(208.9 KiB, 437 DLs)

Exchange Fluctuation loss on pending forward contracts is an “accrued” loss

The assessee, a foreign bank carrying on business in India, entered into forward contracts with its clients to buy or sell foreign exchange at an agreed price on a future date. On the date of maturity, the contract was executed which resulted in either profits or losses to the assessee. There was no dispute that the loss was on revenue account and that loss arising on execution of the contracts in the same year were allowable as a deduction. With respect to contracts where the date of maturity fell beyond the accounting period, the assessee valued the forward contracts on the last day of the accounting period on the basis of rate of foreign exchange prevailing on that date and accounted for the loss or profit, as the case may be. The AO taxed the profits on such contracts though he disallowed the losses on the ground that they were “notional”. The Special Bench had to consider whether the loss was a “notional” or “contingent” loss or whether it was an “accrued” loss. HELD deciding in favour of the assessee:

(i) The Act allows a deduction in respect of crystallized liabilities. While as per commercial principles of policy of prudence, all anticipated liabilities have to be accounted for, as per the Act only “accrued” liabilities are allowable. While anticipated liabilities which are contingent in nature are not allowable, an anticipated liability coupled with a present obligation can be said to be a crystallized liability. A contingent liability depends purely on the happening or not happening of an event whereas if an event has already taken place, such as the entering into the contract and undertaking of an obligation to meet the liability, and only consequential effect of the same is to be determined, then, the liability is not a contingent liability (Woodward Governor 312 ITR 254 (SC) & Bharat Earth Movers 245 ITR 428 (SC) followed, Principles of law on accrual of income & loss summarized);

(ii) Accounting Standard -11 (AS-11) issued by the ICAI is mandatory and provides that if foreign exchange transactions are not settled in the same accounting period, the effect of exchange difference has to be recorded on 31st March;

(iii) On facts, the foreign currency was the assessee’s stock-in-trade and the forward foreign exchange contracts entered into by it created a continuing binding obligation on the date of contract against the assessee to fulfill the same on the date of maturity. The assessee has consistently followed the same method of accounting in regard to recognition of profit and loss. The AO, having assessed the profits, could not have disallowed the loss;

(iv) Accordingly, where a forward contract is entered into by the assessee to sell foreign currency at an agreed price at a future date falling beyond the last date of accounting period, a loss is incurred by the assessee on account of valuation of the contract on the last date of the accounting period and before the date of maturity of the forward contract.

(194.5 KiB, 601 DLs)

Fee for software is NOT royalty & TDS u/s 195 not required

The assessee applied to the AO for a NOC u/s 195(2) for remittance of a fee to IXOS Software, Singapore, to acquire software. The assessee claimed that the fee was commercial profits and not taxable in the hands of the recipient under Article 7 of the India-Singapore DTAA as the recipient did not have a PE in India. The AO & CIT (A) took the view that as the software was a “copyright” / “secret process” and the assessee had merely acquired a ‘non-exclusive & non-transferable’ license to use the software and as the Singapore Company continued to be the owner of the software, the fee constituted “royalty” under s. 9(1)(vi) of the Act and Article 12 of the DTAA and that it was chargeable to tax in India. On appeal by the assessee, HELD allowing the appeal:

The effect of the judgements in Tata Consultancy Services vs. State of AP 271 ITR 401 (SC), Samsung Electronics Co 94 ITD 91 (Bang), Motorola Inc 95 ITD 269 (SB) & Dassault Systems 229 CTR 105 (AAR) is that the primary condition for coming within the definition of ‘royalty’ is that the payment must be received as consideration for the use of or right to use any copyright of a literary, artistic or scientific work etc. A ‘right to use the copyright’ is totally different from the ‘right to use the programme embedded in a CD’. In acquiring a ready made off-the-shelf computer programme, no right was granted to the assessee to utilize the copyright of the computer programme. The assessee had merely purchased a copy of the copyrighted article, namely, a computer programme which is called ‘software’. Computer software when put into a media and sold becomes goods like any other audio cassette or painting on canvas or book. Accordingly, the amount paid by the assessee towards purchase of the software cannot be treated as payment of “royalty” so as to be taxable in India under Article 12 of the DTAA and the assessee was not liable to deduct tax at source.

