NOVELL INC (NOW KNOWN AS MICRO FOCUS SOFTWARE),MUMBAI vs. ASST CIT (IT) RANGE 3 (3)91), MUMBAI

Appearances: Ketan Ved for the appellant S. S. Iyangar for the respondent Date of concluding the hearing : June 15, 2021 Date of pronouncing the order : August 31, 2021 O R D E R Per Pramod Kumar, VP: 1. By way of this appeal, the assessee-appellant has challenged the correctness of the order dated 18th September 2019, passed by the Disputes Resolution Panel-3, Mumbai in the matter of assessment under section 144C(1) of the Income Tax Act, 1961, for the assessment year 2015-16.

2. Grievances raised by the appellant are as follows:- 1. On the facts and in the circumstances of the case and in law, the Assessing Officer erred in treating the sale of Novell Software Products of Rs.19,64,74,163 as 'Royalties' on substantive basis both under the Income-tax Act, 1961 ("the Act") as well as the Double Taxation Avoidance Agreement entered into between India and USA ('India-USA DTAA'). In accordance with India-USA DTAA, the receipts from sale of Novell Software Products being in the nature of business income and in the absence of Permanent Establishment ('PE') of appellant in India, the receipts from Assessment year: 2015-16 Page 2 of 18 sale of Novell Software Products ought to have been considered as not taxable in India.

2. Without prejudice to Ground No.1, on the facts and in the circumstances of the case and in law, the Assessing Officer erred in holding that Novell Software Development India Private Limited ('NSDIPL') is a Dependent Agency Permanent Establishment ('DAPE') of Appellant in India by misinterpreting and misunderstanding the "Principal to Principal" arrangement between Novell Inc. and NSDIPL under the Distribution Agreement and disregarding the arm length arrangement between Appellant and NSDIPL, as accepted by the Transfer Pricing Authorities.

3. Without Prejudice to Ground No.1 and Ground No.2 above, on the facts and in the circumstances of the case and in law, the Learned Assessing Officer erred in taxing the revenues from supply of Novell Software Products to NSDIPL as Business Income attributable to such alleged DAPE on protective basis and also erred in attributing 100 percent of the gross revenue from sale of Novell Software Products to such alleged DAPE without appreciating the Functions, Assets and Risks ('FAR') analysis including the Resale Price Method adopted by the Appellant and examined by Transfer Pricing Authorities.

4. Without Prejudice to the Ground No.1 to Ground No. 3. on the facts and in the circumstances of the case and in law, the Learned Assessing Officer erred in holding that the transaction of sale of software is not at arm's length ignoring the fact that the transfer pricing documentation relied upon by the Company has been examined by Transfer Pricing Authorities.

5. Without Prejudice to the Ground No.1 to Ground No. 4, of the facts and in the circumstances of the case and in law, the Learned Assessing Officer erred in arriving at a conclusion that the Assessee company has not provided the relevant Transfer Pricing documentation of NSDIPL so as to assessee the arm’s length arrangement between the parties although the same were duly submitted during the course of assessment proceedings.

6. Without Prejudice to the Ground No.1 to Ground No.5, on the facts and in the circumstances of the case and in law, the Learned AO erred in taxing the receipts from supply of Novell Software products on gross basis by applying Gross Profit Ratio of 41.07 percent instead of applying the Net Profit Ratio of Novell Inc. or by not reducing at least 38 percent of remuneration retained by NSDIPL for sale of such Novell Software products in relation to which the income is sought to be taxed in India.

Assessment year: 2015-16 Page 3 of 18

Assessment year: 2015-16 Page 6 of 18 (i) he has and habitually exercises in that first-mentioned State, an authority to conclude contracts in the name of the enterprise, unless his activities are limited to the purchase of goods or merchandise for the enterprise; or (ii) he habitually maintains in that first-mentioned State a stock of goods or merchandise belonging to the enterprise from which he regularly fulfils orders on behalf of 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, where such persons are acting in the ordinary course of their business. However, when the activities of such an agent are devoted exclusively or almost exclusively on behalf of that enterprise, he will not be considered an agent of an independent status within the meaning of this paragraph.

