KPMG Flash News 25 May 2011

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1 KPMG IN INDIA KPMG Flash News 25 May 2011 TAX Interest earned on Income-tax refund from tax department cannot be considered as arising from indebtedness that is effectively connected with Permanent Establishment and is therefore taxable at 15 percent as per Article XI of India-Australia tax treaty Recently, a special bench of Delhi Income-tax Appellate Tribunal (the Tribunal) in case of Clough Engineering Ltd. 1 (the taxpayer) held that interest income earned by tax resident of Australia in India; on refund of tax dues could not be treated as business income under Article VII of India-Australia tax treaty (tax treaty) as such refund was not effectively connected with the Indian Permanent Establishment (PE) of the taxpayer. Accordingly, it was held that such interest was taxable at concessional rate of 15 percent under Article XI(2) of tax treaty. Facts of the Case The taxpayer, a tax resident of Australia was engaged in carrying out contractual work in the nature of designing, engineering, procuring, fabricating, installing, laying of pipeline, testing, pre-commissioning of off-shore platforms etc. During the relevant year, it had a PE in India, which reported business income from contracts entered with ONGC Ltd, Cairn Energy Ltd and Niko Resources Ltd. The income declared by the taxpayer inter-alia included interest income on Income-tax refund, which was offered to tax at the rate of 15 percent on gross basis as per Article XI(2) of the tax treaty. The Assessing Officer (AO) held that interest income had been received by the taxpayer on the refund of tax deducted at source, made from business receipts and was effectively connected with the 1 ACIT v. Clough Engineering Ltd [2011] 11 taxmann.com 70 (Del) 1

2 PE. Hence, the same was chargeable as profits of the PE on a net basis under Article VII read with Article XI(4) of the tax treaty. The Commissioner of Income Tax [CIT (A)] upheld the decision of the AO on the basis that it was an admitted fact that the taxpayer was carrying on business through a PE and that interest income was not covered by provision contained in section 44BB of the Income-tax Act,1961 (the Act). Since there were conflicting decisions of the Delhi Tribunal in cases of B.J.Services Co. Middle East Ltd 2 and Pride Foramer France SAS 3 on this matter, the question was referred to President for constituting a Special Bench to decide the matter. Taxpayer s Contentions Under section 90(2) of the Act, the provisions of the Act or the tax treaty shall apply to the extent they are more beneficial to the taxpayer. The provisions specified in Article XI of tax treaty were more beneficial as compared to Act and therefore tax treaty provisions should be made applicable to it. Under the provisions of section 2(28A) of the Act, interest means any interest payable in any manner in respect of any monies borrowed or debt incurred. The interest received by the taxpayer falls within the definition of interest under the Act. The source on which the interest income received by the taxpayer was the tax deducted at source. Such tax was deducted by operation of law and therefore the indebtedness cannot be said to arise in the course of carrying on the business and therefore is not effectively connected to the business carried out by the PE. Therefore, under the Act, the taxpayer was liable to be taxed on the amount under residuary head and not under the business head. The payment of tax was the responsibility of the foreign company and not that of the PE which was operating in India. Since the PE was not the creditor of the Income-tax department, the indebtedness was not effectively connected with PE. Accordingly, the interest income should be taxable at the rate of 15 percent as per Article XI(2) of the tax treaty. The taxpayer relied on the Tribunal decisions in case of Traco Cable Co. Ltd. 4, wherein it was held that interest income is normally taxable under the head Income from Other Sources unless the source of the interest in the business of the taxpayer. 2 B.J.Services Co Middle East Ltd v. CIT [2009] 29 SOT 312 (Del) 3 ACIT v. Pride Foramer France SAS [2008] 22 SOT 204 (Del) 4 Traco Cable Co Ltd v. CIT, Ernakulum [1968] 72 ITR 503 (Ker) 2

