NEW CAPITAL ALLOCATION RULES FOR PERMANENT ESTABLISHMENTS (ARTICLE 7 AOA)

The 2010 Commentary to the OECD Model contains the new Rules for the Authorised OECD Approach (AOA) for attributing capital of business to Permanent Establishment (PEs). The AOA provides that the profit that should be attributed to a PE is the profit it might be expected to make if it were separate and independent enterprise. The principle underlying it is that the arm’s length principle should be applied to attribute profits to PEs. Put simply, in split of recognizing that a PE is part of the global business enterprise, each part is sought to be treated as a separate and distinct enterprise, and arm’s length pricing between each arm is sought to be introduced, for all transactions. By extending this analogy, even part of the debt at the enterprise level is sought to be allocated  to the PE, and hence the corresponding interest cost is to be considered as deductible. This will significantly reduce the tax base in the developing countries, in favour  of the developed countries, which is analysed in the Article.

Peculiarities of Taxation of Permanent Establishments (“PEs”)

Taxation of PE has been a problem due to the fact that it is not a legal entity, and therefore there is a gap between tax law and private law. In 2008, the Committee on Fiscal Affairs of OECD published a report on the issue of attribution of profits (or losses) to a PE. Article 7 of the Model Convention (“MC”) provides that the profit that should be attributed to a PE is the profit it might be expected to make if it were a separate and independent enterprise. The principle underlying it is that the arms’ length principle should be applied to attribute profits to PEs. The 2008 report culminated a change in the OECD MC in 2010. While doing so, it extended the limited independence fiction of the 2008 report to the extended independence fiction. Article 7.1 of the MC provides that the profit 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 PE situated therein. The profits attributable to the PE, in accordance with Article 7.2 , may be taxed in that state. Further, Article 7.2 provides that the PE shall be seen as a separate and independent enterprise in particular in  dealing with other parts of the enterprise,  when the PE is engaged in the same or similar activities under the same or similar conditions taking into account the functions performed, assets used and risks assumed by the enterprise through the PE and through the other parts of the enterprise.

Article 7 does not seek to allocate the overall income of the whole enterprise to the PE, instead it requires the profits or losses attributable to the PE to be calculated as if it was a separate enterprise. Income may thus be attributed to a PE even though the enterprise has not made any profits and the other way around.

The focus is on formulating the most preferable approach to attribute profits to a PE under Article 7.2 of the MC in a modern way. The report is based upon an analogy to the TP Guidelines. The new approach of the OECD for attribution of profits to a PE is known as the Authorised OCED Approach (“AOA”). In this article, an analysis on the AOA, to the extent it deals with capital attribution, has been made. Some of the conclusions in this regard are also applicable treatment  of royalties between different parts of the same enterprise.

The Authorised OECD Approach (“AOA”)

The AOA is to apply the TP Guidelines by analogy. The profit of the PE is the profit attributable to it according to the arm’s length principle, in particular in dealings with other parts of the enterprise,  as if it was a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the PE and through other parts of the enterprise.

According to the AOA  a two-step analysis is required for this purpose. Step one consists of a functional and factual analysis, which must identify the economically significant activities and responsibilities  undertaken by the permanent establishment. Step two consists of applying the transfer pricing tools in Article 9 of the MC applied by analogy to dealings between the PE and the rest of the enterprise, by reference to functions performed, assets used and risks assumed. The end result of this two-step analysis is to determine the calculation of profits (or losses) of the PE from all its activities.

The focus is on formulating the most preferable approach to attribute profits to a PE under Article 7.2 of the MC in a modern way. The report is based upon an analogy to the  TP Guidelines. The new approach of the OECD for attribution of profits to a PE is known as the Authorised OCED Approach (“AOA”)

Step One – The functional and factual analysis

The functional and factual analysis, in the first step, takes account of the functions performed by the personnel (the people functions) of the enterprise as a whole and assesses what  significance they have in generating profit. Risks and assets must be attributed to the PE on the basis of the functions performed, and an “open minded” approach is required in order to determine to which part of the enterprise the economic ownership of the assets should be attributed. The economic ownership principle is vital to the attribution of profits to the PEs, and is based on the assumption that assets are to be economically attributed to that part of the enterprise that needs them in order to perform its functions, Once the exercise of attribution of assets (which may also include intangible assets, self generated or otherwise) risks based on functional analysis is completed, the next step is to determine and attribute “free capital” to the PE.

Measurement of Capital under the AOA

The term “free” capital is defined as an investment which does not give rise to an investment return in the nature of interest that is deductible for tax purposes. According to the AOA, the PE should have an appropriate amount of capital in order to support the functions it performs, the assets it uses and the risks it assumes. The process of attributing “free” capital to the PE involves two stages; the first involves a measurement of the risks and valuation of the assets attributed to the permanent establishment, and the second is to determine the “free” capital the permanent establishment needs to support these risks and assets. This results in a need to draw up a “tax balance sheet” of the PE. The “separate and independent enterprise” hypothesis requires that an appropriate portion of the enterprise’s “free” capital be attributed to its PEs for tax purposes. An attribution of “free” capital in excess of the amounts recorded in or allotted to the PE by the home cothe PE for any other purpose”.

The process of attributing “free capital” to the PE involves two stages; the first involves a measurement of the risks and valuation of the assets attributed to the permanent establishment, and the second is to determine the “free” capital the permanent establishment needs to support these risks and assets.

The purpose of preparing the tax balance sheet and determination of free capital is to determine how much debt of the enterprise as a whole can be considered as attributed to the PE, and consequently how much of the corresponding interest cost can also be so attributed while determining the income of the PE. Till the 2008 report, such interest allocation while computing PE profits was not possible. When it comes to the valuation of assets, there are several options. One option is to use the accounting value of the assets, another is to use the market value of the assets and third is to use the purchase price or cost. While the third method seems to have certain advantages, mainly because if there was a debt incurred for the acquisition of the assets, the debt would also be corresponding to such cost itself, when it comes into measurement of the risks, one may use the enterprise’s own measurement tools. The attribution of “free” capital to the PE needs to be done on an arm’s length basis, i.e. in accordance with where the assets and associated risks have been attributed and should take into account the specific functions, assets and risks of the PE relative to the functions, assets and risks of the enterprise as a whole.

The AOA has several approaches for the  determination of the “free” capital, which are briefly discussed below:

(i) Under the capital allocation approach, “free” capital allocated on the basis of the proportion of assets and risks attributed to the permanent establishment. The problem with this approach is the possibility with this existence of different market conditions, different business activities or that the enterprise itself is thinly capitalized, which may or may not get fructified.

(ii) Under the thin capitalization approach, “free” capital is allocated on the basis of debt-equity ratios of independent enterprises in the host country of the PE, carrying on the same or similar activities under the same or similar conditions. The problem with approach is that it might be hard to apply it outside the financial sector.

(iii) Under the economical capital allocation approach, “free” capital is allocated on the basis of the measurement of the risks. The problem with the approach is that the non-financial enterprise do not have developed system for measurement of risks.

(iv) Under the safe-harbour approach/quasi thin capitalization approach/regulatory minimum capital approach, the free capital is based on local regulatory requirements, especially for banks. This per se is not based on principal of AOA, as the AOA starts with premise that the business and the PE have the same creditworthiness. In practice, it is also difficult to find a objective benchmark which could be applied.

(v) In addition, other method have been discussed for insurance business. Which are not discussed here, as being too specific.

(vi) There are also discussions for thinly capitalized businesses, (the so-called $2 companies, which have $2 as capital, and $1 million as debt). For the same reason as in the processing paragraph, these too are not discussed here.

Allocation of Funding Cost/interest Expense.

The AOA acknowledges that the PE needs funding, made up of both “free” capital and interest-bearing debts. Once the amount of funding required is established, based on the foregoing discussion, the “free” capital of PE is determined. The excess of assets attributed to the PE over its “free” capital is the debt attributed to the PE. Cost of such debt needs to beascertained for attributing to the PE, so that its profits can be ascertained.

According to AOA there are two approaches to determine an allowable interest deduction for the PE. These are (i) the tracing approach; where the interest rate on the funds provided to the PE are determined to be the same as the actual interest of the third party provider of the funds; and (ii) the fungibility approach; where the PE is allocated a portion of the whole enterprise’s actual interest rate paid to the third party. Such interest attribution only for the purpose of ascertaining  the profits of the PE, and no actual payment of such interest to the other parts of the enterprise is expected. This being so, in the absence of actual payment of interest from the source country, it will not be able to even collect withholding tax on such interest being reduced while ascertaining the PE profits. The 2010 Report, under certain circumstances, also permits allocation of interest cost on internal debts, i.e. which are not backed by a debt from a lender either in the head office, or in any other part of that enterprise.

Step Two – Determination of profits of the PE

This step involves determination of profits of the PE. When it comes to the determination of profit of the separate and independent enterprises, the AOA is to undertake a comparison of dealings between the PE and the rest of the enterprise, with transactions between independent enterprises, which includes allowance for interest incurred at a place other than the PE state.

Example

Notes :

1. Capital  at enterprise level is 20% of assets, hence at PE level also taken in same proportion.

2. In interest tracing option debt for PE attributed fully to PE. Excess funding by the Head office, by whatever name called, will not get any interest attribution.

3. In fungible interest option, entire excess of assets over capital treated a composite debt, and interest allocated on proportion of debt a PE (400) to aggregate debt (800) – i.e. 50%.

The excess of assets attributed to the PE over its “free” capital is the debt attributed to the PE. Cost of such debt needs to be ascertained for attributing to the PE, so that its profits can be ascertained.

A Critique of the AOA

1. The AOA does not discuss frequency of recalculation of capital, viz. at beginning, or after every transaction, or at year end”

2. Interest cost allocation will generally reduce the profits remaining taxable for the PE. Besides, as noted earlier, the source state will not be able to tax the interest so allowed in the hands of the recipient of interest, loading to base erosion in the PE state.

3. The interest cost allocable to the PE can significantly increase if the “tax balance sheet” is drawn at market values (especially if intangibles are also included), which is one of the permitted methods of drawing it up. This will jack up the assets base to be allocated, and any allocation on such higher base to the PE, will result in higher assets being attributed to the PE, will result in higher assets being attributed to the PE, leading to higher debt being so attributed, and therefore higher interest cost, and so lower profits remaining to the taxes at the PE.

4. As a result of such interest attribution and erosion of tax base in the source country,  what will happen is that that the source state will get less tax. As a corollary, in the residence state, the enterprise will get lower tax credit taxes paid in source states. Consequently, the residence state will get a higher tax quantum. In other words, the taxpayer in  residence country will incur compliance costs to increase the taxes in his country, and not to save his own overall tax liability.

5. The AOA also seeks to recognize royalties between different arms of the same enterprise. This will further erode the tax base in the source country.

6. It is generally known that PEs are located in developing countries, while the business have their residence developed countries. The latter being part of the OECD,  and the former by the UN. Both these organizations have different interest groups to support , and at times conflicting interests are compared with a football match. Looking at the glaring unfairness in the allocation of income to the PE state under the new approach, the developing countries sure hope and pray that the UN wins this game, as even though there are provisions of letting the domestic law prevail, and the recourse to MAP, how many countries will be able to resist the “persuasive” pressure from OECD MC ? will David win over Goliath again? Else the developing countries will be deprived of their share in the pie.

7. This view is based on the concept that is the place of income generating activity rather that the jurisdiction where the income producer resides that economically contributes to the production of income and should be compensated for that contribution.

8. Perhaps if there are so many contradicting views on calculation of profit attribution to a PE, then it is right time that an alternative tax system is conceived, which allocates taxing rights beyond PEs.

Interest cost allocation will generally reduce the profits remaining taxable for the PE. Besides, as noted earlier, the source state will not be able to tax the interest so allowed in the hands of the recipient of interest, leading to base erosion in the PE state.

 Fixed Place of Business

The starting point for determination if a permanent establishment exists is generally a fixed place of business. The definition of permanent establishment in the OECD Model Income Tax Treaty is followed in most income tax treaties.[3]

The commentary indicates that a fixed place of business has three components:

• • Fixed refers to a link between the place of business and a specific geographic point, as well as a degree of permanence with respect to the taxpayer. An "office hotel" may constitute a fixed place for a business for an enterprise that regularly uses different offices within the space. By contrast, where there is no commercial coherence, the fact that activities may be conducted within a limited geographic area should not result in that area being considered a fixed place of business.

  • A place of business. This refers to some facilities used by an enterprise for carrying out its business. The premises must be at the disposal of the enterprise. The mere presence of the enterprise at that place does not necessarily mean that it is a place of business of the enterprise. The facilities need not be the exclusive location, and they need not be used exclusively by that enterprise or for that business. However, the facilities must be those of the taxpayer, not another unrelated person. Thus, regular use of a customer's premises does not generally constitute a place of business.

  • Business of the enterprise must be carried on wholly or partly at the fixed place.

However, it would be pertinent to note that the requirements of what constitutes a 'permanent establishment' within the scope of a particular treaty would depend on what interpretation a particular country places on that term, in context of the text of that treaty. As per Article 3 of the Vienna Convention, no one is entitled to claim rights under a particular treaty unless otherwise authorized by the contracting state. Therefore if a particular contracting state places a different meaning on the term permanent establishment than what the taxpayer seeks to place, the taxpayer would be left with virtually no remedy within that state, other than to seek a mutual agreement to that dispute with the other contracting state to that treaty.

[] Specifically included Places

The following are generally considered, prima facie, as constituting permanent establishments

• • A branch

  • A warehouse (but see excluded places below)

  • A factory

  • A mine or place of extraction of natural resources

  • A place of management

[] Specifically excluded Places

Many treaties explicitly exclude from the definition of PE places where certain activities are conducted. Generally, these exclusions do not apply if non-excluded activities are conducted at the fixed place of business. Among the excluded activities are:

• • Ancillary or preparatory activities

  • The use of a storage facility solely for delivery of goods to customers

  • The maintenance of a stock of goods owned by the enterprise solely for purposes of processing by another enterprise (sometimes referred to as toll processing)

  • Purchasing or information gathering activities

[] Other specific provisions

Many treaties provide specific rules with respect to construction sites. Under those treaties, a building site or construction or installation project constitutes a PE only if it lasts more than a specified length of time. The amount of time varies by treaty.

In addition, the activities of a dependent agent] may give rise to a PE for the principal.  Dependent agents may include employees or others under the control of the principal. A company is generally not considered an agent solely by reason of ownership of the agent company by the principal. However, activities of an independent agent generally are not attributed to the principal.

Some treaties deem a PE to exist for an enterprise of one country performing services in the other country for more than a specified length of time or for a related enterprise.

When a foreign enterprise undertakes any work in India involving construction, assembly, installation or commissioning of any building or project or supervisory activities in connection therewith, a question arises whether such activities create the foreign enterprise’s Permanent Establishment (PE) in India or not. The foreign enterprise will be liable to tax in India only if the PE exists.

Normally, all the tax treaties contain a definition of PE. PE generally means a fixed place of business. It includes a construction site and installation project provided such activities last more than the specified time. For example, as per Article-5 of Indo-Mauritius tax treaty: “A building site or construction or assembly project or supervisory activities in connection therewith, where such site, project or supervisory activities continue for a period of more than nine months” will constitute a PE. In other words, if the activities are for less than nine months, there will be no PE.

This issue has recently been discussed in case of Cal Dive Marine Const. (Mauritius) Ltd. 182 Taxman 124 (AAR).

A Mauritian company entered into an agreement with an Indian company for laying pipelines under the Indian Ocean. The Mauritian Company’s scope of work includes services to be executed partly outside India and partly within Indian territorial waters.

Based on the above facts the Mauritian Company approached the Authority for Advance Ruling (AAR) to decide its tax liability in India.

The AAR debated at length whether the activities of Mauritian company in India would constitute a Permanent Establishment within the meaning of Indo-Mauritius tax treaty.

The relevant dates for deciding this issue are as underDate of signing of agreement: 04.12.2007

Intermittent visits of project management Intermittent visits of project management: April ’08 to September ’08

A visit of PM TeamA visit of PM Team: January ’09 to February ’09

Commencement of logistic services: September 2008.

Pre-construction surveyPre-construction survey : November ’08

Entry into sea waters to lay pipeline: 09.02.2009

The expected date of completion: 31.03.2009

The foreign company submitted that the project commences only on 09.02.2009 when the actual work would start. In that case, the period of project is much less than 9 months. On the other hand, the department argues that starting point of limit should be reckoned from the date of signing of the contract. If this view is accepted then the duration of project would be more than 9 months.

The AAR observed that the argument that the starting point of time-limit has to be reckoned from the date of signing the contract seems to be far-fetched. The project commencement cannot in the absence of any definite indicia be equated to be contract signing date.

On the other hand, it would be too narrow a view to take if the commencement of active phase of construction / installation is held to be the starting point. The preparatory stages leading to the actual commence­ment of the work such as gathering the equipment and arranging the infrastructure for carrying out the work in full swing should legitimately fall within the ambit of the project duration.

In fact the correct legal position is that which strikes a balance between the extreme and narrow views. Accordingly, preparatory work for starting the project has to be distinguished from purely preliminary activities. Occasional short visits for negotiations or doing some paper work in connection with the project or for taking the soil samples, broadly speaking, will not trigger the start of the time-limit.

It is implicit in the very concept of PE and the expression ‘fixed place of business’ that it should be in existence for a fairly long time and merely carrying on some activities intermittently or for a short while do not impress the place with the character of a fixed place through which the business of the enterprise is carried on.

In view of the above, in the instant case, the starting point cannot be earlier than October, 2008.

Term Resident In DTA Agreemnet

A resident: The definition of the term, resident, is central to the application of a treaty because treaties often assign the taxing authority to the state of residence. Each contracting state defines residence for individuals and companies under its domestic law. However, the definition of residence under a DTAA may be the same as that under the regular tax laws of a contracting state, i.e. based on the number of days stay in that country or other such criterion, or on the basis of whether he has a permanent home in both states, or where his personal and economic relations (center of vital interest are greater.

If the center of the vital interests cannot be determined, then the habitual abode test is applied. In the absence of habitual abode, citizenship may be the determining factor. If the person is a citizen of both/ states or neither, some DTAAs specify that it will be the phase of effective management which is determinative.

Term Permanent Establishment

One important term that occurs in all the Double Taxation Avoidance Agreements is the term 'Permanent Establishment' (PE), which has not been defined in the Income- tax Act.

There is a consensus that the host country can tax income of foreign companies only if it maintains a PE. Normally, a PE includes the following:

• • a place of management.

  • a branch.

  • an office.

  • a factory.

Thus, a PE takes the form of a facility, a construction site or an agency relationship, all of which require a measure of permanence.