(303.3 KiB, 443 DLs)

Amount paid for non-compete rights while acquiring business is capital expenditure

Tecumseh USA, a global compressor manufacturer, was interested in entering the Indian market. It entered into a MOU with Whirlpool India & Whirlpool-USA under which Whirlpool-India agreed to sell its compressor business to the assessee, a wholly owned subsidiary of Tecumseh USA, for the total consideration of Rs. 52.5 crores. The agreement also provided that Whirlpool would not compete with Tecumseh. To give effect to the MOU, the assessee entered into an agreement dated 2.7.97 with Whirlpool India. The agreement provided a split of the consideration of up to Rs. 49.85 crores between land, building, inventories etc. The agreement provided that a separate non-compete agreement would be entered into which was entered into on 10.7.1997 and provided for a consideration of Rs. 2.65 crores. The period of non-compete was 5 years. The consideration of Rs. 52.5 crores agreed to in the MOU was accordingly bifurcated between the assets (Rs. 49.85 crores) and the non-compete covenant (Rs. 2.65 crores). The Special Bench had to consider whether the said payment for the non-compete was capital or revenue expenditure. HELD deciding against the assessee:

(i) The contention that the non-compete agreement should be considered separately from what was paid by the assessee to acquire the business is not acceptable. The terms of the MOU and agreement made it clear that the parties had agreed on the total consideration of 52.5 crores and it was allocated between the assets and the non-compete covenant. Accordingly, the non-compete agreement cannot be considered on a stand alone basis. All agreements form one transaction which are interwoven by a common thread. The agreements are not mutually exclusive as one cannot be fulfilled without fulfilling the other;

(ii) The general proposition of the assessee that in all cases of payment of non-compete fee, the purpose of making such payment is to maintain/protect the profitability of the business by insulating the same from the risk of competition and that it is, therefore, revenue in nature is not acceptable;

(iii) There are several tests formulated by Courts to distinguish between capital and revenue expenditure such as the test of initial outlay of the business, the aim and object of the expenditure, enduring benefit test and the test of fixed and circulating capital. These tests continue to be applicable even in the context of the modern situation. (Case Laws discussed in detail);

(iv) As the ‘non-compete agreement’ is part & parcel of the entire transaction of acquisition of business, it falls under the first test which is that if the expenditure is made for the initial outlay or for the expansion of business or a substantial replacement of the equipment, then, it is capital expenditure. The incurring of expenditure also brought enduring benefit to the assessee. In Assam Bengal Cement Company a period of five years was regarded as providing enduring advantage to the assessee irrespective of the fact that the payment was to be made annually. The argument that this was a case of acquiring monopoly rights is not right because in Coal Shipment it was held that even payment made to ward off competition from a rival dealer would constitute capital expenditure;

(v) Accordingly, the amount paid under the non-compete agreement is capital expenditure.

(74.1 KiB, 703 DLs)

Default u/s 194C does not result in s. 40(a)(ia) disallowance if TDS paid before due date of filing ROI

The assessee made payments to sub-contractors during the previous year and though s. 194C requires TDS at the stage of payment/credit, did not do so. The tax was, however, deducted on 31st March and paid over in Sept before the due date for filing the return. The AO took the view that while the payment made to the sub-contractor for March was allowable, the payments for the earlier months was disallowable u/s 40(a)(ia). This was confirmed by the CIT (A). On appeal by the assessee, HELD allowing the appeal:

Failure to deduct or deposit tax as per s. 194C or Chapter-XVII makes the assessee liable to the consequences provided under the said Chapter-XVII. However, s. 40(a)(ia) is in addition to Chapter XVII. S. 40(a)(ia)(A) provides that if tax is deducted during the last month of the previous year and paid on or before the due date of filing of return as per s. 139(1), then such sum shall be allowed as deduction. In cases where tax is deducted other than the last month of previous year but is deposited before the last day of the previous year, then it will be allowed as deduction. Therefore, the conditions for allowability of deduction are prescribed u/s 40(a)(ia) itself and Chapter-XVII and s. 194C are not relevant. If the condition of deduction and payment prescribed u/s 194C / Chapter XVII are held applicable for disallowance of deduction u/s 40(a)(ia), then s. 40(a)(ia) will be rendered meaningless, absurd and otiose. Since the assessee had (belatedly) deducted tax in the last month of the previous year i.e. March 2005 and deposited the same before the due date of filing the return u/s 139(1), deduction had to be allowed u/s 40(a)(ia) (A).

