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Income Tax Appellate Tribunal, MUMBAI ‘K’ BENCH, MUMBAI
By way of this appeal, the assessee appellant has called into question correctness of the order dated 26th February 2009, passed by the learned CIT(A), in the matter of assessment under section 143(3) of the Income Tax Act, 1961 (‘the Act’ hereinafter) for the Assessment Year 2004-05.
In the first ground of appeal
, the assessee has raised the following grievance, the assessee is aggrieved that the learned CIT(A) erred “in not accepting the claim that the rate of tax applicable to domestic companies and/or co-operative banks for Assessment Year 2004-05 is also applicable to the Appellant, in accordance with the provisions of Article
26. (Non-discrimination) of the double taxation avoidance agreement between India and the Republic of France ('India - France tax treaty')”.
Learned counsel fairly accepts that the issue is covered, against the assessee, by a series of orders passed by the various co-ordinate benches in assessee’s own case as also in the cases of Chohung Bank vs. DDIT [(2006) 6
Assessment Year: 2004-05 Page 2 of 11 SOT 144 (Mum)] and JCIT vs. Sakura Bank Limited [(2006) 100 ITD 215 (Mum)].In this view of this undisputed position and the conclusions arrived at by the learned CIT(A) being in harmony with the views of the co-ordinate benches, we reject the grievance of the assessee. No interference is thus called for.
Ground no.1 is thus dismissed.
In second ground of appeal
, the assessee is aggrieved that the learned CIT(A) has erred “in subjecting to tax, the interest paid by the Indian branches to the head office and overseas branches, amounting to Rs.1,59,32,854, as interest income, applying the provisions of Article
12. (Interest) of the India- France tax treaty.”
So far as this grievance of the assessee is concerned, relevant material facts are like this. The assessee before us is a foreign company, incorporated in France, carrying on the business of banking in India through it’s branch offices. During the course of scrutiny assessment proceedings, the Assessing Officer noted that the India Office of the assessee has paid interest to the tune of Rs.1,59,32,854/- to it’s head offices and overseas branches. It was in this backdrop that the assessee was required to show cause as to why interest so earned by the head office and overseas branches of the assessee not be treated as income of the assessee and brought to tax, in it’s hands, in India. It was explained by the assessee that since he was carrying on business in India, through a permanent establishment by way of branch, it is only the income of permanent establishment, on net basis, which can be taxed in India under Article 7. The income so earned by the permanent establishment has already been offered to tax, and nothing remains to be taxed. However, the Assessing Officer rejected these submissions and proceeded to bring the amount of Rs.1,59,32,854/- to tax in the hands of the assessee. His reasoning, in support of this action, is as follows:
6.3 I have considered the submissions of the assessee and the same are not acceptable on the basis of the following arguments. 6.3.1 Under the treaty, the income of a non-resident is characterized under the various head like business income, royalty, interest, fees for technical services, dividend etc. In case of business profits, income is to be computed only if the non-resident has a Permanent Establishment in India and the income attributable to such Permanent Establishment is taxable in India. In case of an assessee other than Bank, the payment of interest, royalty etc. by the branch to the Head Office is not allowable as a deduction (Refer to Article 7 (3) (b) of India France DTAA). However, in case of banks such deduction is specifically allowed. But such interest received by Head Office from the branch will be taxable under Article 12 of the Treaty at a lower rate of taxation. It is the benefit available to the banks in the Treaty and which is more beneficial than the provisions of the I.T. Act because if no deduction is Assessment Year: 2004-05 Page 3 of 11 allowed, the interest income will be taxable @ 40% and if the benefit is allowed, the same income is being taxed @ 10%. The CBDT circular No. 740 is dearly applicable to this case. Reliance can also be placed on the commentary of Klaus Vogel in his book “Klaus Vogel on Double Taxation Conventions-Third Edition" at para no.89 and 90 of page no. 750 which is reproduced as under: “89(b) Rule: Under article 11(5), interest shall be deemed to arise in a contracting state when- - the payer is - a resident of that State or - where, irrespective of the payer's residence, the interest is paid on the indebtedness of a permanent establishment (or fixed base) in that Contracting State and is borne by such permanent establishment (or fixed base). 90(d) The third criterion does not attach to the debtor's legal nature of residence. Instead, it attaches to the incurring of a debt for a permanent establishment (or a fixed base) and on the tatter's bearing the interest. Article 11(5) presupposes that the interest will reduce the profits to be taxed in the State of Permanent Establishment and that it will thus reduce that State's tax revenue. This loss is meant to be compensated by the arrangement in Article 11(2), which leaves taxation of interest to that State, as to the terms of Permanent Establishment.” The argument of the assessee regarding Article 7 are not applicable because of the deeming provision in article 7 which provides that the income of the branch should be computed as if it is a separate and distinct entity from the non-resident. 6.3.2 For the purpose of assessment, the entity is one though for the purpose of computation of income these are two separate entities. It means that if the assessee has business income from the branch and it has some other income like royalty which is received directly by Head Office and in which Permanent Establishment has no role to play the assessee is not required to file two separate returns for business income and royalty income. There will be only one return and one assessment but for the purpose of computation of income, branch is a separate entity and Head office is another entity.