India's approach has been to enlarge the definition of PE, so as to get maximum tax revenue. In general terms, a business connection is deemed to exist if there is any continuous relationship between a business carried on in India and, a non-resident person who derives income through this connection. There must be a continuity of transactions so as to establish a business connection. Normally, the time period to constitute a PE in the host country is six months. Another issue is the scope of income earned by a PE in a country, i.e., what is the portion of the income of PE earned in India that can be taxed. Under the 'Attribution Rule', only those profits are taxable which are attributable to the PE, computed on the basis of a hypothesis that the establishment in a country is completely independent of the head office in another country. The profits, which such an independent enterprise might be expected to derive on the amount so ascertained, are taken into account in the computation of the business income of the PE. Under the force of an attraction rule, the income, arising from all sources in a country, where a foreign enterprise maintains a PE is subject to tax in that country. This means that in addition to the profits attribution to the PE, those attributable to the sale of goods or merchandise and activities, similar to those carried on through the PE in another country are also taxable in the source country. Thus, in keeping with India's stand that the country of source has a greater right to tax the profits of all enterprises of the country as compared to what it had in the treaties, based on the OECD model. As an alternative, all income in the source country which is not covered by the PE may be subject to the withholding tax if under the domestic law of the country, the income in question is taxable.

Term Busines Income In DTA Agreement

As a general rule, each country will tax a non-resident enterprise, engaged in the active pursuit of business in its territory, with a certain degree of intensity and regularity. Historically, the treatment of business income of a taxpayer is governed by a tax convention, which is tied to the 'permanent establishment' concept. A business enterprise or undertaking is subject to income tax on its industrial and commercial profits on parity with local enterprises in a treaty country, but only when it is engaged in trade or business in the country through a permanent establishment.

Income From Air And Shipping Transport, Taxed Under A DTA Agreement Income, derived from the operation of Air transport in international traffic by an enterprise of one contracting state, will not normally be taxed in the other contracting state. An air transport company will be liable to tax only in the treaty country in which it is incorporated. However, this does not apply to aircraft companies, engaged in domestic traffic. In respect of an enterprise of one contracting state, income earned in the other contracting state from the operation of ships in international traffic, will be taxed in that contracting state, wherein the place of effective management of enterprise is situated. However, some DTA agreements contains provisions to tax the income in the other contracting state also, although, at a reduced rate. These provisions do not apply to coastal traffic.

To-constitute-fixed-place-permanent-establishment-three-criterias-needs-to-be-satisfied-

Mumbai Ruling: In order to constitute a fixed place permanent establishment (PE), three criteria have to be satisfied viz. (a) the physical criterion (existence of physical location) (b) subjective criterion (right to use that place) and (c) functional criterion (carrying on business through that place). It is only when the three conditions are satisfied that a PE under the basic rule can be said to have come into existence. The onus is on the Revenue to show that the assessee has a PE (Airlines Rotables Limited v JDIT).

Facts:

Airlines Rotables Limited (the assessee / ARL), a resident of United Kingdom (UK), was engaged in providing spares and component support for aircraft to the aircraft operators. The assessee entered into an agreement with Jet Airways Limited (the airline), an Indian company engaged in the business of air transportation, for providing certain support services in respect of Boeing 737 aircrafts.

As per the agreement, when the airlines discovered that an aircraft component became operationally unserviceable (not in a condition to be used or was not airworthy), the same was to be repaired or overhauled by the assessee and the assessee also had to ensure that airworthiness directives in respect of the same were to be complied with. In addition to repairs and overhauling, the assessee also had to provide a replacement component which could be used by the airline during the period its original equipment was under repairs or overhauling by the assessee. The assessee was also responsible for providing replacement rotables (see Note- 1) , on exchange basis, required for an aircraft as a result of operational unserviceablity.

In order to ensure availability of replacement components and no interruption of the flight operations due to repairs and servicing of the components, the assessee company had provided stock of such components, as agreed with the airlines, at the operating bases of the airlines. In addition to this, the assessee had also maintained a stock of components at its main depot in the UK from which the assessee used to provide replacement components within time limits specified in the agreement and which varied depending upon the urgency of requirements. As the assessee did not have any storage or support facilities in India, the stock in India were in the possession of the airlines itself, though as a bailee.

During the course of assessment proceedings, the Assessing officer (AO) did not accept the claim of the assessee that it did not have a PE in India. The AO noted that the store staff of airline was acted as agent of the assessee and this relationship had resulted in a PE coming into existence. In this regard, he relied upon Article 5(4) of India-UK Double Tax Avoidance Agreement (tax treaty) – dependent agent on account of habitual maintainance and regular supply of goods therefrom. Further, he was of the view that assessee’ s stock were permanently kept at fixed places in India, with clear identification of each of stock item and therefore, the assessee had a fixed placed of business in India. He also noted that the exclusions clauses in Article 5(3) of the tax treaty were not applicable in the instant case. Accordingly, he concluded that the assessee had a PE in India as per Article 5 of the tax treaty and hence, receipts would be taxable in India as business profits. He further estimated 10% of gross receipts as its profits liable to be taxed in India.

On appeal, the Commissioner of Income tax (Appeals) [CIT(A)] held that the assessee had a fixed place of business within the meanings of Article 5(1) and 5(4) of the tax treaty since the assessee was having a fixed place of business in which goods were kept as stock for sale. He also observed that “the issue of sale has to be understood in its widest meaning in relation to business transactions” and added that “the assessee is engaged in the business or providing repairs to the faulty components of Boeing”. The CIT(A) thus justified that delivery of such repaired parts amount to sales as income is arising out of such delivery of goods and the repaired parts.

The assessee therefore preferred an appeal before the Income tax Appellate Tribunal (Tribunal). Questions before the Tribunal:

•        Whether the assessee had a PE in India?

•        Whether an adhoc rate of 10% can be applied for determining the profits attributable to alleged PE in India?

Tribunal’s observation and Ruling:

•        In terms of Article 5(1), i.e. the basic rule, a PE is said to exist in the other contracting state when an enterprise of one of the contracting states has a fixed placed of business, in that other contracting state, through which business is carried out – wholly or partly.

There are three criterions embedded in this definition – (i) physical criterion i.e. existence of physical location, (ii) subjective criterion i.e. right to use that place and (iii) functionality criterion i.e. carrying out of business through that place. It is only when these conditions are satisfied, a PE under the basic rule can be said to have come into existence.

•        Undoubtedly, the consignment stock of the assessee was stored at specific physical locations; but this storage was under control of the airline and the assessee did not have place at its disposal in the sense that it could carry out his business from that place.

•        The consideration for the services rendered by the assessee was divided into two parts: one segment as a consideration for repairing and overhauling of rotables and other segment as consideration for use, or right to use, of the replacement equipments.

As for the consideration for repairs and overhauling of equipments, no part of the profits thereon could be taxed in India for the reason that these activities were carried outside India and, even if there is a PE, only such profits as attributable to PE can be taxed in India under Article 7(1).

As far as the consideration for use or right to use the replacement equipments are concerned, the location of such equipments so given for use or right to use cannot be viewed as a place of carrying on its business, which is limited to, qua that consignment, the consignment so having been given for use or right to use. The business with regard to that consignment is over when that consignment is given for standby purposes to the airline. Accordingly, the Tribunal has observed that not only that the assessee did not any right to use the location of consignment stock, such a location was also not used for the purposes of assessee’s business.

•        There is also no projection of the assessee at this physical location in the sense that the business is carried out, or sought to be carried out or even projected, from these locations. When the physical locations at which consignment stock is kept do not project the assessee, it cannot be said that these locations constitute PEs of the assessee.

•        The Tribunal has not found any substance in the argument of the Revenue that the assessee was storing the goods and using the place for securing the orders, and for this reason, the physical location of storing consignment stock should be treated as a PE.

•        The Tribunal has observed that unless it is a warehouse and the storage of goods is for outsiders, which certainly not in the instant case, therefore, the storage of goods cannot lead to a PE. That apart, it is not the case of storage of goods even, since the consignment stock is handed over to the airline for use as standby replacement components. There is something more than storage simplicitor involved in this exercise, and that is the right to use the stock for the airline’s operational requirements on as and when required basis.

•        As regards using the place of storage as a location to securing the sale orders, the components stored are for standby use of the airline and it is not even the business of the assessee to sell those components.

•        As regards the dependent agent PE, the Tribunal has observed that no business is carried out through the agent, even if there be an agent in keeping the consignment stock, because this consignment stock with the airline is the end result of the assesee’ s business and not an intermediate step to get business. What the assessee was paid for, vis-à-vis the consignment stock, is consideration for so placing the consignment stock at the disposal of the airline. The only part of the consideration received by the assessee is for repairs and overhauling of aircraft rotables, a work which is entirely carried outside India and no part of profit thereon could be taxed in India as attributable to PE. It would be absurd to contend that the airline is dependent agent of its suppliers for the purposes of giving out replacement component.

There is no material whatsoever to establish, or even indicate, that airline or it staff constitute dependent agent of the assessee. Even if one assumes that airline can be treated as an agent of the assessee for this purpose, airline will at best be an independent agent and custodian of the consignment stock, covered by the first limb of Article 5(5). Unless second limb of Article 5(5) is satisfied (i.e. authority to negotiate and conclusion of contact, maintainance of stock for delivery purpose for and on behalf of the enterprise and securing of order on behalf of), taxability as a dependent agent PE will not arise. The CIT(A) has also erred in observing that the delivery of repairs part amounts to sales because the assessee is being paid for repairing the components owned by the airlines. The Tribunal has failed to understand how can one sell something to a person who already owns that thing. The delivery is for standby use of equipment and not for its sales.

•        The onus is on the Revenue to demonstrate that a PE of the foreign enterprise exists in India. That onus is not discharged in the instant case and therefore, the business model of the assessee is such that in the above arrangements, a PE in the source location does not come into existence.

•        In view of the above, the Tribunal has held that the assessee did not have any PE in India and accordingly, the entire income attributable to the India operations could not have been taxed in India.

•        The Tribunal has, however, noted that its finding that the assessee did not have a PE in India, by itself, would not take the assessee out of ambit of taxability in India. While the consideration for use or right to use the consignment stock of equipments is taxable under Article 7(1) read with Article 13(6), in a situation when the assessee has a PE in the contracting state, even when the assessee does not have PE, its taxability is still required to be considered in the light of Article 13(3)(b) (Royalty – for use of, or right to use of, any industrial, scientific or commercial equipment) on gross basis. Having held that the assessee had a PE in India, the lower authorities were not required to give a finding on that aspect whether it is taxable as royalty on gross basis. Non taxability under Article 7 will still mean that application of Article 13 is to be considered and adjudicated upon. However, since this aspect was not considered by lower authorities, the matter has been remitted back to the CIT(A) for limited adjudication on this aspect of the matter.

Our View:

This judgement has correctly brought out the important ingredients of a fixed place PE i.e. existence of physical location, right to use that place and carrying on business through that place. It is only then, a PE under the basic rule can be said to have come into existence. This important live- link of carrying on the business through a fixed place PE had been well brought out by Authority for Advance Ruling in Morgan Stanley (284 ITR 260), which has been confirmed by the Supreme Court (292 ITR 416).

This decision finely distinguishes between having a stock of goods for incidental activity as in the instant case and having stock of goods, stored in a warehouse for sale, which clearly results in a fixed place PE.

The Tribunal has further held that the onus is on the Revenue to show that the assessee has a PE.

Business Connection

As per section 9(1)(i) of the Act where any income arises to a non resident though a business connection in India, then such income is deemed to accrue or arises in India and hence taxable in India. However, the term business connection has been defined in the Act in an inclusive manner to include activities carried on through dependent agency. There is no definitive meaning of the term business connection and so steering needs to be drawn from various judicial precedents1 which have probed the scope and meaning of the term business connection.

The principle engrossing from judicial precedent on the term “business connection” can be summarized as under:

• • Business connection means something more than business;

  • There should be some connection between business carried on by non-resident which earn profit and some activity in India;

  • There should be a real and intimate relation between the trading activity carried on outside India and trading activity in India; and

  • There should be an element of continuity between the business of non-resident and activity in India.

Permanent Establishment (‘PE’)

The conception of PE is important to determine the right of contracting state to tax the business profits of an enterprise of another contracting state. The business profits of an enterprise of one contracting state are taxable in the other state if the enterprise maintains a PE in the latter state and only to the extent the business profits are attributable to such PE.

Article 5 of the tax treaty defines PE and broadly covers the following type of PE’s

Fixed place PE

As per Article 5 (1) of the tax treaty, the term PE means a fixed place of business through which the business of an enterprise is wholly or partly carried on.  Article 5(2) list out illustration of general PE which includes place of management, branch, and office premises etc.

The essential characteristic of a fixed place PE are as follows:

• • Existence of a fixed place of business2;

  • Place of business must be at the disposal of a foreign enterprise; and

  • The business of the foreign enterprise should be carried through this fixed place of business.

It might interest you to note that for constitution of a fixed place PE, no time threshold has been fixed. However, through analysis of commentaries and opinion of tax laureate PE is normally consider to exist where a business in carried on in a contracting state through a place of business for six months or more.

Installation PE

As per Article 5(2)(k) a building site or construction, installation or assembly project or supervisory activities constitute a PE only if the site, project or activities (together with such site, project or activities if any) continue for a specified period ( 120 days as per India – Us treaty) or more. Further, even the services performed by a sub-contractor to whom the work has been subcontracted will also be counted for the purpose of determination of PE of the main contractor.

It is pertinent to note that term installation, project has not been defied in the Act or tax treaty and hence the meaning ascribed in the commentaries would be relied on.

Service PE

As per article 5(2)(l), a PE is deemed to exist if services, other than royalties or fees for technical services ,are furnished in a contracting state by the employees or other personnel of foreign enterprise for a specified period (90 days as per India – Us treaty) or more.

In the context of service PE, it is important to highlight the term ‘other personnel’.  There are two views possible as to the meaning and interpretation of the term ‘personnel’. First personnel should only include individuals and second should includes non individuals also. However, through interpretation of word ‘personnel’ as used in treaty one may defend that personnel is restricted to individual only. 

Agency PE

As per Article 5(4) of the tax treaty, a foreign enterprise is deemed to have a PE if a person (other than independent agent) is acting on behalf of a foreign enterprise in a contracting state and can exercise the following:

• • Conclude contract on behalf of a foreign enterprise;

  • Habitually maintains and deliver stock on behalf of such foreign enterprise; and

  • Habitually secures orders for the foreign enterprise

It is pertinent to note that before analyzing whether an agent satisfy the condition laid down in Article 5(4) it is important to check that is doesn’t satisfy the condition given in Article 5(4) i.e independent agent.

To determine the status of Indian Co. (whether dependent or independent) following test are necessary:

• • Whether or not the I Co. is legally or economically independent of foreign enterprise.

  • Whether the I Co. is acting in the ordinary course of business, when acting as an agent of foreign enterprise.

  • Whether the I Co. activities are devoted wholly or almost wholly on behalf of foreign enterprise.

1. CIT v. R.D. Agarwal & Co. [1965] 56 ITR 20 (SC). Barendra Prasad Ray v. ITO [1981] 129 ITR 295 (SC).  Blue Star Engg. Co. (Bombay) (P.) Ltd .vs. CIT [1969] 73 ITR 283 (Bom.). CIT v. R.D. Aggarwal & Co. [1965] 56 ITR 20

2. ‘Place of business’ covers any premises, facilities, or installation used for carrying on the business of the enterprise whether or not   they are exclusive used for that purpose. Such place of business may also be rented place.

IN THE SUPREME COURT OF INDIA

CIVIL APPELLATE JURISDICTION

CIVIL APPEAL No. 2914 of 2007

(arising out of S.L.P. (C) No. 12907 of 2006)

with

CIVIL APPEAL No. 2915 of 2007

(arising out of S.L.P. (C) No. 16163 of 2006

AIT Head Note: To conclude, we hold that the AAR was right in ruling that MSAS would be a Service PE in India under Article 5(2)(1), though only on account of the services to be performed by the deputationists deployed by MSCo and not on account of stewardship activities.  As regards income attributable to the PE (MSAS) we hold that the Transactional Net Margin Method was the appropriate method for determination of the arms length price in respect of transaction between MSCo and MSAS.  We accept as correct the computation of the remuneration based on cost plus mark-up worked out at 29% on the operating costs of MSAS.  This position is also accepted by the Assessing Officer in his order dated 29.12.2006 (after the impugned ruling) and also by the transfer pricing officer vide order dated 22.9.06.  As regards attribution of further profits to the PE of MSCo where the transaction between the two are held to be at arms length, we hold that the ruling is correct in principle provided that an associated enterprise (that also constitutes a PE) is remunerated on arms length basis taking into account all the risk-taking functions of the multinational enterprise.  In such a case nothing further would be left to attribute to the PE.  The situation would be different if the transfer pricing analysis does not adequately reflect the functions performed and the risks assumed by the enterprise.  In such a case, there would be need to attribute profits to the PE for those functions/risks that have not been considered.  The entire exercise ultimately is to ascertain whether the service charges payable or paid to the service provider (MSAS in this case) fully represents the value of the profit attributable to his service.  In this connection, the Department has also to examine whether the PE has obtained services from the multinational enterprise at lower than the arms length cost?  Therefore, the Department has to determine income, expense or cost allocations having regard to arms length prices to decide the applicability of the transfer pricing regulations.(Para 33)

Economic nexus is an important aspect of the principle of Attribution of Profits. (Para 34)

In the light of what is stated above, the impugned ruling by AAR stands modified to the extent indicated hereinabove.  Accordingly, both the civil appeals filed by the applicant (MSCo) and by the Department are partly allowed with no order as to costs. (Para 35)

JUDGMENT

KAPADIA, J.

            Leave granted

2.         In these civil appeals we are concerned with the articles in Double Tax Avoidance Agreement (DTAA) between India and United States which have implication on transfer pricing legislation.  The said Treaty either advocates application of arms length principle or provides a mechanism for avoiding double taxation on income.

3.         Morgan Stanley Groups (MS Group) is one of the worlds largest diversifying financial services companies.  It is a world wide leader in investment banking and it is ranked amongst the top institutions in merger and acquisitions, underwriting of equity and equity and related transactions.  It has a major presence in major securities market, with traders in numerous countries around the world offering a unique distribution of products.  It has three main lines of business, namely securities investment management and investment banking and credit services.  Morgan Stanley and Company (for short, MSCo) is an investment bank engaged in the business of providing financial advisory services, corporate lending and securities underwriting.  One of the group companies of Morgan Stanley, Morgan Stanley Advantages Services Pvt. Ltd. (for short, MSAS) entered into an agreement for providing certain support services to MSCo.  MSCo outsourced some of its activities to MSAS.  The said MSAS was set up to support the main office functions in equity and fixed income research, account reconciliation and providing IT enabled services such as back office operation, data processing and support centre to MSCo.

