory or auxiliary character’ qualify such scientific research and other activities enlisted in the Article?

Attribution of profits3.31. The general rule is that business profits of an enterprise of one country cannot be

taxed by the other country unless the enterprise carries on business in that other country through a permanent establishment situated there. Where that condition is met, the country in which the permanent establishment exists may tax the income of the enterprise to the extent of the profits attributable to

(a) that PE;

(b) sales of goods or merchandise of the same or similar kind as those sold through that PE; or

(c) other business activities carried on in that country of the same or similar kind as those effected through that PE.



3.32. The attribution principle is split into three limbs. The first limb deals with profits attributable to PE itself; the second extends to any sale of goods or merchandise in the other country which is same or similar to those sold through PE. The third limb extends the scope to those business activities carried on in the other country which is same or similar to those effected through a PE.

3.33. India-US DTAA includes the ‘force of attraction’ rule whereby the income chargeable to tax in India is not only limited to the PE but also other similar sales or activities. The basic philosophy underlying the ‘force of attraction’ rule is that when an enterprise sets up a PE in another country, it brings itself within the jurisdiction of that other country to such a degree that such another country can tax profits that the enterprise derives from such country – whether the transactions are routed and performed through the PE or not.

3.34. Similar provisions are not found in the domestic tax provisions. ‘Business connection’ under the domestic law does not include any provisions similar to that of ‘force of attraction’ rule. This being the case, there cannot be any income which can be held chargeable to tax under domestic tax provisions under a ‘force of attraction’ rule. It is a trite to state that tax treaties are relief mechanisms and cannot render any person worse-off by its application.

3.35. The question is whether in the absence of ‘force of attraction’ rule under the Indian tax laws, can the India-US DTAA (through the force of attraction rule) tax those incomes which are not chargeable to tax under the domestic tax provisions? Can the recently inserted explanation 4 to section 9(1)(i) [which clarifies the expression “through” to mean and include “by means of”, “in consequence of” or “by reason of”] be interpreted to denote ‘force of attraction rule’ under the Act? Even assuming that Explanation 4 has such a role to play, whether its scope is to be held as curtailed by Explanations 1(a) and 3 to section 9? Participants may deliberate on the same.

(B) Royalty 3.36. The term “royalty” is defined in Article 12(3) of the India-USA Treaty as under:

“(a) payments of any kind received as a consideration for the use of, or the right to use, any copyright or a literary, artistic, or scientific work, including cinematograph films or work on film, tape or other means of reproduction for use in connection with radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience, including gains derived from the alienation of any such right or property which are contingent on the productivity, use, or disposition thereof ; and

(b) payments of any kind received as consideration for the use of, or the right to use, any industrial, commercial, or scientific equipment, other than payments derived by an enterprise described in paragraph 1 of Article 8 (Shipping and Air Transport) from activities described in paragraph 2(c) or 3 of Article 8.” (emphasis supplied)

3.37. In the light of the above definition the overall question is whether payments made by a resident towards outsourcing services rendered by a non-resident would constitute



royalty under the treaty. The definition under the Act (as discussed earlier) is wide. However, certain exceptions are provided thereunder. Comparison of the definition of ‘royalty’ under the Act vis-à-vis tax treaty would enable the determination of the most beneficial provision/position.

3.38. Under the provisions of the Act [section 9(1)(vi), royalty is deemed to accrue or arise in India if royalties are ‘payable’ by the residents in India. Contrastingly, the treaty provisions contemplate payments ‘received’ as a consideration for the use of, or the right to use the specified assets or rights. Section 9(1)(vi) is triggered on the royalties being payable whereas the treaty provisions require actual payment/ receipt. There is a timing difference. Accordingly, in a particular year, if there is any sum payable as royalty (although not actually paid), can the provisions of India-US treaty be invoked? – participants may deliberate.

3.39. The language in Article 12(3) does not include any ‘indirect usage of intangibles or equipments’ or ‘usage sans possession or control of such IPR(s) and equipments’. Explanation 5 to section 9(1)(vi) specifies that any consideration in respect of any (i) rights; (ii) property; or (iii) information irrespective of ‘possession’ or ‘usage’ or ‘locale’, would constitute royalty. Explanation 5 [which seeks to expand the meaning of royalty], in its opening portion uses the words “includes and is always included”. Thus royalty as per the Act is to be understood in the light of the Explanations 2 and 5 [along with Explanation 4 and 6 – not discussed herein] to Section 9(1)(vi) of the Act. The definition of ‘royalty’ in the treaty is narrower than that given in Act. Consequently, a tax payer would rely on narrower meaning in the tax treaty in place of wider meaning in the Act. Does this mean that the amendments to section 9(1)(vi) through insertion of Explanation 5 (along with Explanations 4 and 6) do not in any manner alter the meaning of the royalty in the DTAA?

3.40. Explanation 5 seemingly disregards the “possession”, “usage” and “locale”. The term ‘used’ in clause (b) is followed by an adverb ‘directly’. It appears to expand the scope of the term “use”. This term [‘use’] is not specifically defined in the Treaty. Can in such circumstances, Article 3(2) of the treaty be relied on which specifies that any term not defined in the Act shall have the meaning in the respective domestic tax provisions of contracting states?

3.41. Sub-clause (vi) of explanation 2 to section 9(1)(vi) states that rendering of services in connection with activities referred to in sub-clauses (i) to (iv), (iva) and (v) would constitute royalty [for example services in connection with transfer of copyright]. This may not be chargeable as ‘royalty’ under the treaty [due to the narrow scope of the definition]. In such circumstances, would the narrow scope of ‘royalty’ definition provide relief from the charge of tax? OR should one refer the article dealing with ‘Fees for technical (included) services’ to determine if it is chargeable under that article? In other words, can an income which is chargeable to tax as ‘royalties’ under the Act be re-characterized as ‘fees for technical services’ under the treaty? Or can it be said that if the income is not taxable under one clause of a treaty, can it be taxable under another clause?

(C) Fees for technical (included) services3.42. The present write-up is largely focused on outsourcing associated with services. Fees

for technical (included) services would therefore constitute a very significant part of the deliberation.



3.43. The relevant portion of Article 12 of the Double Taxation avoidance agreement between India and USA is as follows:

“For purposes of this Article, “fees for included services” means payments of any kind to any person in consideration for the rendering of any technical or consultancy services (including through the provision of services of technical or other person nel) if such services:

(a) are ancillary and subsidiary to the application or enjoyment of the right, property or information for which a payment described in paragraph 3 is received; or

(b) make available technical knowledge, experience, skill, know-how, or processes, or consist of the development and trans fer of a technical plan or technical design.”

3.44. The meaning of the term “included services” has been explained in the MOU between India-US DTAA as follows:

“Under paragraph 4, technical and consultancy services are consid ered included services only to the following extent: (1) as described in paragraph 4(a), if they are ancillary and subsidiary to the application or enjoyment of a right, property or informa tion for which are royalty payment is made; or (2) as described in paragraph 4(b), if they make available technical knowledge, experience, skill, know-how, or processes, or consist of the development and transfer of a technical plan or technical design. Thus, under paragraph 4(b), consultancy services which are not of a technical nature cannot be included services.”

3.45. One notices that ‘Fees for technical services’ includes technical or consultancy services which:

(a) are ancillary and subsidiary to the application or enjoyment of a right, property or informa tion for which are royalty payment is made; or

(b) make available technical knowledge, experience or skill or consist of the development and transfer of a technical plan or technical design.

3.46. Condition (a) pre-supposes that the services (ancillary or subsidiary) are rendered in relation to royalty payments. Para 3(b) of the definition in the first part deals with the concept of ‘make available’. The term ‘making available’, is explained in the protocol to the India-USA Treaty as referring to a situation where the acquirer of the services is enabled to apply the technology. The Memorandum of Understanding concerning fees for included services under the Indo-US treaty elucidates the concept of “make available” as follows:

“Generally speaking, technology will be considered “made available” when the person acquiring the service is enabled to apply the technology. The fact that the provision of the service may require technical input by the person providing the service does not per se mean that technical knowl edge, skills, etc., are made available to the person purchasing the service, within the meaning of paragraph 4(b). Similarly, the use of a product which embodies technology shall not per se be considered to make the technology available.”

3.47. The term “make available” has a distinct meaning under the Treaty. It postulates a concept wherein the recipient of the services is not only benefited by the services



but there is also a transfer of the technology, processes, skill etc., to the recipient in a manner which will enable the latter to apply the technology, processes, skill etc., in future without recourse to the service provider. The term “make available” encompasses some sort of durability and stability with reference to the transfer of technology, processes and skill, etc., so that the same is not regarded as transient or ephemeral.

3.48. Under section 9(1)(vii) of the Income-tax Act, mere rendering services is sufficient to deem the accrual of income. A rendering of services normally translates into a utilisation of such services by the recipient. In other words, generally, when a person renders services, the other person is said to have made use of those services. Making use of services is therefore a consequence of the rendering of services. Under the Treaty however, it not just the “rendering of” or “making use of” services that enables the classification of the payment as fees for technical services. A payment would be classified as fees for technical services only when it “makes available” technical knowledge, skill, experience or processes. “Making available” refers to a stage deeper than the “making use of” services. One may refer in this connection to the decisions in CIT v. De Beers India Minerals Private Limited (ITA No. 549 of 2007); Raymond Ltd. v. DCIT (2003) 86 ITD 791 (Mum-Trib); ACIT v. Wockhardt Ltd. [2011] 10 Taxmann.com 208 (MUM); Anapharma Inc. [2010] 189 Taxmann 270 (AAR); Diamond Services International (P.) Ltd. v Union of India [2008] 304 ITR 201 (Bom.), etc.

3.49. Some decisions have imparted a refinement to the concept of “making available”. The Bangalore Tribunal in the case of Filtrex Technologies (P) Limited v. ACIT 47 SOT 69 held that the presence of a ‘confidential information’ clause along with non-disclosure obligation in the contract is a pointer to the fact that technical knowledge, skill, experience, etc. have been made available to the service recipient. The Authority of Advance Ruling in the case of Perfetti Van Melle Holding B.V AAR/869/2010 held that the expression ‘make available’ only means that the recipient of the service should be in a position to derive an enduring benefit and be in a position to utilize the knowledge or know-how in future on his own. It held that for a service to fall under ‘rendering of any technical or consultancy service’ mere development and transfer of technical plan and technical design should be sufficient. The AAR also held that the concept of making available is to be associated with technical services. For the other limb of Art. 12 viz. consultancy services, the aspect of “making available” is not appropriate and hence not relevant [Verizon Data Services India (P) Ltd., In re (2011) 337 ITR 192 (AAR)]. Consultancy services would therefore constitute technical services, whether or not technology is made available. However, the ruling of AAR in the case of Verizon was set aside by the Madras High Court. Subsequently, the AAR in the case of Centrica India Offshore (P) Ltd., In re (2012) 348 ITR 45 (AAR) acknowledged that the finality of Verizon case had gone. Participants may deliberate on the above.

3.50. The closing portion of clause (b) includes development and transfer of a technical plan or technical design within the precincts of the term ‘fee for technical services’. A consideration paid would constitute FTS under the treaty if the Foreign company ‘develops’ and ‘transfers’ any technical plan or design. Both conditions of development and transfer have to be satisfied. [One may refer Perfetti Van Melle Holding BV (2011) 16 taxmann.com 207 (AAR); Nimbus Sport International Ptr Limited v. DCIT (Del.-ITAT)



(2011) TII-178-ITAT-Del-INTL) etc.]. The below illustrated case study throws some issues for deliberation:

Figure 5

3.51. In the aforesaid diagram, there is an Indian company [“India Co”] which outsources onsite software development support to one of its group companies [“Group Co”] outside India. The services are to be ultimately rendered to an overseas client. The client would make a payment to the India Co for the overall software development contract. The India Co would in turn remunerate the Group Co for its efforts in onsite software development. If this were to be the fact pattern, various questions arise in the context of determining the taxability of payments made by India Co.

