If a foreign company is liable to tax in India, even if not actually paying tax, has to necessarily file a return u/s 139(1): AAR

Also held:

The transfer pricing provisions from section 92 to 92F of the Act not attracted when sale and purchase of shares between non- resident companies.

VNU International v. Director of Income Tax, 28^th March, 2011

AAR No. 871 of 2010

Relevant Facts:

1. The applicant states that it is a tax resident of the Netherlands and does not have any permanent establishment in India.

2. The applicant first transferred 50% of shares it held in ORG-IMS, a company incorporated in India to IMS-AG, a company incorporated in Switzerland. After the transfer, the applicant was left with 50,765 shares of ORG-IMS, amounting to 50% of the total shares.

3. In a subsequent SPA, the applicant transferred 50% of the shares (50,765 shares) to IMS-AG & Interstatistik AG for a total consideration of ` 74,08,643. The shares were acquired for a consideration of ` 4,61,500.

Questions for consideration:

1. On the facts and circumstances of the case, whether any capital gain earned by VNU International on transfer of 50,765 shares of ORG-IMS to the purchasers would be liable to tax in India as per the provisions of the Act and the Tax Treaty between India and the Netherlands?

2. On the facts and circumstances of the case, if the capital gain is not taxable in India, whether the applicant is required to file any return of income under section 139 of the Act?

3. On the facts and circumstances of the case, whether the transfer of shares by the applicant to IMS AG attracts the transfer pricing provisions of section 92 to 92F of the Act?

4. On the facts and circumstances of the case, whether IMS AG were liable to withhold taxes under section 195 of the Act and if so, on what amount would the tax have to be deducted?

Partly upholding the application of the applicant, the Hon’ble Court held that:

Para 7: “ Transfer pricing provisions from section 92 to 92F of the Act would not be attracted as the sale and purchase of shares is between non- resident companies of the Netherland and Switzerland. Since there is no income chargeable to tax, there would be no liability to deduct tax u/s.195 of the Act.”

Para 8: “We are in agreement with the Learned Advocate that the capital gains earned by the applicant on transfer of shares would be covered by Article 13(5) of the Tax Treaty and shall be taxable only in the Netherlands, the state in which the transferor is a resident.”

Para 13: “...Then, as per the third proviso, every company is required to file its return of income, whether it has an income or a loss. The applicant being a foreign company, is covered within the definition of a company under section 2(17) of the Act. The applicant does not dispute that the income arising from the sale of shares is liable to be taxed in India by virtue of section 5(2) of the Act, though no tax is actually paid in India. It is a different matter that by virtue of DTAA the applicant is actually paying tax in the Netherlands. If the power to tax be granted it is difficult to appreciate the argument that when the resulting income is nil, there is no obligation to file return of income. It may be mentioned that where it is not necessary for a non- resident to furnish return under section 139(1) of the Act, the statue has specifically provided, as is the case under section 115AC(4) of the Act. Apart, it is necessary to have all the facts connected with the question on which the ruling is sought or is proposed to be sought in a vide amplitude by way of a return of income than alone by way of an application seeking advance ruling in Form 34C under IT Rules 1962. Instead of causing inconvenience to the applicant, the process of filing of return would facilitate the applicant in all future interactions with the Income tax department.”

The decision is available here.

Defining ‘Permanent Establishment’ in Electronic Commerce

The changing face of technology has also changed the way businesses function across jurisdictions. Transactions originate off the shore of the receiving country, yet the utilization occurs in the latter, or even in a third country. Section 9 of the Income Tax Act, 1961 in India seeks to tax such offshore transactions. However, the allocation of the right to tax is guided through the principles of the Double Taxation Avoidance Agreements (DTAA’s).

The Organization for Economic Co-Operation and Development (the “OECD”), has produced a Model Tax Convention on Income and on Capital (the “OECD Model Treaty”) which serves as a guide to treaties across jurisdictions.

Article 5 of the OECD Model Treaty defines a permanent establishment (“PE”). A PE is a concept used to determine the right of one treaty country to tax the profits of a resident of an enterprise of the other treaty country. Such profits that are attributable to the PE are subjected to tax.

To assist persons in understanding and applying the OECD Model Treaty, the OECD also publishes commentary (the “OECD Commentary”) on the model treaty. One issue specifically addressed in the OECD Commentary on Article 5 is the extent to which engaging in electronic commerce may result in a PE (See Paragraphs 42.1 to 42.10 of the OECD Commentary on Article 5, available here).