Aggrieved, assessee carried the matter in appeal before the learned CIT(A) but without any success. Learned CIT(A) upheld the addition made by the Assessing Officer. While doing so, he relied upon the observations made by a co- ordinate bench, in the case of Dresdner Bank AG vs. ACIT [(2007) 108 ITD 375 (Mum)], to the effect that “for determination of income accruing or arising in India in the case of a foreign enterprise operating in India, it’s India operations
Assessment Year: 2004-05 Page 4 of 11 are to be taken as hypothetically independent unit, and therefore, intra organisation interest income would have to be taken into account to arrive at income accruing or arising in India under section 5(2)”. Learned CIT(A) then referred, and relied upon, the co-ordinate bench decision in the case of DCIT vs. British Bank of Middle East [(2008) 19 SOT 730 (Mum)] which also dealt with “interest income received by an Indian branch of a foreign banking company” from it’s head office and overseas branches. Relying upon these judicial precedents learned CIT(A) confirmed the impugned addition of Rs.1,59,32,854. The assessee is aggrieved and is in further appeal before us.
We have heard the rival contentions, perused the material on record and duly considered factual matrix of the case in the light of applicable legal position.
As for the Dresdner Bank decision (supra), relied upon by the learned CIT(A), we cannot be oblivious to the fact that Dresdner Bank case (supra) was dealing with a situation in which the assessee had specifically abandoned it’s reliance on the applicable tax treaty as evident from the Tribunal’s observations, in paragraph 20 of the order, that “we may place on record the fact that, during the course of arguments before us, the assessee abandoned it’s plea that in terms of the India Germany DTAA [(1997) 223 ITR (St.) 1307], the income of Rs.5,17,39,005 on account of interest received from head office and other branches of the assessee could not be taxed in the hands of the assessee” and that “in response to our specific question, …… (learned counsel) stated at the bar the assessee does not seek any treaty protection and would like this grievance to be adjudicated upon in the light of the provisions of the Income Tax Act.” As against this factual scenario, in the present case, the assessee has sought treaty protection and relied upon the provisions of the applicable DTAA, i.e. India France DTAA [(1994) 209 ITR (St.) 130]; [Indo French DTAA, in short]. Learned CIT(A) was thus completely in error in relying upon the Dresdner Bank decision (supra) on the facts of this case. As for the British Bank of Middle East decision (supra), it simply follows the Dresdner Bank decision and is not, therefore, required to be dealt with on standalone basis. The reliance on British Bank of Middle East decision (supra) thus is equally misplaced. The reasoning adopted by the first appellate authority was thus wholly devoid of legally sustainable basis.It is also important to bear in mind the fact that the decisions relied upon by the learned CIT(A) deal with the taxability of interest received by a PE from the GE (i.e. interest received by India branch of a foreign company from it’s head offices and foreign branches), whereas in the present case we are dealing with taxability of interest received by the head office or foreign branches, from the Indian PE of the foreign bank. These two situations, for the reasons we will set out in a short while, are materially different situations and are governed by different principles of determining taxable profits. Suffice to note, for the time being, that, under the scheme of tax treaties, what holds good for deduction in respect of interest received by the Indian PE from the overseas GE does not Assessment Year: 2004-05 Page 5 of 11 necessarily hold good, for the converse situations, i.e. interest paid by the Indian PE to the overseas GE. We will deal with this aspect of the matter, while dealing with the core contention of the Assessing Officer, in the analysis which is to follow.