4.         On 19.5.2005 MSCo (Applicant) filed its advance ruling application in Form 34-C inviting its advance ruling on the points enumerated hereinbelow.  The basic question relating to the transaction between the applicant and MSAS on which advance ruling was sought was two fold namely, whether the applicant was having a PE in India under Article 5(1) of the DTAA on account of the services rendered by MSAS under the Services Agreement dated April 14, 2005 entered into by MSAS with the applicant and if so, the amount of income attributable to such PE.

5.         By the impugned ruling delivered on 13.2.2006 by the Authority for Advance Ruling (for short, AAR) it was held, inter alia, that the applicant cannot be regarded as having a fixed place of business PE under Article 5(1) of the DTAA; that MSAS cannot be regarded as an agency PE under Article 5(4) of the DTAA; that the applicant would be regarded as having a PE in India under Article 5(2)(1) if it were to send some of its employees to India as stewards or as deputationists in the employment of MSAS.  Against this ruling of the AAR the applicant and the Department have come to this Court in appeal by way of special leave petition.  According to the Department the applicant should be regarded as having a fixed place in India under Article 5(1) as the applicant proposes to carry on its business through MSAS in India.  According to the Department MSAS was the PE of the MSCo in India.  They had a fixed place of business in Mumbai.  According to the Department the nature of the activities proposed to be performed by MSAS in Mumbai indicated that the said company represented the business presence of the MSCo in India.  The Department also submitted that MSAS was legally and financially dependent upon the applicant and consequently MSAS constituted an agency PE of the applicant under Article 5(4) of the DTAA.  Both these contentions were rejected by the AAR vide the above impugned ruling.  However, it has been ruled by the AAR that MSAS should be regarded as constituting a service PE under Article 5(2)(1) as it proposed to send its employees to India for undertaking stewardship activities and for undertaking to send some of its employees to India as deputationists in the employment of MSAS.  It is against this ruling of the AAR that the applicant has come to this Court by way of appeal.  On the second question the AAR ruled that the Transactional Net Margin Method (TNMM) was the most appropriate method for the determination of the Arms Length Price (ALP) in respect of the service agreement dated 14.4.2005 between the applicant and the MSAS and as the said method meets the test of arms length as prescribed under Section 92-C of the 1961 Act, no further income was attributable in the hands of MSAS in India.  The said ruling of the AAR on the question of income attributable to the PE is the subject matter of challenge by the Department.

EXISTENCE OF P.E. IN INDIA

6.         With globalization, many economic activities spread over toe several tax jurisdiction.  This is where the concept of P.E. becomes important under Article 5(1).  There exists a P.E. if there is a fixed place through which the business of an enterprise, which is multinational enterprise (MNE), is wholly or partly carried on.  In the present case MSCo is a multinational entity.  As stated above it has outsourced some of its activities to MSAS in India.  A general definition of the P.E. in the first part of Article 5(1) postulates the existence of a fixed place of business whereas the second part of Article 5(1) postulates that the business of the MNE is carried out in India through such fixed place.  One of the questions which we are called upon to decide is whether the activities to be undertaken by MSAS consists of back office operations of the MSCo and if so whether such operations would fall within the ambit of the expression the place through which the business of an enterprise is wholly or partly carried out in Article 5(1).

7.         We quote herein below Articles 5 and 7 of the DTAA:

Article 5

PERMANENT ESTABLISHMENT

1.         For the purposes of this Convention, the term permanent establishment means a fixed place of business through which the business of an enterprise wholly or partly carried on.

2.         The term permanent establishment includes especially:

(a)        a place of management;

(b)        a branch;

(c)        an office;

(d)        a factory;

(e)        a workshop;

(f)         a mine, an oil or gas well, a quarry or any other place of extraction of natural resources;

(g)        a warehouse, in relation to a person providing storage facilities for others;

(h)        a farm, plantation or other place where agriculture, forestry, plantation or related activities are carried on;

(i)         a store or premises used as a sales outlet;

(j)         an installation or structure used for the exploration or exploitation of natural resources, but only if so used for a period of more than 120 days in any twelve month period;

(k)        a building site or construction, installation or assembly project or supervisory activities in connection therewith, where such site, project or activities (together with other such sites, projects or activities, if any) continue for a period of more than 120 days in any twelve month period;

(l)         the furnishing of services other than included services as defined in Article 12 (Royalties and Fees for Included Services), within Contracting State by an enterprise through employees or other personnel, but only if;

(i)         activities of that nature continue within that State for a period or periods aggregating more than 90 within any twelve-month period; or

(ii)        the services are performed within that State for a related enterprise (within the meaning of paragraph 1 of Article 9 (Associated Enterprise).

3.         Notwithstanding the preceding provisions of this Article, the term permanent establishment shall be deemed not to include any one or more of the following:

(a)        the use of facilities solely for the purpose of storage, display or occasional delivery of goods or merchandise belonging to the enterprise;

(b)        the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display, or occasional delivery;

(c)        the maintenance of a stock of goods, or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;

(d)        the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise;

(e)        the maintenance of a fixed base of business solely for the purpose of advertising, for the supply of information, for scientific research, or for other activities which have preparatory or auxiliary character, for the enterprise.

4.         Notwithstanding the provisions of paragraphs 1 and 2, where a person other than an agent of an independent status to whom paragraph 5 applies is acting in a Contracting State on behalf of an enterprise of the other Contracting State other Contracting State, that enterprise shall be deemed to have permanent establishment in the first-mentioned State if:

(a)        he has an habitually exercises in that first-mentioned State an authority to conclude contracts on behalf of the enterprise, unless his activities are limited to those mentioned in paragraph 3 which, if exercised through a fixed place of business, would not make that fixed place of business, would not make that fixed place of business a permanent establishment under the provisions of that paragraph;

(d)        he has no such authority but habitually maintains in the first-mentioned State a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the enterprise, and some additional activities conducted in that State on behalf of the enterprise have contributed to the sale of the goods or merchandise; or

(c)        he habitually secures orders in the first-mentioned State, wholly or almost wholly for the enterprise.

5.         An enterprise of a Contracting State shall not be deemed to have a permanent establishment in the order Contracting State merely because it carries on business in that State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business.  However, when the activities of such an agent are devoted wholly or almost wholly on behalf of that enterprise and the transactions between the agent and the enterprise and the transactions between the agent and the enterprise are not made under arms length conditions, he shall not be considered an agent of independent status within the meaning of this paragraph.

6.         The fact that a company which is a resident of a Contracting State controls or is controlled by a company which is a resident of the other Contracting State, or which carries on business in that order State (whether through a permanent establishment or otherwise), shall not of itself constitute either company a permanent establishment of the other.

Article 7

BUSINESS PROFITS

1.         The profits of an enterprise of a Contracting State shall be taxable only that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein.  If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to (a) that permanent establishment; (b) sales in the other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment; or (c) other business activities carried on in the other State of the same or similar kind as those effected through that permanent establishment.

2.         Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly at arms length with the enterprise of which it is a permanent establishment and other enterprises controlling, controlled by or subject to the same common control as the enterprise, in any case where the correct amount of profits attributable to a permanent establishment is incapable of determination or the determination thereof presents exceptional difficulties, the profits attributable to the permanent establishment may be estimated on a reasonable basis.  The estimate adopted shall, however, be such that the result shall be in accordance with the principles contained in this Article.

3.         In the determination of the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the business of the permanent establishment, including a reasonable allocation of executive and general administrative expenses, interest and other expenses, incurred for the purposes of the enterprise as a whole (or the part thereof which includes the permanent establishment), whether incurred in the State in which the permanent establishment is situated or elsewhere, in accordance with the provisions of and subject to the limitations of the taxation laws of that State.  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, know-how or other charges for specific services performed or for management, or except in the case of 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 toward 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, know-how or other rights, or by way of commission or other charges 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.

4.         No profits shall be attributed to a permanent establishment by reason of the mere purchase by that permanent establishment of goods or merchandise for the enterprise.

5.         For the purposes of this Convention, the profits to be attributed to the permanent establishment as provided in paragraph 1 (a) of this Article shall include only the profits derived from the assets and activities of the permanent establishment and shall be determined by the same method year by year unless there is good and sufficient reason to the contrary.

6.         Where profits include items of income which are dealt with separately in other Articles of the Convention, then the Articles of the Convention, then the provisions of those Articles shall not be affected by the provisions of this Article.

7.         For the purposes of the Convention, the term business profits means income derived from any trade or business including income from the furnishing of services other than included services as defined in Article 12 (Royalties and Fees for Included Services) and including income from the rental of tangible personal property other than property described in paragraph 3(b) of Article 12 (Royalties and Fees for Included Services).

8.         In our view, the second requirement of Article 5(1) of DTAA is not satisfied as regards back office functions.  We have examined the terms of the Agreement along with the advance ruling application made by MSCo inviting the AAR to give its ruling.  It is clear from reading of the above Agreement/application that MSAS in India would be engaged in supporting the front office functions of MSCo in fixed income and equity research and in providing IT enabled services such as data processing support centre and technical services as also reconciliation of accounts.  In order to decide whether a P.E. stood constituted one has to undertake what is called as a functional and factual analysis of each of the activities to be undertaken by an establishment.  It is from that point of view, we are in agreement with the ruling of the AAR that in the present case Article 5(1) is not applicable as the said MSAS would be performing in India only back office operations.  Therefore to the extent of the above back office functions the second part of Article 5(1) is not attracted.

9.         Lastly, as rightly held by the AAR there is no agency PE as the PE in India had no authority to enter into or conclude the contacts.  The contracts would be entered in the United States.  They would be concluded in US.  The implementation of those contracts only to the extent of back office functions would be carried out in India, and therefore, MSAS would not constitute an Agency PE as contended on behalf of the Department.

10.       In the DTAA, the term P.E. means a fixed place of business through which the business of an MNE is wholly or partly carried out.  The definition of the word P.E. in Section 92(F) (iii) is inclusive, however it is not under Article 5(1) of the Treaty.  It is for this reason that Article 5(2) of the DTAA herein refers to places included as P.E. of the MNE.  One such place is mentioned in the Article 5(2)(1) which deals with furnishing of services.

11.       The concept of P.E. was introduced in 1961 Act as part of the statutory provisions of transfer pricing by the Finance Act of 2001. In Section 92-F (iii) the word enterprise is defined to mean a person including a P.E. of such person who is proposed to be engaged in any activity relating to the production.. Under the CBDT circular No. 14 of 2001 it has been clarified that the term P.E. has not been defined in the Act but its meaning may be understood with reference to the DTAA entered into by India. Thus the intention was to rely on the concept and definition of P.E. in the DTAA. However, vide Finance Act, 2002 the definition of P.E. was inserted in the income Tax Act, 1961 (for short, I.T. Act) vide Section 92-F (iiia) which states that the P.E. shall include a fixed place of business through which the business of the MNE is wholly or partly carried on. This is where the difference lies between the definition of the word P.E. in the inclusive sense under the I.T. Act as against the definition of the word P.E. in the exhaustive sense under the DTAA. This analysis is important because it indicates the intention of the Parliament in adopting an inclusive definition of P.E so as to cover service P.E., agency P.E, software P.E, Construction PE etc.

12.       There is one more aspect which needs to be discussed namely, exclusion of P.E under Article 5(3). Under Article 5(3) (e) activities which are preparatory or auxiliary in character which are carried out at a fixed place of business will not constitute a P.E. Article 5(3) commences with a non obstante clause. It states that notwithstanding what is stated in Article 5(1) or under Article 5(2) the term P.E. shall not include maintenance of a fixed place of business solely for advertisement, scientific research or for activities which are preparatory or auxiliary in character. In the present case we are of the view that the above mentioned back office functions proposed to be performed by MSAS in India falls under Article 5(3) (e) of the DTAA. Therefore, in our view in the present case MSAS would not constitute a fixed place P.E. under Article 5(1) of the DTAA as regards its back office operations.

13.       However, the question which arises for determination in the present case is the nature of activities performed by stewards and deputationists deployed by MSCo to work in India as employees of MSAS. Under Article 5(2)(1) furnishing of services through the fixed place in India can constitute a P.E. The AAR in the impugned ruling has held that the stewards and deputationists are proposed to be sent by the MSCo from U.S. According to the AAR there is a flow of services from the MSCo to the MSAS when the former deputes its own employees to work in India in MSAS. Therefore, according to the AAR the service Agreement between MSCo and MSAS dated 14.4.2005 would fall under Article 5(2)(1) and consequently the transfer pricing regulation would apply for evaluating the charges payable by MSCo to MSAS in India for such service contract. This ruling has been challenged by the applicant.

14.       Article 5(2)(1) of the DTAA applies in cases where the MNE furnishes services within India and those services are furnished through its employees. In the present case we are concerned with two activities namely stewardship activities and the work to be performed by deputationists in India as employees of MSAS. A customer like an MSCo who has world wide operations is entitled to insist on quality control and confidentiality from the service provider. For example in the case of software P.E. a server stores the data which may require to act according to the quality control specifications imposed by its customer. It may be required to maintain confidentiality. Stewardship activities involve briefing of the MSAS staff to ensure that the output meets the requirements of the MSCo. These activities include monitoring of the outsourcing operations at MSAS. The object is to protect the interest of the MSCo. These stewards are not involved in day to day management or in any specific services to be undertaken by MSAS. The stewardship activity is basically to protect the interest of the customer. In the present case as held hereinabove the MSAS is a service P.E. It is in a sense a service provider. A customer is entitled to protect its interest both in terms of confidentiality and in terms of quality control.  In such a case it cannot be said that MSCo has been rendering the services to MSAS. In our view MSCo is merely protecting its own interests in the competitive world by ensuring, the quality and confidentiality of MSAS services. We do not agree with the ruling of the AAR that the stewardship activity would fall under Article 5(2)(1). To this extent we find merit in the civil appeal filled by the appellant (MSCo) and accordingly its appeal to that extent stands partly allowed.

15.       As regards the question of deputation, we are of the view that an employee of MSCo when deputed to MSAS does not become an employee of MSAS. A deputationist has a lien on his employment with MSCo. As long as the lien remains with the MSCo the said company retains control over the deputationists term and employment. The concept of a service PE finds place in the U.N. Convention. It is constituted if the multinational enterprise renders services through its employees in India provided the services are rendered for a specified period. In this case, it extends to two years on the request of MSAS. It is important to note that where the activities of the multinational enterprise entails it being responsible for the work of deputationists and the employees continue to be on the payroll of the multinational enterprise or they continue to have their lien on their jobs with the multinational enterprise,  service PE can emerge. Applying the above tests to the facts this case we find that on request/requisition from MSAS the applicant deputes its staff. The request comes from MSAS depending upon its requirement. Generally, occasions do arise when MSAS needs the expertise of the staff of MSCo. In such circumstances, generally, MSAS makes a request to MSCo. A deputationist under such circumstances is expected to be experienced in banking and finance. On completion of his tenure he is repatriated to his parent job. He retains his lien when he comes to India. He lends his experience to MSAS in India as an employee of MSCo as he retains his lien and in that sense there is a services PE (MSAS) under Article  5(2)(1). We find no infirmity in the ruling of the ARR on this aspect. In the above situation, MSCo is rendering services through its employees to MSAS. Therefore, the Department is right in its contention that under the above situation there exists a Service PE in India (MSAS). Accordingly, the civil appeal filed by the Department stands partly allowed.

Income Attributable to PE

16.       Under Article 7, the taxability is of the MNE. What is to be taxed under Article 7 is income of the MNE attributable to the P.E. in India. The income attributable to the said P.E. is the income attributable to foreign companys operations in India, which in terms, implies the income attributable to the activities carried on by the MNE through its P.E. in India. Therefore, there is a difference between the taxability of the P.E in respect of its income earned by it in India which is in accordance with the Income-Tax Act, 1961 and which has nothing to do with the taxability of the MNE, which is also taxable in India under Article 7, in respect of the profits attributable to its P.E. Under Article 7, the taxability is of the MNE. What is taxable under Article 7 is profits earned by the MNE. Under the said IT Act the taxable unit is the foreign company, though the quantum of income taxable is income attributable to the P.E. of said foreign company in India.

17.       An important question which arises for determination is whether the AAR is right in its ruling when it says that once the transfer pricing analysis is under taken there is no further need to attribute profits to PE. Computation of income arising from international transactions has to be   done keeping in mind the principle of arms length price. Charges paid or payable by MSCo to MSAS under the service contract have to be accounted as income at arms length price. There are different methods for determining appropriate transfer pricing. Under Section 92C(1) of the I.T. Act, arms length price in relation to international transaction has to be determined by any of the following methods:

(a)        Comparable Uncontrolled Price Method (CUPM)

(b)        Resale Price Method (RPM)

(c)        Cost Plus Method (CPM)

(d)        Profit Split Method (PSM)

(e)        Transactional Net Margin Method (TNMM)

(f)         Such other method as may be prescribed by CBDT

18.       The taxpayer is required to compute arms length price for a transaction(s) using one of the five methods stipulated in the Income Tax Rules. Rule 10C(1) of Income Tax Rules defines the most appropriate methods as the method which is best suited to the facts and circumstances of each particular international transaction. As per Rule 10C(2) the most appropriate methods has to be selected having regard to number of factors which are enumerated therein. The arms length price has to be computed by the application of methods mentioned in Section 92C(1) of the I.T. Act.

19.       In the present case, the applicant has taken the opinion of Earnest and Young (for short, E & Y),  Consultants, as experts who have suggested, keeping in mind the various activities undertaken by MSCo and MSAS in India, TNMM as the most appropriate methods for determination of arms length price in respect of transaction between MSCo and MSAS. The applicant sought a ruling from the ARR on the appropriateness of the said method. On the adequacy of the mark-up the applicant relied upon a transfer pricing review undertaken by E & Y, an independent consultant, for benchmarking the transaction between  the applicant and MSAS and as per that review, the average mark-up (on costs) of comparable companies providing similar services, was taken in to account at 29%. This was agreed upon by MSAS and the applicant (MSCo). It has been accepted by the Transfer Pricing Officer and by the Assessing Officer. It has not been disputed by T.N. Chopra & Associates, consultants appointed by the Department.

20.       Accordingly, the applicant (MSCo) preferred an applicant to the AAR on the following issues:

(i)         Appropriateness of TNMM for determination of arms length in respect of transaction between MSCo and MSAS.

(ii)        Adequacy of the mark-up charged by MSAS for provision of services to MSCo based on arms length principle.

(iii)       Attribution of further profits in the hands of PE of MSCo where the transaction is at arms length.

(iv)       Appropriateness of remuneration based on margin on total operating cost of PE for determining profit attributable to service PE.