11. The case of the Revenue is thus clearly confined to the existence of DAPE on the facts of this case. The question thus arises as to what are the tax implications of the existence of a dependent agent permanent establishment (DAPE) under Article 5(4). The DAPE is, after all, a type of permanent establishment, and the very concept of permanent establishment is a compromise between source rule and residence rule inasmuch as it provides justification to trigger source jurisdiction taxation over business activities of a foreign enterprise. Unless there is a PE in the source jurisdiction, there cannot be taxation of business profits of the foreign enterprise in the source jurisdiction, and when there is a PE in the source jurisdiction, only so much of profits of the foreign enterprise, as are attributable to a PE, can be taxed in the source jurisdiction- as is the unambiguous mandate of Article 7(1). It is in this context one has to examine the tax implications of DAPE, and that tax implication is that the profits attributable to the DAPE are brought to tax in the source jurisdiction. The next logical point, therefore, as to how to compute profits attributable to a DAPE, and it is this aspect of the matter which has been a subject matter of academic debates and controversies. There are two approaches to it i.e., to borrow the terminology employed by International Tax Law Reports (see 2007, Volume 9; Part 5; at pages 963-964), first- a "single taxpayer" or "zero-sum approach", and, second- "two taxpayers" or "non zero-sum approach". While Philip Banker, a well known international tax lawyer, has all along advocated zero-sum approach, late Klaus Vogel touched a different chord, in his column 'Tax Treaty Monitor' in the 'Bulletin for International Taxation (November 2007 at page 475) and given his approval for "two taxpayers approach". The latter is also in consonance with Authorised OECD Approach of the OECD. On materially similar facts of dependent agency permanent establishment for a similarly placed foreign telecasting company as in this case, in the case of DDIT v. Set Satellite (Singapore) Pte Ltd [2007] 106 ITD 175 (Mum), a coordinate bench, speaking through one of us, (i.e. the Vice President), had upheld the "two taxpayer approach", in computation of DAPE profits, and observed as follows:

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12. Learned counsel, however, contends that since the profit attributable to the PE are the profits which the PE "might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is permanent establishment", the taxable profits of the foreign enterprise cannot extend beyond the profit earned by the dependent commission agent. The line of reasoning adopted by the learned counsel is that PE is nothing but the dependent agent, and, the taxability of PE can only, Assessment year: 2015-16 Page 9 of 18 therefore, be in respect of the earnings of the agent. Learned counsel has, with his inimitable oration, erudition and legal skills, woven a complex web of arguments to support this legal proposition. However, as it sometimes happens, the quality of arguments in support of a legal proposition is inversely proportional, proportional if it is, to the merits of the proposition sought to be advanced. This is one such occasion. Let us set out the reasons why we think so, and, in the process, deal with various arguments of the learned counsel one by one.

13. At the outset, we must reiterate that a dependent agent (DA) and a dependent agent permanent establishment (DAPE), in our humble understanding, are two distinct things. As we have stated earlier, it is as a result of existence of a dependent agent that the foreign enterprise is 'deemed to have' a permanent establishment in the country in which dependent agent is situated.

14. Under Article 7 of the treaty, the taxability is of the foreign company. What is taxable under Article 7 is profit earned by the foreign enterprise, as it Article 7(i) provides that "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". Agency remuneration paid by the foreign enterprise is not an income of the foreign enterprise but an expenditure of the foreign enterprise. The taxability of any profit under Article 7 has to be in the hands of the foreign company and not the host company of which dependent agent is resident. Therefore, in it is patently erroneous to suggest that by payment of tax liability by the dependent agent, tax liability of the foreign principal is discharged. So far as Article 7 is concerned, it deals with the taxability of the foreign company.

16. Learned counsel has relied upon the commentaries of various authors including Phillip Baker, Prof. Roy Rohtagi and Prof. David R. Davies. It is contended that according to these distinguished authors, payment of arms length remuneration by a foreign company to its agent extinguishes tax liability of the foreign principal. With respect, and for the reasons we have set out above, we are of the considered view that in the dependent agency permanent establishment situation, this proposition does not hold good. In any event, this approach proceeds on the assumption, which turns out to be fallacious assumption on the facts of the present case, that dependent agent and dependent agent permanent establishment are one and the same thing.

Assessment year: 2015-16 Page 10 of 18 17. Learned counsel has then relied upon the order of this Tribunal in the case of Dy. CIT v. Roxon OY [2006] 103 TTJ (Mum.) 8911 which was authored by one of us. This decision, however, did not deal with the peculiarities of a dependent agent permanent establishment. This decision dealt with the taxability of the installation PE, and, the principles dealing with computation of profits of installation PE, in our considered view, do not have any bearing on the computation of profits of the dependent agency PE. We are, therefore, not persuaded by this reasoning either.