Electronic commerce is the ability to perform transactions involving the exchange of goods or services between two or more parties, using electronic tools and techniques, which includes physical telecommunications networks, cable television, mobile, and cellular networks.

The OECD Commentary states that a web site does not itself involve any tangible property, and thus, cannot constitute a PE. However, if there exists a physical location and the requirement of the equipment being fixed is met, then the tangible property may constitute a PE.

This distinction between a web site and the server on which the web site is stored and used is important since the enterprise that operates the server may be different from the enterprise that carries on business through the web site. A server is generally owned and controlled by an unrelated Internet service provider (“ISP”). A contract for such hosting services does not typically result in the server and its location being at the disposal of the enterprise carrying on a business through the web site.

Consequently, the enterprise does not have any physical presence at the location where the server is located. This is because the web site is not tangible and the server is not at the disposal of the enterprise. The OECD Commentary notes that it would be very unusual for the ISP to be deemed to constitute a PE of the enterprise carrying on a business through a web site hosted on the ISP’s servers. Generally, the ISP will lack authority to conclude contracts in the name of the enterprise conducting the web site business (and will not regularly conclude such contracts) and will constitute an independent agent acting in the ordinary course of its business. The result may be different if the enterprise carrying on business through a web site has the server at its disposal because, for example, it owns (or leases) and operates the server. In such a case, the place where the server is located may constitute a PE. The argument that a server constitutes permanent establishment has been relied upon in certain negotiations for taxation in India.^[i]

Policy Comments: The basis of the PE principle rested on the concept in the pre-digital age whereby accessing a market would require a business to establish in a host state in some form. This can now be achieved by sending bits of information via web into the host state, including exchange of payment.^[ii] The erosion of PE as a tax treaty principle has been advocated by Arvid Skaar in his book ‘Permanent Establishment: The Erosion of a Tax Treaty Principle, 1st Indian reprint, Wolters Kluver India, New Delhi, 2008.

It is clear that in the present day scenario, the use of PE as a method of taxing operations in the host state is not feasible. This is due to the growth of e-commerce as a tool of business. The High Powered Committee on Indian Electronic Commerce and Taxation, has suggested a ‘base erosion’ approach to tax non-residents. The salient features of the concept are:

• The concept is applied to all commerce and not just e-commerce.
• The tax is implemented through a low withholding tax on all tax-deductible payments to the foreign enterprise.
• Preferably, the withholding tax is final without option of tax on net income being given to the taxpayer or the tax administration.

However, this would involve the concept of indirect taxation, including customs and thus, might not be a viable concept.

A more practical concept to adopt would be the “proxy access to market” concept. Under this concept, there is a radical shift from the country of 'value creation' to the country in which the market is accessible. While creation of value can now be achieved by automated software functions bearing no relationship to geographic boundaries, the same can be said for businesses' market access efforts. This subtle distinction between "location of value-creation" and a "market access" vantage also shifts consideration away from the existing arguments about e-commerce taxing jurisdiction and stimulates greater scrutiny of the activities used by e-traders/service providers to market their products. This would benefit developing nations to tax offshore operations of business, channeled through e-commerce.

Adding this market access proxy approach to the current debate featuring arguments for either revision or preservation of the traditional permanent establishment principles, in many cases, adds increased complexity and justification to proposals advocating reform.

Under the current PE rules, producers are increasingly able to use the nebulous nature of the web to avoid or minimize tax liabilities. We shall discuss in detail how Google has achieved an effective tax rate of 2.4% through its business structuring. At the same time it also translates into revenue loss for the exchequer.

Post Scriptum: It is important to note that the rules discussed above apply only in the treaty context, i.e., where the enterprise operating the website and the ISP are located in countries that have concluded an income tax treaty based on the OECD Model Treaty. Entirely different rules can apply if there is no treaty to rely upon.

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[i] Jonathan Rickman, Indian, U.S. Authorities Agree Server Constitutes PE, 32 TAX NOTES INT'L 134 (2003)

[ii] Arthur J. Cockfield, Designing Tax Policy for the Digital Biosphere: How the Internet is Changing Tax Laws, 34 CONN. L. REV. 333 (2002)