(a) Whether payment made to Group Co towards software development support constitutes FTS under the treaty?

(b) Under what circumstances can it be construed that the Group Co ‘makes available’ any technical knowledge, experience, skill, know-how, or processes?

(c) Although software is ultimately developed for overseas client, can it be argued that Group Co has effectively or implicitly developed and transferred the software to India Co (to enable ultimate delivery to the overseas client)? Even if the Group Co delivers it to the client, could it be said that the same would be on behalf of and for the benefit of the India Co?

(d) In relation to services, the law envisages development and transfer of a technical plan or design. In the earlier part of Act 12 dealing with royalty, reference is to alienation. Is there a distinction between the two?

(e) Whether software developed would fit within the ambit of technical plan and design? Particularly so when those words are used simultaneously and in addition to copyright, of which software is generally a part.

(f) If by virtue of the contract with the outsourcing entity, the IPR in the software developed always belongs to the client, the question of either making available



technology or transfer of technical plan or design should never arise. Whether therefore could it be argued that the services would not be classified as fees for included service as defined?

Treaties in which ‘fees for technical services’ clause is present but without ‘make available’ clause3.52. There are many tax treaties signed by India wherein such ‘make available’ conditions

are not found. In such an eventuality, the scope of the treaty definition gets narrowed down. The question then is whether the definition in the treaty provisions becomes similar to that of the Act?

3.53. It is a trite to state that territorial nexus with India is required to engulf a payment within the precincts of tax in India as FTS. The Apex Court in Ishikawajima-Harima Heavy Industries Ltd. v. DIT [2007] 288 ITR 408, while interpreting section 9(1)(vii)(c) held that the services must be ‘rendered’ as well as ‘utilised’ in India in order to attract section 9(1)(vii)(c). The relevant observations of the Supreme Court are as under.

“Section 9(1)(vii)(c) clearly states “. . .where the fees are payable in respect of services utilised in a business or profession carried on by such person in India...” It is evident that section 9(1)(vii), read in its plain, same envisages the fulfilment of two conditions : services, which are source of income sought to be taxed in India must be (i) utilised in India and (ii) rendered in India. In the present case, both these conditions have not been satisfied simultaneously.”

3.54. Finance Act, 2007 inserted Explanation 2 below section 9(2) with retrospective effect from 01-06-1976. The said Explanation read as under:

“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.”

3.55. Memorandum explaining the provisions of Finance Bill, 2007 stated that Explanation 2 is being inserted to specifically reaffirm the source rule whereby irrespective of the situs of the services, the situs of the payer and the situs of the utilisation of services will determine the jurisdiction in which the income from services would be taxable.

3.56. The Karnataka High Court in Jindal Thermal Power Company Limited v. DCIT (TDS) (2010) 321 ITR 0031 held that the ratio of the Supreme Court’s decision in Ishikawajima-Harima Heavy Industries Ltd. v. DIT [2007] 288 ITR 408 applied even after the insertion of Explanation 2 below section 9(2).

3.57. The Explanation was again amended by the Finance Act, 2010 with retrospective effect from 01.06.1976. The memorandum explaining the provisions of Finance Bill 2010 [321 ITR (St.) 33], in the context of the amendment, provides that the source rule under section 9 would be attracted only if the services are utilised in India. As per the amended Explanation, income of a non-resident shall be deemed to accrue or arise in India under clauses (v) (vi) or (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.

3.58. As per the amended Explanation, place of business, residence or business connection in India is not a pre-requisite for chargeability of interest, royalty or fees for technical services payable to a non resident. Place of rendering of services is also immaterial. Services may be rendered in India or outside India.

3.59. Although the Indian income-tax statute was amended vide Finance Act 2010, there have been no changes in the language of the treaties signed by India. Since no change is made in the treaties, it is fair to state that the understanding of the provisions of the treaty has not undergone any change. It is a trite to state that any change in the domestic tax provisions would not affect the treaty provisions. A country who is party to a treaty cannot unilaterally alter the provisions. If there is no amendment to the treaty but there is some amendment adverse to the assessee in the Act; the amendment shall have no effect on the computation of total income of the assessee if the treaty provisions are relied upon. The subsequent amendments to section 9 should not influence the understanding of the treaty provisions. Accordingly, the Apex Court decision in the case of Ishikawajima-Harima should continue to be applicable while interpreting the provisions of the treaty.

3.60. The learned authors Kanga and Palkhivala views in their treatise ‘The Law and Practice of Income Tax’ [page 384 – 9th edition] observe as follows:

“Clause (i) to (iv) of section 9(1) which deem foreign income to accrue in India, are intra vires the powers of the Parliament, since they proceed upon a sufficient territorial connection. But clauses (v)(b), (vi)(b) and (vii)(b) seek to charge a foreigner in respect of his income outside India only because the payment is made by an Indian resident, even where in the income arises under a contract which is made and performed entirely outside India and neither the income nor the contract has any connection with India. Unlike the residence of the assessee himself, the residence of the person from whom the income is received can never afford a sufficient, real or pertinent territorial nexus to justify the levy of income-tax on a foreigner in respect of his income which has nothing to do with India. Under the clauses, the foreigner is made liable to Indian income-tax in every case in respect of interest, royalty or fees received abroad from an Indian resident for services or other consideration rendered wholly abroad, the only exception being the case where the payment is made for the purpose of the Indian resident’s business, profession or source of income abroad. If the Indian Parliament can cast the net wide enough to collect tax in such cases where the foreigner’s income has no nexus with India, only because the income is derived from a transaction within an Indian, it can equally levy a tax on a hotel in a foreign country where an Indian goes to stay or dine, or on a foreign store where an Indian buys shirts or grocery, or on a foreign physician whose services are sought by an Indian while abroad. Not only are the clauses contrary to the well-settled international norms of taxation of foreigner in respect of his income accruing, arising and received outside the taxing state, but they are against the letter and the spirit of the various tax treaties entered into by India with foreign countries, though they do not, and cannot, supersede those treaties.”(emphasis supplied)



3.61. The learned authors while expressing the above thoughts have relied on the decisions of Queen v. Melford Developments 82 DTC 6281 (Supreme Court of Canada) and Citizen Watch v. IAC 148 ITR 774.

3.62. Applying these principles in the present case, although there might not be a “make available” condition in the definition of FTS in certain treaties, the payments cannot mechanically be categorised as technical services. Further, as per the learned authors, payer of a sum being a resident, would not constitute an adequate territorial nexus to invite a tax liability in India. The source may have to be something deeper. Participants may deliberate.

Treaties in which ‘FTS’ clause is present but without ‘make available’ but restricted only to services rendered overseas3.63. There are certain treaties wherein to constitute FTS, the services must be provided by

resident of one contracting state in another contracting state. For instance, article 12 of the India-China treaty deals with “fees for technical services”; relevant portion of which is as under:

“4. The term “fees for technical services” as used in this Article means any payment for the provision of services of managerial, technical or consultancy nature by a resident of a Contracting State in the other Contracting State, but does not include payment for activities mentioned in paragraph 2(k) of Article 5 and Article 15 of the Agreement.” (emphasis supplied)

3.64. The first part of the above definition provides that fees for technical services means payment for provision of services of managerial, technical or consultancy nature. To this extent, the definition would be similar to the definition in explanation 2 to section 9(1)(vii). However, the fact that payment is for managerial, technical, consulting services alone would not result in characterisation of such payment as ‘fees for technical services’ under the Treaty. The other requirement is that the services of managerial, technical or consultancy should be provided by the resident of a contracting state in the other contracting state. The expression ‘in the contracting state’ mandates the rendering or provision of services by a resident in the other contracting state.

3.65. Under Article 12(4) of the Treaty between India - China, the place of rendering of services is thus important. Payment for technical services to a resident of China would be chargeable to tax in India only if such services are rendered in India. If such services are rendered outside India, the payment would not be in the nature of ‘fees for technical services’ under Article 12(4) of Treaty between India - China. Although a contrary view was taken by the Mumbai Tribunal in the case of Ashapura Minichem (2010) 40 SOT 220 (MUM).

Treaties wherein the scope of “make available” is wider [or FTS is narrower]3.66. The definition of ‘fees for technical services’ in certain treaties are narrower that that

defined under India-US treaty. In the India-Singapore treaty, the definition reads as under:

“payments of any kind to any person in consideration for services of a managerial, technical or consultancy nature (including the provision of such services through technical or other personnel) if such services :




(b) make available technical knowledge, experience, skill, know-how or processes, which enables the person acquiring the services to apply the technology contained therein; or

(c) consist of the development and transfer of a technical plan or technical design, but excludes any service that does not enable the person acquiring the service to apply the technology contained therein.” (emphasis supplied)

3.67. The India-US Treaty deals with two kinds of payments – (i) For services making available technical knowledge, experience, skill, know-how or process; and (ii) services consisting of development and transfer of technical plan or design. The condition of ‘make available’ qualifies only the first condition.

3.68. Contrastingly, in the treaties such as India-Singapore treaty, the development and transfer activity is also qualified by the “make available” clause. The exclusion reads - excludes any service that does not enable the person acquiring the service to apply the technology contained therein. The exclusion does not employ the phrase ‘make available’ in a positive sense. It negatively states that services concerning development and transfer of technical plan or design that do not enable the payer to apply the technology, would be excluded. The definition of included services in the India-Singapore treaty is narrower than that in the India-USA treaty.

3.69. Could this mean ‘make available’ [in the first limb] is different from ‘enabling a person acquiring to apply the technology’ [in the second limb]? - participants may deliberate on the ramifications of the terminology employed.

Treaties in which clause on ‘fees for technical services’ is absent3.70. There are certain tax treaties signed by India wherein a separate clause for fees for

technical services is not present [E.g. Sri Lanka, Mauritius, Belgium, Ireland, Poland etc]. Where, the Article on FTS is absent in a Tax Treaty, such a payment is generally classifiable as “Business Profit” to be governed by Article 7 of the relevant Tax Treaty. If the payee does not have a Permanent Establishment in India in terms of Article 5 of the Treaty, the same will not be liable to tax in India. [Refer Spice Telecom v. ITO (2008) 170 Taxman 82 (Bang); Golf In Dubai v. DIT (2008) 174 Taxman 480 (AAR – New Delhi); Christiani & Nielsen Copenhagan v. First ITO (1991) 39 ITD 355 (Mum.)]

3.71. One could possibly argue that the payments could constitute ‘Other income’ under the treaty. The term ‘Other Income’ or ‘income not expressly mentioned’ refers to items of income which are not expressly dealt with in any of the other Articles of the tax treaties.

3.72. The ‘Other income’ article is a residuary provision. It covers income of a class not expressly dealt with otherwise. The other income article deals with income which is not covered but also income not dealt with in any of the preceding articles of the tax treaty. Each article specifies the nature of income and then defines the income sought to be covered by it. Because of its nature or its source, if an income could not be dealt with under any of the articles, it is dealt with the article on ‘Other Income’. The



residuary article comes into operation only when the preceding articles are excluded. Hence, where a particular type of income is proposed to be covered under this Article, it should be of a nature that does not fall under the purview of the preceding Articles of the Treaty.

3.73. An income is “dealt with” in another article if it is the type of income described therein {DCIT v. Andaman Sea Food Pvt. Ltd. [2012] 22 taxmann.com 400 (Kol.); Essar Oil Limited v. DCIT [2006] 5 SOT 669 (Mum); Channel Guide India Limited v. ACIT (ITA No.579/Mum/2006); Gearbulk AG [2009] 184 TAXMAN 383 (AAR); P.T. McKinsey Indonesia v. Deputy Director of Income-tax (International Taxation) – 4(1) [ITA No. 7625/M/2010]}.