We have noted that there is no dispute about deductibility of the interest payments in question in the computation of income of the assessee from it’s permanent establishment in India. The controversy is confined to the taxability of this amount in the hands of the assessee, as, according to the Assessing Officer, while the foreign company is one unit for the assessment purpose, “for the purpose of computation of income, these (i.e. HO and Indian PE) are two separate entities.” Thus, going by the revenue’s stand when an Indian PE claims deduction in respect of any payment to it’s head office or other branches, while deduction will be allowed in computation of profits attributable to the PE, corresponding addition will be made in the hands of the foreign branches or head office, as the case may be. A deduction thus allowed to the PE, if revenue’s contention is to be upheld, will be completely profit neutral.
The approach so adopted by the revenue authorities, on the first principles, is contrary to the scheme of the tax treaties.
The fiction of hypothetical independence of a PE vis-a-vis it’s GE and other PEs outside the source jurisdiction is confined to the computation of profits attributable to the permanent establishment and, in our considered view, it does not go beyond that, such as for the purpose of computing profits of the GE. Article 7(2) of the India France DTAA specifically provides that when enterprise of a treaty partner country carries out business through a permanent establishment, “there shall, in each contracting state, be attributed that permanent establishment, the profit which it 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 a permanent establishment”. This fiction comes into play for the limited purposes of computing profits attributable to permanent establishment only and is set out under the specific provision, dealing with computation of such profits, in the tax treaties, including in the Indo French DTAA. There is nothing, therefore, to warrant or justify application of the same principle in computation of GE profits as well. Clearly, therefore, the fiction of hypothetical independence is for the limited purpose of profit attribution to the permanent establishment.
To that extent, this approach departs from the separate accounting principle in the sense that the GE, to which PE belongs, is not seen in isolation with it’s PE, and a charge, in respect of PE – GE transactions, on the PE profits is not treated as income in the hands of the GE.
Assessment Year: 2004-05 Page 6 of 11 14. As a corollary to the above position, the observations made in the Dresdner Bank’s case (supra) to the effect that “since there are no specific legislative provisions to keep pace with this aspect of increased cross-border commerce, by providing for mechanism to compute profits accruing or arising in India in the hands of the foreign entities, the profits attributable to Indian PE of foreign enterprise are required to be computed in terms of general provisions of the IT Act, and the normal accounting principles” and that “Therefore, ascertainment of a foreign GE’s taxable business profits in India involves an artificial division of the overall profits of the GE—between profits earned in India and profits earned outside India. Indian IT Act can only be concerned with the profits earned in India, and, therefore, a method is to be found to ascertain profits accruing or arising in India” which were also expressed by Hon’ble Supreme Court in the case of CIT Vs Hyundai Industries Co Ltd [(2007) 291 ITR 482 (SC)], do not apply to the treaty situation such as we are dealing with at present. On both of these occasions, before the coordinate bench as also before Hon’ble Supreme Court, these observations were made in the context of ascertainment of profits under the scheme of the Income Tax Act, 1961. That’s not the situation in the treaty situation, and, as per the mandate of Section 90, the provisions of the Income Tax Act cannot be thrust upon the assessee unless these provisions are favourable to the assessee vis-à-vis treaty provisions. That is the reason that the theory of separate profit allocation for the PE and GE, and computation of profits of the GE on the basis of its hypothetical independence- which has been reiterated, and thus approved, by Hon’ble Supreme Court in the case of Hyundai Industries Co Ltd (supra), does not come into play in respect of the treaty situations.
15 As far as the treaty situations, as in the case of Indo French DDTAA, are concerned, once an enterprise is found to be carrying on the related business or profession through a permanent establishment or a fixed base in the other contracting state, the scheme of taxability on the gross basis, as implicit in the taxation of dividend, interest, royalties and fees for technical services, and other incomes, under the tax treaties, comes to an end. In Indo French DTAA, for example, articles 11(6), 12(5), 13(6) and 23(2) provide so.