(137.3 KiB, 477 DLs)

If brokerage offered to tax, the principal debt qualifies as a “bad debt” u/s 36(1)(vii) r.w.s. 36(2)

The assessee, a broker, claimed deduction for bad debts in respect of shares purchased by him for his clients. The AO rejected the claim though the CIT (A) upheld it. On appeal by the Revenue, the matter was referred to the Special Bench. Before the Special Bench, the department argued that u/s 36(2), no deduction on account of bad debt can be allowed unless “such debt or part thereof has been taken into account in computing the income of the assessee”. It was argued that as the assessee had offered only the brokerage income to tax but not the value of shares purchased on behalf of clients, the latter could not be allowed as a bad debt u/s 36(1)(vii). HELD rejecting the claim of the department:

(i) In Veerabhadra Rao 155 ITR 152 the Supreme Court held in the context of a loan that if the interest is offered to tax, the loan has been “taken into account in computing the income of the assessee” and qualifies for deduction u/s 36(1)(vii). The effect of the judgement is that in order to satisfy the condition stipulated in s. 36(2)(i), it is not necessary that the entire amount of debt has to be taken into account in computing the income of the assessee and it will be sufficient even if part of such debt is taken into account in computing the income of the assessee. This principle applies to a share broker. The amount receivable on account of brokerage is a part of debt receivable by the share broker from his client against purchase of shares and once such brokerage is credited to the P&L account and taken into account in computing his income, the condition stipulated in s. 36(2)(i) gets satisfied. Whether the gross amount is reflected in the credit side of the P&L A/c or only the net amount is finally reflected as profit after deducting the corresponding expenses or only the net amount of brokerage received by the share broker is reflected in the credit side of the P&L account makes no difference because the ultimate effect is the same;

(ii) The argument that the loss was suffered owing to breach of SEBI Guidelines framed to safeguard the interest of brokers in respect of amount receivable from the clients against purchase of shares is irrelevant. If the broker chooses not to follow the guidelines, it is a decision taken by him as a businessman having regard to his business relations with the client. The loss cannot be equated to expenditure incurred by the assessee for any purpose which is an offence or which is prohibited by law. (CIT vs. Pranlal Kesurdas 49 ITR 931 (Bom) followed where bad debts on account of forbidden vayada transactions were held allowable);

(iii) The contention of the Revenue that the sale value of the shares remaining with the assessee should be adjusted against the amount receivable from the client so as to arrive at the actual amount of bad debt should be raised, if permissible, before the Division Bench.

(458.4 KiB, 1,181 DLs)

Professional Firms can have a ‘service PE’. The words “indirectly attributable to the PE” encompass the “force of attraction” principle and even services rendered offshore for Indian projects are assessable in India

The assessee, a UK based law firm, rendered services to clients with operations / projects in India. The assessee did not have an office in India and to render the services, its’ partners and employees visited India. The assessee took the view that as it did not have a permanent establishment (PE) or fixed base in India, its income was not assessable to tax under Articles 7 or 15 of the India-UK DTAA. The AO took the view that as the assessee had furnished services in India for more than 90 days, it had a PE under Article 5(2)(k) of the DTAA. On the quantum, he held that the entirety of the invoices raised by the assessee was assessable in India. On appeal, the CIT (A) upheld the existence of the PE though he held that only the income attributable to the PE was assessable to tax. On appeal to the Tribunal, HELD:

(a) As regards taxability under the domestic law, the argument on the basis of Ishikawajima 288 ITR 408 (SC) & Clifford Chance 318 ITR 237 (Bom) that only services rendered in India are assessable is not acceptable in view of the retrospective amendment to s. 9(1) by the Finance Act, 2010. The result of the amendment is that utilization of the services in India is sufficient to attract taxability in India. The said judgements are no longer good law. (Concept of territorial nexus and source rule discussed);