12. Late Prof Klaus Vogel, one of the very eminent international tax scholars of our times, had favoured the path adopted by the coordinate bench. In his last in Tax Treaty Monitor (Bulletin for International Taxation, November 2007, page 475), referring to the above coordinate bench decision, he had this to say: "One can understand that many have problems imagining how profits should arise to a permanent establishment which, as the Tribunal itself repeatedly stated, does not exist in reality and is a non-entity "wholly hypothetical and fictional". Such sceptics should consider, however, that the parent enterprise as a rule will aim to realize receipts from the contracts concluded by the dependent agent which, in addition to compensating the agent's fee, include a surplus profit, for otherwise the parent would lack any commercial reason for employing the agent. This surplus is not- or only secondarily- attributable to activities in the parent's residence country. Rather, it is a profit that the parent obtains through employing the agent in the country in which the profits arise. Fairness ("inter-nations equity") requires that the surplus profit be taxed in that state. If the drafters of a treaty or model treaty want to provide this, they must notionally attribute it to a contact in that state. This does not mean that they must attribute it to a person or an object in the real world. In the world of law, a legal concept, a figure of thought, will do. The agency permanent establishment is such a figure of thought which makes it technically possible to connect the surplus profit to the agent's state. Thus, it is not only possible, but it is the rule that a profit exceeding the agent's compensation will be submitted to the agent's state". Philip Baker, another eminent international tax expert whose work in referred to, with approval and respect, in many of the judicial precedents from Hon'ble Courts above, did not agree with this approach. In his editorial comments in the International Tax Law Reports, he has favoured the other alternative approach to this issue, i.e., the single taxpayer approach. He observed that, "One view (to which editor of these law reports subscribes) is that if the dependent agent is being remunerated on a correct arm's length price for the function he performs, risks he assumes, and the assets he employs in his agency, there is no basis for attributing any further profits to the DAPE over and above the arm's length remuneration to the agent", and reasoned the same by observing that "As soon as one abandons the single taxpayer approach, one needs to start attributing the DAPE functions that were not performed by the agent, assets that were not employed by it and the risks that were not assumed by it. In other words, the two taxpayer approach requires an abandonment of reality and entirely hypothetical attribution which, in arm's length world which must have some basis in reality, is simply a licence for arbitrary allocation of profits. Ultimately, that's what Tribunal did here". There is thus a cleavage of academic opinion on the approach to the DAPE profit attribution and that is a highly contentious issue on the first principles. When the matter travelled before Hon'ble High Court, however, these views of the coordinate bench did not find favour with Their Lordships. Rejecting the theory about Assessment year: 2015-16 Page 11 of 18 separate profit attribution for the dependent agency permanent establishment vis-à- vis the dependent agent, Their Lordships have, in the judgment reported as Set Satellite Pte Ltd. v. CIT [2009] 307 ITR 205 (Bom), observed as follows: 10. From a reading of Article 7(1) of the DTAA it is clear that 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. The profits of the enterprise may be taxed in the other State but only so much of them as is directly or indirectly attributable to that permanent establishment. In para 2 while determining the profits attributable to the permanent establishment the expression used is "estimated on a reasonable basis". The DTAA does not refer to arm's length payment. The principles contained in the matter of income from international transaction on an arm's length price are contained in section 92 of the Income-tax Act. The principles have been clarified by the Finance Act, 2001 as also Finance Act, 2002. From the order of the CIT, which has been accepted it is clear that the Appellant herein has paid to its PE on arm's length principle. It recorded a finding of fact that the Appellant had paid service fees at the rate of 15 per cent of gross ad revenue to its agent, SET India, for procuring advertisements during the period April 1998 to October, 1998. The fact that 15 per cent service fee is an arm's length remuneration is supported by Circular No. 742 which recognizes that the Indian agents of foreign telecasting companies generally retain 15 per cent of the ad revenues as service charges. Effective November 1998, a revised arrangement was entered into between the parties whereby the aforesaid amount was reduced to 12.5 per cent of net ad revenue (i.e., gross ad revenues less agency commission). Simultaneously, the Appellant also entered into an arrangement entitling SET India to enter into agreements, collect and retain all subscription revenues. Considering all these aspects and the fact that the agent has a good profitability record, it held that the Appellant has remunerated the agent on an arm's length basis. This finding of the Tribunal has not been disputed by the Revenue. The entire contention of the Revenue is that the advertisement revenue pertaining to its own channel and AXN Channel are also taxable in India.

