The Paper.

“Outsourcing” & “Business Process Outsourcing”.

1.1

Outsourcing can be for anything. It may be for physical goods. For illustration, U.S. automobile manufacturer outsources the manufacture of several components to India. This outsourcing is very common all over the world. However, it did not create any controversy. The reason is: It involved physical activities.

Existing principles of taxation and DTA can be applied to it. Hence there is no major controversy. Differences in interpretation of several clauses did exist. They will, always. But E-Commerce has thrown up major challenges.

1.2

Business Process Outsourcing refers to outsourcing the work through internet/telecom or such other medium. A company resident & physically present in one country; is doing business activities in another country without being physically present there. This has thrown up business opportunities which did not exist earlier. These business processes were not considered (because they were not even imagined) when the current principles of international tax were being drafted.

1.3

The existing basic principles of international taxation have to apply to E-Commerce also just as they apply to the traditional commerce. This has been accepted at the OTTAWA conference of OECD. (Link in Annexure.)

And accepted by the tax profession in general.

1.4

However, there is some mix-up between basic principles and machinery provisions. And both have some impurities. These impurities or compromises to principles are creating difficulties in application of existing principles to E-Commerce. This subject is discussed in Rashmin Sanghvi’s IFA report for the 2001 Congress and not discussed further in this paper.

“Core Vs. Incidental”

Let us consider an illustration to clarify - what is a “Core activity” and what is an “Incidental activity”. (Paragraph II.4.1.)

Illustration No. 1: British Airways.

2.1

British Airways is a resident of U.K. Its core business activity is to fly aeroplanes. It carries passengers & cargo from one place to another place. British airways sets up a branch in India and outsources certain functions to the Indian branch. The functions concerned are: accounts writing, call services, entertaining & replying queries through e-mails, booking the tickets through internet & telecom, receiving payments through credit cards and other safe payment systems on the internet, issuing receipts for payment. One might say, considerable business activity is done in India.

Booking the tickets and receiving money amounts to entering into contracts. This is sales activity. Undoubtedly it generates profits. The Supreme Court has clearly stated in R. D. Aggarwal’s case that the profits accrue in the country in which contract is executed. (For an extract of the decision, see paragraph III.5.3.)

2.2

Of course, there is a controversy. The call service operator is located in India but the customer is located anywhere outside India. Both of them enter into a transaction on the internet. Where is the contract executed? Is it executed in India where the operator enters into the contract on behalf of the British Airways; or is it executed in the country from where the customer is calling?

In our submission, under the existing legal concepts known to us, there is no answer to this question.

2.3

Assuming that the contract is entered into India, it would be liable to tax in India as decided in the Supreme Court decision. Assuming that the contract is entered outside India, R. D. Aggarwal’s case is not attracted.

2.4

However, is all the outsourced activity the core business of British Airways? Undoubtedly “NO”. The core business of British Airways is carrying passengers & cargo. All the outsourced activities are “incidental”. What circular No. 1 of 2004 does is, it exempts even those profits which are, under the existing law, taxable in India. The circular under paragraphs (1) to (4) highlights this situation and provides that all the profits accruing due to incidental activities will be exempt from tax.

2.5

Thus, this is a circular giving relief to the tax payer.

The circular does not try to tax what is not taxable otherwise. Even if it tried, it would fail for want of jurisdiction.

This illustration distinguishes “Core” activity, and “Incidental” activity.

Focus of the Controversy in India.

Which is the component of income, that may be taxable under circular No.1; but according to the opponents of the circular, should not be taxed!

This component of income is highlighted in the following illustration.

Illustration No. 2: Glaxo.

3.1

Its core business is manufacturing & marketing of medicines. However, companies do have several ‘core’ activities. For a pharmaceutical company, Research & Development is also a core activity.

3.2

Glaxo has a profit center for Research & Development work. The location of the main R & D office is in U.K. The main office sets up a research unit in India. The Indian unit is a PE.

The R & D unit develops a new drug. The Intellectual Property Rights (IPR) belong to the main - head office right from inception; as per the legal paper work.

The cost of this research in U.K./U.S.A. would have been Rs. 45 millions. Actual cost in India is Rs. 10 millions.

There is no question of transferring IPR. But the agreed profit offered to the Indian unit is Rs. 1.50 million (mark up @ 15% of cost). Total cost to the U.K unit, Rs. 11.50 millions.

3.3

Company has saved Rs. 35 millions. ( 45 -10). (Total of profits to PE & HO.) The Indian unit pays tax on Rs. 1.50 million. No issue.