3.74. The OECD Commentary to the Model Tax Treaty, describes ‘Other Income’ article as follows– “This Article provides a general rule relating to income not dealt with in the foregoing Articles of the Convention. The income concerned is not only income of a class not expressly dealt with but also income from sources not expressly mentioned.”

3.75. Reliance can also be placed on the ‘Klaus Vogel on Double Taxation Conventions’ - Third Edition. The relevant extract therefrom is as below:

“the ‘Other income’ clause applies to items of income ‘not dealt with’ in the foregoing Articles of the Treaty and does not extend the scope of the Treaty’s application to items of income not covered by the Treaty as a whole. To determine whether a particular class of income falls under this clause, it must be first determined, whether the said income can be categorised under any of the preceding Articles of the Treaty. It is only when such an exercise reveals that none of the preceding Articles cover the income in question can the Article 21 be applied.

3.76. An item of income may be dealt with in any preceding article. It may not however suffer tax. An exemption in the relevant article may help achieve this. For example, Business income may not be taxed if the activity continues for less than the threshold number of days. This is because a PE is not created. Article 7 may therefore be unable to fix a charge of tax. This does not however mean that the said income would fall to be taxed under the residuary income article.

4. OTHER RELEVANT AREAS OF CONCERN

Reimbursement of expenses – Whether taxable as FTS?4.1. In an outbound outsourcing model, there would be payment made by an Indian

concern to the overseas entity (to which the task/services are outsourced). This payment could be in the nature of ‘business income’, ‘royalty’ or ‘fees for technical services’. Reimbursement of expenses incurred by the overseas entity (pursuant to outsourcing) is one more possibility. On various occasions, the Revenue authorities have sought to consider such reimbursement of expenses as ‘FTS’.

4.2. The term ‘fees for technical services’ is defined in Explanation 2 to section 9(1)(vii). Section 9(1)(vii) is attracted only when a payment partakes the character of ‘fees’. The word ‘fees’ is not defined in the Act. As per New Webster’s Dictionary, ‘fees’ means: ‘A remuneration for professional service, as of a physician’. As per Chamber’s



Dictionary, ‘fees’ means ‘money, price paid for services, as to a lawyer or physician’ (emphasis supplied).

4.3. The ordinary meaning of the word ‘fees’ means a remuneration or price paid for services rendered. It would include only those charges which are paid for services availed. Unless services are performed/ rendered, the payment would not constitute fees.

4.4. The phrase ‘by way of ’ used before the words ‘income’ under section 9(1)(vii) is crucial. As per the Oxford Concise Dictionary ‘by way of’ means “with intention of”. As per the Chambers Dictionary the said term means “in a character of”. The above meaning were cited with approval by Andhra Pradesh High Court in Bhupathiraju Narasimharaju v. CGT (1966) 59 ITR 178,183. The correct meaning of these words in the present context would be “in character of”. In other words, for section 9(1)(vii) or the treaty to be attracted the payment must be in character of fees.

4.5. ‘Fees for technical services’ as per section 9(1)(vii) means any ‘consideration’ for rendering of managerial, technical or consultancy services (including the provision of services of technical or other personnel). The definition contemplates the existence of ‘consideration’. The term ‘consideration’ as per ‘word web’ means ‘a fee charged in advance to retain the services of someone’. It means something given in return for obtaining or getting a thing. In the context of section 9(1)(vii), the payment has to be paid in return for rendering managerial, technical or consultancy services.

4.6. The question is whether payment towards reimbursement of expenses is - (i) towards services performed by the overseas entity; (ii) in the character of fees; and (iii) a consideration in return for rendering managerial, technical or consultancy services. Participants may deliberate on the above in the light of the below illustrated case study and the questions thereto.

Figure 8

4.7. In the aforesaid diagram, there is an Indian company [“India Co”] which outsources software development support to one of its group companies [“Group Co”]. The India



Co would remunerate the Group Co for its efforts in onsite software development. Additionally, India Co would reimburse actual expenditures incurred by Group Co in the course of the onsite software development. If this were to be the fact pattern, various questions arise in the context of reimbursement of expenses.

(a) Whether reimbursement of expenses by India Co to Group Co would be chargeable to tax in India?

(b) Would it make a difference if there is a mark-up charged on such reimbursements? Is there a need for a mark up at all?

(c) Would “make-available” condition be satisfied under these arrangements?

(d) Would the answer change if the liability of the Indian company to pay is pursuant to a cost contribution agreement?

Location saving4.8. There could be several reasons why companies outsource work. The primary reason

is pecuniary savings. Many service providers can offer to get the work done at lower costs, as they have fewer/lower overhead expenses and perhaps operate in a different economical environment. When a company outsources peripheral work, it is able to concentrate on core business issues. Outsourcing is an excellent option to a company that plans to expand geographically. The company can start its operations in a different country more economically than doing it itself or through a local provider. Thus, there is a location saving that is inherent in an outsourcing exercise. This is better explained through an illustration below:

Figure 9

4.9. In the aforesaid diagram, there is an Indian company [“India Co”] which outsources onsite software development support to one of its group companies [“Group Co”] outside India. India Co opts to outsource the work to Group Co due to the cost efficiency achieved. India Co would remunerate the Group Co for its efforts. India Co



leverages on the lower cost of service and thereby makes a notional gain. If this were to be the fact pattern, various questions arise in the context of these location savings (which are notional).

(a) Can India Co be subjected to tax in the foreign jurisdiction on location savings made by outsourcing to an overseas jurisdiction?

(b) Can Group Co be subjected to tax on this notional income by deeming such income to be received/receivable by Group Co?

(c) Would the locational savings be taxed in the hands of India Co despite it being demonstrated that the profit margins or price of Group Co are at arm’s length?

Employee secondment or deputation4.10. One of the attached or consequent implications of business outsourcing is employee

deputation or secondment for carrying out the services/tasks outsourced.

4.11. The movement abroad may be under a “deputation” or a “secondment”. Deputation means “appointment, assignment to an officer, function”. It refers to persons appointed on a particular mission. It is an appointment as a substitute, representative or deputy.

4.12. “Secondment” as per the dictionary means “a temporary transfer to another position or employment”. It means support, backup, assistance.

4.13. The dictionary meaning of “deputation” and “secondment” generally rely on the duration test. Secondment is defined to be a temporary transfer. Deputation by inference is believed to be for a longer duration. Corporate world, in their relationship not only take into account the duration test but also the aspect of control. In a deputation, the control of the employee is ceded to the organisation where the employee is sent. In a secondment, generally the control is retained. Deputation as well as secondment is generally evidenced by a tripartite agreement. Additionally, the organisation to which the employee is deputed may enter into a separate contractual arrangement.

4.14. The determination who exercises control, determines the person for whom or on whose behalf the services are rendered. This also determines who shall bear the salary and the need if any, for a cross charge of the salary. The nature of control (and the consequential question for whom the services are rendered) would determine whether the employee constitutes an extension of the deputing organisation and leads to its presence (service PE) in the foreign soil. This aspect of employee secondment thus includes its own heaps of tax consequences, implications and unresolved issues.

4.15. The Apex Court in the case of DIT v. Morgan Stanley and Co. Inc. (2007) 292 ITR 416 (SC) observed that when an employee of one company [legal employer] is deputed to another, such person does not become the employee of the company [economic employer] where he is sent. As long as the lien remains with the legal employer, it retains control over the deputationist’s terms and employment. Where the activities of the multinational enterprise entails it being responsible for the work of deputationists and the employees continue to be on the payroll of the multinational enterprise or they continue to have their lien on their jobs with the multinational enterprise, a service PE would emerge.



4.16. However, the Tribunals in many cases, notably IDS Software Solutions India (P) Ltd. v. ITO (2009) 122 TTJ 410 (Bangalore), M/s. Abbey Business Services (India) Private Limited v. DCIT 1141/Bang/2010/2005-06 have laid down various tests to determine who the employer (legal employer or economic employer) is as under:

a. For ascertaining whether a person is a servant a rough and ready test is whether under the terms of the employment, the employer exercises a supervisory control in respect of the work entrusted to him;

b. The nature of employment can be determined by the Articles of Association of the company and/or the agreement, if any, under which a contractual relationship between him and the company is brought about;

c. Control need not necessarily be of one who tells him what to do from day-today, nor is it necessary that the company’s supervision over him should be a continuous exercise of power to oversee or superintend the work to be done;

d. Control and supervision is exercised and is exercisable in terms of the employee contract;

e. The employee not only receives instructions from his employer but is also subject to the right of the employer to control the manner in which he should carry out such instructions, a significant feature of employer-employee relationship being ‘control and command’;

f. When rights such as the right to hire or accept the secondment, right to control and supervise, right to instruct, right to terminate from secondment are satisfied, the employer-employee relationship is satisfied.

4.17. In the context of an outsourcing arrangement, which generally involves the deputation or secondment of employees the challenge would be of determining the real employer of the employees deputed/seconded. Would one look at the ‘lien of employment and the contractual relationship’ or ‘the aspect of control and supervision’? – participants may deliberate.

Cross charge (Reimbursement) of salary – An offshoot of deputation & secondment4.18. Cross border deputation and secondment are off-shoots of a typical outsourcing

arrangement. In such cases, the salary cost of the seconded employees may be cross charged by the foreign entity to Indian entity. In such cases, there could be issues around the payment of salary costs. The issues could be in terms of the character or nature ascribed to such payments (whether salary reimbursements or fees for technical services).

4.19. Not all monies paid towards expenses incurred by a person can be branded as reimbursements. The relationship between parties and the nature of transaction will determine whether the amount paid back constitutes a reimbursement. For a reimbursement to arise, the existence of an obligation on one, which is monetarily satisfied/ discharged by another has to be demonstrated. That other person then seeks reimbursement of the monies paid. A refilling of the coffers of the person initially making the payment is the sine qua non of reimbursement. As reimbursement merely refills the coffers; it does not give rise to any income in his hands.



4.20. A primary obligation of one discharged by another gives rise to a relationship like that of a principal and an agent. Where the relationship between parties is in the nature of principal and agent, and the principal pays back money to the agent any expenses incurred on his behalf, the money will not constitute income in the hands of the agent. The agent may have incurred the expense either under the instruction of the principal, or in the due course of and within his authority or outside his authority but ratified later by the principal. It is however essential that the expenses should have been incurred by the agent for the benefit of and on behalf of the payer. The primary liability for the payment of the expenses should have been that of the principal and not the recipient of the reimbursement.

In this background, participants may deliberate on the following issues:

�� actually technical fees camouflaged as recharge?

�� !� �� be demonstrated in the context of salary reimbursement/ cross-charge?

�� "�� #$��

Body shopping4.21. In a body shopping arrangement, the workers are delivered on a project basis, usually

as full-time equivalents of employees. Revenue authorities do not recognize onshore services done by employees as ‘export of services’. Revenue from such work is being denied the tax sops meant for exports [sections 10A and 10AA]. The tax authorities contend that the IT/ITES companies indulge in “Deputation of Technical Manpower” under the technical professionals are sent abroad to work in the customer locations under the control and supervision of such customers. The companies would bill the customer on a ‘time cost’ basis for each of the technical professional deputed. Hence, the receipts under such contracts are not eligible for tax holiday benefit.

4.22. Although the tax benefit for software exporters under section 10A of Act ended more than two years ago, the issue becomes relevant in the context of the on-going litigation in relation to claim of tax holiday for earlier assessment years. The issue of ‘body shopping’ is attached to the claim under section 10AA (SEZ units) as well.