11. We may firstly point out that CIT has dealt with the issue as to why the advertisements received by the Appellant were not liable for being taxed in India based on the CBDT Circular No. 23, dated 23-7-1969 which clearly sets out that where a non-resident's sales to Indian customers are secured through the services of an agent in India, the assessment in India of the income arising out of the transaction will be limited to the amount of profit which is attributable to the agent's services, provided that (i) the non-resident principal's business activities in India are wholly channelled through his agent; (ii) the contracts to sell are made outside India; and (iii) the sales are made on a principal-to-principal basis. The CIT(A) had recorded a specific finding in favour of the Appellant in the affirmative on all three counts. It is in these circumstances that it was held that the advertisement revenue received by the Appellant may be from the customers in India is not liable for tax in India. That CBDT Circulars are binding needs no repetition. If authorities need be cited. We may now refer to the judgment of the Supreme Court in UCO Bank v. CIT [1999] 237 ITR 889. In that judgment the issue was whether Assessment year: 2015-16 Page 12 of 18 Circular of 9-10-1984 was inconsistent or whether there was contradiction in the circular and Section 145 of the Income-tax Act. The Supreme Court observed that :— "... In fact, the circular clarifies the way in which these amounts are to be treated under the accounting practice followed by the lender. The circular, therefore, cannot be treated as contrary to section 145 of the Income-tax Act or illegal in any form. It is meant for a uniform administration of law by all the income-tax authorities in a specific situation and, therefore, validly issued under section 119 of the Income-tax Act. As such, the circular would be binding on the department." (p. 901) See also CIT v. Hero Cycles (P.) Ltd. [1997] 228 ITR 463 (SC). It would thus be clear that the Circular No. 23 would be binding on the Assessing Officer and had to be considered while assessing the tax liability of an assessee. The Tribunal in its judgment has not considered the effect of the finding recorded by the CIT (Appeals) based on the Circular and which circular was relevant for the purpose of deciding the controversy in issue. This circular read with Article 7(1) of the DTAA would result in holding that the income from advertisement if neither directly nor indirectly attributable to that of the permanent establishment, would not be taxable in India. The Tribunal in fact in para 10 has recorded a finding that Article 7(2) provides that the arm's length price is the criterion for computation of these hypothetical profits. In our opinion the entire rational or reasoning given by the Tribunal has to be set aside. In matters of tax what has to be considered and more so in international transactions if there be a treaty, the provisions of the treaty and if the provisions of the treaty are more advantageous to an assessee, then the construction will have to be given which is advantageous to the assessee. At this stage we may note that on behalf of the assessee learned Counsel has produced an order passed by the Additional CIT (Transfer Pricing-II), Mumbai in the matter of determination of arm's length price with reference to all the transactions reported in Form No. 3CEB filed by the assessee. The assessee is SET India, the depending agent. The order records that the assessee is engaged in the business of providing audio-visual television content and also acts as an advertising agent of Set Satellite Singapore Pvt. Ltd. The assessee distributes these channels to the Indian cable operators and that the assessee has applied the TNM method to determine the arm's length price for its international transaction. It, however, clarified that the order is in respect of reference received for assessment year 2002-03 and not for subsequent assessment years.

13. Considering the above principle as may be discerned from the judgment in DIT (International Taxation) 292 ITR 416 (supra) it would be clear that— (1) Considering the CBDT Circular No. 742 it would be fair and reasonable that the taxable income is computed at 10 per cent of the gross profits. In the instant case insofar as marketing services are concerned by the arm's length principle what has been paid is more than 10 per cent as can be seen from the order of CIT(A). This was not disputed by the revenue in its Appeal before the ITAT. (2) The only contention advanced and which found favour with the Tribunal was that the advertisement revenue received by the assessee was also income liable to tax in India. The CIT(A) relied upon Circular No. 23 of 1969. That Circular read with Article 7(1) would result in holding that advertisement revenue received by the appellant are not taxable in India as long as the treaty and the Circular stands.

14. In the light of the above Appeal filed by the Appellant herein is allowed and the order of the ITAT is set aside. Merely because tax on income was paid for some assessment years would not stop the assessee from contending that its income is not liable to tax. The order of CIT is restored except to the extent that it has said that it cannot interfere because the Appellant had paid the tax. That part is set aside.