3.4

Is Glaxo PLC liable to any Indian Income-tax on the saving of Rs. 33.50 millions - or any part of the profit attributable to its Indian operations! This is the focus of the controversy under circular 1 of 2004.

The financial position is summarised below.

3.5

Glaxo then markets this drug and makes a profit of Rs. 5.00 mn. per year. That is entirely Glaxo U.K. profit & not taxable in India.

This illustration focuses the area of the controversy.

3.6

Some people find it difficult to appreciate that an R&D unit can make profits. They consider R&D as only a cost centre. The purpose of taking this illustration is to submit our view that an R&D unit can be a cost-centre or a profit centre.

It is a question of fact - which changes from case to case.

Certain terms used in business.

4.1

There are certain terms like - ‘cost’, ‘profit’, ‘sales price’, & ‘value’. At times, people confuse these terms & hence controversies arise. In the Glaxo illustration given in paragraph III.3, these terms have following meanings. Rs. 10.00 millions is the “cost” of services to the Indian unit. Its “profits” are Rs. 1.5 millions & “sales price” is Rs. 11.5 millions. Now the sales price for the Indian unit is also the “purchase price” for Glaxo PLC, the British head office. Its “purchase price” is its “cost” (Ignoring for simplicity, the freight, customs duties, etc.) For the British unit, the “value” of the services is much higher than its cost. The value here is Rs. 45 millions.

4.2

It is a normal logic that unless the “value” is higher than the “cost”; a person would not buy a product or a service. This business logic demands that there will, normally, be a profit accruing to the Non-resident and attributable to the Indian activities. The profit is the difference between ‘value’ and ‘cost’. Part of these profits would be attributable to the PE & part to the H.O.

4.3

There can be other situations also. In a highly competitive business, profit margins get really compressed. The head office may be interested if just the PE makes profits and the H.O. does not make any profits at all; over and above the PE profits. After all, the PE profits also belong to the H.O.

4.4

There have been several situations where the Indian PE makes profits but H.O. actually incurs losses. In the interest of setting up a presence in India, foreign companies would set up a unit in India and suffer losses for the first few years.

4.5

In real life, anything can happen - ‘profits’, ‘break-even’ or ‘losses’. And profits etc. of the H.O. can be different from those of the PE.

In the illustrations taken in this paper, we have considered the possibilities that the H.O. makes profits over and above the profits earned by the PE. It is possible otherwise also. Whether the H.O. makes profits attributable to the PE, or not; is a question of facts. And facts differ from case to case.

III.5

Permanent Establishment.

Illustration No. 3: Microsoft.

5.1

An illustration of transfer of “Core” activity to the BPO unit.

This illustration discusses position under Indo-U.S. DTA; hence the concept of “Permanent Establishment” (PE).

5.2

Microsoft Corporation (MS) has its core business of developing & marketing computer softwares. It is understood that the development and marketing are two separate profit centers. Major portion of profits is allocated to marketing. Development work gets lower portion of profits.

Microsoft has 20,000 software developers working in U.S.A. Microsoft decides to transfer 500 software developers in India for developing Microsoft - Office - Hindi version. After the completion of Hindi version, it would develop the same version in ten other Indian languages.

Let us consider this illustration in three different variations branch, subsidiary and third party.

5.3

Branch.

The Indian unit is a branch of Microsoft. The software once developed, automatically belongs to Microsoft - U.S.A. There is no question of the Indian unit being owner of the intellectual property rights (IPR) of the software. There is no question of transfer of IPR to Microsoft U.S.A. The IPR belongs to Microsoft U.S.A. - ab initio.

5.3.1

Branch makes losses.

Let us assume that this whole unit of 500 people fails in developing any marketable software package. Entire project is written off. The cost of this department for one year was U.S. $ 10 millions. Can Microsoft U.S.A. claim the expenses/losses incurred by the Indian unit!

Of course it can and it will. Losses of the branch are the losses of the head office.

The Indian PE will file its returns in India and claim its losses. Microsoft U.S.A. will also file its return in U.S.A. The loss of the Indian PE will be set off against its profits from other activities.

5.3.2

Branch makes profits.

Another assumption. The Indian unit is eminently successful in developing the software. Against the total cost of U.S. $ 10 millions, it sells the Hindi version for U.S. $ 50 millions. Its marketing costs are $ 5 millions. Net profits amount to $ 35 millions.

Let us further assume that entire marketing is done by another unit of Microsoft U.S.A. For internal record purposes, the Indian software development unit has transferred the product to the U.S. marketing unit at a mark up of 15%. In other words, the product was transferred internally at a price of $ 11.5 millions.