4.23. CBDT vide circular 1 of 2013 has clarified that tax holidays shall not be denied merely on the ground that the “software was developed onsite” so long as the same is developed pursuant to a contract between the client and the eligible Unit/Undertaking, depicting the direct and intimate nexus or connection of the development of software abroad with the Unit/Undertaking in India. However, the circular is conspicuously silent on how should the nexus or connection be established. This leaves the matter open to litigation. The challenge is around substantiation of facts. How to demonstrate the factum of nexus? What is the documentation requirement? – participants may deliberate on the same in addition to the following issues:

(a) CBDT vide its Notification No. SO 890(E) dated 26-9-2000 has notified ‘Human resource services’ to be an eligible service for section 10A deduction. Does this mean that income from body-shopping activity is eligible to a tax holiday?



(b) Rule 76 of the SEZ Rules, 2006 defines “services” to include “human resource services”. Does explicit inclusion of such services in the SEZ statute itself strengthen the case of the SEZ units claiming a tax holiday?

(c) Explanation 3 to section 10A/10B and Explanation 2 to section 10AA grant tax holiday to onsite software development – including services for development of software. Onsite services per se are therefore eligible for deduction under section 10A/10B/10AA.

i. Is ‘Human resource services’ referred above covered within the precincts of the aforesaid explanation?

ii. Is Pure on-site service (i.e., onsite services which is not integrated with off-shore model) covered within the explanation?

Tax deduction at source on salary income4.24. Once salary is chargeable to income-tax, withholding obligation will arise. Laws of the

respective contracting states will determine, inter alia, the person responsible to deduct tax at source, time at which tax is to be deducted and the extent of deduction.

4.25. Sections 15 to 17 read with section 5 determine the quantum of salaries taxable in India. Under the Income-tax Act, section 192 regulates deduction of tax at source in respect of salary chargeable in India. Further, the residential status of employer is immaterial. A non-resident/foreign employer is equally responsible to deduct tax [Refer P. No. 13 of 1995, In re, [1997] 228 ITR 487 (AAR)].

4.26. Double Taxation Avoidance Agreements, if any, entered into between India and the other state come to the aid of such employees, by providing for a relief under section 90 against double taxation.

4.27. Section 192 does not specifically provide for allowing section 90 relief to the employees, while deducting tax on salaries. Nor does it prohibit the same. The question is whether relief under section 90 can also be considered while computing tax to be deducted at source under section 192. Participants may deliberate upon this issue along with certain other issues mentioned below.

i. Employees of an Indian company could earn salary (and other income) in and outside India. Is the onus on the Indian employer to collect details of the foreign salary and club the same with the domestic income while deducting tax on salaries under section 192?

ii. Even in a case where the Indian employer is aware of the foreign salary details, is it under an obligation to aggregate such income and deduct tax on the aggregate?

iii. Alternatively, should the withholding be restricted to the salary disbursed in India?

iv. Section 192 of the Act requires employer to deduct tax at source at the average rate of tax. Section 2(10) defines ‘average rate of tax’ to mean the rate arrived at by dividing the amount of income tax calculated on the total income, by such total income. Total income as noted earlier is the income as computed under



the provisions of the Act. Whether the tax payable on such total income, refers to that which remains due after giving effect to the rebates and reliefs. In other words, should all the benefits, which an employee is entitled under law, be taken into consideration while computing amount to be deducted as source, including section 90 relief?

v. Section 192 is a deduction of taxes on salaries on ‘payment’ basis. ESOP being perquisite is taxable as a salary in the hands of the employee. In a typical ESOP scheme there is no ‘payment’ made to an employee. The difference between the market price and the exercise price is a benefit to the employee and an amount forgone for the employer. Whether section 192 of the Act would apply to ESOP benefit – as there is no ‘payment’ but only a benefit forgone?

vi. As per section 9(1)(ii) of the Act the place of accrual of salary income is where the services are rendered. Section 17(2)(vi) provides that benefit from allotment of ESOP to employees is chargeable to tax as ‘perquisites’. In a particular year, an employee may exercise his right to subscribe (to ESOP) outside India which were granted to him for employment services in India. In such an eventuality, whether the value of perquisites would be taxable in India (since services rendered in India) or outside India (since the exercise of ESOPs happened outside India)? What would be the conclusion in a vice versa situation?

vii. Residential status of the employee plays a pivotal role in reckoning the applicability and scope of TDS on salary. Business outsourcing has accelerated the movement of employees from one place (country) to another. The span of their stay in India would thus become critical for crystallizing the TDS liability. How does one determine the residential status of employees especially while leaving India for the purpose of employment? Could the explanation to section 6(1) be used by the employee even when he is sent on deputation?

Tax credit under the Treaty4.28. Normally credit against double taxation is available to a person in computing the

tax liability under the laws of the Contracting State of which he is a resident. Credit is available in respect of any income, which is taxed in both contracting states. In other words, no tax credit will be available where the amount is taxed in only one Contracting State. Further, the credit is generally available for incomes on which tax is levied in accordance with the convention. Where an income is not taxed in accordance with the convention, credit may not be available. The amount of credit, will be the tax that is paid in the source state subject to specified limits.

4.29. In case the deputed employee for example is a resident of USA, and the salary income is taxable both in India and USA, credit will available in USA under Article 25 of the Treaty. The extent of credit will be subject to USA tax law on the point.

4.30. The case of USA is being discussed here because of its peculiar tax culture. In the USA, domestic law overrides the Treaty law. Under the domestic law, a citizen or a green card holder is considered a resident of USA. Such a person, because of physical presence test may be regarded as a resident of another state, say India. Under the tie breaker test, he may continue to be held a resident of India. But this would be a



unilateral view as USA may also continue to regard him as resident because of his citizenship or green card status. The employee may then be exposed to unlimited tax liability in both the countries; his global income being taxed in both the countries. How is the tax credit provision to be applied in such situations? Is it possible to claim a “mutual” tax credit – credit in USA for India sourced income aggregated there and simultaneous credit in India for US sourced income aggregated in India. Participants may deliberate upon this.

5. TRANSFER PRICING5.1. Designed to be an anti avoidance provision, Chapter X [on transfer pricing] seeks to

protect the tax base of India. Its aim is to prevent the flight of taxable profits from India. Assessees are required to show/unearth comparables. Comparables are those that function in uncontrolled conditions. The margins/price in such uncontrolled conditions is benchmarked against the assessee’s performance. Assessee is required to demonstrate that the price/margin in transactions with affiliate(s) are equal to or more than the bench marked figure; or if lower, it is within the prescribed bandwidth.

5.2. Comparability analysis is thus the key to the determination of arm’s length price. No two businesses function alike. To call one as comparable with another is therefore fraught with serious challenges. The equalisation of two entities or transactions [to make comparability meaningful] can only happen with assumptions. The differences exposed by these assumptions are to be ironed out. The impact of differences on profits or margins is to be negated by a quantitative adjustment. A mathematical adjustment is thus assigned to a qualitative difference. All these make the entire analysis subjective.

5.3. Outsourcing happens to take advantage of cost arbitrage, availability of skilled manpower, infrastructure, etc. These locational advantages prompt the outsourcing of functions. Even though functions are outsourced, risks may not necessarily be shared. The party, to whom the work is outsourced, may not therefore necessarily be a ‘risk bearing’ entity. Comparability study cannot be oblivious to these differences. A “non-consensual” approach is likely to result if the perceptions of the revenue vary significantly with those of the assessee. Certain points of debate in the context of transfer pricing and outsourcing as under:

A) RISKS5.4. Other things being equal risk attaches and follows functions. In such circumstances,

risk is not an independent element but is attached to functions performed and assets employed. Not being divorced from functions and assets, risks are to be naturally factored in determining arms length price or margin.

5.5. It is also arguable that the contractual risks could continue to be assumed by the party securing the contract. That the work under the contract is outsourced, does not necessarily mean that risks are also passed over. In fact the client may not agree to risks being shared. Otherwise this will warrant him to undertake multiple legal actions, if defects are noticed in the deliverables. Though part of the work is assigned, [and accepted by the client] risks remain with the party securing the contract. Even the Rangachary Committee in its report and recommendations of 14th September, 2012, has acknowledged that risks may not accompany the outsourcing of functions.



5.6. Risks are therefore controllable as also allocable. If risks are not assumed by the entity to whom the work is outsourced, the comparison is to be made after the results of the comparables are adjusted to eliminate the effect of risks on profits. The current models/ methods for risk adjustment [e.g. Capital Asset Pricing Model – CAPM, etc.] have short comings. Couple of ITAT decisions [for instance, Sony’s case, Philip software’s case] have outlined ‘convenient’ and not ‘convincing’ adjustments for differences in risks. Participants may debate on the appropriateness of risk adjustment as also the method of giving effect to it.

B) LOCATIONAL SAVINGS5.7. Locational savings refer to ‘cost savings’ in low cost jurisdictions, MNE(s) continually

strive to identify means of lowering cost to increase profits. From an outsourcing angle, India provides the following location specific advantages in addition to location savings.

i) Specialised and skilled manpower

ii) Growing local/regional market

iii) Good information network

iv) Superior distribution network

5.8. A bone of emerging contention is whether the revenue authorities are justified in expanding the tax base by including a portion of the incremental profits due to locational savings and advantages. The global profit is then split by assessing the contribution of the respective participants. It is argued that the profit split method would be the most appropriate method. The revenue contends that the normal comparability analysis help only in determining the pricing of a transaction. It does not take into account, the contribution of locational savings.

5.9. In such a scenario, many issues emerge for discussion. An illustrative list of such issues could be:

i) Comparables also function with similar locational advantages. In their bargaining they would have factored these advantages. There could be no doubt of the price bargained by them being at arm’s length. If the price or margin in the transaction between affiliates matches those with comparables, is there a need for separate and additional analysis to additionally consider the location savings?

ii) Whether PSM could be the most appropriate method? Out of the 5 specific methods, only for PSM, the criteria for its applicability are outlined. Transfer of unique intangibles is required or inter related transactions incapable of separate evaluation is envisaged. Whether an outsourcing deal will meet with these criteria?

iii) While determining transfer pricing provisions in the context of outsourcing (outbound or inbound), should the Revenue authorities necessarily compare it with a similar outsourcing arrangement or can it be compared with a hypothetical in-house execution of the outsourced tasks would the sixth method prescribed by CBDT enable such an analysis?



iv) Unlike a normal business transaction (wherein the ‘contract of service’ and ‘execution of service’ rests with the same person); an outsourcing transaction deals with hiving off some or all facets of such transactions although retaining the overall responsibility. The considerations and reasons for outsourcing could be many. Is it possible to factor in all these considerations? Whose FAR analysis would help in determining the arm’s length price – (i) ‘outsourcing’ entity; (ii) ‘outsourced’ entity; (iii) both?

v) Under the Treaty, the determination of the profits of a PE is based upon a fiction that the Head Office and PE are distinct entities and their relationship is at arm’s length. Could the determination of arm’s length under the Treaty be by a difference process than that contemplated under chapter X?

vi) While examining the appropriateness of the expenditure under section 40A(2), it was never referred to be demonstrated that the price paid for is comparable with the “average” of the comparables. Any one instance of a beneficial comparison would have sufficed. It is necessary therefore that the average of the entire population is to be employed in benchmarking the price paid/charged? Does the statutory language permit the adoption of a single comparable?

vii) If under the TNMM, the net margins are demonstrated at arm’s length, does it presuppose that all the AE’s dealings are also at arm’s length?

viii) Is the revenue empowered to examine independently the pricing of a transaction on a standalone basis although the overall margins are at arm’s length or vice versa?

ix) The Supreme Court of Finland has held that if the functions performed are different from that in the home country from where the outsourcing has happened locational savings need not be factored in determining ALP. Whether this ruling or its ratio would be relevant in the Indian context?