The incomes, so relatable to the PE, are then taxable on the net basis as the PE income in the sense when these are earned from third parties through the PE, these receipts constitute incomes attributable to the PE, and when these receipts are by the enterprise from the PE itself, the entire income, generated by the business with the help of the inputs for which payments are made by the PE to the HO, is taxed as income attributable to the income of the PE.
So far as the banking business is concerned, an exception, with respect to deductibility of, and taxation of, intra GE interest is carved out in the relevant treaty provision itself. Article 7(3)(b) of the Indo French DTAA provides as follows:
Assessment Year: 2004-05 Page 7 of 11
(b) However, no such deduction shall be allowed in respect of amounts, if any, paid (otherwise than towards reimbursement of actual expenses) by the permanent establishment to the head office of the enterprise or any of its other offices, by way of royalties, fees or other similar payments in return for the use of patents or other rights, or by way of commission for specific services performed or for management, or, except in the case of a banking enterprise, by way of interest on moneys lent to the permanent establishment. Likewise, no account shall be taken, in the determination of the profits of a permanent establishment, for amounts charged (otherwise than towards reimbursement of actual expenses), by the permanent establishment to the head office of the enterprise or any of its other offices, by way of royalties, fees or other similar payments in return for the use of patents or other rights, or by way of commission for specific services performed or for management, or, except in the case of a banking enterprise, by way of interest on moneys lent to the head office of the enterprise or any of its other offices. [Emphasis, by underlining, supplied by us] 18. In view of the above specific provision, interest payments to the GE or other intra GE units abroad is fully deductible. This provision, however, is banking industry specific and it is a double edged sword inasmuch as it provides for the deduction in respect of interest paid to the GE and other intra GE units and it does also provide for taxation of interest received from the GE and other intra GE units.
Quite clearly, the provisions of the India France DTAA are materially different from the provisions of other tax treaties that the special bench was dealing with i.e. India Japan DTAA and India Belgium DTAA. In none of these treaties, there was no specific reference to taxability of interest received from the GE in the hands of the PE, as in the case of Indo French DTAA. What we have before us is a peculiar situation in which interest received from the GE, despite specific provision to that effect in article 7(3)(b), is not treated as taxable on the basis that interest credit in this regard is to be taxed on the basis of logic flowing from judicial precedents in the cases of CIT Vs Sir Kikabhai Premchand [(1953) 24 ITR 506 (SC)] and Betts Hartley Huett & Co Ltd Vs CIT [(1979) 116 ITR 425 (Cal)] and on the basis that the observations made in the CIT Vs Hyundai Industries Co Ltd [(2007) 291 ITR 482 (SC)] will not be apply to this situation, while interest paid to GE is held to be deductible in the light of the provisions of article 7(3)(b) being applied on the interest debit, which are preferred over the provisions of the domestic law in view of the provisions of section 90 of the Act. In effect, it is a hybrid application of the taxability under the domestic tax law and the treaty provisions on the same item in the same profit and loss account though appearing on different sides, i.e. debit and credit. Article 7(3)(b) of Indo French DTAA is thus partly applied and partly not applied. That’s what a series of coordinate benches, following the five member bench in the case of Sumitomo Mtsui Bank Corp (supra), have held to be permissible.
Assessment Year: 2004-05 Page 8 of 11 20. The peculiarities of Indo French DTAA do not, however, mitigate the overall scheme of the treaty that once the resident of the contracting state has a PE in other contracting state, what is taxable is the profit of the PE and on a net basis. Of course, going by the plain words of this particular treaty provision, interest received from the GE and other intra GE units is also to be taken into account in the computation of income attributable to the PE, but then we need really be concerned about that aspect of the matter since neither this issue is dispute before us nor the decision of a five member bench of this Tribunal in the case of Sumitomo Mitsui Banking Corp vs DDIT [(2012) 16 ITR (Tribunal) 116 (Mum)] is overruled as yet. To that extent, the provisions of the domestic law, having been held to be more beneficial to the assesses, hold the field.