On a fair estimate, the profits of $ 35 millions may be divided between development & marketing units as under: $ 10 millions for the development activity. And $ 25 millions for the marketing activity. (Also see paragraph III.8.1 & 8.2 for this concept of apportionment of profits between production and marketing divisions.)

The Indian PE has filed its return of income in India showing a net profit of $ 1.5 millions. It has paid the tax.

As per Microsoft’s own internal analysis, a further profit of $ 8.5 millions is attributed to the Indian unit. Should the Microsoft Corporation file a tax return in India and submit the remaining $ 8.5 millions to taxation in India?

This is the focus of the issue comparable to paragraph -III.3.4. Let us discuss the legal position applicable to this issue. However, before considering the legal issues, we will see some variations in the illustration.

5.4

Tabulation:

The above figures are summarised in the following table for ease in further references.

5.5

Clarifications:

5.5.1

There is a difference between the meanings of the phrases - “profits derived by” and “profits attributable to”. The latter phrase is wider. See the Indian Supreme Court decision in the matter - “Indian Leather Corporation Pvt. Ltd. Vs. CIT” 227 ITR 552 (Year 1997). As seen in the above table, profits derived by BPO unit are small - $ 1.5 mn. But profits attributable to BPO are much higher - $ 10.00 mn. The difference of $ 8.5 mn. is derived by the H.O.

5.5.2

In the matter of software and other BPO operations, there is a significant difference in costs that may be incurred in U.S.A. and the costs that may be incurred in India. When the value to the U.S. unit is much higher than the price paid to the Indian unit; there is no question of illegitimate “transfer or shift of profits” from one unit to another. The Indian unit will be paid only that price which another competing Indian unit may charge at arm’s length.

5.6

Subsidiary.

In this variation, we assume that instead of opening a branch in India, Microsoft has opened a subsidiary in India. The profits & losses of the Indian subsidiary cannot be automatically transferred to the books of Microsoft U.S.A. Both are separate legal entities. All other facts remain same.

When the Indian subsidiary files a return of income for $ 1.5 millions, does the balance amount of $ 8.5 millions escape taxation in India!

5.7

Third Party.

A further variation from the illustration. Instead of a captive subsidiary, Microsoft U.S.A. has given all the operations to a third party. The third party files its return of a profit of $ 1.5 millions. Microsoft U.S.A. has earned $ 8.5 millions extra by outsourcing the activity to the Indian BPO company. Should Microsoft U.S.A. file the return of income in India and submit to tax the balance amount?

5.8

The legal position.

5.8.1

Under the Indian Income-tax Act, a non-resident of India is primarily not taxable in India. However, if the non-resident carries on business in India through a permanent establishment (PE) then it is taxable.

5.8.2

In case of a branch, it becomes a PE under DTA clause 5(1) or 5(2). If it is doing purely ‘preparatory or auxiliary’ activities, it will not be a PE because of clause 5(3).

However, a subsidiary or a third party will not become a PE under clauses 5(1) or 5(2). It can become a subsidiary only under the agency clause. In our illustration, the Indian unit does not act as an agent. Hence the agency clause is not applicable.

5.8.3

Article 7(1) of the Indo-U.S. DTA - Second Sentence.

When a non-resident carries on business in India through a PE, he is liable to tax in India. What is the scope of the income that is liable to tax?

Amount to be taxed is - “Profits of the Enterprise”. As discussed in Microsoft illustration, the profits arise to both - the PE and the H.O. Both are parts of the Enterprise. “Profits of the Enterprise” means the profits derived by the PE as well as the H.O. Hence both are taxable.

However, only that portion will be taxable in India, which is “attributable” to the PE.

5.8.4

We examine all of the above referred variations vis-à-vis article (5) of Indo-U.S. DTA and above referred legal position.

5.9

Variation 1. Branch. In this case, the Indian unit is a branch of the Microsoft U.S.A. It is covered by article (5) clauses (1) & (2). It is not covered by sub-clause (3). [Clause (3) lists the establishments which will not be considered as ‘Permanent Establishment’.] Hence it is a permanent establishment. Hence $ 8.5 millions being profits attributable to the Indian PE, are taxable in India.

5.10

Subsidiary.

5.10.1

The Indian unit is a subsidiary of Microsoft U.S.A. Here, clauses (1) & (2) of article (5) are not applicable because a subsidiary is not a branch or ‘place of business’ of the holding company. Article (3) is not applicable. Now we have to consider only the agency clause. Let us see clause (4).