C) INTRA GROUP SERVICES5.10. Shared services are a natural consequence of globalisation and the desire to achieve

efficiency. Some of such services may be a duplication of what the AE’s independently perform. Some services may be in the character of a legal owner rather than as a business partner. Some such services may not invariably be availed, had the parties not been AEs. Identification of the services which require an arm’s length remuneration is thus a key challenge for both the revenue as also comparables. The Indian tax authorities are generally known to examine the pricing mechanism of intra group services with the following doubts/skepticism.

5.11. The Indian transfer pricing administration generally considers following questions in order to identify intra group services requiring arm’s length remuneration:

i. Whether Indian subsidiaries have received any related party services i.e., intra group services?

ii. Nature and details of services including quantum of services received by the related party.



iii. Whether services have been provided in order to meet specific need of recipient of the services?

iv. What are the economic and commercial benefits derived by the recipient of intra group services?

v. Whether in comparable circumstances an independent enterprise would be willing to pay the price for such services?

vi. Whether an independent third party would be willing and able to provide such services?

D) FINANCIAL TRANSACTIONS5.12. Outsourcing may involve intercompany loan. Transactions involving credit guarantees

may also be present. The following conditions are generally associated with these financial transactions.

�� %��'� �� '� ��

�� *��'� �� '� �� !�

�� '��'� ��

�� +�� <��

5.13. The Indian transfer pricing administration has determined that since loans are advanced from India and Indian currency has been subsequently converted into the currency of the geographic location of the AE, the Prime Lending Rate [PLR] of the Indian banks should be applied as the external CUP and not the LIBOR or EURIBOR rate.

CONCLUDING THOUGHTSCommercially, ‘Outsourcing’ has always been defined to mean ‘sourcing out’ of business process/ activity. When viewed differently, it means employing an outsider to source the income for oneself. Thus, outsourcing means ‘import of services’. The choice of ‘outsourcing’ has not been easy. The path is littered with challenges. It is tough to invite an ‘outsider in’ or divorce an ‘in-house process out’.

This intake of outsider service has however made slow and steady inroads into the business world. It initially lured then supported sometimes became indispensible. Today, it has left many handicapped. The story of ‘in’ and ‘out’ does not end here. Outsourcing has gripped facets of life which should have always remained ‘in’ but are ‘out’. Outsourcing has thus become the “in thing”. One can only remain consoled that outsourcing is not a recent phenomenon. The story of outsourcing is seen and heard right from the mythological epics till date. We have heard of passing out of ‘motherhood’ by Devaki to Yashoda [in the age of Mahabharath]. Today we are learning about many such attempts including the outsourcing of the “pain of labour” (pun intended).



Annexure I

Royalty defined in explanation 2 to section 9(1)(vi):

For the purposes of this clause, “royalty” means consideration (including any lump sum consideration but excluding any consideration which would be the income of the recipient chargeable under the head “Capital gains”) for—

(i) the transfer of all or any rights (including the granting of a licence) in respect of a patent, invention, model, design, secret formula or process or trade mark or similar property;

(ii) the imparting of any information concerning the working of, or the use of, a patent, invention, model, design, secret formula or process or trade mark or similar property;

(iii) the use of any patent, invention, model, design, secret formula or process or trade mark or similar property;

(iv) the imparting of any information concerning technical, industrial, commercial or scientific knowledge, experience or skill;

(iva) the use or right to use any industrial, commercial or scientific equipment but not including the amounts referred to in section 44BB;

(v) the transfer of all or any rights (including the granting of a licence) in respect of any copyright, literary, artistic or scientific work including films or video tapes for use in connection with television or tapes for use in connection with radio broadcasting, but not including consideration for the sale, distribution or exhibition of cinematographic films; or

(vi) the rendering of any services in connection with the activities referred to in sub-clauses (i) to (iv), (iva) and (v).

Annexure II

Fees for technical services is defined in explanation 2 to section 9(1)(vii):

Explanation [2].—For the purposes of this clause, “fees for technical services” means any consideration (including any lump sum consideration) for the rendering of any managerial, technical or consultancy services (including the provision of services of technical or other personnel) but does not include consideration for any construction, assembly, mining or like project undertaken by the recipient or consideration which would be income of the recipient chargeable under the head “Salaries”.

Annexure III

Relevant Articles extracted from India-USA treaty

ARTICLE 5

Permanent establishment1. For the purposes of this Convention, the term “permanent establishment” means a

fixed place of business through which the business of an enterprise is wholly or partly carried on.



2. The term “permanent establishment” includes especially:

(a) a place of management;

(b) a branch;

(c) an office;

(d) a factory;

(e) a workshop;

(f) a mine, an oil or gas well, a quarry, or any other place of extraction of natural resources;

(g) a warehouse, in relation to a person providing storage facilities for others;

(h) a farm, plantation or other place where agriculture, forestry, plantation or related activities are carried on;

(i) a store or premises used as a sales outlet;

(j) an installation or structure used for the exploration or exploitation of natural resources, but only if so used for a period of more than 120 days in any twelve-month period;

(k) a building site or construction, installation or assembly project or supervisory activities in connection therewith, where such site, project or activities (together with other such sites, projects or activities, if any) continue for a period of more than 120 days in any twelve-month period;

(l) the furnishing of services, other than included services as defined in Article 12 (Royalties and Fees for Included Services), within a Contracting State by an enterprise through employees or other personnel, but only if:

(i) activities of that nature continue within that State for a period or periods aggregating more than 90 days within any twelve-month period; or

(ii) the services are performed within that State for a related enterprise [within the meaning of paragraph 1 of Article 9 (Associated Enterprises)].

3. Notwithstanding the preceding provisions of this Article, the term “permanent establishment” shall be deemed not to include any one or more of the following:

(a) the use of facilities solely for the purpose of storage, display, or occasional delivery of goods or merchandise belonging to the enterprise;

(b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display, or occasional delivery;

(c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;

(d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise;

(e) the maintenance of a fixed place of business solely for the purpose of advertising, for the supply of information, for scientific research or for other activities which



have a preparatory or auxiliary character, for the enterprise.

4. Notwithstanding the provisions of paragraphs 1 and 2, where a person—other than an agent of an independent status to whom paragraph 5 applies - is acting in a Contracting State on behalf of an enterprise of the other Contracting State, that enterprise shall be deemed to have a permanent establishment in the first-mentioned State, if:

(a) he has and habitually exercises in the first-mentioned State an authority to conclude on behalf of the enterprise, unless his activities are limited to those mentioned in paragraph 3 which, if exercised through a fixed place of business, would not make that fixed place of business a permanent establishment under the provisions of that paragraph;

(b) he has no such authority but habitually maintains in the first-mentioned State a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the enterprise, and some additional activities conducted in the State on behalf of the enterprise have contributed to the sale of the goods or merchandise; or

(c) he habitually secures orders in the first-mentioned State, wholly or almost wholly for the enterprise.

5. An enterprise of a Contracting State shall not be deemed to have a permanent establishment in the other Contracting State merely because it carries on business in that other State through a broker, general commission agent, or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business. However, when the activities of such an agent are devoted wholly or almost wholly on behalf of that enterprise and the transactions between the agent and the enterprise are not made under arm’s length conditions, he shall not be considered an agent of independent status within the meaning of this paragraph.

6. The fact that a company which is a resident of a Contracting State controls or is controlled by a company which is a resident of the other Contracting State, or which carries on business in that other State (whether through a permanent establishment or otherwise), shall not of itself constitute either company a permanent establishment of the other.

ARTICLE 7

Business profits1. The profits of an enterprise of a Contracting State shall be taxable only in that State

unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to (a) that permanent establishment; (b) sales in the other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment ; or (c) other business activities carried on in the other State of the same or similar kind as those effected through that permanent establishment.



2. Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly at arm’s length with the enterprise of which it is a permanent establishment and other enterprises controlling, controlled by or subject to the same common control as that enterprise. In any case where the correct amount of profits attributable to a permanent establishment is incapable of determination or the determination thereof presents exceptional difficulties, the profits attributable to the permanent establishment may be estimated on a reasonable basis. The estimate adopted shall, however, be such that the result shall be in accordance with the principles contained in this Article.

3. In the determination of the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the business of the permanent establishment, including a reasonable allocation of executive and general administrative expenses, research and development expenses, interest, and other expenses incurred for the purposes of the enterprise as a whole (or the part thereof which includes the permanent establishment), whether incurred in the State in which the permanent establishment is situated or elsewhere, in accordance with the provisions of and subject to the limitations of the taxation laws of that State. However, no such deduction shall be allowed in respect of amounts, if any, paid (otherwise than towards reimbursement of actual expenses) by the permanent establishment to the head office of the enterprise or any of its other offices, by way of royalties, fees or other similar payments in return for the use of patents, know-how or other rights, or by way of commission or other charges for specific services performed or for management, or, except in the case of a banking enterprises, by way of interest on moneys lent to the permanent establishment. Likewise, no account shall be taken, in the determination of the profits of a permanent establishment, for amounts charged (otherwise than toward reimbursement of actual expenses), by the permanent establishment to the head office of the enterprise or any of its other offices, by way of royalties, fees or other similar payments in return for the use of patents, know-how or other rights, or by way of commission or other charges for specific services performed or for management, or, except in the case of a banking enterprise, by way of interest on moneys lent to the head office of the enterprise or any of its other offices.

4. No profits shall be attributed to a permanent establishment by reason of the mere purchase by that permanent establishment of goods or merchandise for the enterprise.

5. For the purposes of this Convention, the profits to be attributed to the permanent establishment as provided in paragraph 1(a) of this Article shall include only the profits derived from the assets and activities of the permanent establishment and shall be determined by the same method year by year unless there is good and sufficient reason to the contrary.

6. Where profits include items of income which are dealt with separately in other Articles of the Convention, then the provisions of those Articles shall not be affected by the provisions of this Article.



7. For the purposes of the Convention, the term “business profits” means income derived from any trade or business including income from the furnishing of services other than included services as defined in Article 12 (Royalties and Fees for Included Services) and including income from the rental of tangible personal property other than property described in paragraph 3(b) of Article 12 (Royalties and Fees for Included Services).

ARTICLE 12

Royalties and fees for included services 1. Royalties and fees for included services arising in a Contracting State and paid to a

resident of the other Contracting State may be taxed in that other State.

2. However, such royalties and fees for included services may also be taxed in the Contracting State in which they arise and according to the laws of that State; but if the beneficial owner of the royalties or fees for included services is a resident of the other Contracting State, the tax so charged shall not exceed:

(a) in the case of royalties referred to in sub-paragraph (a) of paragraph 3 and fees for included services as defined in this Article [other than services described in sub-paragraph (b) of this paragraph] :

(i) during the first five taxable years for which this Convention has effect,

(a) 15 per cent of the gross amount of the royalties or fees for included services as defined in this Article, where the payer of the royalties or fees is the Government of that Contracting State, a political sub-division or a public sector company; and

(b) 20 per cent of the gross amount of the royalties or fees for included services in all other cases; and

(ii) during the subsequent years, 15 per cent of the gross amount of royalties or fees for included services; and

(b) in the case of royalties referred to in sub-paragraph (b) of paragraph 3 and fees for included services as defined in this Article that are ancillary and subsidiary to the enjoyment of the property for which payment is received under paragraph 3(b) of this Article, 10 per cent of the gross amount of the royalties or fees for included services.

3. The term “royalties” as used in this Article means:

(a) payments of any kind received as a consideration for the use of, or the right to use, any copyright of a literary, artistic, or scientific work, including cinematograph films or work on film, tape or other means of reproduction for use in connection with radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience, including gains derived from the alienation of any such right or property which are contingent on the productivity, use, or disposition thereof; and

(b) payments of any kind received as consideration for the use of, or the right to use, any industrial, commercial, or scientific equipment, other than payments



derived by an enterprise described in paragraph 1 of Article 8 (Shipping and Air Transport) from activities described in paragraph 2(c) or 3 of Article 8.