15. It has not been the case of the revenue authorities at any stage that the remuneration paid to the Indian agent is not an arm's length remuneration for the services rendered by the agents concerned, yet a prayer is now made that the matter should be sent back to the assessment stage for detailed findings in this regard. In a written note filed by the learned Departmental Representative, it has been submitted that, " it is humbly submitted that in the case of DIT v. Morgan Stanley (292 ITR 416 (SC) The Hon'ble Apex Court in para 32 of its order (page 124 of PB II) has carved out an exception. It has held that 'The situation would be different if transfer pricing analysis does not adequately reflect the functions performed and the risks assumed by the enterprise. In such a situation, there would be a need to attribute profits to the PE Assessment year: 2015-16 Page 16 of 18 for those functions/risks that have not been considered. Therefore, in each case, the data placed by the taxpayer has to be examined as to whether the transfer pricing analysis placed by the taxpayer is exhaustive of attribution of profits and that would depend on the corporates on the basis of the concept of Economic Nexus is an important feature of Attributable Profits (profits attributable to the PE)'. Taking into considering the above and applying to the facts of the case, it is humbly submitted that all the international transactions entered into by assessee have not been examined by the authorities below". There is no material whatsoever before us to show, or even indicate, that the remuneration paid to the agents is not arm's length remuneration. In any case, the agent has been paid a remuneration at the rate of ten percent of the related revenues which is accepted as an arm's length price, in similar circumstances, in a large number of cases- including assessee's own cases for the assessment years, other than the assessment years in which this aspect of the matter is requested to be sent back for specific adjudication. Learned Departmental Representative himself submits that so far reliance of the assessment on the coordinate bench decisions for the assessment years 2006-07 to 2012-13 are concerned, "in the other cases relied upon by the assessee, the transfer pricing adjudication was made while in the present case, no such adjudication was made, and hence the decisions are not applicable as distinguishable on facts". We have also noted that the matter has come up for specific consideration of the Assessing Officer, and yet he has not found any deficiencies on the specific issue of adequacy of arm's length remuneration. It is not that this aspect was not examined. It was examined but the Assessing Officer did not find specific fault in the agent's remuneration not being in accordance with the FAR analysis. He has rather proceeded to, in a way, disregard the foreign entity altogether by suggesting that no business risk is assumed by the foreign company, i.e. the assessee, as the content is provided by the Indian agent and the viewership is Indian, and, for that reason, the viewership is linked to the Indian PE. We have noticed that the Assessing Officer has specifically picked up the aspect of "functions and risk taken by the PE" under that heading and title of the paragraph 5.3.4, in the assessment year 2002-03 for example at page 31 of the assessment order, noted that "there is no reason as to why the assessee should assume risk after having acquired the content in a working state from the content provider", that "all risks for up linking and finally relaying the signals in India is borne by the transponder company and not the assessee", and, therefore, concluded that "in view of the above discussions, it can be seen that major part of the risk in terms of market risk and technology risks are borne by the ZTL/El Zee" and that "almost 85% to 90% revenues from advertisement and subscription of the assessee comes through Indian viewership which is undoubtedly linked with the PE i.e., ZTL/El Zee". This is not the Indian viewership which is relevant in this context. What was relevant was the role played by the agent in India and whether the remuneration paid by the assessee company, for the services of the agent, was a fair and arm's length remuneration vis-à-vis the functions performed, assets employed and risks assumed by the Indian agent. No issues are raised on the inadequacy of agent's remuneration by the Assessing Officer, and now a fresh inning is sought to find these inadequacies and improve the case of the revenue. That is impermissible. In his analysis, while the Assessing Officer has proceeded on sweeping generalizations about the risks assumed by the PE but there is no specific FAR analysis which could support that the agent's remuneration not being an arm's length remuneration, and the Assessing Officer has proceeded on the basis that all the business risks of the assessee (i.e. the foreign company) are borne by the PE as PE is the content provider Assessment year: 2015-16 Page 17 of 18 and responsible for up linking activity. That's too sweeping a generalization to meet any judicial approval, and, on the same set of findings, the coordinate benches have disapproved the stand of the Assessing Officer. Under these circumstances, we see no reasons to remit the matter to the file of the Assessing Officer for a fresh round of ALP ascertainment proceedings, as prayed by the learned Departmental Representative. The plea of the assessee, as raised in the cross-objections, therefore, merits acceptance. Whether there is a DAPE or not, there are no additional profits to be brought to tax as a result of the existence of the DAPE, and, therefore, the question about the existence of a DAPE on the facts of this case is wholly academic.

are thus infructuous.

17. In view of the above position, the issue raised in the departmental appeals is wholly academic and does not call for any adjudication at this stage.

4. We see no reasons to take any other view of the matter than the view so taken by the co-ordinate bench. In this view of the matter, and having regard to the undisputed position vide TPO’s order dated 31.10.2017 that the transactions in question were at arm’s length price, no taxability survives in the hands of the assessee. Once basic taxability under the DAPE itself comes to an end, all other issues raised in the appeal are rendered academic and infructuous. We, therefore, uphold the plea of the assesee to this extent.

4. Learned representatives have also fairly agreed that the issues raised on this appeal are squarely covered by the aforesaid decision. We see no reasons to take any other view of the matter then the view so taken by the coordinate bench.