5.10.2

The Indian subsidiary is wholly dependent on the principal. Hence it is not a person of independent status.

5.10.3

The Indian subsidiary is acting on its own behalf and not on behalf of the principal. Hence it is not an agent.

5.10.4

The Indian subsidiary does not do any marketing at all. The only contract it has is of developing the software. This contract is signed between the Indian subsidiary and the principal. There is no other contract.

Of course there will be internal contracts. For example, contracts of employment with 500 software developers, typists, accountants and other supporting staff. There will be contracts with service providers etc. All these contracts will be signed by the subsidiary on its own behalf. There will be no contract on behalf of the principal. The subsidiary does not have any authority to enter into any contracts on behalf of the principal. The subsidiary does not actually enter into any contracts on behalf of the principal.

5.10.5

The Indian subsidiary does not store Microsoft - office - Hindi packages and does not market them. For marketing the software, another independent enterprise has been appointed. In this article tax issues arising out of marketing agent are not discussed. It would be a digression from ‘BPO’ subject.

5.10.6

The Indian subsidiary does not secure orders for marketing the software. In these circumstances, the Indian subsidiary is not a permanent establishment of Microsoft U.S.A. Hence Microsoft U.S.A. is not taxable in India on $ 8.5 millions profit.

5.11

Third Party.

Indian unit is a third party company. It simply develops the software. All the sub-paragraphs discussed in paragraph (III.5.10) above will apply. The third party unit will not be a permanent establishment of Microsoft U.S.A.

5.12

Microsoft is doing business. Its activities are covered by article (7). There is no way under the Indo-U.S. DTA that Microsoft can be taxed in India in absence of a permanent establishment. Hence the position will be as under:

Under the DTA, if Microsoft has its own branch, it will be taxable for the profits attributable to its Indian PE. However, if it opens up a subsidiary or if it gives the BPO contract to a third party, then its profits would not be taxable in India. (In reality, most of the foreign companies have opened subsidiaries in India. They have not made any P.E.s in India. And hence, under the existing law, they do not have any thing to fear about taxability.)

5.13

Under the Indian Income-tax Act, Section 9, can the Indian subsidiary be treated as a “Business Connection” (BC)!

Even if the Indian unit can be treated as a BC, it is a settled principle of law in India that:

Between the DTA & the Indian Income-tax Act, that provision which is more beneficial to the tax payer, will apply. (Treaty Override.) Under the DTA, Microsoft U.S.A. is not taxable under two circumstances (subsidiary & third party). Hence the DTA will apply. In case of a branch, under both, DTA as well as IT Act, Microsoft U.S.A. is taxable in India.

Circular No. 1 of 2004 provides that, when a Non-resident carries on “Incidental” activities in India through a Permanent Establishment (a branch etc.); it is normally taxable in India. However, the circular provides the relief that it will NOT be taxed.

If the Non-resident carries on business in India without a PE, under the DTA, it cannot be taxed. Circular does not attempt to tax it - whether the activity is ‘Core’ or ‘Incidental’.

If the Non-resident carries on “Core” activity through an Indian PE, it is taxable under the domestic law & under DTA; and it will be taxed. CBDT cannot give it any relief.

Illustration & discussion on Permanent Establishment, paragraph III.5 completed.

III.6

BUSINESS CONNECTION:

In the above case of Microsoft, we have considered a non-resident taxpayer from U.S.A. doing business with an Indian company. The transaction is covered by Indo-U.S. DTA. Let us consider a case not covered by DTA.

6.1

Illustration No. 4: There is a software company set up in a country with which India has not signed DTA. For example, Hongkong. All other facts are similar to the case of Microsoft. This Hongkong company has three options for outsourcing the work to India:

(i) Setting up a branch in India,

(ii) Opening a subsidiary in India, or

(iii) Giving the BPO contract to a third party which is unrelated.

Since there is no DTA, the question of permanent establishment does not arise. In this situation, we have to consider section 9(1)(i) of the Indian Income-tax Act - the concept of Business Connection. Relevant portion of the section is reproduced below.

6.2

Indian Income-tax Act - Section 9

“9. Income deemed to accrue or arise in India.--(1) The following incomes shall be deemed to accrue or arise in India -

(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 situate in India ;

(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;

. . . . .

. . . . .

(Agency Clause which has been added in the year 2003.)