21.       As stated above, one of the main points which arises for determination in the present case is: whether the AAR was right in ruling that as long as MSAS was remunerated for its services at arms length, there should be no additional profits attributable to the applicant or to MSAS in India.

22.       To answer the above question one has to examine the provisions of the I.T. Act as well as the provisions of DTAA between India and U.S.A.

23.       Sections 92 to 92E of the I.T. Act contains transfer pricing provisions in the I.T. Act with effect from the financial year commencing from 1.4.2001. With the enactment of the said sections the rules for the interpretation and implementation of the said provisions were also amended so as to include Rules 10A to 10E in the Income Tax Rules. Sections 92A and 92B provide meanings of the expressions Associated Enterprise and International Transaction respectively with reference to which the income is to be computed under Section 92 of I.T. Act.

24.       We quote hereinbelow Sections 92A and 92B of the I.T. Act:

Meaning of associated enterprise

Section 92A.   (1) For the purpose of this section and sections 92, 92B, 92C, 92D, 92E and 92F, associated enterprise, in relation to another enterprise, means an enterprise

(a)        which participates, directly, or indirectly, or through one or more intermediaries, in the management or control or capital of the order enterprise; or

(b)        in respect of which one or more persons who participate, directly or indirectly, or through one or more intermediaries, in its management or control or capital, are the same persons who participate, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise.

(2)        For the purpose of sub-section (1), two enterprise shall be deemed to be associated enterprises if, at any time during the previous year,

(a)        one enterprise holds, directly or indirectly, shares carrying not less than twenty-six percent of the voting power in the other enterprise; or

(b)        any person or enterprise holds, directly or indirectly, shares carrying not less than twenty-six percent of the voting power in each of such enterprises; or

(c)        a loan advanced by one enterprise to the other enterprise constitutes not less than fifty-one percent of the book value of the total assets of the other enterprise; or

(d)        one enterprise guarantees not less than ten per cent. Of the total borrowings of the other enterprise; or

(e)        more than half of the board of directors or members of the governing board, or one more executive directors or executive members of the governing board of one enterprise, are appointed by the other enterprise; or

(f)         more than half of the directors or members of the governing board, or one or more of the executive directors or members of the governing board, of each of the two enterprises are appointed by the same person or persons; or

(g)        the manufacture or processing of goods or article or business carried out by one enterprise is wholly dependent one the use of know-how, patents, copyrights, trade-marks, licences franchises or any other business or commercial rights of similar nature, or any data, documentation, drawing or specification relating to any patent, invention, model, design, secret formula or process, of which the other enterprise is the owner or in respect of which the other enterprise ha exclusive rights; or

(h)        ninety per cent.  Or more of the raw materials and consumables required for the manufacture or processing of goods or articles carried out by one enterprise, are supplied by the other enterprise, and the prices and other conditions relating to the supply are influenced by such other enterprise; or

(i)         the goods or articles manufactured or processed by one enterprise, are sold to the other enterprise or to persons specified by the other enterprise, and the prices and other conditions relating thereto are influenced by such other enterprise; or

(j)         where one enterprise is controlled by an individual, the other enterprise is also controlled by such individual or his relative or jointly by such individual and relative of such individual; or

(k)        where one enterprise is controlled by a Hindu undivided family , the other enterprise is controlled by a member of such Hindu undivided family, or jointly by such  member and his relative; or

(l)         where one enterprise is a firm, association of persons or body of individuals, the other enterprise holds not less than ten per cent. Interest in such firm, association of persons or body of individuals; or

(m)       there exist between the two enterprises, any relationship of mutual interest, as may be prescribed.

            Meaning of international transaction

Section 92B. (1) For the purposes of this section and sections 92, 92C, 92D and 92E, international transaction means a transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature or purchase, sale or lease of tangible or intangible property, or provision of services, or lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises and shall include a mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of , or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises.

(2)        A transaction entered into by an enterprise with a person other than an associated enterprise shall, for the purposes of sub-section (1), be deemed to be a transaction entered into between two associated enterprises, in there exists a prior agreement in relation to the relevant transaction between such other person and the associated enterprise; or the terms of the relevant transaction are determined in substance between such other person and the associated enterprise.

(emphasis supplied)

25.       Section 92B defines International Transaction to mean a transaction between two or more associated enterprises which are, either or both of whom are non residents. The said transaction covers purchase, sale or lease of tangible or intangible property or provision of services or lending or borrowing money or any other transaction having an impact on the profits, income, losses or assets of such enterprises and shall include a mutual arrangement between two or more associated enterprises for the allocation or apportionment of any cost or expense incurred in connection with the benefit, service or facility provided to anyone or more of associated enterprises.

26.       Determination of arms length price in relation to international transaction is provided for in Section 92C to the I.T. Act read with Rule 10B. We quote herein below Section 92C of the I.T. Act read with Rules 10B and 10C of the Income Tax Rules which reads as under:

            Computation of arms length price

Section 92C.   (1)        The arms length price in relation to an international transaction shall be determined by any of the following methods, having regard to the nature of transaction or class of transactions or class of associated persons or functions performed by such persons or such other relevant factors as the Board may prescribe, namely:-

(a)        comparable uncontrolled price method;

(b)        resale price method;

(c)        cost plus method;

(d)        profit split method;

(e)        transactional net margin method;

(f)         such other method as may be prescribed by the Board.

(2)        The most appropriate method referred to in sub-section (1) shall be applied, for determination of arms length price, in the manner as may be prescribed:

            Provided that where more than one price is determined by the most appropriate method, the arms length price shall be taken to be the arithmetical mean of such prices, or, at the option of the assessee, a price which may vary from the arithmetical mean by an amount not exceeding five percent of such arithmetical mean.

(3)        Where during the course of any proceeding for the assessment of income, the Assessing Officer is, one the basis of material or information or document in his possession, of the opinion that-

(a)        the price charged or paid in an international transaction has not been determined in accordance with sub-sections (1) and (2); or

(b)        any information and document relating to an international transaction have not been kept and maintained by the assessee in accordance with the provisions contained in sub-section (1) of section 92D and the rules made in this behalf; or

(c)        the information or data used in computation of the arms length price is not reliable or correct; or

(d)        the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub-section (3) of section 92D,

the Assessing Officer may proceed to determine the arms length price in relation to the said international arms length price in relation to the said international transaction in accordance with sub-sections (1) and (2), on the basis of such material or information or document available with him:

            Provided that an opportunity shall be given by the Assessing Officer by serving a notice calling upon the assessee to show cause, on a date and time to be specified in the notice, why the arms length should not be so determined on the basis of material or information or document in the possession of the Assessing Officer.

(4)        Where an arms length price is determined by the Assessing Officer under sub-section (3), the Assessing Officer may compute the total income of the assessee having regard to the arms length price so determined:

            Provided that no deduction under section 10A or section 10B or under Chapter VI-A shall be allowed in respect of the amount of income by which the total income of the assessee is enhanced after computation of income under this sub-section.

            Provided further that where the total income of an associated enterprise is computed under this sub-section on determination of the arms length price said to another associated enterprise from which tax has been deducted or was deductible under the provisions of Chapter XVIIB, the income of the other associated enterprise shall not be recomputed by reason of such determination of arms length price in the case of the first mentioned enterprise.

Determination of arms length price under section 92C.

Rule 10B.       (1) For the purposes of sub-section (2) of section 92C, the arms length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, in the following manner, namely: -

(a)        comparable uncontrolled price method, by which, -

(i)         the price charged or paid for property transferred or services provided in a comparable uncontrolled transaction, or a number of such transactions, is identified;

(ii)        such price is adjusted to account for differences, if any, between the international transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market;

(iii)       the adjusted price arrived at under sub-clause (ii) is taken to be an arms length price in respect of the property transferred or services provided in the international transaction;

(b) resale price method, by which, -

(i)         the price at which property purchased or services obtained by the enterprise from an associated enterprise is resold or are provided to an unrelated enterprise, is identified;

(ii)        such resale price is reduced by the amount of a normal gross profit margin accruing to the enterprise or to an unrelated enterprise from the purchase and resale of the same or similar property or from obtaining and providing the same or similar services, in a comparable uncontrolled transaction, or a number of such transactions;

(iii)       the price so arrived at is further reduced by the expenses incurred by the enterprise in connection with the purchase of property or obtaining of services;

(iv)       the price so arrived at is adjusted to take into account the functional and other differences, including differences in accounting practices, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market;

(v)        the adjusted price arrived at under sub-clause (iv) is taken to be an arms length price in respect of the purchase of the property or obtaining of the services by the enterprise from the associated enterprise;

(c)        cost plus method, by which, -

(i)         the direct and indirect costs of production incurred by the enterprise in respect of property transferred or services provided to an associated enterprise, are determined;

(ii)        the amount of a normal gross profit mark-up to such costs (computed according to the same accounting norms) arising from the transfer or provision of the same or similar property or services by the enterprise, or by an unrelated enterprise, in a comparable uncontrolled transaction, or a number of such transactions, is determine;

(iii)       the normal gross profit mark-up referred to in sub-clause (ii) is adjusted to take into account the functional and other differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect such profit mark-up in the open market;

(iv)       the costs referred to in sub-clause (i) are increased by the adjusted profit mark-up arrived at under sub-clause (iii);

(v)        the sum so arrived at is taken to be an arms length price in relation to the supply of the property or provisions of services by the enterprise;

(d)        profit split method, which may be applicable mainly in international transactions involving transfer of unique intangibles or in multiple international transactions which are so interrelated that they cannot be evaluated separately for the purpose of determining the arms length price of any one transaction, by which,

(i)         the combined net profit of the associated enterprises arising from the international transaction in which they are engaged, is determined;

(ii)        the relative contribution made by each of the associated enterprises to the earning of such combined net profit, is then evaluated on the basis of the functions performed, assets employed or to be employed and risks assumed by each enterprise and on the basis of reliable external market data which indicated how such contribution would be evaluated by unrelated enterprise performing comparable functions in similar circumstances;

(iii)       the combined net profit is then split amongst the enterprises in proportion to their relative contributions, as evaluated under sub-clause (ii);

(iv)       the profit thus apportioned to the assessee is taken into account to arrive at an arms length price in relation to the international transaction:

Provided that the combined net profit referred to in sub-clause (i) may, I the first instance, be partially allocated to each enterprise so as to provide it with a basic return appropriate for the type of international transaction in which it is engaged, with reference to market returns achieved for similar types of transactions by independent enterprises, and thereafter, the residual net profit remaining after such allocation may be split amongst the enterprises I proportion to their relative contribution in the manner specified under sub-clauses (ii) and (iii), and in such a case the aggregate of the net profit allocated to the enterprise in the first instance together with the residual net profit apportioned to that enterprise on the basis of its relative contribution shall be taken to be the net profit arising to that enterprise from the international transaction;

(e)        transactional net margin method, by which, -

(i)         the net profit margin realized by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;

(ii)        the net profit margin realized by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;

(iii)       the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market;

(iv)       the net profit margin realized by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii);

(v)        the net profit margin thus established is then taken into account to arrive at an arms length price in relation to the international transaction.

(2)        For the purposes of sub-rule (1), the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to the following, namely:

(a)        the specific characteristics of the property transferred or services provided in either transaction;

(b)        the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to be transactions;

(c)        the contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions;

(d)        conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail.

(3)        An uncontrolled transaction shall be comparable to an international transaction if

(i)         none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from such transactions in the open market; or

(ii)        reasonably accurate adjustments can be made to eliminate the material effects of such differences.

(4)        The data to be used in analyzing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into:

Provided that data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared.

Most appropriate method.

Rule 10C.       (1) For the purposes of sub-section (1) of section 92C, the most appropriate method shall be the method which is best suited to be facts and circumstances of each particular international transaction, and which provides the most reliable measure of an arms length price in relation to the international transaction.

(2)        In selecting the most appropriate method as specified in sub-rule (1), the following factors shall be taken into account, namely: -

(a)        the nature and class of the international transaction;

(b)        the class of classes of associated enterprises entering into the transaction and the functions performed by them taking into account assets employed or to be employed and risks assumed by such enterprises:

(c)        the availability, coverage and reliability of data necessary for application of the method;

(d)        the degree of comparability existing between the international transaction and the uncontrolled transaction and between the enterprises entering into such transactions;

(e)        the extent to which reliable and accurate adjustments can be made to account for differences, if any, between the international transaction and the comparable uncontrolled transaction or between the enterprises entering into such transactions;

(f)         the nature, extent and reliability of assumptions required to be made in application of a method.

(emphasis supplied)

27.       The methods, quoted above, namely, CUPM, RPM, CPM, PSM, TNMM etc. are mentioned in Section 92C read with Rule 10B.  The most appropriate method has to be applied for computation of the arms length price.  It will depend on the facts and circumstances of each particular international transaction (see: Rule 10C).  Section 92C inter alia provides that if the Assessing Officer, during the course of any proceedings for the assessment on income, is of the opinion on the basis of material or information or document that the price charged or paid in an international transaction has not been determined on arms length basis or if he finds that the assessee has not maintained proper documents relating to the international transaction in accordance with the provisions of the IT Act or if he finds that the data used in the computation of arms length price is not reliable, the Assessing Officer may proceed to determine the arms length price in relation to the said transaction.  Rules 10B, 10C and 10D explains the determination of ALP under each of the above methods.

28.       At this stage, it may be noted that on the question of appropriateness of the said TNMM, the AAR did not give its ruling as the transfer pricing as proceedings had commenced before the tax officer before MSCo could seek the ruling.  However, after the impugned ruling, Transfer Pricing Officer and the Assessing Officer have found the said method (TNMM) to be appropriate.  In our view, apart from the orders passed by the Assessing Officer and the Transfer Pricing Officer, the said method (TNMM) is the appropriate method in the case of Service PE as TNMM apportions the total operating profit arising from the transaction on the basis of sales, costs, assets, etc.

29.       As regards determination of profits attributable to a PE in India (MSAS) is concerned on the basis of arms length principle we have quoted Article 7(2) of the DTAA.  According to the AAR where there is an international transaction under which a non-resident compensates a PE at arms length price, no further profits would be attributable in India.  In this connection, the AAR has relied upon Circular No. 23 of 1969 issued by CBDT as well as Circular No. 5 of 2004 also issued by CBDT.  This is the key question which arises for determination in these civil appeals.

30.       To answer the above question we quote Article 7 of the U.N. Model Convention which reads as under:

            ARTICLE 7:            ATTRIBUTION OF BUSINESS PROFITS

            Article 7 of the UN Model Convention states as under:

business profits

1.      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.  If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to (a) that permanent establishment; (b) sales in that other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment; or (c) other business activities carried on in that other State of the same or similar kind as those effected through that permanent establishment.

2.      Subject to the provisions of paragraph 3, where en enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under he same or similar conditions and dealing wholly or independently with the enterprise of which it is a permanent establishment.

3.      In the determination of the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the business of the permanent establishment including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere.  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.

4.      Insofar as it has been customary in a Contracting State to determine the profits to be attributed to a permanent establishment on the basis of an apportionment of the total profits of the enterprise to its various parts, nothing in paragraph 2 shall preclude that Contracting State from determining the profits to be taxed by such an apportionment as may be customary; the method of apportionment adopted shall, however, be such that the result shall be in accordance with the principles contained in this article.

5.      For the purposes of the preceding paragraphs, the profits to be attributed to the permanent establishment shall be determined by the same method year-by-year unless there is good and sufficient reason to the contrary.

6.      Where profits include items of income which are dealt with separately in other articles of this Convention, then the provisions of those articles shall not be affected by the provisions of this article.

Note: The question of whether profits should be attributed to a permanent establishment by reason of the mere purchase by that permanent establishment of goods and merchandise for the enterprise was not resolved.  It should therefore be settled in bilateral negotiations.

31.       Article 7 of the U.N. Model Convention inter alia provides that only that portion of business profits is taxable in the source country which is attributable to the PE.  It specifies how such business profits should be ascertained.  Under the said Article, a PE is treated as if it is an independent enterprise (profit centre) dehors the head office and which deals with the head office at arms length.  Therefore, its profits are determined on the basis as if it is an independent enterprise.  The profits of the PE are determined on the basis of what an independent enterprise under similar circumstances might be expected to derive on its own.  Article 7(2) of the U.N. Model Convention advocates the arms length approach for attribution of profits to a PE.

32.       The object behind enactment of transfer pricing regulations is to prevent shifting of profits outside India.  Under Article 7(2) not all profits of MSCo would be taxable in India but only those which have economic nexus with PE in India.  A foreign enterprise is liable to be taxed in India on so much of its business profit as is attributable to the PE in India.  The quantum of taxable income is to be determined in accordance with the provisions of IT Act.  All provisions of IT Act are applicable, including provisions relating to depreciation, investment losses, deductible expenses, carry-forward and set-off losses etc.  However, deviations are made by DTAA in cases of royalty, interest etc.  Such deviations are also made under the IT Act (for example: Sections 44BB, 44BBA etc.).  Under the impugned ruling delivered by the AAR, remuneration to MSAS was justified by a transfer pricing analysis and, therefore, no further income could be attributed to the PE (MSAS).  In other words, the said ruling equates an arms length analysis (ALA) with attribution of profits.  It holds that once a transfer pricing analysis is undertaken; there is no further need to attribute profits to PE.  The impugned ruling is correct in principle insofar as an associated enterprise, that also constitutes a PE, has been remunerated on an arms length basis taking into account all the risk-taking functions of the enterprise.  In such cases nothing further would be left to be attributed to the PE.  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 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 functional and factual analysis to be undertaken in each.  Lastly, it may be added that taxing corporates on the basis of the concept of Economic Nexus is an important feature of Attributable Profits (profits attributable to the PE).

Conclusion:

33.       To conclude, we hold that the AAR was right in ruling that MSAS would be a Service PE in India under Article 5(2)(1), though only on account of the services to be performed by the deputationists deployed by MSCo and not on account of stewardship activities.  As regards income attributable to the PE (MSAS) we hold that the Transactional Net Margin Method was the appropriate method for determination of the arms length price in respect of transaction between MSCo and MSAS.  We accept as correct the computation of the remuneration based on cost plus mark-up worked out at 29% on the operating costs of MSAS.  This position is also accepted by the Assessing Officer in his order dated 29.12.2006 (after the impugned ruling) and also by the transfer pricing officer vide order dated 22.9.06.  As regards attribution of further profits to the PE of MSCo where the transaction between the two are held to be at arms length, we hold that the ruling is correct in principle provided that an associated enterprise (that also constitutes a PE) is remunerated on arms length basis taking into account all the risk-taking functions of the multinational enterprise.  In such a case nothing further would be left to attribute to the PE.  The situation would be different if the transfer pricing analysis does not adequately reflect the functions performed and the risks assumed by the enterprise.  In such a case, there would be need to attribute profits to the PE for those functions/risks that have not been considered.  The entire exercise ultimately is to ascertain whether the service charges payable or paid to the service provider (MSAS in this case) fully represents the value of the profit attributable to his service.  In this connection, the Department has also to examine whether the PE has obtained services from the multinational enterprise at lower than the arms length cost?  Therefore, the Department has to determine income, expense or cost allocations having regard to arms length prices to decide the applicability of the transfer pricing regulations.