It is also important to bear in mind the fact that a deduction, in respect of an internal charge, as is the inherent nature of an intra GE interest payment, being allowed in the computation of income attributable to the permanent establishment in the hands does not result in an income arising in the hands of the GE. It is a notional adjustment which is allowed in the computation of profit attributable to the permanent establishment. Explaining this hypothesis, Prof. Kees Van Raad, a well known international tax scholar, in his preface to “The Attribution of Profits to Permanent Establishments – The taxation of intra-company dealings [ISBN 90-76078-84-X; published by IBFD, Amsterdam]”, made the following observations:
“Since my early days of teaching international tax law I have tried to explain to students the relationship between a PE and the general enterprise of which the PE is a part, as that of an egg and the yolk it contains. I have further explained that, with regard to income attribution to PEs, the OECD Model does not require that a general enterprise is divided into two separate parts – a head office and a PE – and that, therefore, an internal charge borne by a PE will not yield income for anyone, but only produces a smaller amount of PE income to be taxed by the PE state and, correspondingly, a smaller amount of foreign income in respect of which the residence state needs to provide relief. I must admit that my attempts to get these views across have met with varying levels of success. Particularly students with an accounting background tend to be on the skeptical side …………………..”.
Clearly, the principles for determining the profits of the PE and GE are not the same, and the fiction of hypothetical independence does not extend to computation of profit of the GE. The principles of computing separate profits for the PE and the GE treating them as distinct entities, in the case of Dresdner Bank (supra), was in the context of Section 5(2). The separate profit centre accounting approach for the HO does not hold good in the treaty context, because, even if it is an income of the GE as a profit centre, all that is taxable as business profits of the GE is the income attributable to the PE. As regards its being treated as interest income of the assessee, arising in the source jurisdiction, i.e. India, can only be taxed under Article
Assessment Year: 2004-05 Page 9 of 11 12 but then as provided in article 12 (5), the charging provisions of Article 12(1) and (2), which deal with taxability of interest in the source state, will not apply “if the beneficial owner of the interest of the interest, being a resident of a contract state, carries on business in the other contracting state in which the interest arises, through a permanent establishment situated therein” and that in such a case the provisions of Article 7, which deal with taxability of profits of the permanent establishment alone will apply. In plain words, when interest income arises to a GE even if that be so, the taxability under article 12 will not apply, and it will remain restricted to taxability of profits attributable to the permanent establishment under article 7. The profits attributable to the PE have anyway been offered to tax. As regards the theory, as advanced by learned Assessing Officer in considerable detail, that for taxing the GE, the taxability has to be in respect of (i) income attributable to the permanent establishment as a profit centre; and (ii) income of the GE in its own capacity by treating it as another independent separate profit centre, for the detailed reasons set out above and particularly as the fiction of hypothetical independence does not extend to the computation of GE profits, we reject the same. The authorities below were, therefore, clearly in error in holding that the interest of Rs.1,59,32,854 paid by the Indian PE to the GE, or its constituents outside India are taxable in India.
We may also add that in the case of Sumitomo Mitsui Banking Corp (supra), a five member bench has held that interest payment by PE to the GE is a payment by a foreign company’s Indian PE to the foreign company itself, it cannot give rise to any income, in the hands of the GE, which is chargeable to tax under the Income Tax Act, 1961 itself, and, as such, treaty provisions are not really relevant. We humbly bow before the conclusions arrived at in this judicial precedent. Of course, we have reached the same destination by following a different path but then as long as reach the same destination, our traversing through a different path does not really matter at all. For this reason also, the grievance of the assessee deserves to be upheld.
Ground No. 2 is thus allowed.
In ground nos.3 & 4, which we will take up together, the assessee has raised the grievance that the CIT(A) erred “in holding that the remuneration aggregating Rs.14,661,695, received for marketing services rendered, as income accruing to the Appellant in Assessment Year 2004-05 even though the amount was crystallised only in Assessment Year 2005-06” and “in charging interest on remuneration for marketing services received in financial year 2004-05, on the premise that the delay in payment constituted a loan on which interest should have been charged at arm’s length”. The assessee has also taken an additional ground of appeal which states that “the learned AO erred in levying interest on the remuneration for marketing services owed to the Indian branches of the Appellant, amounting to Rs 1,46,61,695, as opposed to the arm's length price
Assessment Year: 2004-05 Page 10 of 11 payable to the Indian branches of the Appellant, amounting to Rs 1,27,95,030” and that “the learned AO erred in levying interest on the remuneration for marketing services, amounting to Rs.9,89,176, in financial year ('FY') 2003-04, as opposed to in FY 2004-05, as was directed by the Transfer Pricing Officer vide her letter dated June 1, 2006.”