(b) As regards the DTAA, the question whether a partnership being a “fiscally transparent entity” is entitled to the benefits under the DTAA is entitled to be raised for the first time by the Tribunal suo moto though not raised by the AO or CIT (A). Under Rule 11 of the Tribunal Rules, while the Tribunal cannot enlarge the scope of ‘subject matter of appeal’ inasmuch as a disallowance or addition not made by the lower authorities cannot be made by the Tribunal, within the subject matter of appeal, the Tribunal can examine any aspect of the matter irrespective of whether the same has been examined by the lower authorities or not. There are no restrictions on the Tribunal as to on what grounds the Tribunal decides the appeal provided it hears the affected party before doing so. (Tata Telecommunications 121 ITD 384 (SB) & Morgan Stanley 39 DTR 240 followed);

(c) On merits, though a UK partnership is a “person” under Article 3(2), the question is whether it is a “resident of UK”. Article 4(1) defines a “resident of a Contracting State” to mean a person “liable to tax in that State by reasons of domicile, residence, place of management or any other criterion of similar nature”. According to the OECD Report on Partnerships, mere computation of income at the level of partnership is not sufficient to hold that the partnership firm is ‘liable to taxation’ in the residence country. However, this view is not correct and has also been rejected by India. A partnership is eligible to the benefits of the DTAA provided the entire profits of the firm are taxed in UK – whether in the hands of the firm (after determining taxable income in relation to the personal characteristics of the partners) or in the hands of the partners directly. (International law on the subject discussed in detail);

(d) The argument that a PE cannot be constituted under Article 5(2)(k) if the basic conditions of Article 5(1) are not fulfilled is not acceptable. While clauses (a) to (i) of Article 5(2) are illustrative of the basic rule of a PE (fixed place of business), clauses (j) and (k) are an extension of the basic rule. The items included in the said clauses (j) & (k) are such as would not constitute a PE under the basic rule of Article 5(1), and it is only on account of the deeming fiction provided in Article 5(2)(j)/(k), that it can be treated as a PE;

(e) The argument that the term “furnishing of services” in Article 5(2)(k) of the DTAA does not cover “rendering of services” by lawyers is not acceptable because both terms are used interchangeably in normal course of business;

(f) The argument that as Article 5 refers to commercial and industrial establishments, it cannot cover the rendition of professional services is not acceptable. The Commentary on the OECD Model Convention shows that income derived from professional services or other activities of independent character have to be dealt with under Article 7 as business profits. Accordingly, even professional services are covered by Article 5(2)(k);

(g) The argument that income from professional services can only be taxed under Article 15 (which applies to individuals and not firms) and in case chargeability under Article 15 fails, it cannot be assessed under Article 7 is not acceptable. While professional services rendered by an individual are governed by Article 15, professional services rendered by an enterprise are governed by Article 5(2)(k) read with Article 7. This view is supported by the UN Model Convention Commentary;

(h) As regards the quantum of profits attributable to the PE, the argument that by virtue of Article 7(2), the PE must be assessed by taking the value of services rendered by the PE at the market value of such services in India and not the price at which the assessee billed its’ clients is not acceptable. The fiction of hypothetical independence in Article 7(2) is confined to a PE’s transactions with its head office and branches and does not extend to transactions with third parties. The fiction of hypothetical independence has no role to play in adjusting actual revenues with independent entities. The arms length principle in Article 7(2) is relevant only for intra organization transactions or transactions with associated enterprises. Accordingly, the revenues earned by the assessee are to be taken at actual figures and no adjustments are permissible in the same;