34.       Economic nexus is an important aspect of the principle of Attribution of Profits.

35.       In the light of what is stated above, the impugned ruling by AAR stands modified to the extent indicated hereinabove.  Accordingly, both the civil appeals filed by the applicant (MSCo) and by the Department are partly allowed with no order as to costs.

Permanent Establishment - A Recent Development

Galileo International Inc Vs. DCIT

FACTS OF THE CASE

Galileo International Inc (‘Galileo’ or ‘assessee’) a resident of USA is engaged in the

provision of services to hotels, airlines etc pertaining to reservations, booking etc through

its Computerized Reservation System (‘CRS’). The services provided by it are as follows:

• Receipt of requests from Travel Agents of airlines etc (or TA) for information

display (as stored in CRS), ticket booking etc;

• Forwarding the aforesaid requests from TA’s to Airline servers, receiving

responses thereupon from Airlines Server, forwarding the same to TA’s etc;

• Generating reports on booking status for Airlines in set format etc.

• Display of real time status qua flight schedules, fares etc.

For this purpose, it maintains and operates a huge master computer system (MCS)

consisting of 18 mainframe computers with its main server located in USA. This main

computer is connected to the airline servers’ to/from which data is continuously sent and

obtained. All the input processing and output is managed, processed and stored by the

appellant through the MCS in USA.

In aforesaid connection, the appellant has entered into agreements (referred as

participating carrier agreements or PCA) with various airlines etc. (referred to as

‘participants’ in the ruling) to provide them with the CRS services. The appellant earns

booking fees from Airlines for services listed in relevant agreement including the abovementioned

services.

The appellant in order to market and distribute the CRS services to the TAs appoints

distributors and pays a distribution fees to them for their services. In India the appellant

has entered into a distribution agreement (DA) dated 25th February 1995 with Interglobe

Enterprises Pvt. Ltd., an unrelated party to market and distribute CRS services to the TAs

in India.

The appellant is also responsible for securing the telecommunication network to enable

the TAs to access the CRS.

In the course assessment and first level appellate proceeding it was decided that Galileo

has a business connection in India and income chargeable to tax as per income tax act

1961, as well as a PE under Article 5 of the DTAA with USA. Galileo has decided to file

an appeal with second level appellate authority against the aggrieved order of first level

appellate authority.

GROUND FOR APPEAL

The appellant filed its return of income for 4 years for the AY 1995-96 to 1998-99,

pursuant to a notice issued by the income tax department and contended as follows:

• No income accrued or arose to it in India nor could any such income be deemed to

accrue or arise in India under section 5(2) or 9(1)(i) of the Income Tax Act,1961

and so it did not have any taxable income in India.

• It did not have any permanent establishment (PE) in India within the meaning of

Article 5 of the DTAA between India and USA (treaty) and so the booking fees

which is in the nature of the ‘business profits’ are not liable to tax in India under

article 7(1) of the treaty.

ISSUES BEFORE THE ITAT

1) Whether Galileo had a Business Connection (BC) in India under section 9(1)(i) of

the Act ?

2) Whether the appellant has any taxable income under section 5(2) of the act?

3) As regards DTAA, whether Galileo had a PE in India (fixed place or agency PE

etc) as per article 5 of the DTAA entered between India and USA? As regards

agency PE under DTAA, whether appellant is eligible to immunity provided

under Para 5 of Article 5 thereof?

4) How much attribution of the income earned by the Galileo is chargeable to tax in

India?

DECISION OF THE ITAT

1) Business connection under section 9(1)(i)of the Income Tax Act.

• The meaning of the word business connection is not exhaustive in nature

in fact it includes some of the activities to be termed as business

connection. It has a wide though uncertain meaning. thus in order to

determine the business connection the facts of each particular case need to

be analyzed.

• As regards accrual of income to assessee under the Act, ITAT ruled that

income accrued to assessee in India and there existed a business

connection for that in India, in view of the following:

• Computer/hardware as well as connectivity via nodes etc. (hired from

SITA) was provided to TA’s etc in India by assessee (which were not

dumb or in nature of Kiosk);

• Booking takes place in India through seamless CRS system of assessee;

• Booking constituted important limb of assessee’s overall operations and

without the same, no income could have accrued to assessee.

• So income which is pertaining to bookings which takes place from the

equipment in India can be deemed to accrue or arises in India and hence

taxable in India.

2) Income accruing or arising under section 5(2) of the Income Tax Act.

In the case of the business of which all the operations are not carried out in

India, the income of the business deemed under this clause to accrue or

arise in India shall be such part of the income as is reasonably attributable

to the operations carried out in India.

• In the given case a majority of work which generates revenue (income) for

the Galileo is carried outside the India. In India only generations of

request and receiving of end results activities is carried on.

• Thus in the case of Galileo lion’s share of the appellants operations took

place outside India, only miniscule portion, adjudicated at 15% of the

appellants income, was held to have accrued in Indian territories. The

extent of work carried out in India is in relation to generating requests and

receiving the end result of the process in India.

• The ITAT held all the expenses in the form of the remuneration to the

Interglobe are held as an allowable deduction and shall be reduced while

computing the income of the appellant and since the payment to the agent

in India is more than what is the income attributable to the PE in India, it

extinguishes the assessment as no further income is taxable in India.. In

this connection, ITAT placed reliance on SC ruling in Morgan Stanley

(supra) and CBDT Circular No. 23 of 1969 (supra).

3) Permanent establishment under DTAA.

. Fixed place rule which is stated in article 5(1)

Article 5(1) gives a general definition of the permanent establishment i.e. it is

a fixed place of business through which the business of an enterprise is partly

or wholly carried on.

The ITAT held that Galileo has a fixed place of business in the form of the

computers installed in the premises of the subscribers (travel agents) through

which it carries its business partially. The justification for this ruling is as

under: -

1. In the case of Galileo, CRS is the main source of revenue, which is

partially existent in the various computers installed at the premises of

the subscribers. These computers perform the functions of reservation

and ticketing and form an integral part of the entire CRS.

2. The computers so installed cannot be shifted from one place to another

even within the premises of the subscriber. Thus the appellant

exercises complete control over the computers installed at the premises

of the subscribers.

3. In some cases the appellant itself has placed those computers and in all

the cases the appellant through its agent installs the telecommunication

network.

4. The ITAT ruled that appellant did have fixed place PE in India, which

comes in existence on operation being performed through computers

in India. Thus the computers/hardware installed at TA’s premises gave

rise to appellant’s fixed place of business in India (as it exercised

complete continuous control over the same).

. Exceptions to the above rule which is stated in article 5(3)

1. Article 5(3) lists a number of activities, which are preparatory and

auxiliary in nature, these activities act as exceptions to the general

definition laid in article 5(1) and which are not regarded as PE’s even

when the activity is carried through a fixed place of business.

2. The activity of the appellant is developing and maintaining a fully

automatic reservation and distribution system with the ability to

perform comprehensive information, reservation, communication,

ticketing, distribution and related function on a world wide basis.

Thus, ITAT ruled that since appellant’s activities in India contributed

directly to revenue generation, it do not fall in umbrella of ‘preparatory

or auxiliary’ clause of subject DTAA. .

. Agency rule stated in Article 5(4)

1. Under the said article, an agent is a person employed to do any act for

another or to represent another in the dealing with the third person. Thus,

any agent can be considered PE only and only if when a person other than

agent of independent status,

i) Has and habitually exercise in that state an authority to conclude

contract, or

ii) Though it has no such authority but habitually maintains stock of

goods from which he regularly deliver goods on the behalf of the

enterprise.

2. In the present case Interglobe is completely dependant on the appellant in

respect of rendering services to the subscribers. Thus that part of the

income, which earns its revenue by rendering services to the subscribers,

is carried on solely by the appellant. Even though the distributor may have

other business activities, in respect of the CRS business the distributor acts

only for the appellant and not for any other person. Thus the tribunal said

that Interglobe is a dependant agent (DA) of the appellant.

3. Also, although the distributor is responsible for entering into the contracts

with the subscribers, yet the appellant through the PCA ensures that the

subscribers are authorized to use the ‘Galileo system’. Therefore,

Interglobe is a DA of the appellant who has habitually exercised the

authority to conclude contracts on the behalf of the appellant

4. In the case of Galileo, if the agent is to deliver the goods either the goods

should be such in which the enterprise deals in or which are regularly

hired out which may be considered as given on bailment from which the

revenue is generated.

But in the present case the computers supplied by Interglobe to the

subscribers are not dealt with by the appellant or which is by itself is the

source of revenue. Thus clause (b) of paragraph 4 of article 5 does not

apply to consider the dependant agent as PE of the appellant in India.

5. In a nutshell, the ITAT held that the distributor is a DA of the appellant to

the extent that it exercises the authority to conclude contracts on behalf of

the appellant.

. Attribution of profits under article 7 of the DTAA.

• Having considered that the appellant had a PE in India under two

forms- fixed place PE and agency PE the ITAT examined as to what is

the profit attributable to the PE under the said article.

• Article 7 of the treaty postulates that only that much of profit as are

arising due to assets and activities of the PE can be brought to tax and

if the whole of the business activities are not apportioned between that

arising in India and outside India.

• Since the entire activity of Galileo is not carried out in India where the

PE is situated so, only that much of the profit is attributable to the

functions carried through the PE, and only this much of the attributed

profit can be taxable in India.

• On attribution front under subject DTAA, ITAT after deliberating

upon Para 5 of Article 7 thereof (supra) reiterated its findings that 15%

of ‘booking’ revenue generated to assessee is taxable in India and

since assessee remunerated Interglobe (agent in India) more than what

is attributable to PE in India, it extinguishes any further assessment.

Conclusion

This ruling enhances the possibility of identified as a PE for the companies using

internet and information technology in the business. This ruling creates

difficulties for the MNC’s for managing the risk of PE. It also needs to review the

importance of this ruling and its effects.

Investor considerations

· India has a growing network of treaties.

· Any applicable treaty or domestic law, whichever is more beneficial applies.

· The treaty definition of "permanent establishment" and taxation of only such business profits as are attributable thereto limit exposure otherwise possible under domestic law.

· Lower withholding rates are available for certain dividends, interest, royalties, land fees for technical services.

· Generally, Indian treaties do not contain a separate article to prevent treaty shopping.

Tax treaty policy

The government of India continues its policy to expand the network of international tax treaties and renegotiate existing treaties. Appendix V lists the treaties in force. The air of the treaties is to relieve double taxation, curb tax evasion, and attract know-how and technology. As a developing country, India seeks inclusion of tax-sparing provisions in its treaties with developed counties, and this has often been a stumbling block in concluding treaties (e.g., with the United States). India also seeks to retian the right to tax royalties land fees for technical services from Indian sources, although in many cases at withholding rates lower than the general rate. Most treaties are comprehensive, but some treaties are limited to aircraft and / or shipping.

The later treaties tend to follow the U.N. Model Convention. Any applicable tax treaty or domestic law, whichever is more beneficial, applies.

Withholding taxes

Under domestic law, the rate of withholding tax is 20 percent from dividends and taxable interest on foreign currency loans payable to nonresidents. A lower rate of 10 percent applies in certain cases (see Appendix IV). The general rate of withholding tax on royalties and fees for technical services payable to foreign companies under agreements approved by the government or in accordance with declared industrial policy is 30 percent.

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Authority Tribunal

In Re: Advance Ruling A. No. P-11 Of ... vs Unknown on 9 February, 1996

Equivalent citations: 1997 228 ITR 55 AAR

Bench: S Ranganathan, D Lal, R Meena

RULINGS

Application No. P-11 of 1995

Decided On: 09.02.1996

Appellants: In Re: Advance Ruling A. No. P-11 of 1995 Vs.

Respondent:

Hon'ble Judges:

S. Ranganathan, J. (Chairman), D.B. Lal and R.L. Meena, Members

Subject: Direct Taxation

Acts/Rules/Orders:

Income Tax Act, 1961

RULING

1. This application seeks the ruling of this Authority as per the provisions of Chapter XIX-B of the Income-tax Act, 1961, on certain questions which arise out of certain transactions entered into by the applicant in India. The applicant is a company duly incorporated and existing under the laws of Singapore. Accordingly, it is a resident of Singapore.

2. The facts having a bearing on the question on which ruling has been sought, as stated by the applicant, and as brought out from the other relevant records, are as follows :

(a) During the previous year ending on March 31, 1995, the applicant entered into the following two contracts with ABC for providing services related to burial of pipelines off-shore India.

(i) X pipeline project ; and

(ii) Y trunk pipeline project.

The scope of work in these contracts included burial of pipelines both onshore and offshore India and involved the following activities :

* mobilisation and demobilisation ;

* pre-trenching survey ;

* installation of pipeline crossing, pipe supports and free span rectification works ;

* subsea welding ;

* installation of submarine cables ;

* pipeline rigging, testing and drying.

(b) The job executed by the applicant was in the nature of a turnkey sub-contract because the main contract from the Oil and Natural Gas Commission was obtained by XYZ. This contract, inter alia, envisaged installation of pipeline crossing, free span rectification works, subsea welding, submarine cables, testing, drying, etc. Part of the job was subcontracted to the ABC by the XYZ. The ABC in turn further sub-contracted the job of burial of pipeline to the applicant. The contracts of the applicant being in the nature of turnkey sub-contracts, all marine vessels, personnel and equipment were provided by the applicant.

(c) The duration of the two contracts was 7 days and 39 days respectively.

(d) The fact that the activities under the contract were performed in Indian territory is undisputed. Therefore, in the normal course the income from such activities would have been assessable to income-tax in India.

3. However, it has been contended by the applicant that the specific provisions of the "Agreement for Avoidance of Double Taxation and Prevention of Fiscal evasion with respect to taxes on income" concluded between the Government of the Republic of India and Republic of Singapore (Agreement for Avoidance of Double Taxation) which came into force on May 27, 1994, should overrule the general provisions of the Indian Income-tax Act, 1961. It has further been contended that as per the provisions of the Agreement for Avoidance of Double Taxation, the applicant does not have a permanent establishment (P. E.), in India and, therefore, it cannot be subjected to income-tax on the profits earned from these operations. Accordingly, the following question has been raised before the Authority :

" The taxability [in terms of Article 5 of the Agreement for Avoidance of Double Taxation concluded between India and Singapore on January 20, 1994] of revenues earned by the applicant, a tax resident of Singapore, from the contracts entered into with ABC during the previous year ended on March 31, 1995."

4. Since any answers to the questions raised by the applicant will involve consideration of the relevant articles of the Agreement for Avoidance of Double Taxation, they may be set out in so far as they are relevant.

(See [1994] 209 ITR (St.) 1, 4, 8).

"Article 5

(1) For the purposes of this Agreement, the term 'permanent establishment' means a fixed place of business through which the business of the enterprise is wholly or partly carried on.

(2) the term 'permanent establishment' includes especially :

(a) a place of management ;

(b) a branch ;

(c) an office ;

(d) a factory ;

(e) a workshop ;

(f) a mine, an oil or gas well, a quarry or any other place of extraction of natural resources ;

(g) a warehouse in relation to a person providing storage facilities for others ;

(h) a farm, plantation or other place where agriculture, forestry, plantation or related activities are carried on ;

(i) premises used as a sales outlet or for soliciting and receiving orders ;

(j) an installation or structure used for the exploration or exploitation of natural resources but only if so used for a period of more than 120 days in any fiscal year ;

(3) A building site or construction, installation or assembly project constitutes a permanent establishment only if it continues for a period of more than 183 days in any fiscal year."

"Article 7

(1) 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. If the enterprise carries on business as aforesaid, 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."

5. The Authority has no hesitation in accepting the contention of the applicant that the specific provisions of the Agreement for Avoidance of Double Taxation should override the general provisions of the Income-tax Act, 1961, because by now it is a settled law. The Department also has not raised any objection against this contention of the applicant. Therefore, it is to be considered whether the income of the applicant earned from the contracts mentioned earlier is taxable or not as per the provisions of the Agreement for Avoidance of Double Taxation. For this purpose it has first to be decided as to whether the applicant had a permanent establishment in India as per the provisions of Article 5 of the Agreement for Avoidance of Double Taxation or not. Since the applicant was only engaged in the burial of pipelines, therefore, it cannot be said that there was any fixed place through which its business was carried on. Thus, the applicant can be said to have a permanent establishment in India only if the nature of its activities in the Bombay High can be brought within the scope of Clause (f) or (j) of para 2 or para 3 of Article 5 of the Agreement for Avoidance of Double Taxation. It was argued on behalf of the applicant that the burial of the pipelines in the seabed amounted to installation as per the requirement of para 3 of Article 5 of the Agreement for Avoidance of Double Taxation. On the other hand, the Additional Commissioner of Income-tax who appeared on behalf of the Commissioner of Income-tax, stressed that the activities of the applicant are covered within the scope of Clause (f) of para 2 of Article 5 of the Agreement for Avoidance of Double Taxation. He maintained that the installation work was in fact carried out by the ABC and the applicant was awarded only a part of the work by the ABC and, therefore, it cannot be said that the applicant has carried out any installation work in the Bombay High. According to him as oil and gas-well has specifically been covered by the Agreement for Avoidance of Double Taxation in Clause (f) of para 2 of Article 5, it cannot be covered under any other Clause of the Agreement for Avoidance of Double Taxation. This argument of the Department cannot be accepted because the applicant has only worked on the oil or gas-well and the oil well in question was not owned or operated by the applicant.

6. From a perusal of the scope of the work carried on by the applicant, it is clear that the applicant was engaged in an installation and assembly project which pertained to the burial of pipelines in the seabed. Such activities are covered by para. 3 of the Article 5 of the Agreement for Avoidance of Double Taxation and not by Clause (f) of para 2 of Article 5 as claimed by the Department. But para. 3 permits such project to be treated as a permanent establishment only if the duration of the project exceeds 183 days in any fiscal year, which is not the case here. It, therefore, follows that the applicant has no permanent establishment in India within the meaning of Article 5 of the Agreement for Avoidance of Double Taxation and since Article 7 of the Agreement for Avoidance of Double Taxation permits the taxation, in the hands of a resident of Singapore, only of the profits attributable to a permanent establishment in India, no part of the profits earned by the applicant from its activities under the contract can be charged to Indian income-tax even though such activities took place within Indian territory and the profits therefrom would have been chargeable to tax in India but for the Agreement for Avoidance of Double Taxation.