4. For purposes of this Article, “fees for included services” means payments of any kind to any person in consideration for the rendering of any technical or consultancy services (including through the provision of services of technical or other personnel) if such services:


(b) make available technical knowledge, experience, skill, know-how, or processes, or consist of the development and transfer of a technical plan or technical design.

5. Notwithstanding paragraph 4, “fees for included services” does not include amounts paid:

(a) for services that are ancillary and subsidiary, as well as inextricably and essentially linked, to the sale of property other than a sale described in paragraph 3(a);

(b) for services that are ancillary and subsidiary to the rental of ships, aircraft, containers or other equipment used in connection with the operation of ships or aircraft in international traffic;

(c) for teaching in or by educational institutions;

(d) for services for the personal use of the individual or individuals making the payments; or

(e) to an employee of the person making the payments or to any individual or firm of individuals (other than a company) for professional services as defined in Article 15 (Independent Personal Services).

6. The provisions of paragraphs 1 and 2 shall not apply if the beneficial owner of the royalties or fees for included services, being a resident of a Contracting State, carries on business in the other Contracting State, in which the royalties or fees for included services arise, through a permanent establishment situated therein, or performs in that other State independent personal services from a fixed base situated therein, and the royalties or fees for included services are attributable to such permanent establishment or fixed base. In such case the provisions of Article 7 (Business Profits) or Article 15 (Independent Personal Services), as the case may be shall apply.

7. (a) Royalties and fees for included services shall be deemed to arise in a Contracting State when the payer is that State itself, a political sub-division, a local authority, or a resident of that State. Where, however, the person paying the royalties or fees for included services, whether he is a resident of a Contracting State or not, has in a Contracting State a permanent establishment or a fixed base in connection with which the liability to pay the royalties or fees for included services was incurred, and such royalties or fees for included services are borne by such permanent establishment or fixed base, then such royalties or fees for included services shall be deemed to arise in the Contracting State in which the permanent establishment or fixed base is situated.



(b) Where under sub-paragraph (a) royalties or fees for included services do not arise in one of the Contracting States, and the royalties relate to the use of, or the right to use, the right or property, or the fees for included services relate to services performed, in one of the Contracting States, the royalties or fees for included services shall be deemed to arise in that Contracting State.

8. Where, by reason of a special relationship between the payer and the beneficial owner or between both of them and some other person, the amount of the royalties or fees for included services paid exceeds the amount which would have been paid in the absence of such relationship, the provisions of this Article shall apply only to the last-mentioned amount. In such case, the excess part of the payments shall remain taxable according to the laws of each Contracting State, due regard being had to the other provisions of the Convention.

ARTICLE 15

Independent personal services1. Income derived by a person who is an individual or firm of individuals (other than a

company) who is a resident of a Contracting State from the performance in the other Contracting State of professional services or other independent activities of a similar character shall be taxable only in the first-mentioned State except in the following circumstances when such income may also be taxed in the other Contracting State:

(a) if such person has a fixed base regularly available to him in the other Contracting State for the purpose of performing his activities; in that case, only so much of the income as is attributable to that fixed base may be taxed in that other State; or

(b) if the person’s stay in the other Contracting State is for a period or periods amounting to or exceeding in the aggregate 90 days in the relevant taxable year.

2. The term “professional services” includes independent scientific, literary, artistic, educational or teaching activities as well as the independent activities of physicians, surgeons, lawyers, engineers, architects, dentists and accountants.

ARTICLE 23

Other income1. Subject to the provisions of paragraph 2, items of income of a resident of a Contracting

State, wherever arising, which are not expressly dealt with in the foregoing Articles of this Convention shall be taxable only in that Contracting State.

2. The provisions of paragraph 1 shall not apply to income, other than income from immovable property as defined in paragraph 2 of Article 6 [Income from Immovable Property (Real Property)], if the beneficial owner of the income, being a resident of a Contracting State, carries on business in the other Contracting State through a permanent establishment situated therein, or performs in that other State independent personal services from a fixed base situated therein, and the income is attributable to such permanent establishment or fixed base. In such case the provisions of Article 7



(Business Profits) or Article 15 (Independent Personal Services), as the case may be, shall apply.

3. Notwithstanding the provisions of paragraphs 1 and 2, items of income of a resident of a Contracting State not dealt with in the foregoing articles of this Convention and arising in the other Contracting State may also be taxed in that other State.

ARTICLE 24

Limitation on benefits1. A person (other than an individual) which is a resident of a Contracting State and

derives income from the other Contracting State shall be entitled under this Convention to relief from taxation in that other Contracting State only if:

(a) more than 50 per cent of the beneficial interest in such person (or in the case of a company, more than 50 per cent of the number of shares of each class of the company’s shares) is owned, directly or indirectly, by one or more individual residents of one of the Contracting States, one of the Contracting States or its political sub-divisions or local authorities, or other individuals subject to tax in either Contracting State on their worldwide incomes, or citizens of the United States ; and

(b) the income of such person is not used in substantial part, directly or indirectly, to meet liabilities (including liabilities for interest or royalties) to persons who are not resident of one of the Contracting States, one of the Contracting States or its political sub-divisions or local authorities, or citizens of the United States.

2. The provisions of paragraph 1 shall not apply if the income derived from the other Contracting State is derived in connection with, or is incidental to, the active conduct by such person of a trade or business in the first-mentioned State (other than the business of making or managing investments, unless these activities are banking or insurance activities carried on by a bank or insurance company).

3. The provisions of paragraph 1 shall not apply if the person deriving the income is a company which is a resident of a Contracting State in whose principal class of shares there is substantial and regular trading on a recognised stock exchange. For purposes of the preceding sentence, the term “recognised stock exchange” means :

(a) in the case of United States, the NASDAQ System owned by the National Association of Securities Dealers, Inc. and any stock exchange registered with the Securities and Exchange Commission as a national securities exchange for purposes of the Securities Act of 1934;

(b) in the case of India, any stock exchange which is recognized by the Central Government under the Securities Contracts Regulation Act, 1956 ; and

(c) any other stock exchange agreed upon by the competent authorities of the Contracting States.

4. A person that is not entitled to the benefits of this Convention pursuant to the provisions of the preceding paragraphs of this Article may, nevertheless, be granted the



benefits of the Convention if the competent authority of the State in which the income in question arises so determines.

PROTOCOL

At the signing today of the Convention between the United States of America and the Republic of India for the Avoidance of Double Taxation and the prevention of Fiscal Evasion with respect to Taxes on Income, the undersigned have agreed upon the following provisions, which shall form an integral part of the Convention:

I. AD ARTICLE 5 – It is understood that where an enterprise of a Contracting State has a permanent establishment in the other Contracting State in accordance with the provisions of paragraph 2(j), 2(k) or 2(l) of Article 5 (Permanent Establishment), and the time period referred to in that paragraph extends over two taxable years, a permanent establishment shall not be deemed to exist in a year, if any, in which the use, site, project or activity, as the case may be, continues for a period or periods aggregating less than 30 days in that taxable year. A permanent establishment will exist in the other taxable year, and the enterprise will be subject to tax in that other Contracting State in accordance with the provisions of Article 7 (Business Profits), but only on income arising during that other taxable year.

II. AD ARTICLE 7 – Where the law of the Contracting State in which a permanent establishment is situated imposes, in accordance with the provisions of paragraph 3 of Article 7 (Business Profits), a restriction on the amount of executive and general administrative expenses which may be allowed as a deduction in determining the profits of such permanent establishment, it is understood that in making such a determination of profits the deduction in respect of such executive and general administrative expenses in no case shall be less than that allowable under the Indian Income-tax Act as on the date of signature of this Convention.

III. AD ARTICLES 7, 10, 11, 12, 15 and 23 – It is understood that for the implementation of paragraphs 1 and 2 of Article 7 (Business Profits), paragraph 4 of Article 10 (Dividends), paragraph 5 of Article 11 (Interest), paragraph 6 of Article 12 (Royalties and Fees for Included Services), paragraph 1 of Article 15 (Independent Personal Services), and paragraph 2 of Article 23 (Other Income), any income attributable to a permanent establishment or fixed base during its existence is taxable in the Contracting State in which such permanent establishment or fixed base is situated even if the payments are deferred until such permanent establishment or fixed base has ceased to exist.

IV. AD ARTICLE 12 - It is understood that fees for included services, as defined in paragraph 4 of Article 12 (Royalties and Fees for Included Services) will, in accordance with United States law, be subject to income-tax in the United States based on net income and, when earned by a company, will also be subject to the taxes described in paragraph 1 of Article 14 (Permanent Establishment Tax). The total of these taxes which may be imposed on such fees, however, may not exceed the amount computed by multiplying the gross fee by the appropriate tax rate specified in sub-paragraph (a) or (b) whichever is applicable or paragraph 2 of Article 12.

V. AD ARTICLE 14 - It is understood that references in paragraph 1 of Article 14 (Permanent Establishment tax) to profits that are subject to tax in the United States



under Article 6 [Income from Immovable Property (Real Property)], under Article 12 (Royalties and Fees for Included Services), as fees for included services as defined in that Article, or under Article 13 (Gains) of this Convention, are intended to refer only to cases in which the profits in question are subject to United States tax based on net income (i.e., by virtue of being effectively connected, or being treated as effectively connected, with the conduct of a trade or business in the United States). Any income which is subject to tax under those Articles based on gross income is not subject to tax under Article 14.

IN WITNESS WHEREOF, the undersigned, being duly authorised by their respective Governments, have signed this Protocol.

DONE at New Delhi in duplicate, this 12th day of September, 1989, in the English and Hindi languages, both texts equally authentic. In case of divergence between the two texts, the English text shall be the operative one.

For the Government of For the Government of the the Republic of India : United States of America : Sd/- Sd/- N.K. Sengupta John R. Hubbard Secretary to the Ambassador Government of India

Embassy of United States of America

New Delhi, September 12, 1989

Excellency : I have the honour to refer to the Convention between the Government of the United States of America and the Government of the Republic of India for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income which was signed today (hereinafter referred to as “the Convention”) and to confirm, on behalf of the Government of the United States of America, the following understandings reached between the two Governments:

Both sides agree that a tax sparing credit shall not be provided in Article 25 (Relief from Double Taxation) of the convention at this time. However, the Convention shall be promptly amended to incorporate a tax sparing credit provision if the United States hereafter amends its laws concerning the provision of tax sparing credits, or the United States reaches agreement on the provision of a tax sparing credit with any other country.

Both sides also agree that, for purposes of paragraph 4(c) of Article 5 (Permanent Establishment) of the Convention, a person shall be considered to habitually secure orders in a Contracting State, wholly or almost for an enterprise, only if:

1. such person frequently accepts orders for goods or merchandise on behalf of the enterprise;

2. substantially all of such person’s sales related activities in the Contracting State consist of activities for the enterprise;



3. such person habitually represents to persons offering to buy goods or merchandise that acceptance of an order by such person constitutes the agreement of the enterprise to supply goods or merchandise under the terms and conditions specified in the order; and

4. The enterprise takes action that give purchasers the basis for a reasonable belief that such person has authority to bind the enterprise.

I have the honour to request Your Excellency to confirm the foregoing understandings of Yours Excellency’s Government.

Accept, Excellency, the renewed assurances of my highest consideration.