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, an authority to conclude contracts on behalf of the non-resident, unless his activities are limited to the purchase of goods or merchandise for the non-resident ; or

(b)

has no such authority, but habitually maintains in India a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the non-resident ; or

(c)

habitually secures orders in India, mainly or wholly for the non-resident or for that non-resident and other non-residents controlling, controlled by, or subject to the same common control, as that non-resident :

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. “

Extract of the section completed.

6.3

In the matter of “Business Connection”, Indian Supreme Court has rendered several decisions. The most important decision is in the case of CIT v. R. D. Aggarwal & Co., 56 ITR 20 (Year 1965). This decision lays down important principles for determination of business connection and taxability of profits arising out of business connection. The relevant portion of the decision is reproduced below.

Note: this decision considered the earlier law - of the year 1922. Current Indian Income-tax Act is of the year 1961. Hence currently applicable sections are different from those stated in the court decision. Current sections are stated by the authors in brackets. Numbers to the paragraphs are also given by the authors to highlight different issues decided by the Honourable Court.

“[1965] 056 ITR 0020-
[Supreme Court of India]
Commissioner of Income-tax
v.
Aggarwal and Co. (R.D.)
SUBBA RAO K. and SHAH J.C. and SIKRI S.M. JJ.
October 06, 1964

“The expression "business" is defined in the Act as any trade, commerce, manufacture or any adventure or concern in the nature of trade, commerce or manufacture, but the Act contains no definition of the expression "business connection" and its precise connotation is vague and indefinite.

The expression "business connection" undoubtedly means something more than " business". A business connection in section 42 (Section 9) involves a relation between a business carried on by a non-resident, which yields profits or gains and some activity in the taxable territories which contributes directly or indirectly to the earning of those profits or gains. It predicates an element of continuity between the business of the non-resident and the activity in the taxable territories: a stray or isolated transaction is normally not to be regarded as a business connection. Business connection may take several forms: it may include carrying on a part of the main business or activity incidental to the main business of the non resident through an agent, or it may merely be a relation between the business of the non-resident and the activity in the taxable territories, which facilitates or assists the carrying on of that business. In each case the question whether there is a business connection from or through which income, profits or gains arise or accrue to a non-resident must be determined upon the facts and circumstances of the case.

(Note: The decision covers under BC, even incidental activities.)

“A relation to be a "business connection" must be real and intimate, and through or from which income must accrue or arise whether directly or indirectly to the non-resident.

But it must in all cases be remembered that by section 42 income, profit or gain which accrues or arises to a non-resident outside the taxable territories is sought to be brought within the net of the income-tax law, and not income, profit or gain which accrues or arises or is deemed to accrue or arise within the taxable territories. Income received or deemed to be received, or accruing or arising or deemed to be accruing or arising within the taxable territories in the previous year is taxable by section 4(1)(a) and (c)[Section 5] of the Act, whether the person earning is a resident or non-resident. If the agent of a non-resident receives that income or is entitled to receive that income, it may be taxed in the hands of the agent by the machinery provision enacted in section 40(2). [Section 163] Income not taxable under section 4 of the Act of a non-resident becomes taxable under section 42(1) [Section 9] if there subsists a connection between the activity in the taxable territories and the business of the non-resident, and if through or from that connection income directly or indirectly arises.

“Turning to the facts of the present case, as found by the revenue authorities, contracts for the sale of goods took place outside the taxable territories, price was received by the non-residents outside the taxable territories, and delivery was also given outside the taxable territories. No operation such as procuring raw materials, manufacture of finished goods sale of goods or delivery of goods against price took place within the taxable territories:”

(Extract of decision completed.) (Note: To avoid tax, to remain within the protection offered by this Supreme Court decision, Non-residents ensure that though they provide goods & services to Indian customers; the contract is executed outside India; sales price is received outside India; and the delivery of goods is made outside India.)

(This paragraph lays down the importance of the place where the contract is executed. If it is executed in India, income is taxable in India. This is a settled principle for several decades.)

III.6.4

In our illustration it is apparent that the non-resident - Hongkong company has an ongoing relationship with the Indian unit. Hence it has a business connection. We have already accepted the position that a profit of U.S. $ 8.5 millions is attributable to the Indian business connection and derived by the H.O. In the circumstances, this amount becomes taxable in India.

When it comes to ‘business connection’, unlike the concept of ‘permanent establishment’, there is no need to fulfill the conditions laid down in article (5) of any DTA. Hence it is not necessary that the Indian unit should be a branch or an office of the non-resident.