7. For the reasons discussed above, the Authority pronounces the following ruling on the question raised in Application No. P-11 of 1995.

RULING

8. The revenues earned by the applicant from the contracts entered into with ABC, Singapore, during the previous year ended on March 31, 1995, would not be liable to tax in India, as it had no permanent establishment in India.

===================================================================================================================================

Income Tax Appellate Tribunal - Kolkata

Abn Amro Bank Nv vs Joint Commissioner Of Income Tax on 17 June, 2005

Equivalent citations: (2005) 96 TTJ Kol 1041

Bench: R Garg, M Bakshi, S Vice, P Kumar

JUDGMENT

M.A. Bakshi, Vice President

1. These 4 appeals of the assessee relating to asst. yrs. 1992-93, 1993-94, 1994-95 and 1995-96 involving some common issues are disposed of by this consolidated order.

2. The appellant is a branch of ABN AMRO Bank NV incorporated in Netherlands, with limited liability having its original office at Singapore. In India, the appellant is registered as a scheduled bank in terms of Schedule II of the Reserve Bank of India (RBI) Act, 1934. The main activities of the appellant in India comprise of accepting deposits, giving loans, discounting/collection of bills, issue of letters of credit/guarantees, executing forward transaction in foreign currencies for importers/exporters, money market lending/borrowings, investment in securities, etc., in terms of the existing rules and regulations governing such transactions. In the years under consideration, the appellant had three branches in India at Mumbai, Kolkata and New Delhi. There is an agreement between India and Netherlands for Avoidance of Double Taxation and Prevention of Fiscal Evasion (hereinafter called as DTAA). Article 7 of the DTAA provides for taxation in India of a foreign enterprise in respect of profits attributable to its permanent establishment (hereinafter referred to as PE) in India. Since the ABN AMRO Bank NV was having a PE in India, the appellant is liable to tax in respect of income attributable to the PE.

3. One of the common issues involved in all the four assessment years is relating to deduction on account of remuneration paid to the expatriate employees outside India for the services rendered in India. Tax deducted at source and paid in previous year relevant to asst. yr. 1995-96 is also claimed as a deduction in the respective assessment years. Interest under Section 201(1A) for delayed payment of TDS paid in 1995-96 is subject-matter of dispute in the appeal for asst. yr. 1995-96 only. By way of additional ground of appeal and as an alternative claim, the appellant has claimed deduction of entire remuneration and TDS pertaining to asst. yrs. 1990-91 to 1995-96 in asst. yr. 1995-96.

4. The relevant grounds of appeal for the respective assessment years are reproduced hereunder :

Asst. yr. 1992-93 :

"1. That, on the facts and in the circumstances of the case, the learned CIT(A) erred in confirming the disallowance of Rs. 23,87,325, being the offshore remuneration paid by the head office in the current financial year to the expatriate employees rendering services in India, on the basis of the reasons stated in his order for the asst. yr. 1995-96, without considering the submissions made by the appellant.

(2) That, on the facts and in the circumstances of the case, the learned CIT(A), on the basis of the reasons stated in his earlier order for the asst. yr. 1995-96, erred in confirming the disallowance of Rs. 29,86,963, being that part of the remuneration of the expatriate employees rendering service in India paid by the appellant and representing the tax deducted at source after grossing up the expatriate's total income taxable in India as per the terms of employment."

Asst yr. 1993-94 :

"1. That, on the facts and in the circumstances of the case, the learned CIT(A) erred in confirming the disallowance of Rs. 61,90,206 under Section 40(a)(i) of the IT Act, 1961 (the Act), representing offshore remuneration paid by the head office to the expatriate employees rendering services in India.

2. That, on the facts and in the circumstances of the case, the learned CIT(A) erred in confirming the disallowance of Rs. 49,44,312 under Section 40(a)(i) of the Act, representing that part of the remuneration of the expatriate employees rendering service in India paid by the appellant and representing the tax deducted at source after grossing up the expatriate's total income taxable in India as per the terms of employment."

Asst. yr. 1994-95 :

"1. That, on the facts and in the circumstances of the case, the learned CIT(A) erred in confirming the disallowance of Rs. 47,16,025, being the offshore remuneration paid by the head office in the current financial year to the expatriate employees rendering services in India, on the basis of the reasons stated in his order for the asst. yr. 1996-97, without controverting the submissions made by the appellant.

2. That, on the facts and in the circumstances of the case, the learned CIT(A), on the basis of the reasons stated in his earlier order for the asst. yr. 1996-97, erred in confirming the disallowance of Rs. 35,86,781, being that part of the remuneration of the expatriate employees rendering service in India paid by the appellant and representing the tax deducted at source after grossing up the expatriate's total income taxable in India as per the terms of employment."

Asst. yr. 1995-96 :

"On the facts and in the circumstances of the case the CIT(A) erred in confirming disallowance of Rs. 89,04,276 being the remuneration, tax and interest paid in the current financial year in respect of the expatriate employees. The CIT(A) erred in not appreciating that all the details and explanations called for by the AO had duly been filed during the course of the assessment proceedings, but, which were not taken note of by the AO in his assessment order. The CIT(A), therefore, erred in not giving cognizance to the appellant's submissions made during the course of the assessment while adjudicating upon this issue.

The CIT(A) erred in rejecting the alternative claim made by the appellant on deduction of the entire amount of Rs. 2,06,54,499, being tax and interest in respect of offshore remuneration of the expatriate employees for all the assessment years including the current assessment year paid in the current assessment year. The CIT(A) erred in holding that the said expenditure is not a revenue expenditure of the appellant on the ground that the taxes have been paid purely on behalf of the expatriate employees and if there is any liability for payment of the same, it rests on those expatriate employees. The CIT(A) failed to appreciate that, once the appellant undertook to discharge the tax liability of the expatriates, it became the obligation of the appellant to pay the necessary taxes to the Government, much in the same way as is the case where an employer undertakes to pay salary net of tax to an employee. The CIT(A), therefore, should have allowed the entire amount of expenditure as revenue expenditure of the appellant."

5. Following additional ground of appeal has been raised for asst. yr. 1995-96 :

"In determining the business profits of the appellant, the sum of Rs. 1,45,31,635 being the offshore remuneration paid by the appellant to its expatriate employees in the asst. yrs. 1990-91 to 1994-95 is (in addition to the sum of Rs. 2,06,54,499, being the tax and interest thereon, already claimed) also allowable as a deduction in the asst. yr. 1995-96, being the year in which the appellant paid the taxes on the said offshore remuneration.

In the asst. yr. 1995-96, the appellant is entitled to a deduction for the aggregate amount of Rs. 4,04,21,356, (i.e., Rs. 1,97,66,857 on account of the offshore remuneration of expatriate employees and Rs. 2,06,54,499 on account of tax and interest thereon)."

Since the additional ground "of appeal is purely legal in nature and no investigation of facts is required, we admit the same for consideration.

6. We now proceed to dispose of the above grounds simultaneously. Under Section 192 of the IT Act 1961, the assessee was required to deduct tax from the salary paid to their expatriate employees. Some of the expatriate employees having rendered services in India, had received their remuneration outside India. It is not disputed that the income derived by such expatriate employees from the services rendered in India is liable to tax in India notwithstanding the fact that they received their remuneration outside India. The assessee had failed to deduct tax from the remuneration paid to the said expatriate employees. Whereas the remuneration paid to the expatriate employees in India had been taken into account in the books of account of the assessee relevant to the PE, the remuneration paid to the offshore employees who had rendered services in India but whose remuneration was paid abroad, had been debited in the books of account of head office. As pointed out earlier, the assessee-bank had failed to deduct taxes under Section 192 in respect of remuneration of such employees paid outside India for services rendered in India. The CBDT, in order to encourage the compliance in respect of TDS, issued Circular No. 685, dt. 20th June, 1994 providing exemption from penalty and prosecution to those employers who paid the tax deducted/deductible at source by the specified date in the circular. The said circular is quoted for ready reference :

"1. It has come to the notice of the Board that some of the employers, including foreign companies operating in India, have been defaulting in deducting tax at source as required under Section 192, on the salaries and allowances paid abroad or perquisites provided abroad, to their employees for services rendered in India. In some cases, tax might have been deducted at source, but not remitted to the Government. All payments and perquisites to employees for services rendered in India are taxable in India irrespective of the place where the payment occurs. The employers are, therefore, liable to deduct tax at source even on payment of salary, allowance and perquisites paid or provided abroad to their employees who have rendered service in India. They are also required to remit such deducted tax to the Government. Failure to comply with these requirements would render the employer an assessee-in-default and would attract interest under Section 201(1A). Penalties under Sections 221 (assessee-in-default) and 271C (failure to deduct tax) are then leviable and prosecution proceedings under Section 276B can also be initiated in such cases.

2. To encourage immediate voluntary compliance, the Board has decided that proceedings under Sections 221 and 271C for levy of penalties and proceedings under Section 276B for prosecution need not be initiated in cases where an employer voluntarily comes forward and pays the whole of the tax due under Section 192, along with interest liability under Section 201(1A) on or before 31st July, 1994.

3. Employers (Indian and foreign), who committed default in the past are advised to make use of this opportunity to pay up arrears of TDS (tax deductible at source) together with interest on or before 31st July, 1994 and avoid penalty and prosecution proceedings."

This was followed by another circular being Circular No. 686, dt. 12th Aug., 1994, which reads as under :

"1. Reference is invited to Board's Circular No. 685, dt. 20th June, 1994 (File No. 275/69/94-ITB), providing for non-initiation of proceedings under Section 221/276B/271C of the IT Act, 1961, in respect of employers defaulting in deducting tax at source on the salaries and allowances paid abroad or perquisites provided abroad to their employees for services rendered in India. Doubts have been raised in some quarters as to whether, due to the disclosure of the excess salary payments by the employers, any consequential action will be taken in the hands of the employees.

2. The Board has considered the matter. The spirit behind issue of Circular No. 685, dt. 20th June, 1994, was to encourage immediate voluntary compliance on the part of the employers defaulting in tax deduction. In order that this intention is fully achieved, the Board has decided that the assessments of the employees, in respect of whom payments of short deduction and interest thereon are made by the employers in pursuance of Circular No. 685, dt. 20th June, 1994, will not be reopened or otherwise disturbed merely on account of the excess salary payments now disclosed by the employers."

7. The assessee took advantage of the circular and paid a sum of Rs. 2,06,54,499 detailed below as tax deducted at source and interest under Section 201(1A) for asst. yrs. 1990-91 to 1995-96. The net offshore remuneration in respect of expatriate employees is also indicated in the statement as under:

Details Asst. yr. Asst yr. Asst yr. Asst yr. Asst. yr. Asst yr. Total

1990-91 1991-92 1992-93 1993-94 1994-95 1995-96

Tax (As TDS 3,61,635 10,54,924 29,86,963 49,44,312 35,86,781 36,15,895 1,65,50,510

arrears)

Int.u/s. 201 2,45,859 5,80,300 12,19,063 13,24,577 6,81,031 53,159 41,03,989

_________ _________ __________ __________ _________ _________ __________

Sub Total 6,07,494 16,35,224 42,06,026 62,68,889 42,67,812 36,69,054 2,06,54,499

Net offshore 3,27,276 9,10,803 23,87,325 61,90,206 47,16,025 52,35,222 1,97,66,857

remuneration paid

in Netherlands

__________ __________ _________ __________ _________ _________ ___________

Total 9,34,770 25,46,027 65,93,351 124,59,095 89,83,837 89,04,276 4,04,21,356

8. For asst. yr. 1995-96, the assessee had charged the total amount of Rs. 2,06,54,499 to the P&L a/c. However, the said amount was added back in the statement of income. A deduction of Rs. 89,04,276 was claimed on account of the remuneration, TDS and interest pertaining to the asst. yr. 1995-96 in the statement of account.

9. For asst. yrs. 1992-93 to 1994-95, the appellant had not made any claim for remuneration or tax component in the returns of income. So, however, for asst. yr. 1992-93, the assessee made claim before the AO in regard to the remuneration and tax deducted at source in respect of expatriate employees having rendered services in India for which the payment had been made abroad, vide letter dt. 13th Jan., 1995. The AO rejected the claim while making the assessment. The relevant portion of the assessment order is reproduced hereunder :

"Our head office has paid remuneration to expatriates offshore who have rendered services in our branches in India. Such remuneration was not debited in the books of account of the branch. We had not claimed the deduction of such remuneration to expatriates offshore in our original computation of total income.

We wish to submit that such remuneration to expatriates offshore is expenditure incurred wholly and exclusively for our business purposes in India and as such is allowable deduction from our taxable income in India. We wish to further submit that the fact that such remuneration was not debited in our books of account in India, would not come in the way of our claiming the said deduction. In this connection we place reliance on the Supreme Court decision in the case of Kedarnath Jute Mfg. Co. Ltd. v. CIT .

Accordingly, we now wish to claim the said deduction to the extent of amount of such remuneration pertaining to fiscal year 1991-92 (relevant to the asst. yr. 1992-93) amounting to Rs. 23,87,325.

(iii) Tax on remuneration paid to expatriates offshore :

The assessee has further stated in the said letter of 13th January as under :

We have paid tax in fiscal year 1994-95 on remuneration to expatriates offshore pertaining to the period under the Amnesty Scheme announced by the CBDT vide Circular No. 685, dt. 17/20th June, 1994.

To the extent such tax pertained to fiscal year 1991-92 (relevant to. asst. yr. 1992-93) we now wish to claim the deduction of tax paid by us in fiscal year 1994-95 in pursuance of the Amnesty Scheme amounting to Rs. 29,86,963.

The break-up of the figures filed by the assessee are as under : Name of the Net offshore Additional tax Total offshore Tax t hereon

expatriates remuneration borne by the remuneration (Rs .)

offshore staff (Rs.) bank (Rs.) (Rs.)

Mr. Moulder 14,00,121 17,81,972 31,82,093 17,81 ,972

Mr. Merckx 7,98,546 10,16,333 18,14,879 10,16 ,333

Mr. Koster 1,88,658 1,88,658 3,77,316 1,88 ,658

___________ ____________ ___________ _____ _____

23,87,325 29,86,953 53,74,288 29,86 ,963"

10. For asst. yr. 1993-94, the assessee had filed a letter dt. 21st April, 1995, during the course of assessment proceedings making the claim for deduction for remuneration and tax paid in respect of expatriate employees who had rendered services in India but had received payment abroad. The AO rejected the claim for the reasons recorded in para 7 of the assessment order which is reproduced hereunder :

"7. By a letter dt. 21st April, 1995, the assessee-bank has claimed the following in the revised computation of income :

(i) Remuneration paid to expatriate offshore Rs. 61,90,206

'Our head office has paid remuneration to expatriates offshore who had rendered services in our branches in India. Such remuneration was not debited in the books of account of the branch. We had, therefore, inadvertently not claimed a deduction of such remuneration to expatriate offshore in our original computation of total income.

We wish to submit that such remuneration to expatriates offshore is expenditure incurred wholly and exclusively for our business purposes in India and as such is allowable deduction from our taxable income in India. We wish to further submit that the fact that such remuneration was not debited in our books of account in India, would not come in the way of our claiming the said deduction. In this connection, we place reliance on the Supreme Court decision in the case of Kedarnath Jute Mfg. Co. Ltd. v. CIT . Accordingly, we have now claimed the said

deduction in the revised computation of total income to the extent of amount of such remuneration pertaining to fiscal year 1992-93 (relevant to the asst. yr. 1993-94) amounting to Rs. 23,87,325.'

(ii) Additional remuneration paid to expatriates towards taxes--Rs. 49,44,312 :

The assessee has further stated in the said letter dt. 21st April, 1995 that--

In fiscal year 1994-95, additional payment for the period 1989-90 to 1994-95 were made to expatriates to cover the tax payable by them under Amnesty Scheme introduced by the CBDT vide Circular No. 685, dt. 17/20th June, 1994. Payments to the extent they relate to the previous year relevant to this assessment year are now claimed as a deduction. We have accordingly, revised the computation of total income.'

I have carefully considered the submissions of the assessee. I, however, find that the facts of the case relied upon by the Authorised Representative are not all for the present case and as such the decision in the case of Kedarnath Jute Manufacturing Co. Ltd. (supra) is not applicable to this case. Salary was paid to the expatriates rendered services in India by the head office of the bank and the same has not been debited to the accounts of the bank in India. In the circumstances, the claim for deduction of Rs. 61,90,206 cannot be accepted. As regards the claim for deduction of Rs. 49,44,312 being tax borne by the bank as salary paid to the expatriates offshore, it is to be noted that the payments have been made only in fiscal year 1994-95. In the circumstances, the assessee's claim for deduction of Rs. 49,44,312 in the assessment for the asst. yr. 1993-94 cannot be entertained.

Hence, the assessee's claim for deduction of Rs. 61,90,206 on account of salary paid to expatriates offshore and Rs. 49,44,312 being tax paid on salaries to expatriates are disallowed in the assessment year but will be considered in the assessment for the asst. yr. 1995-96 relevant to the fiscal year 1994-95."

11. For asst. yr. 1994-95, the assessee vide letter dt. 8th Oct., 1996, claimed a deduction in respect of offshore remuneration and the tax paid in respect of such remuneration. The claim of the assessee was rejected by the AO vide para 8 of the assessment order, which is reproduced hereunder :

"8. Offshore payments (gross) made to expats : Rs. 83,02,812 :

The assessee-bank vide its letter of 8th Oct., 1996 has given the break-up of the above figure which is as under :

(i) Net offshore remuneration paid by the head office in Amsterdam 47,16,0 25

(ii) Tax perquisite--being tax borne by the bank in India 36,86,7 81

_______

____

84,02.8

06

_______

____

This aspect has been discussed in detail by my predecessor in his order dt. 25th March, 1996 (p. 3, para 7 of the said order) passed under Section 143(3) of the IT Act for the asst. yr. 1993-94, and in view of the reasons stated therein, the aforesaid amount of Rs. 83,02,812 disallowed in this assessment and the same will be considered in asst. year 1995-96."

12. For asst. yr. 1995-96, in the assessment order, the AO has mentioned that the assessee had in course of assessment proceedings claimed deduction of the entire amount of Rs. 2,06,54,499 on the basis of Section 43B of the IT Act, 1961. However, the AO disallowed the claim of the assessee relating to the earlier years for the following reasons :

"(i) TDS paid for earlier years is not covered under Section 43B as it is not regular payment of tax or Government dues. The amount has been paid under Amnesty Scheme and, therefore, it is not allowable. Moreover, the amount does not pertain to the year under consideration.