(i) Further, as regards the quantum of profits attributable to the PE, Article 7 (1) provides for the taxability of profits “directly or indirectly attributable” to the PE. The words “profits indirectly attributable to the PE” incorporates the “force of attraction” principle. To give effect to the “force of attraction” principle, in addition to taxability of income in respect of services rendered by the PE in India, any income in respect of the services rendered to an Indian project, which is similar to the services rendered by the PE is also to be taxed in India in the hands of the assessee – irrespective of whether such services are rendered through the PE or directly by the GE. There cannot be any professional services rendered in India which are not, at least indirectly, attributable to carrying out professional work in India. This indirect attribution is enough to bring the income from such services within ambit of taxability in India. The two conditions to be satisfied for taxability of related profits are (i) the services should be similar or relatable to the services rendered by the PE in India; and (ii) the services should be ‘directly or indirectly attributable to the Indian PE’ i.e. rendered to a project or client in India. The result is that the entire profits relating to services rendered by the assessee, whether in India or outside, in respect of Indian projects is taxable in India.

(134.9 KiB, 529 DLs)

Royalty paid by non-resident does not “arise” in India if there is no “economic link” between the PE and the royalty

The assessee, a Singaporean company with a PE in India, obtained rights from the Global Cricket Council, Singapore, for telecast of cricket matches in India. The AO took the view that the payment for the said rights constituted “royalty” in the hands of GCC u/s 9(1)(vi) & Article 12(7) of the India-Singapore DTAA and that it had arisen in India on the ground that the payer had a PE in India and there was a direct nexus between collection of advertisement revenue in India and payment for the rights. The assessee was held liable u/s 201 for failure to deduct tax u/s 195. On appeal, the CIT (A) disagreed with the AO. On appeal by the department to the Tribunal, HELD dismissing the appeal:

Assuming the payment for obtaining cricket telecast rights is “royalty”, under the first limb of Article 12(7) of the DTAA, royalties can be said to have arisen in India only if the payer is a resident of India. This condition is not fulfilled as the assessee was a non-resident. Under the second limb of Article 12(7), payments made by a non-resident are deemed to arise in India if the non-resident has a PE in India with which the liability to pay the royalties is incurred and such royalties are borne by the PE. This condition is also not fulfilled because the mere existence of a PE in India does not mean that royalties arise in India. In addition to the existence of PE, it is essential that liability to pay such royalties has been “incurred in connection with” and is “borne by” the PE of the payer in India. There must be an “economic link” between the liability for payment of such royalties and PE. As there was no economic link between the payment of royalties and the PE of the assessee in India, the payments to GCC are not incurred “in connection” with the PE in India. Further, the PE was also not involved in any way with the acquisition of the right to broadcast the cricket matches, nor did the PE bear the cost of payments to GCC. Thus the payments to GCC were not “borne by” the PE in India.

(292.3 KiB, 531 DLs)

Transfer Pricing TNMM must be applied to transaction margins and not to enterprise level margins. Adjustments must be confined to international transactions

The assessee, engaged in the business of manufacture and export of diamonds and jewellery, claimed that having regard to the nature of the product, none of the transfer pricing methods were applicable for benchmarking the international transactions with associated enterprises. The TPO rejected the argument on the ground that the Transactional Net Margin Method (TNMM) was applicable and made an adjustment by comparing the enterprise level operating margins. This was upheld in principle by the CIT(A). On appeal to the Tribunal, HELD:

(i) It is mandatory for an assessee to follow one of the methods prescribed in Rule 10B and demonstrate that the international transactions entered into by it with an associated enterprise are at arms’ length. The argument that no method is applicable is unsustainable;

(ii) However, the TPO is wrong in adopting the enterprise level margins as the TNMM. U/s 92F (ii) r.w.s. 10B(e), TNMM requires comparison of net profit margins realized by an enterprise from an international transaction(s) and not comparison of operating margins of enterprises;

(iii) Further, the adjustments arising due to computation of ALP should be restricted only to the international transactions and not to the entire turnover of the assessee. No addition can be made to local transactions under Chapter X of the Act.