In the first case where the Indian unit is a branch of the non-resident, the business connection is clearly established and is taxable. In the second case, where the Indian unit is a captive subsidiary, still the business connection exists. There is no need under this concept that the BC should be executing any contracts for and on behalf of the non-resident. The BC exists. It is causing some income to the non-resident. Hence the income is taxable. Similarly, even in the third case where the Indian unit is a third party, the income is still taxable. A third party is also a BC for the non-resident. An income accrues to the non-resident because of the business connection with the third party. Hence the income is taxable.

6.5

The illustration very clearly reiterates the well-known understanding. It is safer to do business with an Indian concern through a country with which India has signed a DTA. The non-resident gets exposed to tax liability even with a meager business connection without having any ownership or agency - when he is coming through non-DTA country.

6.6

The Supreme Court has considered some very interesting issues. Where does the profit of $ 8.5 millions accrue? Let us assume that the profit accrues outside India. In this case, in Hongkong. Still it is taxable in India. The Court explains: If the profit is accruing within India, in any case, it is taxable in India under section (5)(2)(b). If the profit accrues outside India but is received in India then it is taxable in India under section (5)(2)(a). Such profits are taxable in India, under the normal provisions of the Income-tax Act. It is when the profits accrue/arise/are received outside India to a Non-Resident, that they are normally, not taxable in India. In this situation, the deeming provisions of section 9(1)(i) apply and the income outside the scope of Indian taxing jurisdiction; is made taxable in India. In other words, profits arising outside India to a non-resident are taxable in India when there is a business connection.

Circular No. 1 of 2004 provides that when the non-resident carries on “Incidental” activities in India through a Business Connection, he will not be taxed in India. When he carries on “Core” activities in India, he may be taxable in India. There are no savings under this circular.

Illustration No. 4 and discussion on the Concept of Business Connection - Paragraph III.6 completed.

III.7

Does the circular attempt to tax what is otherwise not taxable!

Due to e-commerce, it is possible for a non-resident to do business in India without having any physical establishment in India. For such activities, the person will not have any permanent establishment in India. And yet, it can have substantial business with India. It can earn substantial profits in India. Should such profits be taxed in India or not?

I had submitted a report on e-commerce at IFA Congress. (link given in the Annexure.) It has been argued at length in the said report that in the e-commerce environment, the concept of permanent establishment is irrelevant. (It will of course continue to remain relevant for businesses which need fixed places of business, establishments etc.) There will be more & more such positions where non-residents will earn more & more profits from India without having any establishments in India. However, that report is part of recommendations for future laws. As far as the present law is concerned, there is no provision in the law to tax a Non-resident’s business income when it has no PE in India.

We would say that the circular does not attempt to tax such profits. However, there have been several cases of assessment orders & even appellate orders where such profits have been sought to be taxed in India. In the authors’ humble submission, all such attempts must fail under the existing law. The reason is given below. Even if we assume that the circular attempts to tax profits of a non-resident coming from a DTA country in absence of a permanent establishment, such attempt would fail.

1.

The CBDT has the authority to issue circulars and grant relief to the tax payers. It has no authority to create tax liability where none exists under the law. There are Supreme Court decisions on the subject. However, this is a settled principle in India and there is no need to go in details.

2.

As seen earlier, under the Indian Income-tax Act, treaty overrides the Act. Under the treaty, the non-resident cannot be taxed in absence of a PE. Hence in the given illustrations, ( MS coming from USA & not having a branch) the circular - paragraph (5) cannot (and in our submission, does not) tax the non-resident’s profits.

The issue of ‘Treaty Override’ can be discussed at length. But that is not the subject matter of this paper.

III.8

Discussion on Illustrations given in Circular No. 1 of 2004.

8.1

Let us consider some other illustrations given in the circular. Paragraph (3). A company carries on the business of manufacture and sale of goods outside India. This means, that the core activity is done outside India. However, incidental activities like procurement of orders and even concluding contracts is done by BPO units in India. As discussed earlier, on account of conclusion of contracts, these activities could be probably taxable in India. The circular gives them relief from taxation.

8.2

Paragraph (4) A company manufactures computers outside India. It sells the computers outside India. However, a call center in India executes the contracts for sale. This illustration highlights that the core activity of manufacture & marketing is done outside India. Hence the incidental activity of concluding contracts is exempted from Indian tax. ( See paragraph II. 4. 4.)

We would submit that this is a bold & landmark circular. Place of signing of contract which was given tremendous importance in R. D. Aggarwal’s case and which has been a settled principle in India; has been diluted.

