|DATE:||(Date of pronouncement)|
|DATE:||June 25, 2012 (Date of publication)|
|Click here to download the judgement (Dongfang_offshore_supplies_vodafone.pdf)|
Law on taxability of “turnkey contracts” for offshore & onshore supply explained
The assessee, a Chinese company, entered into two contracts with WBPDCL, one for the offshore supply of equipment and the other for onshore supplies, design, engineering and construction etc. Separate consideration was specified for each activity. The assessee claimed, relying on Ishikawjima-Harima 288 ITR 408 (SC), that the profits from offshore supply was not taxable in India. The AO rejected the claim on the ground that the project was a “turnkey” one with “cross-fall breach clause” and “single point responsibility” and that the split contracts were entered into only for convenience. It was held that the project office PE played a role in the offshore supplies. He referred the matter of determination of ALP of the onshore supplies to the TPO who determined a profit of Rs. 24 crores as against the loss of Rs. 67 crores offered by the assessee. This was upheld by the DRP. On appeal by the assessee to the Tribunal, HELD:
(i) As regards the assessee’s claim, relying on Ishikawajima-Harima, that offshore supply contracts cannot be taxed, there is a school of thought as advocated in Alstom Transport SA (AAR) that in view of the later & larger bench judgement in Vodafone International 341 ITR 1, the Ishikawajima-Harima principle is not good law and a “dissecting approach” cannot be adopted. While it is arguable that the observations in Vodafone regarding “looking at the transactions as a whole and not adopting dissecting approach” cannot be applied in all cases where separate contracts are entered into for offshore supplies and onshore services, the observations are applicable in cases where the values assigned to the onshore services are prima facie unreasonable vis-à-vis values assigned to the offshore supplies, which make no economic sense when viewed in isolation with offshore supplies contract. The transactions have to be looked at as a whole, and not on standalone basis, when the overall transaction is split in an unfair and unreasonable manner with a view to evade taxes. In order that such a situation can arise, it is sine qua non that while the assessee submits the bids for different segments (e.g. offshore and onshore) separately, these bids are considered together, as a single cohesive unit, by the other party, and this fact must be apparent from material on record. The fact that there is a “cross fall breach clause” which provides that a breach in one contract will automatically be classified as breach of the other contract give an indication that the “offshore supplies” contract and “onshore supplies” contract have to be viewed as an integrated contract, this fact by itself does not indicate that the onshore services and supplies contract is understated so as to avoid tax in the source country. That would be the situation in which while offshore supplies show unreasonable profits while onshore supplies and services result in unreasonable losses;
(ii) The fact that the assessee claims to have made a loss on its entire project, including the onshore activities, is not reason enough to show that the value of the onshore activities was deliberately kept at a lower amount to avoid taxability in India because it may make commercial sense that the offshore supplies are made at loss, as long as these supplies are at less than incremental costs i.e. marginal costs of offshore supplies, and thus overall losses of the assessee are minimized (matter remanded for the AO to examine the assessee’s claim regarding overall loss on the project).
Trust Mr Pramod Kumar to reconcile the AAR’s logic with established SC decisions on offshore supply.
The main question is the manner of determination of the PE’s profits. The ITAT has implied that if the overall contract (onshore + offshore) has resulted in a loss, no profits should be attributable to the PE (Pg 18 Para 12). This logic is somewhat faulty. Even while the overall contract results in a loss, could there not be a situation where the onshore activity is profitable while the the offshore part is loss making? As per Art 7 of the PRC-India DTAA, the PE is to be considered to be a “distinct and separate enterprise engaged in the same or similar activities” for the purpose of profit attribution. Thus, if the onshore part is profitable, such profits would be taxable in India, irrespective of whether the overall contract results in a loss.
The ITAT says that in order to determine the onshore profits, the first step should be to correctly split the overall consideration between the offshore and onshore portions. This would necessitate some sort of CUP to be identified for the services rendered / goods procured. Generally, application of CUP requires a high degree of similarity between the comparable and the transaction being tested. Identifying comparables with a sufficient level of similarity to apply CUP would be exceedingly difficult, especially where the equipment / services are somewhat unique. Finding comparable power plant supplies would be non-trivial at best.
Profit based methods such as TNMM on the other hand are more resilient to use of inexact comparables. Considering this, the only feasible way would be to apply profit-based methods (TNMM etc) to estimate the profit / loss earned by the PE in India. The assessee argued that unexpected delays etc drove up the cost resulting in losses. Expenses attributable to such delays etc can be considered as exceptional items and dealt with appropriately. To this extent, the approach followed by the AO in computing the onshore profits appears to be correct.