His Excellency Sd/- Dr. N.K. Sengupta, John R. Hubbard Secretary (Revenue), Ambassador Ministry of Finance, New Delhi. Secretary, Government of India Ministry of Finance (Department of Revenue) New Delhi, September 12, 1989. Excellency :

I have the honour to acknowledge receipt of Your Excellency’s Note of today’s date, which reads as follows :

“I have the honour to refer to the Convention between the Government of the United States of America and the Government of the Republic of India for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income which was signed today (hereinafter referred to as “the Convention”) and to confirm, on behalf of the Government of the United States of America, the following understandings reached between the two Governments :

Both sides agree that a tax sparing credit shall not be provided in Article 25 (Relief from Double Taxation) of the Convention at his time. However, the Convention shall be promptly amended to incorporate a tax sparing credit provision if the United States hereafter amends its laws concerning the provision of tax sparing credits, or the United States reaches agreement on the provision of a tax sparing credit with any other country.

Both sides also agree that, for purposes of paragraph 4(c) of Article 5 (Permanent Establishment) of the convention, a person shall be considered to habitually secure orders in a Contracting State, wholly or almost wholly for an enterprise, only if :

1. such person frequently accepts orders for goods or merchandise on behalf of the enterprise;

2. substantially all of such person’s sales related activities in the Contracting State consist of activities for the enterprise;

3. such person habitually represents to persons offering to buy goods or merchandise that acceptance of an order by such person constitutes the agreement of the enterprise to supply goods or merchandise under the terms and conditions specified in the order; and



4. the enterprise takes actions that give purchasers the basis for a reasonable belief that such person has authority to bind the enterprise.

I have the honour to confirm the understandings contained in Your Excellency’s Note, on behalf of the Government of the Republic of India.


His Excellency Sd/- Dr. John R. Hubbard N.K. Sengupta Ambassador of the United States of America New Delhi. Embassy of the United States of America New Delhi, September 12, 1989. Excellency :

I have the honour to refer to the Convention signed today between the United States of America and the Republic of India for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to taxes on Income and to inform you on behalf of the United States of America of the following :

During the course of the negotiations leading to conclusion of the Convention signed today, the negotiators developed and agreed upon a memorandum of understanding intended to give guidance both to the taxpayers and the tax authorities of our two countries in interpreting aspects of Article 12 (Royalties and Fees for Included Services) relating to the scope of included services. This memorandum of understanding represents the current views of the United States Government with respect to these aspects of Article 12, and it is my Government’s understanding that it also represents the current views of the Indian Government. It is also my Government’s view that as our Government gain experience in administering the Convention, and particularly Article 12, the competent authorities may develop and publish amendments to the memorandum of understanding and further understandings and interpretations of the Convention.

If this position meets with the approval of the Government of the Republic of India, this letter and your reply thereto will indicate that our Governments share a common view of the purpose of the memorandum of understanding relating to Article 12 of the Convention.


His Excellency Sd/- Dr. N.K. Sengupta, John R. Hubbard Secretary (Revenue), Ambassador Ministry of Finance, New Delhi. Government of India, Ministry of Finance (Department of Revenue) New Delhi, September 12, 1989. Excellency :

I have the honour to acknowledge receipt of Your Excellency’s Note of today’s date, which reads as follows :



“I have the honour to refer to the Convention signed today between the United States of America and the Republic of India for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and to inform on behalf of the United States of America of the following :

During the course of the negotiations leading to conclusion of the Convention signed today, the negotiators developed and agreed upon a memorandum of understanding intended to give guidance both to the taxpayers and the tax authorities of our two countries in interpreting aspects of Article 12 (Royalties and Fees for Included Services) relating to the scope of included services. The memorandum of understanding represents the current views of the United States Government with respect to these aspects of Article 12, and it is my Government’s understanding that it also represents the current views of the Indian Government. It is also my Government’s view that as our Governments gain experience in administering the Convention, and particularly Article 12, the competent authorities may develop and publish amendments to the memorandum of understanding and further understandings and interpretations of the Convention.

If this position meets with the approval of the Government of the Republic of India, this letter and your reply thereto will indicate that our Governments share a common view of the purpose of the memorandum of understanding relating to Article 12 of the Convention.”

I have the honour to confirm the understanding contained in Your Excellency’s Note, on behalf of the Government of the Republic of India.


His Excellency Sd/- Dr. John R. Hubbard Dr. N.K. Sengupta, Ambassador of the United States of America New Delhi.

May 15, 1989

U.S.-INDIA TAX TREATY

Memorandum of understanding concerning fees for included services in Article 12

Paragraph 4 (in general)

This memorandum describes in some detail the category of services defined in paragraph 4 of Article 12 (Royalties and Fees for Included Services). It also provides examples of services intended to be covered within the definition of included services and those intended to be excluded, either because they do not satisfy the tests of paragraph 4, or because, notwithstanding the fact that they meet the tests of paragraph 4, they are dealt with under paragraph 5. The examples in either case are not intended as an exhaustive list but rather as illustrating a few typical cases. For case of understanding, the example in this memorandum described U.S. persons providing services to Indian persons, but the rules of Article 12 are reciprocal in application.



Article 12 includes only certain technical and consultancy services. But technical services, we mean in this context services requiring expertise in a technology. By consultancy services, we mean in this context advisory services. The categories of technical and consultancy services are to some extent overlapping because a consultancy service could also be a technical service. However, the category of consultancy services also includes an advisory service, whether or not expertise in a technology is required to perform it.

Under paragraph 4, technical and consultancy services are considered included services only to the following extent: (1) as described in paragraph 4(a), if they are ancillary and subsidiary to the application or enjoyment of a right, property or information for which are royalty payment is made; or (2) as described in paragraph 4(b), if they make available technical knowledge, experience, skill, know-how, or processes, or consist of the development and transfer of a technical plan or technical design. Thus, under paragraph 4(b), consultancy services which are not of a technical nature cannot be included services.

Paragraph 4(a)Paragraph 4(a) of Article 12 refers to technical or consultancy services that are ancillary and subsidiary to the application or enjoyment of any right, property, or information for which a payment described in paragraph 3(a) or (b) is received. Thus, paragraph 4(a) includes a technical and consultancy services that are ancillary and subsidiary to the application or enjoyment of an intangible for which a royalty is received under a licence or sale as described in paragraph 3(a), as well as those ancillary and subsidiary to the application or enjoyment of industrial, commercial, or scientific equipment for which a royalty is received under a lease as described in paragraph 3(b).

It is understood that, in order for a service fee to be considered “ancillary and subsidiary” to the application or enjoyment of some right, property, or information for which a payment described in paragraph 3(a) or (b) is received, the service must be related to the application or enjoyment of the right, property, or information. In addition, the clearly predominant purpose of the arrangement under which the payment of the service fee and such other payments are made must be the application or enjoyment of the right, property, or information described in paragraph 3. The question of whether the service is related to the application or enjoyment of right, property, or information described in paragraph 3 and whether the clearly predominant purpose of the arrangement is such application or enjoyment must be determined by reference to the facts and circumstances of each case. Factors which may be relevant to such determination (although not necessarily controlling) include :

1. The extent to which the services in question facilitate the effective application or enjoyment of the right, property, or information described in paragraph 3;

2. The extent to which such services are customarily provided in the ordinary course of business arrangements involving royalties described in paragraph 3;

3. Whether the amount paid for the services (or which would be paid by parties operating at arm’s length) is an insubstantial portion of the combined payments for the services and the right, property, or information described in paragraph 3;

4. Whether the payment made for the services and the royalty described in paragraph 3 are made under a single contract (or a set of related contracts); and



5. Whether the person performing the services is the same person as, or a related person to, the person receiving the royalties described in paragraph 3 [for this purpose, persons are considered related if their relationship is described in Article 9 (Associated Enterprises) or if the person providing the service is doing so in connection with an overall arrangement which includes the payer and recipient of the royalties].

To the extent that services are not considered ancillary and subsidiary to the application or enjoyment of some right, property, or information for which a royalty payment under paragraph 3 is made, such services shall be considered “included services” only to the extent that they are described in paragraph 4(b).

Example 1

Facts:A U.S. manufacturer grants rights to an Indian company to use manufacturing processes in which the transferor has exclusive rights by virtue of process, patents or the protection otherwise extended by law to the owner of a process. As part of the contractual arrangement, the U.S. manufacturer agrees to provide certain consultancy services to the Indian company in order to improve the effectiveness of the latter’s use of the processes. Such services include, for example, the provision of information and advice on sources of supply for materials needed in the manufacturing process, and on the development of sales and service literature for the manufactured product. The payment allocable to such services do not form a substantial part of the total consideration payable under the contractual arrangement. Are the payments for these services fees for “included services” ?

Analysis:The payments are fees for included services. The services described in this example are ancillary and subsidiary to the use of manufacturing process protected by law as described in paragraph 3(a) of Article 12 because the services are related to the application or enjoyment of the intangible and the granting of the right to use the intangible as the clearly predominant purpose of the arrangement. Because the services are ancillary and subsidiary to the use of the manufacturing process, the fees for these services are considered for included services under paragraph 4(a) of Article 12, regardless of whether the services are described in paragraph 4(b).

Example 2

Facts:An Indian manufacturing company produces a product that must be manufactured under sterile conditions using machinery that must be kept completely free of bacterial or other harmful deposits. A U.S. company has developed a special cleaning process for removing such deposits from that type of machinery. The U.S. company enters in to a contract with the Indian company under which the former will clean the latter’s machinery on a regular basis. As part of the arrangement, the U.S. company leases to the Indian company a piece of equipment which allows the Indian company to measure the level of bacterial deposits on its machinery in order for it to known when cleaning is required. Are the payments for the services fees for included services ?



Analysis:In this example, the provision of cleaning services by the U.S. company and the rental of the monitoring equipment are related to each other. However, the clearly predominant purpose of the arrangement is the provision of cleaning services. Thus, although the cleaning services might be considered technical services, they are not “ancillary and subsidiary” to the rental of the monitoring equipment. Accordingly, the cleaning services are not “included services” within the meaning of paragraph 4(a).

Paragraph 4(b)Paragraph 4(b) of Article 12 refers to technical or consultancy services that make available to the person acquiring the services, technical knowledge, experience, skill, know-how, or processes, or consist of the development and transfer of a technical plant or technical design to such person. (For this purpose, the person acquiring the service shall be deemed to include an agent, nominee, or transferee of such person). This category is narrower than the category described in paragraph 4(a) because it excludes any service that does not make technology available to the person acquiring the service. Generally speaking, technology will be considered “made available” when the person acquiring the service is enabled to apply the technology. The fact that the provision of the service may require technical input by the person providing the service does not per se mean that technical knowledge, skills, etc., are made available to the person purchasing the service, within the meaning of paragraph 4(b). Similarly, the use of a product which embodies technology shall not per se be considered to make the technology available.

Typical categories of services that generally involve either the development and transfer of technical plants or technical designs, or making technology available as described in paragraph 4(b), include :

1. Engineering services (including the sub-categories of bio-engineering and aeronautical, agricultural, ceramics, chemical, civil, electrical, mechanical, metallurgical, and industrial engineering) ;

2. Architectural services ; and

3. Computer software development.

Under paragraph 4(b), technical and consultancy services could make technology available in a variety of settings, activities and industries. Such services may, for examples, relate to any of the following areas :

1. Bio-technical services ;

2. Food processing ;

3. Environmental and ecological services ;

4. Communication through satellite or otherwise ;

5. Energy conservation ;

6. Exploration or exploitation of mineral oil or natural gas ;

7. Geological surveys ;



8. Scientific services ; and

9. Technical training.

The following examples indicate the scope of the conditions in paragraph 4(b) :

Example 3

Facts:A U.S. manufacturer has experience in the use of a process for manufacturing wallboard for interior walls of houses which is more durable than the standard products of its type. An Indian builder wishes to produce this product for its own use. It rents a plant and contracts with the U.S. company to send experts to India to show engineers in the Indian company how to produce the extra-strong wallboard. The U.S. contractors work with the technicians in the Indian firm for a few months. Are the payments to the U.S. firm considered to be payments for “included services” ?