8.3

Consider an insurance company. Insurance business is something where a lot of activities can be outsourced through the internet. The illustration given in paragraph (4) of the circular considers a case where the insurance company carries out its core activities outside India. The insurance, the risk and the investment are outside India. However, the call center gives considerable information to potential customers. These are incidental activities and the circular provides that the income, if any, accruing to the Non-resident shall not be taxed in India.

8.4

Another example is given of a foreign credit card company. The company and its customers are outside India. The business of credit card is carried outside India. However, several functions are outsourced to an Indian entity. The Indian call center entertains customers’ queries and even issues new credit cards. Yet these functions are described as incidental activities and the transactions become tax free in the hands of the non-resident company.

8.5

Paragraph 5 of the circular. Core Activity.

On the other hand, if a non-resident transfers his core activity into India, he cannot escape Indian tax. Atleast, the CBDT does not have power to grant exemption. We have seen one case of Microsoft transferring software development activity into India. The circular gives several other illustrations of travel agent, software maintenance, investment consultant, debt collection service etc. The non-resident enterprise has a core activity and the core activity is transferred to India, profits arising from such activity shall be taxable in India.

This is only a reiteration of existing law. There is nothing new. It has been decided in the year 1965 by the Honourable Supreme Court of India. (R. D. Aggarwal’s case.) The issue has become a settled principle for both - the tax department and the taxpayer.

III.9

Some other principles of International Taxation.

9.1

Where do the profits accrue?

When do the profits accrue?

In a sale of goods, the title to the goods passes when sale is completed. The sale may be transacted orally or in writing. That is not significant. In current times, the sale may be concluded on the internet by human intervention or simply by the software sitting on a website. In other words, the contract may be concluded by the software itself without any human intervention. Yet the title to the goods does pass.

To highlight “where” do profits accrue; let us consider - General Motors comes to India and sells its car to an Indian in Mumbai. The title to the car passes in India. General Motors earns profits in India. These profits are taxable in India. (Only that portion which is attributable to the Indian operation of sale.) General Motors is a non-resident of India. It does the whole of its business of procurement of materials, manufacture of car and even marketing outside India. The only function of actual sale is done in India. It attracts tax.

On the other hand, the Indian buyer goes to U.S.A. He buys a car from General Motors. The sale is completed within U.S.A. The title to the car passes in U.S.A. The profit accrues to General Motors when the car is sold. The profit accrues to General Motors in U.S.A. where the car is sold.

Thus, traditionally, the function of sale and its location has been given considerable importance. Circular 1 of 2004 dilutes this importance. It attaches more importance to the real life activity. Where the core activity is done.

9.2

Apportionment or Attribution of Profits.

9.2.1

The profits of an enterprise can be apportioned or attributed to different functions of the enterprise. For example, one enterprise may have its purchasing department more competent than others. Hence it may make purchases at lower costs than the competitors. This is the profit attributable to the function of purchase.

Again, its production department may be more or less efficient than similar departments of competitors. The profits or losses of the enterprise due to production may be attributed to the production department.

The sales department of the enterprise will have its own share of profits or losses.

9.2.2

In a company, which gives bonuses depending upon individual department’s profits, this kind of attribution of profits to different departments can be very sophisticated. This departmental attribution of profits is very common amongst the businessman. However, some people are not accepting this concept. Hence the following case laws are given. It is interesting to note that the case laws are more than five decades old.

9.2.3

M/s. Kanga & Palkhiwala in their treatise on “The Law And Practice of Income-tax” cite the following case laws. Eighth edition, volume 1, pages 230 & 231 under the commentary on Section 5; paragraph title - “Apportionment of Profits where goods are manufactured in one place and sold in another.”

The first case reported is an Australian case - Commissioners of Taxation Vs. Kirk - 1900 AC 588. The Privy Council held that the business of the assessee was divided into four different departments. Its profits were also similarly apportioned. The departments were in two different countries. Accordingly, the profits were taxable in two different countries.

9.2.4

The Indian case law on the subject is as under:

Supreme Court decision in CIT Vs. Ahmedbhai Umarbhai - 18 ITR 472. In the case, before independence (in the year 1947) the assessee manufactured oil in their oil mill in Hyderabad state. The sale took place in British India. It was held that not all the profits accrued in British India where sale took place. (Note: Before independence, India was broadly divided into two parts. The British India & the princely states. The Indian Income tax Act applied in the British India; but not in the princely states. Business took place all over India normally. However, when a businessman sold goods from the princely states to British India, issues that arose were like issues of International Tax.) The Supreme Court held that:

“Profits are not wholly made by the act of sale and do not necessarily accrue at the place of sale …. To the extent that the profits are attributable to the manufacture of oil it is not possible to say that they accrue or arise at any place different from the place where the manufactured article came into existence”.