The relevant material facts are like this. During the course of assessment proceedings, the Assessing Officer noted that the assessee had signed a transfer pricing agreement with it’s Singapore branch for the marketing service provided by India branch in respect of External Commercial Borrowings. Even though this agreement was signed on 28th March, 2005, it was retrospective in effect inasmuch as the services rendered from 1st August, 2003 were covered by this agreement. It was also noted that, in terms of the agreement, the assessee was entitled to “one third of interest margin, commitment fees etc.” It was noted that the amount of Rs.1,46,61,695 which pertained to the previous year relevant to this assessment year (i.e. year ended 31st March, 2004) but it is shown as income of the next year, i.e. year ended 31st March, 2005. It was also noted that even though the amount has been paid to the assessee after such a long time after the end of financial year ended 31st March, 2004, but no interest has been charged on the overdue amount. It was in this backdrop that the Assessing Office made an addition of Rs.1,46,61,695/- being remuneration for marketing services rendered during the relevant previous year, plus of Rs.9,89,176 being interest @ 7.36% on the delayed payment of this amount by the AE based in Singapore. Aggrieved, assessee carried the matter in appeal before the learned CIT(A) but without any success. Learned CIT(A) confirmed the stand of the Assessing Officer and justified the same as follows:- 86. I have gone through the issue. It is an admitted fact that Indian Branch provided the services to Singapore Branch during the accounting period relevant to this assessment year i.e. Assessment year 2004-05. The income accrues as and when the services are provided. There is no other contingencies available to show that the income has not accrued. The appellant is following the mercantile system of accounting and hence the income is taxable in this assessment year. The TPO and the AO has very elaborately discussed the issue and come to the correct decision. I completely concur with the decision. Further Transfer Pricing Regulations are in force for this assessment year. Even if the assessee has not raised and accounted the receipts for the services rendered, the AO is empowered to determine the Arms Length Price (ALP) and determine the income. The AO has properly determined the income as per the Transfer Pricing Regulations. In view of this addition made is in order and I uphold the AO’s action.”
The assessee is not satisfied and is in further appeal before us.
We have heard the rival contentions, perused the material on record and duly considered factual matrix of the case in the light of applicable legal position.
Assessment Year: 2004-05 Page 11 of 11 29. In our considered view, learned CIT(A) was completely in error in proceeding on the basis that income accrues when the services are rendered – even in situation in which consideration for services so rendered is not finalised. Unless the consideration for services is finalised between the parties, income from such services cannot even be quantified, and obviously quantification of income must precede it’s accrual. It is an undisputed position that the arrangements, which include the consideration for which services were rendered, were finalised only on 28th March, 2005. Such being the undisputed position, income could not have been quantified or accrued earlier. The very foundation of impugned addition is thus devoid of legally sustainable foundation.
As for the levy of interest, or ALP adjustment for interest, there cannot be any occasion to levy interest unless there is an unreasonable delay in realisation of debts. The question of delay comes into play when liability to pay has crystallized. The liability of interest on account of delay in payment will arise only when there is a liability to pay, and the liability to pay will arise, only when the liability has crystallized. The liability had not even crystallized at the material point of time. The order passed by the Transfer Pricing Officer does not give any reasons as justification for such a levy does not even recommend this adjustment.
In view of the above discussions, as also bearing in mind entirety of the case, we uphold the grievance of the assessee. Accordingly, addition of Rs.1,46,61,695 for marketing services and of Rs.9,89,176 in delay in realisation of the dues is deleted. This income of Rs.1,46,61,695 will, however, be taxable in the year in which right to receive the dues has crystallised.
With these observations, ground nos.3 and 4 and the additional grounds of appeal are allowed in the terms indicated above.