3 Further, the taxpayer also relied on the decisions of Atria Power Corporation Ltd 5, Hapag Lloyd Container Linie GmbH 6, High Court decisions in case of Samir Diamond Exports Ltd 7, Collis Line Pvt. Ltd 8, Madhya Pradesh State Industries Corporation Ltd 9 wherein it was held that interest on Income-tax refund is taxable under the head Income from other Sources unless the source of interest is the business of the taxpayer. Tax department s Contentions The interest on Income-tax refund, although not arising out of business transaction, the indebtedness had a direct nexus with the assets of the business as tax was deducted from monies receivable in the course of the business of the PE. If the taxpayer opted to be taxed under the tax treaty, the classification of income was not required to be done under the five heads of income which was specified in the Act as no heads of income had been prescribed under the tax treaty. The expression used in the tax treaty is that the indebtedness is effectively connected to the PE and not the interest income. If the FAR analysis is carried out, the assets will have to be allocated to the PE. Accordingly, economic ownership of the debt lies with the PE and therefore asset-test was satisfied. Further, tax was deducted from the business receipts of the taxpayer, even the activity-test stood satisfied because it was in the course of the business transactions of the taxpayer that the debt arose and accordingly PE exists in this case. Accordingly, the interest on Income-tax refund was liable to be taxed as per Article VII of tax treaty at the rate applicable to foreign companies on net basis. Tribunal Ruling The Tribunal held that provisions of the Act should apply to the extent they are more beneficial to that taxpayer as per Section 90 (2) of the Act. The Tribunal observed that the taxpayer was not engaged in the business of obtaining tax refund and earning interest. The Tribunal relied on the decision in case of Pride Foramer France SAS, wherein it was held that interest on income tax refund was neither derived from, nor attributable to the business activities of the taxpayer and 5 Atria Power Corpn Ltd v. DCIT [2011] 128 ITD 322 (Bang) 6 Hapag Lloyd Container Linie GmbH v. ADIT [2011] 9 taxmann.com 126 (Mum) 7 CIT v. Samir Diamond Exports Ltd [2000] 245 ITR 548 (Bom) 8 Collis Line Pvt. Ltd v. ITO [1981] 135 ITR 390 (Ker) 9 Madhya Pradesh State Industries Corporation Ltd v. CIT [1968] 69 ITR 824 (MP) 3

4 accordingly the interest income cannot be said to be related to the business of PE in India. The Tribunal held that the real test is not whether the interest is business income or not, but whether the indebtedness is effectively connected with the PE. The Tribunal also observed that the payment of tax is the responsibility of the foreign company, which is determined after computation of its income. The tax is not expenditure but is an item of appropriation of profits. Therefore, even if the debt is connected with the receipts of the PE, it cannot be said to be effectively connected with such receipts. The Tribunal observed that the bank interest income was an example of effective connection with the PE as the indebtedness is closely connected with the funds of the PE. However, the same cannot be said in respect of interest on Income-tax refund since it was not effectively connected with PE either on the basis of asset-test or activity-test. Accordingly, the interest income on Income-tax refund is taxable under Article XI(2) of the tax treaty on a gross basis at 15 percent. Our Comments This is important ruling by the Special Bench of the Tribunal wherein it was held that interest income received on Income-tax refund could not be said to be effectively connected with PE and therefore cannot be taxed as business profits. The ruling also elaborates on the principles for treating an income to be effectively connected with the PE. It is imperative to note that the above decision has been rendered on the facts, and therefore, it would need to be examined on a case-to-case basis as to whether an income is effectively connected with the PE, in order for such income to be taxed as business profits. 4

5 Bangalore Maruthi Infotech Centre, 11-12/1 Inner Ring Road Koramangala, Bangalore Phone: Fax: Chennai KPMG House No.10, Mahatma Gandhi Road, Nungambakkam High Road, Chennai Phone: Fax: Chandigarh SCO st Floor, Sector 8 C Madhya Marg Chandigarh Tel: Fax: Mumbai Lodha Excelus, Apollo mills compound, NM Joshi Marg, Mahalaxmi, Mumbai India Phone: Fax: Pune 703, 7th Floor Godrej Castlemaine, Next to Ruby Hall Clinic, Bund Garden Road, Pune Phone: /65 Fax: Kochi 4/F, Palal Towers, M. G. Road, Ravipuram, Kochi Phone: +91 (484) Fax: +91 (484) Delhi DLF Cyber City, Building no. 10, Block B, Phase II Gurgaon, Haryana Phone: Fax: Hyderabad KPMG, /2 Reliance Humsafar, 4th Floor Road No.11, Banjara Hills Hyderabad Phone: Fax: Kolkata KPMG Infinity Benchmark Plot No. G-1, 10th floor Block - EP & GP, Sector V, Salt Lake City Kolkata Phone: The information contained herein is of a general nature and is not intended to address the circumstances of 2011 KPMG, an Indian Partnership and a member firm any particular individual or entity. Although we endeavour to provide accurate and timely information, there of the KPMG network of independent member firms can be no guarantee 2011 that KPMG, such information an Indian Partnership is accurate as and of the a member date it is firm received of the or that KPMG it will network continue of to independent affiliated member with KPMG firms International affiliated with Cooperative ( KPMG be accurate in KPMG the future. International No one should Cooperative act on such ( KPMG information International ), without appropriate a Swiss professional entity. All rights advice reserved. International ), a Swiss entity. All rights reserved. after a thorough examination of the particular situation. 1

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