(193.7 KiB, 520 DLs)

Even exempt income is taxable under MAT / s.115JB

The assessee credited its P&L A/c with an amount of Rs. 149.77 crores being the profit on sale of assets to its wholly owned subsidiary. As the said profits were not chargeable to tax u/s 47(iv), the assessee took the view that the same had also to be reduced from the “book profits” u/s 115JB. The Special Bench had to consider whether exempt income could be excluded from the computation of “book profits” u/s 115JB. HELD deciding against the assessee:

(i) The AO can alter the “book profit” only in two circumstances (a) if the P&L A/c is not drawn up in accordance with Parts II & III of Schedule VI to the Companies Act or (b) If accounting policies & standards, method & rate of depreciation have been incorrectly adopted for preparation of the P & L A/c. Except for the said two cases, the AO has no power to alter the net profit shown in the P&L A/c. Under (a), the AO cannot disturb the Net Profit shown by the assessee where there are no allegations of fraud or misrepresentation but only a difference of opinion as to whether a particular amount should be properly shown in the P&L A/c or Balance sheet;

(ii) Parts II & III of Schedule VI to the Companies Act do not permit the exclusion of capital gain from the P & L A/c. The P & L A/c is required to disclose every material feature including credits or receipts and debits or expenses in respect of non-recurring transactions or transactions of an exceptional nature including capital profits (Veekaylal Investments 249 ITR 597 (Bom) followed). Items referred to in the Notes are a part of the P&L A/c (Sain Processing 221 CTR 493 (Del) followed;

(iii) The assessee had included the said capital gains in the P & L A/c and it was not its’ case that same was not includible. The fact that the capital gains was exempt u/s 47(iv) does not mean it can be excluded from the “book profit” because no such exclusion was permitted under the Explanation to s. 115JB. The taxability of capital gain is relevant only for the purpose of computation of income under the normal provisions and has nothing to do with the computation of “book profits”. {N.J. Jose & Co 217 CTR 479 (Ker) (capital gains exempt u/s 54E) followed};

(iv) The argument that as s. 115JB (4) provides that “save as otherwise provided in this section all other provisions of the Act shall apply” does not mean that the exemption provisions of s. 47(iv) can be read into s. 115JB. This only means that while the computation has to be as per s. 115JB, anything over and above that will be subject to other provisions of the Act. Frig Sales 4 SOT 376 (Mum) overruled);

(v) Accordingly, in the absence of any provision for exclusion of exempted capital gain in the computation of book profit u/s 115JB, the assessee is not entitled to the exclusion claimed.

(52.1 KiB, 531 DLs)

Profits from supply of ‘shrink-wrapped’ software is not ‘royalty’

The assessee, a Mauritius company, was engaged in supply of software. It supplied “off-the-shelf” “shrink-wrapped” software to Infosys Technologies and took the view that the profits there from was not taxable in India as it did not have a Permanent Establishment in India. The AO assessed the profits as royalty u/s 9(1)(vi) of the Act and this was confirmed by the CIT (A). On appeal by the assessee, HELD allowing the appeal:

(i) In CIT vs. Samsung Electronics 227 CTR 335 the Karnataka High Court has confined its decision to the issue of responsibility of the assessee u/s 195 in deducting tax at source before making remittances to non-residents. Even though the court held in favour of the Revenue on the application of the TDS provisions, the court made it clear in paragraph 78 that it has not examined the question of tax liability of the non-resident assessees in respect of the payments received from assesses in India.

(ii) On the question whether income from supply of software can be assessed as royalty, in Motorola Inc vs. DCIT 95 ITD 269, the Delhi Special Bench held that the crux of the issue was whether the payment was for a copyright or for a copyrighted article. If it was for a copyright, it had to be classified as ‘Royalty’ under the Act and the DTAA. If it was for a copyrighted article, then it only represented the purchase price of an article and could not be considered as Royalty either under the Act or under the DTAA. This principle was upheld by the AAR in Airports Authority of India and the ITAT in Sonata Software 6 SOT 700 and it was held that the payments partook the character of purchase and sale of goods; and as there is no PE in India, no income accrued or deemed to accrue or arise in India. Immense support can be drawn from Tata Consultancy Services v. State of AP 271 ITR 401 (SC) where it was held that though copyright in a software programme may remain with the originator of the programme, the moment copies are made and marketed, it becomes goods which are assessable to sales-tax. It was held that even intellectual property become “goods” once put to a media whether in the form of books or computer disks or cassettes. Accordingly, profits on sale of software cannot be assessed as royalty either under the Act or under the DTAA.