(ii) Remuneration and TDS paid by the assessee for the earlier years have not been included by the concerned employees for their income-tax purposes in India for which the assessee is liable.

(iii) Interest on TDS is not a business expenditure and it does not pertain to the year of assessment, i.e., asst. yr. 1995-96."

13. In regard to the disallowance of Rs. 89,04,296 pertaining to the asst. yr. 1995-96, the AO disallowed the claim for the following reasons :

"(a) Assessee has not given detail as to how much amount out of such remuneration has already been claimed as expenditure by any other office of the assessee, particularly because assessee is not allowed to claim the same expenditure twice, once in other country and again in India.

(b) Assessee has not given details of services rendered, place of services rendered and terms of agreement regarding such employees/offshore expatriates.

(c) The said remuneration has not been included in the income of concerned employees for taxation in India for which assessee is, therefore, liable.

(d) The payment has been made under Amnesty Scheme and it is not a regular payment. Therefore, not allowable under regular provisions.

(e) Assessee is allowed head office expenses @ 5 per cent of taxable income in India. Therefore in such expenditure including the remuneration under consideration has merged with head office expenses and, therefore, it is treated as allowed by way of head office expenses."

The AO has further observed in the assessment order as under :

"The above said reasons for not allowing offshore expatriates remuneration applies to interest, TDS and remuneration paid for earlier years also. Therefore, in view of the above discussion and reasons, the claim of assessee relating to interest, TDS and remuneration for earlier years and for the year under consideration is disallowed."

14. The CIT(A) has confirmed the disallowance. The relevant portion of the order being paras 8, 9 and 10 are reproduced hereunder :

"8. Ground No. 4(a) of appeal relates to disallowance of a sum of Rs. 89,04,276 being the remuneration, tax and interest paid in the current financial year to the expatriate employees. While disallowing, the AO has given the following reasons :

(a) the payment has been made under Amnesty Scheme and it is not a regular payment, therefore, not allowable under regular provisions.

(b) the said remuneration has not been included in the income of concerned employees for taxation in India for which assessee is, therefore, liable.

(c) Assessee has not given details of services rendered, place of services rendered and terms of agreement regarding such employees/offshore expatriates.

(d) Assessee has not given detail as to how much amount out of such remuneration has already been claimed as expenditure by any other office of the assessee. Particularly because assessee is not all to claim the same expenditure twice, once in other country and again in India.

(e) Assessee is allowed head office expenses @ 5 per cent of taxable income in India. Therefore, in such expenditure including the remuneration under consideration has merged with head office expenses and, therefore, it is treated as allowed by way of head office expenses.

9. Keeping in view the detailed reasons given by the AO and also after carefully examining the arguments put forward by the appellant-company, I am of the opinion that the AO was perfectly justified in disallowing the sum of Rs. 89,04,276. The addition made by the AO is, therefore, confirmed.

10. Ground No. 4(b) of appeal relates to the AO rejecting the claim of the appellant for deduction of the entire amount of Rs. 2,06,54,499 being tax and interest on offshore remuneration of the expatriate employees for all the assessment years including the current assessment year paid in the current assessment year. The facts are that CBDT had launched a scheme whereby defaulters of TDS in terms of salary and remuneration paid to expatriate employees abroad tax could be paid by the employer. The appellant-company took advantage of this scheme and paid tax and interest due thereupon for several assessment years with respect to payment made to its expatriate employees to save itself from the rigour of prosecution, although in other sense of the term, these taxes were due and collectable from the expatriate employees from whom the appellant-company in earlier years had failed to collect taxes in accordance with the Indian law and pay the same. Even now, I will say that these taxes have been paid purely on behalf of the expatriate employees and if there is any liability for payment of the same to the bank it rests on those expatriate employees. The appellant cannot say that this should be treated as revenue expenditure. Therefore for the detailed reasons given above, I am of the opinion that the taxes paid by the appellant-company because of its own fault in not collecting taxes from its expatriate employees in time and depositing the same with the Government of India cannot be allowed as a revenue expenditure. The AO was perfectly justified in disallowing the same and, therefore, the addition of Rs. 2,06,54,499 is sustained."

15. The learned counsel for the assessee contended that the assessee is entitled to deduction on account of remuneration paid to expatriate employees outside India for the services rendered in India. Since the expenditure is directly related to PE in India, deduction is allowable as expenses pertaining to the PE. It was pointed out that the salary paid to the employees does not fall within the ambit of Section 44C as head office expenses. The learned counsel pointed out that the 'head office expenditure' is defined to mean executive and general administration expenditure incurred by the assessee outside India, including specified expenses referred to in the definition under Expln. (iv) to Section 44C of the IT Act. It was further pointed out that similar issue had come up for consideration of the Tribunal in the assessee's own case for the asst. yr. 1996-97 in ITA No. 692/Cal/2000, dt. 30th March, 2001 and the same has been decided in favour of the assessee. It was, accordingly, pleaded that the deduction may be allowed to the assessee either in the year to which the remuneration, etc., pertains to or in the year the tax has been deducted and paid to the Government of India. In this connection our attention was invited to Section 40(a) which prohibits the allowance on account of fee for technical services or other sums chargeable which is payable outside India on which tax has not been paid or deducted under Chapter XVII-B. The learned counsel pointed out that the proviso to the said section provides for a deduction in the year in which such tax has been paid or deducted. It was," accordingly, pleaded that the deduction for the entire amount may be allowed to the assessee in the asst. yr. 1995-96 as the tax has been deducted and paid in the previous year relevant to the said assessment year.

16. The learned Departmental Representative, on the other hand, relied upon the orders of the Revenue authorities. Our attention was invited particularly to the reasons given by the AO in asst. yr. 1995-96 for making the disallowance.

17. We have given our careful consideration to the rival contentions. We propose to consider the dispute separately under three heads, viz., (a) remuneration; (b) tax deducted at source; and (3) interest. First we take up the issue relating to remuneration.

Remuneration :

18. The assessee had failed to deduct tax in respect of the remuneration paid to the expatriate employees outside India and after taking advantage of the amnesty granted by the Government of India in respect of penalty and prosecution, had deposited the tax deductible from such expatriate employees. For asst. yrs. 1992-93 to 1994-95, no deduction, either in respect of remuneration or tax payment, was claimed in the original returns. So, however, after having paid the tax, deduction was claimed in course of the assessment proceedings for the respective assessment years. Article 7 of the DTAA between India and Netherlands provides for taxation of income of the PE. The said article also provides certain guidelines for determination of the profits of PE for the purpose of taxation in India. It will be useful to reproduce paras 2 and 3(a) of Article 7 of the DTAA :

"2. Subject to the provisions of para 3, where an enterprise of one of the States carries on business in the other State through a permanent establishment situated therein, there shall in each State be attributed to that permanent establishment the profits 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 permanent establishment. In any case, where the correct amount of profits attributable to a permanent establishment is incapable of determination or the determination thereof presents exceptional difficulties, the profits attributable to the permanent establishment may be estimated on the basis of an apportionment of the total profits of the enterprise to its various parts, provided, however, that the result shall be in accordance with the principles contained in this article.

3.(a) In determining the profits of a permanent establishment, there shall be allowed as deduction, expenses which are incurred for the purposes of the permanent establishment, including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere, in accordance with the provisions of and subject to the limitations of the taxation laws of that State. Provided that where the law of the State in which the permanent establishment is situated imposes a restriction on the amount of the executive and general administrative expenses which may be allowed, and that restriction is relaxed or overridden by any Convention between that State and a third State which enters into force after the date of entry into force of this Convention, the competent authority of that State shall notify the competent authority of the other State of the terms of the corresponding paragraph in the Convention with that third State immediately after the entry into force of that Convention and, if the competent authority of the other State or requests, the provision of this sub-para shall be amended by protocol to reflect such terms."

19. It is evident from above that para 2 of Article 7 provides that where an enterprise of one of the States carries on business in the other State through a PE situated therein, there shall in each State be attributed to that PE the profits 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 PE.

20. Para 3(a) of Article 7 provides that in determining the profits of a PE, there shall be allowed as deductions, expenses which are incurred for the purposes of the PE including executive and general administrative expenses so incurred, whether in the State in which the PE is situated or elsewhere, in accordance with the provisions of and subject to the limitations of the taxation laws of that State. Thus, it is evident from the above quoted article of the DTAA that any expenditure which is attributable to PE is to be taken into consideration for the purpose of computation of profits of the PE. We have, therefore, no doubt in our minds that the assessee is entitled to deduction in respect of the remuneration paid to the expatriate employees having rendered services in India notwithstanding the fact that the payment for such remuneration was paid to them outside India. This view has also been taken by the co-ordinate Bench in the assessee's own case for the asst. yr. 1996-97 and the issue has been decided vide paras 12 and 13 of the order in ITA No. 692/Cal/2000, dt. 30th March, 2001. The relevant portion of the said order of the Tribunal is reproduced hereunder :

"12. When the undisputed facts are that the employees concerned rendered wholetime services in India throughout the accounting year under consideration, any salary paid to them, whatever the same may be, will have to be allowed as expenses pertaining to the business of the assessee in India. It is also the case of the assessee that even taxes were deducted at source from those components of salary payment to the three expatriate employees in Netherlands and that the said taxes were duly deposited with the Government of India. If that be the case, we do not find any reason to disallow the claim of the assessee. In principle, therefore, we hold that the claim of the assessee towards offshore payment to the expatriate employees in India will have to be allowed.

However, it is found that the assessee charged Rs. 2.55 crores as head office charges on accrual basis in the books of account which was ultimately allowed in the assessment under Section 44C. The assessee also claimed in ground No. 7(b), before the CIT(A), alternatively that the remuneration to the expatriate employees rendering services in India should be included with the head office expenses for the purpose of allowing deduction under Section 44C. The CIT(A) has accepted the contention of the assessee and directed the AO to include the amount, if not already included, for the purpose of allowing deduction under Section 44C. In such a case, a separate claim of the assessee perhaps in respect of the same expenditure is certainly unwarranted. Even the learned counsel for the assessee also did not draw our attention to the allowance of the same amount under Section 44C as directed by the CIT(A). We feel that although the amount under consideration is required to be allowed in principle, the said allowance should, however, be allowed only once, i.e., either by way of salary payment to the expatriate employees or as a part of head office expenses under Section 44C. Since we have held that the amount should be allowed as salary payment to the expatriate employees, we specifically direct that the same amount should not be allowed as a part of head office expenses under Section 44C. The direction given by the CIT(A) in this regard at para 8 of his appellate order is, therefore, reversed as a corollary to our order with regard to the ground taken up by the assessee in this regard."

21. It is evident from the above order of the Tribunal that the claim of the assessee in regard to the payment of remuneration to the expatriate employees rendering whole time services in India throughout the accounting year has been accepted in principle as allowable deduction in computing the profits of the PE. This is, however, with the rider that such payment is not taken into account in working out the deduction under Section 44C. We adopt the above direction in regard to the remuneration paid to the expatriate employees for the whole time services rendered in India, subject to further rider placed under provisions of Section 40(a) of the IT Act, 1961. We direct the AO to consider the claim of the assessee for asst. yrs. 1992-93, 1993-94 and 1994-95 as under :

In principle, the remuneration paid to expatriate employees for the services rendered in India is to be accepted as allowable deduction in computing the profits attributable to PE. So, however, the AO is required to verify that the assessee has not taken such remuneration into account in working out the head office expenses under Section 44C. Section 44C reads as under :

"44C. Notwithstanding anything to the contrary contained in Sections 28 to 43A, in the case of an assessee, being a non-resident, no allowance shall be made, in computing the income chargeable under the head "Profits and gains of business or profession", in respect of so much of the expenditure in the nature of head office expenditure as is in excess of the amount computed as hereunder, namely :

(a) an amount equal to five per cent of the adjusted total income; or

(b) ...

(c) the amount of so much of the expenditure in the nature of head office expenditure incurred by the assessee as is attributable to the business or profession of the assessee in India,

whichever is the least."

Once the AO is satisfied that the assessee is entitled to deduction in respect of remuneration, the claim of the assessee shall have to be dealt with in accordance with Section 40. Relevant portion of Section 40(a) is reproduced hereunder :

"40. Notwithstanding anything to the contrary in Sections 30 to 38, the following amounts shall not be deducted in computing the income chargeable under the head "Profits and gains of business or profession",

(a) in the case of any assessee--

(i) any interest (not being interest on a loan issued for public subscription before the 1st day of April, 1938), royalty, fees for technical services or other sum chargeable under this Act, which is payable outside India, on which tax has not been paid or deducted under Chapter XVII-B :

Provided that, where in respect of any such sum, tax has been paid or deducted under Chapter XVII-B in any subsequent year, such sum shall be allowed as a deduction in computing the income of the previous year in which such tax has been paid or deducted.

Explanation--For the purposes of this sub-clause,--

(A) "royalty" shall have the same meaning as in Expln. 2 to Clause (vi) of Sub-section (1) of Section 9;

(B) "fees for technical services" shall have the same meaning as in Expln. 2 to Clause (vii) of Sub-section (1) of Section 9."

It may be pointed but that Section 44C provides for restriction for the allowance of head office expenses. The maximum deduction permissible is 5 per cent of the adjusted total income. The AO has allowed straightway deduction of 5 per cent and there is no reference of the computation of head office expenses which presumably are more than 5 per cent of the adjusted total income. The AO shall accordingly, verify the claim in accordance with the provisions of Section 44C for taking a decision in the light of the directions of the Tribunal in assessee's own case for asst. yr. 1996-97 (supra) which we have adopted for the years under appeal.

22. The aforementioned direction is valid for the offshore remuneration pertaining to asst. yrs. 1992-93, 1993-94, 1994-95 and 1995-96. In case after verification the AO comes to the conclusion that the assessee has not taken the amount of remuneration into consideration in working out the deduction under Section 44C, the claim would in principle be permissible in the respective assessment years. So, however, deduction has got to be allowed, as already pointed out, in accordance with Section 40(a) read with proviso. The tax not having been deducted at source in the respective assessment years but having been paid in asst. yr. 1995-96, the deduction in respect of remuneration is allowable in the year of payment, i.e., asst. yr. 1995-96. This takes care of part of the additional ground raised by the assessee before us in asst. yr. 1995-96, whereby the deduction in respect of the remuneration and tax component pertaining to asst. yrs. 1992-93 to 1994-95 is claimed as deduction in asst. yr. 1995-96. For asst. yr. 1995-96, tax has been paid by the assessee in the same assessment year. Therefore, the prohibition under Section 40(a) is not attracted. The claim of the assessee shall be considered accordingly. We direct accordingly.

23. Tax deducted at source in respect of remuneration paid outside India to the expatriate employees :

As pointed out earlier, the assessee had neither deducted nor paid any tax in respect of the remuneration paid to the expatriate employees. It is the claim of the assessee that expatriate employees are paid remuneration net of taxes all over the world. The assessee has taken into account the tax perquisite while working out the tax deductible in respect of remuneration paid to expatriate employees. In asst. yr. 1994-95 in the written submissions filed before the CIT(A), reproduced by him in the appellate order, we find a reference to the policy of the assessee in regard to the payment of remuneration to its employees working in all branches around the world. Since it is relevant for deciding the issue on hand, it will be worthwhile to reproduce the same :

"For the year under consideration the appellant paid Rs. 35,86,781 (Pl. refer attachment 1 for details) as the tax deductible at source from the total remuneration of the expatriate employees taxable in India under the Amnesty Scheme announced by the CBDT vide Circular No. 685, dt. 17/20th June, 1994. This amount has been separately claimed as deductible expenses vide letter filed in the course of assessment. A brief background of the appellant's policy in regard to taxation of expatriate employee's income is given hereunder :

Expatriate employees all over the world cannot be transferred from one country to another country if there is not a continuity and consistency in their remuneration. Therefore, the bank has a worldwide salary policy for its expatriate staff. This policy is laid down in the Bank's Guide Expatriate Staff and Guide International Career Bankers.

'Guide Expatriate Staff'--Principle

Expatriate employees all over the world cannot be transferred from one country to another if there is not a certain continuity and consistency in their remuneration. Therefore, the bank has a worldwide salary policy for its expatriate staff. In order to ensure that changes in local taxes and social security regulations do not influence the application of this policy, a net salary system is effective for all expatriates.

Net salary package--The net salary allowance and benefits to which the employees is entitled are determined by head office. Both the expatriate staff member and the local management will be duly informed by International Human Resources of the actual amounts to be paid.

Gross up : Once an employee's net salary, allowance and benefits are determined, his/her gross income for (a part of) the current fiscal year should be calculated by or in consultation with the bank's external tax adviser.

Payment of taxes and social security

Taxes and social security premiums (employer's as well as employee's share) should, if possible be paid by the bank direct to the respective authorities as soon as these are due.

Guide International Career Bankers (ICB)

Expatriate salary--System--General.

In order to ensure that changes in local taxes and social security regulations do not influence the application of this policy a net salary system is effective for all ICBs.

The net base salary is defined as a base salary less tax, social security, schooling and housing expenses. It includes typical expatriate allowances.

Net Guarantee/Gross up

The ICB's salary is a net salary which means that tax, social security premiums, etc., related to the employment income will be for account of the bank. Exception is made for the Line of Business Bonus. Tax and social security premiums from other personal income are not for account of the bank.

We, thus, submit that it is the bank's responsibility and obligation to bear the Indian taxes on offshore remuneration of expatriate employees rendering services in India.

In the computation of remuneration and tax of the expatriate employees (for the purpose of deduction of tax at source) apart from salary also included is the local taxable remuneration being inter alia the perquisite value on account of rent-free accommodation, utilities and the additional remuneration/benefit of the tax borne. In effect, the total taxable remuneration is thus increased/ grossed up to include the tax deductible on the offshore remuneration. This methodology of increasing/grossing up the amount of tax has been done in accordance with the provisions of Section 195A of the Act. The amount by which the income is thus grossed up is in the nature of a taxable perquisite under Section 17(2) in the hands of the employee and thereby an allowable expenditure in the hands of the appellant.

To summarise we wish to state as under with regard to the local remuneration and perquisites.

Without prejudice to our contention that offshore remuneration is an allowable deduction, we wish to distinguish the fact that the local remuneration paid to the expatriate employees stands on a completely different footing as compared to the offshore remuneration.

The local remuneration is paid in India.

The tax borne by the appellant on the offshore remuneration is part and parcel of the local remuneration and is grossed up for the purpose of calculation of taxable income. In fact, the tax on the total income is only a measure for calculating the additional remuneration/benefit for inclusion in the total income as such the result (is the additional remuneration) does not partake the character of tax. Reference is drawn to the Supreme Court judgment in the case of Senairam Doongarmall v. CIT .