9.2.5

Conclusion: Profits may be attributed to all identifiable departments of an enterprise.

In Anglo-French Textile Co. Ltd. Vs. Commissioner of Income-tax, 25 ITR 27, in the year 1954; the Supreme Court of India held as under:

“Though profits may not be realised until a manufactured article is sold, profits are not wholly made by the act of sale and do not necessarily accrue at the place of sale. To the extent profits are attributable to the manufacturing operations, profits accrue at the place where the business operations are carried on.”

9.2.6

All the case laws on the subject are unanimous on the issue that - there can be no standard guideline for attribution of profits. It will depend upon the facts of the case. See 18 ITR 472, Supreme Court; 66 ITR 159, Supreme Court.

Demand by some people that the circular should give guidelines on “Attribution” of profits is unjustified. (See paragraph II.6.2.2.)

OECD has done substantial work on the subject. See discussion Draft on The Attribution of Profits to Permanent Establishment. (link in the Annexure.)

Yet the OECD paper is a draft. Even when the final paper comes out, one cannot expect anything more than “Guiding Principles” for attribution. If a matter is essentially, a matter of facts, no circular can cover the subject. In depth study of ‘Costing’ & ‘Transfer Pricing’ is involved here.

9.3

Some people have raised a query. Section 10A & 10B grant exemption from Indian Income-tax Act to BPO units in certain circumstances. People have argued that circular 1 of 2004 takes away the exemption already granted. (Paragraph II.6.2.3.)

Our Submission is:

1.

Circular has no legal authority to take away any exemption granted under the law.

2.

The circular does not even try to do so. Section 10A & 10B exemptions are granted to the BPO undertakings. There is no exemption under these sections to the non-resident principal. The circular talks of taxing the principal when he carries on core activities in India.

9.4

Circular 23 of 1969 & 1 of 2004:

9.4.1

Does circular 1 of 2004 take away the exemption granted by or clarification made by Circular 23 of 1969! (See paragraph II.6.5.)

Both the circulars cover taxability of the non-resident principal for profits derived by the principal and attributable to the Indian operations. Paragraph 6(c) is the relevant paragraph.

In our view, this circular covers only those cases where the “value” to the non-resident principal is equal to its cost. In other words, the non-resident does not derive any profits, which are attributable to the operations of the Business Connection in India. (Please also see paragraph III.4.) In a case where the profits derived by the non-resident are available after deducting the charges paid to the ‘Business Connection’; such surplus will of course be taxable in India.

Circular No. 1 of 2004 does not contradict Circular No. 23. It is complementary/additional/clarificatory to the latter circular in this respect.

9.4.2

Circular No. 23 of 1969 & modifications necessary:

This is a circular issued before thirty-five years, under the then situation prevailing. It is necessary to revise and update the circular to consider the current business circumstances.

1.

For example, the circular covers only the business in “Goods”. The same logic should also apply to the business in “services”. Circular should be amended to cover all “goods & services”, “tangibles & intangibles”.

2.

The circular applies only to “Business Connection”. Same clarifications should also be applied to “Permanent Establishments”.

9.4.3

A distinction can be drawn between -

(i) Simple purchase of goods &/or services from a PE; &

(ii) Actually doing a business through the PE.

(i) A PE may just supply some services or goods to the H.O. In such a case, Circular 23, paragraph 6(c) will apply and no profits will be taxed in the hands of the H.O.; in India. The circular makes provision for only “goods”. However, what applies to “goods”, shall also apply to “services”. The reason is that this circular is stating the law as derived from Supreme Court decisions. The ratio of the decisions must apply to goods and services - both.

(ii) There may be situations where the H.O. is involved considerably in the PE activities and its management. The PE is marketing the goods/providing the services to third parties. In such cases the H.O. is doing business in India through the P.E. It will be taxable in India on the profits attributed to the PE activities.

9.5

“Incidental” = “Preparatory or Auxiliary”.

Please see the issue raised in paragraph II.6.6.

It has been suggested by some authors that the circular No. 1 of 2004 should have used the phrase “preparatory or auxiliary” instead of “incidental”.

This suggestion is incorrect.

It should be noted that if the Indian activities are only preparatory or auxiliary; they would not constitute a PE as provided in the exemption clause in definition of PE. Hence income attributable to such activities would simply not be taxable in India under the provisions of the DTA.

This circular goes one step further. Even when certain profits are taxable under the DTA; the circular grants an exemption.