Analysis:The payments would be fees for included services. The services are of a technical or consultancy nature; in the example, they have elements of both types of services. The services make available to the Indian company technical knowledge, skill and processes.

Example 4

Facts:A U.S. manufacturer operates a wallboard fabrication plant outside India. An Indian builder hires the U.S. company to produce wallboard at that plant for a fee. The Indian company provides the raw materials, and the U.S. manufacturer fabricates the wallboard in its plant, using advanced technology. Are the fees in this example payments for included services ?

Analysis:The fees would not be for included services. Although the U.S. company is clearly performing a technical service, no technical knowledge, skill, etc., are made available to the Indian company, nor is there any development and transfer of a technical plant or design. The U.S. company is merely performing a contract manufacturing service.

Example 5

Facts:An Indian firm owns inventory control software for use in its chain of retail outlets throughout India. It expands its sales operation by employing a team of travelling salesmen to travel around the countryside selling the company’s wares. The company wants to modify its software to permit the salesmen to assess the company’s central computers for information on what products are available in inventory and when they can be delivered. The Indian firm hires a U.S. computer programming firm to modify its software for this purpose. Are the fees which the Indian firm pays treated as fees for included services?



Analysis:The fees are for included services. The U.S. company clearly performs a technical service for the Indian company, and it transfers to the Indian company the technical plan (i.e., the computer programme) which it has developed.

Example 6

Facts:An Indian vegetable oil manufacturing company wants to produce a cholesterol-free oil from a plant which produces oil normally containing cholesterol. An American company has developed a process for refining the cholesterol out of the oil. The Indian company contracts with the U.S. company to modify the formulas which it uses so as to eliminate the cholesterol, and to train the employees of the Indian company in applying the new formulas. Are the fees paid by the Indian company for included services ?

Analysis:

The fees are for included services. The services are technical, and the technical knowledge is made available to the Indian company.

Example 7

Facts:The Indian vegetable oil manufacturing firm has mastered the science of producing cholesterol-free oil and wishes to market the product worldwide. It hires an American marketing consulting firm to do a computer simulation of the world market for such oil and to adverse it on marketing strategies. Are the fees paid to the U.S. company for included services ?

Analysis:The fees would not be for included services. The American company is providing a consultancy service which involves the use of substantial technical skill and expertise. It is not, however, making available to the Indian company any technical experience, knowledge or skill, etc., nor is it transferring a technical plan or design. What is transferred to the Indian company through the service contract is commercial information. The fact that technical skills were required by the performer of the service in order to perform the commercial information service does not make the service a technical service within the meaning of paragraph 4(b).

Paragraph 5Paragraph 5 of Article 12 describes several categories of services which are not intended to be treated as included services even if they satisfy the tests of paragraph 4. Set forth below are examples of cases where fees would be included under paragraph 4, but are excluded because of the conditions of paragraph 5.

Example 8

Facts:An Indian company purchases a computer from a U.S. computer manufacturer. As part of the purchase agreement, the manufacturer agrees to assist the Indian company in setting up



the computer and installing the operating system, and to ensure that the staff of the Indian company is able to operate the computer. Also, as part of the purchase agreement, the seller agrees to provide, for a period of ten years, any updates to the operating system and any training necessary to apply the update. Both of these service elements to the contract would qualify under paragraph 4(b) as an included service. Would either or both be excluded from the category of included services, under paragraph 5(a), because they are ancillary and subsidiary, as well as inextricably and essentially linked, to the sale of the computer?

Analysis:The installation assistance and initial training are ancillary and subsidiary to the sale of the computer, and they are also inextricably and essentially linked to the sale. The computer would be of little value to the Indian purchaser without these services, which are most readily and usefully provided by the seller. The fees for installation assistance and initial training, therefore/are not fees for included services, since these services are not the predominant purpose of the arrangement.

The services of updating the operating system and providing associated necessary training may well be ancillary and subsidiary to the sale of the computer, but they are not inextricably and essentially linked to the sale. Without the upgrades, the computer will continue to operate as it did when purchased, and will continue to accomplish the same functions. Acquiring the updates cannot, therefore, be said to be inextricably and essentially linked to the sale of the computer.

Example 9

Facts :An Indian hospital purchases an X-ray machine from a U.S. manufacturer. As part of the purchase agreement, the manufacturer agrees to install the machine, to perform an initial inspection of the machine in India, to train hospital staff in the use of the machine, and to service the machine periodically during the usual warranty period (2 years). Under an optional service contract purchased by the hospital, the manufacturer also agrees to perform certain other services throughout the life of the machine, including periodic inspections and repair services, advising the hospital about developments in X-ray film or techniques which could improve the effectiveness of the machine, and training hospital staff in the application of those new developments. The cost of the initial installation, inspection, training and warranty service is relatively minor as compared with the cost of the X-ray machine. Is any of the services described here ancillary and subsidiary, as well as inextricably and essentially linked, to the sale of the X-ray machine ?

Analysis:The initial installation, inspection, and training services in India and the periodic service during the warranty period are ancillary and subsidiary, as well as inextricably and essentially linked, to the sale of the X-ray machine because the usefulness of the machine to the hospital depends on the service, the manufacturer has full responsibility during this period and this cost of the services is a relatively minor component of the contract. Therefore, under paragraph 5(a) these fees are not fees for included services, regardless of whether they otherwise would fall within paragraph 4(b).



Neither the post-warranty period inspection and repair services, nor the advisory and training services relating to new developments are “inextricably and essentially linked” to the initial purchase of the X-ray machine. Accordingly, fees for these services may be treated as fees for included services if they meet the tests of paragraph 4(b).

Example 10

Facts:An Indian automobile manufacturer decides to expand into the manufacturer of helicopters. It sends a group of engineers from its design staff to a course of study conducted by the Massachusetts Institutes of Technology (MIT) for two years to study aeronautical engineering. The Indian firms pays tuition fees to MIT on behalf of the firm’s employees. Is the tuition fee a fee for an included service within the meaning of Article 12?

Analysis:The tuition fee is clearly intended to acquire a technical service for the firm. However, the fee paid is for teaching by an educational institution, and is, therefore, under paragraph 5(c), not an included service. It is irrelevant for this purpose whether MIT conducts the course on its campus or at some other location.

Example 11

Facts:As in Example 10, the automobile manufacturer wishes to expand into the manufacturer of helicopters. It approaches an Indian university about establishing a course of study in aeronautical engineering. The university contracts with a U.S. helicopter manufacturer to send an engineer to be a visiting professor of aeronautical engineering on its faculty for a year. Are the amounts paid by the university for these teaching services fees for included services?

Analysis:The fees are for teaching in an educational institution. As such, pursuant to paragraph 5(c), they are not fees for included services.

Example 12

Facts:An Indian wishes to install a computerised system in his home to control lighting, heating and air-conditioning, a stereo sound system and a burglar and firm alarm system. He hires an American electrical engineering firm to design the necessary wiring system, adapt standard software, and provide instructions for installations. Are the fees paid to the American firm by the Indian individual fees for included services?

Analysis:The services in respect of which the fees are paid are of the type which would generally be treated as fees for included services under paragraph 4(b). However, because the services are for the personal use of the individual making the payment, under paragraph 5(d) the payments would not be fees for included services.



Indo-US Double Taxation Avoidance Convention (DTAC) – Suspension of Collection during Mutual Agreement ProcedureArticle 27 of the Indo-USA DTAC provides for Mutual Agreement Procedure (MAP) for avoidance of double taxation. Paragraph 4 of article 27 authorises the competent authorities to develop appropriate bilateral procedures, conditions, methods and techniques for implementation of MAP provided for in the article. Accordingly, with a view to avoid the unintended hardship to the taxpayers, as well as for the efficient management of collection of revenue, the Competent Authorities of India and USA had entered into a Memorandum of Understanding (MoU) regarding suspension of collection during the pendency of MAP.

2. This MoU was brought to the notice of field formation vide Instruction No. 2/2003, dated 28-4-2003 (F. No. 500/56/99-FTD) wherein it was stated that the collection of outstanding taxes in the case of a taxpayer, who is a resident of USA and whose request under MAP is under consideration of the Competent Authorities, shall be kept in abeyance subject to furnishing of a bank guarantee of an amount equal to the amount of tax under dispute and interest accruing thereon as per the provisions of the Income-tax Act.

3. Now references have been received for extending the applicability of MoU to Indian resident entities in cases where Mutual Agreement Procedure has been invoked by the US resident. In order to avoid hardship to Indian resident taxpayers especially in cases involving transfer pricing, where the Indian resident entity is liable to pay taxes on such income which may have been charged to tax in the hands of the associated entity in USA, it has been decided to extend the applicability of the MoU to such Indian resident entities during the course of the pendency of the MAP invoked by a resident of USA.

4. On receipt of a formal request for suspension of collection of outstanding tax in terms of the MoU from a taxpayer being, a resident of USA or an Indian resident entity, in a case where MAP has been invoked through US Competent Authority and the same has been admitted by the Indian Competent Authority, the Assessing Officers are required to keep the enforcement of collection of outstanding taxes in abeyance in respect of such taxpayers—

(i) after obtaining a confirmation regarding pendency of MAP from the Foreign Tax and Tax Research Division of the Central Board of Direct Taxes and

(ii) on receipt of a bank guarantee in the model draft format annexed to the MoU for an amount calculated in accordance with the manner indicated therein.

5. All the other conditions of MoU as enumerated in Instruction No. 2 of 2003, dated 28-4-2003 shall remain the same.

6. These instructions are issued under section 119 of the Income-tax Act and the same may be brought to the notice of all the officers in your charge.

Instruction : No. 10/2007, dated 23-10-2007.

��


INDIA’S RANKING IN THE WORLD — SELECTED INDICATORS

World total

India India’s rank

in the world

General

Area ........................................... (Mn. km2) 133.9 3.3 7

Population .................................. (Mn.) 6,855.0 1,210.0 2

Gross National Income ............. (US $ bn.) 62,364.0 1,567.0 10

Electricity generation ................. (Bn. kwh.) 20,079.0 899.4 5

Exports of goods ......................... (US $ bn.) 15,237.0 220.0 20

Exports of services ...................... (US $ bn.) 3,695.0 123.0 7

Agriculture & allied#

Arable land*................................. (Mn. hect.) 1,381.2 157.9 2

Irrigated area ................................. (Mn. hect.) 286.8 63.2 1

No. of Tractors in use#................... (Per ‘000 hect) 20.2 17.9 75

Production

Rice (paddy) ................................... (Mn. tonnes) 696.3 148.3 2

Wheat ..........................................…. ( “” ) 653.7 78.5 2

Fresh Vegetables .............................. ( “” ) 257.1 77.2 2

Fruits ..........................................….... ( “” ) 554.8 72.0 1

Tea ..........................................…........ ( “” ) 3.9 1.0 2

Cotton lint ......................................... ( “” ) 23.3 5.7 6

Sugar cane ......................................... ( “” ) 1,711.1 292.3 2

Note: Data generally relate to 1999 to 2010. Figures for India shown here are largely taken from publications of the FAO and the World Bank

* Including area under temporary crops

# Pertains 2008

(Source: Statistical Outline of India by Dept. of Economics & Statistics, Tata Services Ltd.)

8 INTERNATIONAL TAX & FINANCE CONFERENCE 2011Bombay Chartered Accountants' Society7, Jolly Bhavan 2, Ground Floor, New Marine Lines, Mumbai - 400020

Website : www.bcasonline.org | Email: [email protected]: www.bcasonline.tv | Tel: +912261377600 | Fax: +91 2261377666


INTERNATIONAL TAX & FINANCE CONFERENCE 2013 Material/ITF2013... · 8 INTERNATIONAL TAX & FINANCE CONFERENCE 2011 ... classes of ICAI teaching Income Tax for CA final students; (c)

Documents