From the above reasons the local remuneration (which includes, inter alia, the gross up of the tax) is an allowable expense. We enclose a copy of letter from International Human Resource Department of the bank at Amsterdam confirming that the tax in respect of the offshore remuneration payable to the expatriate employees is to be borne by the bank.

In view of the above submission made we urge that the claim of the appellant for Rs. 35,86,781 on account of the local remuneration being the tax paid in India on the expatriate employees taxable income should be allowed as deductible expense."

24. It is evident from above that the salary paid to the expatriate employees is net of taxes. The assessee had neither paid nor deducted taxes in asst. yrs. 1992-93 to 1994-95. However, in asst. yr. 1995-96, the assessee has paid the tax deductible at source. Therefore, in principle the assessee would be entitled to deduction in respect of the tax component of the salary also if the salary is found to be deductible as per the directions of the Tribunal for asst. yr. 1996-97 (supra), which has also been adopted by us. So, however, no deduction will be permissible in asst. yrs. 1992-93 to 1994-95 by operation of Section 40(a)(i) of the IT Act, 1961. The claim for the said assessment years shall have to be disallowed for the reason of non-deduction of tax. So, however, the deduction shall have to be considered for asst. yr. 1995-96 as per proviso to Section 40(a)(i).

25. Thus, subject to verification that the claim of remuneration and tax deductible has not been taken into account under Section 44C in regard to the expatriate employees, the deduction relating to asst. yrs. 1992-93 to 1994-95 would be permissible in asst. yr. 1995-96 as per proviso to Section 40(a)(i). For asst. yr. 1995-96, the assessee has paid the tax and, therefore, Section 40(a) is not attracted. The assessee shall be entitled to deduction in respect of remuneration as well as the tax paid pertaining to asst. yr. 1995-96. It is pertinent to mention that the objection raised by the Revenue about the assessee having failed to establish as to whether the services have been rendered by the expatriate employees in regard to the PE of the assessee in India, we find, is uncalled for. If the employees have not rendered services in India, for which the remuneration had been received abroad, then how is it that the assessee was under an obligation to deduct tax from their remuneration. The very fact that the assessee has accepted its obligation to deduct taxes from the salary paid to the expatriate employees is, in our view, sufficient to infer that the services had been rendered by them in India.

26. The second objection raised by the Revenue is that the assessee has only paid the tax deducted at source and not the tax on behalf of the expatriate employees. This objection is also, in our view, unfounded. Section 199 provides that any deduction made in accordance with provisions of Section 192 and paid to the Central Government shall be treated as a payment of tax on behalf of the person from whose income deduction is made. Under Section 205 of the IT Act, 1961, there is a bar for the Revenue to demand tax from the assessee to the extent the amount has been deducted from his income. Thus, the tax deducted at source by the assessee and paid to the Government is treated as the tax paid on behalf of the expatriate employees. It is true that the expatriate employees have a right to demand refund of the tax deducted at source if not found chargeable in the assessment in their hands. However, in this case the assessee has paid remuneration net of tax. Therefore, refund, if any, claimed on behalf of the expatriate employees would be assessable to tax in the year of refund in the hands of the appellant. Therefore, the objection of the Revenue is overruled. We, accordingly, direct the AO to consider the claim of the assessee in regard to the remuneration and the taxes paid relating to asst. yrs. 1992-93 to 1995-96 in asst. yr. 1995-96 in accordance with the directions contained in this order.

27. In asst. yr. 1995-96, the assessee has also claimed a deduction for remuneration and tax paid in regard to the asst. yrs. 1990-91 and 1991-92. No evidence has been placed on record to establish that the assessee had at any stage made the claim for deduction in the said assessment years. In principle, the claim of the assessee has got to be considered in the assessment year to which the claim pertains to. It is only when the claim is considered and found allowable but for provisions of Section 40(a) that the same can be allowed in the year of payment. Since the claim for asst. yrs. 1990-91 and 1991-92 is not established to have been made and considered in earlier years, the benefit is not permissible in asst. yr. 1995-96 merely because the tax has been paid in the year under appeal. The benefit of the proviso to Section 40(a)(i) is thus not available to the assessee for which no claim is made in the respective assessment years. Therefore, the claim of the assessee does not fall for consideration in asst. yr. 1995-96 on the basis of provisions of Section 40(a) read with proviso. The disallowance pertaining to asst. yrs. 1990-91 and 1991-92 in regard to the remuneration and the tax component in asst. yr. 1995-96 is upheld.

28. Interest :

That leaves us to consider the interest paid by the assessee under Section 201(1A). Before proceeding to consider this issue, we would like to make it clear that for asst. yrs. 1992-93 to 1994-95, interest paid by the assessee was neither claimed in the course of assessment proceedings nor in the grounds of appeal before the CIT(A) or before us. The claim was however, made in asst. yr. 1995-96. Thus, at the very outset the claim of interest pertaining to the period falling in asst. yrs. 1990-91 to 1994-95 is disallowable in any case for the reason that no such claim has ever been made for the relevant years.

29. We now proceed to consider if the claim is otherwise allowable. At the cost of repetition, it is stated that the assessee had not deducted tax in respect of remuneration paid to expatriate employees for the services rendered in India, for which the payment was made abroad by the head office. The interest was paid under Section 201 of the IT Act on account of non-deduction and non-payment of the tax deducted at source. The deduction was claimed in asst. yr. 1995-96 which has been disallowed. The learned counsel for the assessee contended that the assessee is entitled to deduction in respect of interest paid under Section 201(1A) for delayed payment of TDS as the same is compensatory and not penal in character. In this connection reliance is placed on the decisions of the Supreme Court in the cases of Mahalakshmi Sugar Mills Co. Ltd. v. CIT , Prakash Cotton Mills (P) Ltd. v. CIT and CIT v. Ahmedabad Cotton Mfg. Co. Ltd. and Ors. . The learned counsel contended that Section 221 provides for payment of penalty in the event of default for non-payment of TDS. Section 271C provides for penalty for non-deduction of tax. Section 201(1A) provides for payment of interest. According to the learned counsel, it is evident from the aforesaid provisions of the Act that the interest under Section 201(1A) is purely compensatory and not penal in character. According to him, since the interest has been paid in the year under appeal, the same is allowable as a deduction in the year of payment by virtue of Section 40(a)(i) as part of remuneration. The learned counsel contended that the deduction may be considered under Section 37 for the expenditure having been incurred for the purposes of business.

30. The learned Departmental Representative, on the other hand, contended that the assessee is not entitled to deduction on account of interest for non-deduction of tax and non-payment of the same as it is neither part of remuneration nor as an expenditure incurred for purposes of business.

31. We have given our careful consideration to the rival contentions. The issue relating to the claim of interest is peculiar in this case insofar as the interest is on account of income-tax, which the assessee was required to deduct at source and pay to the Government. We have dealt with this issue relating to the remuneration and tax component on the remuneration and in principle agreed that the assessee would be entitled to deduction subject to the verification as laid down in the order. It would appear that when the assessee is entitled to deduction on account of income-tax, the same principle would apply to the interest charged for non-payment of tax--the interest being compensatory in nature.

32. For appreciation of the issue in proper perspective, it would be relevant to consider as to whether the income-tax is allowable as a deduction. If income-tax is allowable as a deduction, the interest payable on such tax being compensatory in nature may qualify for deduction. Interest on sales-tax of compensatory nature is allowable as a deduction not merely because it is not penal in character but because the sales-tax is chargeable on the commodities sold by the assessee as an incidence of business. The interest is thus allowable as part of tax. In this case the assessee has paid remuneration to the expatriate employees. The assessee as an employer has undertaken to pay taxes on their behalf. Since the income of the expatriate employees is liable to tax, the assessee would be obliged to file the returns of income and discharge the obligations which, but for the agreement of employment with the assessee, the expatriate employees had to discharge. The monetary consequence of failure to discharge the obligation on behalf of the expatriate employees may, in certain circumstances, qualify for deduction as an incidence of business. Section 17(2)(iv) treats any sum paid by the employer in respect of any obligation which, but for such payment, would have been payable by the employee as perquisite assessable in the hands of the employee. So, however, it is interesting to note that in this case the assessee has not discharged the obligation on behalf of the expatriate employees insofar as taxes have not been paid as an obligation on behalf of the employees. The assessee has neither filed the returns nor has any assessment made. No interest has been charged by the Revenue for non-payment of taxes by the employees. That is one aspect of the matter.

33. The other side of the matter is that the assessee was under a statutory obligation to deduct tax from the remuneration paid/payable to the nonresident expatriate employees and pay the same to the Government. This is an independent statutory obligation imposed upon the assessee. The tax deducted at source by the assessee and payment thereof to the Government does not by itself qualify for deduction as business expenditure by reason of the compliance of statutory obligation made by the assessee. It is important to bear in mind that the deduction of tax claimed by the assessee is as part of the agreement for payment of remuneration net of salary and not as part of the fulfillment of the statutory obligation. For better appreciation of this issue, relevant sections may be quoted hereunder :

"192(1). Any person responsible for paying any income chargeable under the head "Salaries" shall, at the time of payment, deduct income-tax on the amount payable at the average rate of income-tax computed on the basis of the rates in force for the financial year in which the payment is made, on the estimated income of the assessee under this head for that financial year.

195A. Where, under an agreement or other arrangement, the tax chargeable on any income referred to in the foregoing provisions of this Chapter is to be borne by the person by whom the income is payable, then, for the purposes of deduction of tax under those provisions, such income shall be increased to such amount as would, after deduction of tax thereon at the rates in force for the financial year in which such income is payable, be equal to the net amount payable under such agreement or arrangement.

200. Any person deducting any sum in accordance with the provisions of Sections 192 to 194, Section 194A, Section 194B, Section 194BB, Section 194C, Section 194D, Section 194E, Section 194EE, Section 194F, Section 194G, Section 194H, Section 194-I, Section 194J, Section 194K, Section 194L, Section 195, Section 196A, Section 196B, Section 196C and Section 196D shall pay within the prescribed time, the sum so deducted to the credit of the Central Government or as the Board directs.

201(1). If any such person and in the cases referred to in Section 194, the principal officer and the company of which he is the principal officer does not deduct or after deducting fails to pay the tax as required by or under this Act, he or it shall, without prejudice to any other consequences which he or it may incur, be deemed to be an assessee-in-default in respect of the tax :

Provided that no penalty shall be charged under Section 221 from such person, principal officer or company unless the AO is satisfied that such person or principal officer or company, as the case may be, has without good and sufficient reasons failed to deduct and pay the tax.

(1A) Without prejudice to the provisions of Sub-section (1), if any such person, principal officer or company as is referred to in that sub-section does not deduct or after deducting fails to pay the tax as required by or under this Act, he or it shall be liable to pay simple Interest at eighteen per cent per annum on the amount of such tax from the date on which such tax was deductible to the date on which such tax is actually paid.

(2) Where the tax has not been paid as aforesaid after it is deducted, the amount of the tax together with the amount of simple interest thereon referred to in Sub-section (1A) shall be a charge upon all the assets of the person, or the company, as the case may be, referred to in Sub-section (1)."

34. It is noteworthy from abovementioned provisions of the Act that the interest levied by the Department is for the assessee having been treated as the "assessee-in-default" for the payment of tax deductible at source. This obligation is independent of the obligation of the assessee as an agent of the expatriate employees. Therefore, the payment of interest does not partake the character of the part of the remuneration package in respect of the expatriate employees. As already pointed out, the interest has been paid as the assessee-in-default. Since the assessee is not entitled to deduction in respect of the tax deducted at source per se, as such the interest paid for the default in payment of tax deducted/deductible at source also does not qualify for deduction. Reference may be useful to the decision of the Calcutta High Court in the case of Jubilee Investments & Industries Ltd. v. Asstt. CIT and Ors. . Their Lordships observed as under :

"The Asstt. CIT has rightly pointed out that once the TDS is deducted from the income of somebody, the assessee is merely a custodian of the TDS amount. He cannot touch the amount. That amount is to be deposited within the time prescribed in the Central Government account and any loss or profit in the business of the assessee has nothing to do with deposit of the TDS amount."

Reference may be made to the definition of tax under the DTAA. Article 3(d) reads as under :

"(d) the term "tax" means Indian tax or Netherlands tax as the context requires, but shall not include any amount which is payable in respect of any default or omission in relation to the taxes to which this Convention applies or which represents a penalty imposed relating to those taxes;"

It is evident from the above definition that even DTAA does not cover such a levy. It may also be pertinent to mention that income-tax paid by the assessee does not qualify for deduction as such. This view is supported by the decision of the Supreme Court in the case of Smt. Padmavati Jaikrishna v. Addl. CIT . In the case of East India Pharmaceutical Works Ltd. v. CIT their Lordships of the Supreme Court held that the interest paid on the overdraft utilized for payment of income-tax is also not allowable as a deduction as it is not an expenditure laid out wholly and exclusively for the purposes of business as contemplated by Sub-section (1) of Section 37 of the IT Act, 1961. On the basis of the above principle of law, the interest paid by the assessee as "an assessee-in-default of the tax" is not eligible for deduction as expenses incurred for purposes of business. The decisions relied upon by the learned counsel for the assessee are accordingly inapplicable to the facts of this case.

35. We now deal with the remaining grounds of appeal for respective assessment years.

Asst. yr. 1995-96 :

For asst. yr. 1995-96, the first ground of appeal raised by the assessee is as under :

"1. Loss on revaluation of securities/investments

On the facts and in the circumstances of the case and in law, the learned Commissioner of Income-tax (Appeal) [CIT(A)] erred in setting aside the assessment in part as regards disallowance of Rs. 2,00,81,000 made by the AO in respect of loss on revaluation of securities/investments held by the appellant instead of deleting the disallowance made by the AO.

The appellant submits that the CIT(A) while fairly conceding that in valuing the securities at market price, if the value of the appellant's stock gets reduced, the appellant should be allowed relief thereon, erred in concluding that the appellant should file all the details regarding each and every security along with nature of securities whether it is current or permanent with the AO so that the AO can decide the issue afresh and set aside the assessment to this limited extent. The CIT(A) should have appreciated that all the details have already been filed with the AO and treatment of the securities as current securities in terms of the RBI guidelines has also been explained to the AO."

The above ground has not been pressed before us and the same is, accordingly, dismissed as not pressed.

36. The second ground of appeal raised by the assessee is as under :

"2. Expenditure on food and beverages provided to the staff

On the facts and in the circumstances of the case, the CIT(A) erred in confirming the disallowance of Rs. 9,72,446 [erroneously mentioned as Rs. 9,77,446 in the CIT(A) order] made by the AO. The CIT(A) failed to appreciate that the appellant's staff would invariably accompany the guest during the course of which the said entertainment expenses were incurred. The CIT(A), therefore, should have first allowed 50 per cent of the total entertainment expenditure as a fully allowable deduction. Without prejudice to this contention and in any event of the matter, the CIT(A) erred in confirming the additional disallowance made by the AO to the extent of Rs. 70,000 on this account. The CIT(A) failed to appreciate that having confirmed the entire amount of entertainment as falling within provisions of Section 37(2), there was no need to confirm any additional ad hoc amount of disallowance."

The assessee had incurred an expenditure of Rs. 19,54,892 on account of entertainment. 50 per cent of the said expenditure was treated as attributable to employees and the balance of Rs. 9,72,446 was offered for taxation in the return of income. However, during the course of assessment proceedings, the assessee claimed that, keeping in view the fact that the employees of the assessee accompanied the customers, deduction to the extent of 50 per cent may be allowed as attributable to employee not amounting to entertainment expenses. The AO did not accept this claim of the assessee as according to him there was no evidence as to how many persons were entertained and how many employees accompanied them and what was the expenditure incurred by employees on guests separately. The AO further held that the guests having been entertained outside the work place, no allowance could be made under Clause (iii) to Explanation to Section 37(2). Therefore, no deduction was allowed out of Rs. 9,72,466 offered for taxation in the return of income. The AO also made a disallowance of Rs. 1,00,000 out of the remaining of Rs. 9,72,446 treated as entertainment expenses pertaining to the employees exclusively as per the past history of the case. The CIT(A) has confirmed the disallowance of Rs. 9,72,446 (wrongly mentioned as Rs. 9,77,446). However, in respect of the estimated expenses of Rs. 1 lakh, a relief of Rs. 30,000 has been allowed and disallowance of Rs. 70,000 sustained. Thus, the total disallowance under the head 'entertainment expenses' after the order of the CIT(A) is of Rs. 10,42,446.

37. It has been brought to our notice that similar issue had come up for consideration of the Tribunal in an appeal of the assessee for asst. yr. 1996-97 in ITA No. 692/Cal/2000 and vide order dt. 30th March, 2001, the Tribunal has accepted 25 per cent of the expenses as attributable to employees participation. Respectfully following the aforementioned decision of the Tribunal in the assessee's own case for asst. yr. 1996-97, we hold that 25 per cent of the entertainment expenses are attributable to the employees participation in entertaining the guests and by virtue of Section 37(2) read with Expln. (iii), the said amount is outside the purview of entertainment expenses. Learned counsel for the assessee pleaded that it may be clarified as to whether 25 per cent disallowance is with reference to Rs. 19,53,892 or 25 per cent of the disallowed portion of entertainment expenses. We hereby clarify that the relief allowable to the assessee is 25 per cent of Rs. 10,42,446 and not 25 per cent of Rs. 19,54,892. It may be pointed out that out of the total amount of Rs. 19,54,892 debited under the head 'entertainment expenses', the assessee has taken out a sum of Rs. 9,72,446 as entertainment expenses exclusively pertaining to the employees. The CIT(A) has sustained a disallowance of Rs. 70,000 out of the said amount. Thus, the total entertainment expenses disallowed under Section 37(2) would work out to Rs. 9,72,446 + Rs. 70,000, aggregating to Rs. 10,42,446. This amount pertains to the entertainment expenses of customers. The claim of the assessee that employees have also participated in entertaining the customers has been accepted to the extent of 25 per cent by the Tribunal. Therefore, the assessee would be entitled to the deduction to the extent of 25 per cent out of the amount treated as entertainment expenses pertaining to customers. This is how the direction to allow 25 per cent of Rs. 10,42,446 is justified. We, therefore, direct the AO to allow relief of Rs. 2,60,610 to the assessee. The ground relating to disallowance of Rs. 70,000 also stands disposed of by respectfully following the order of the co-ordinate Bench for asst. yr. 1996-97 (supra) subject to 25 per cent relief as indicated above.

Asst. yrs. 1992-93. 1993-94 and 1994-95 :

38. The following common grounds of appeal relating to rate of tax applicable in the case of the appellant-company have been raised :

"(1). That, on the facts and in the circumstances of the case, the action of the learned CIT(A) in enhancing the rate of tax applicable to the appellant on the basis of his earlier order for asst. yr. 1996-97, relying on the ruling of the Hon'ble Authority for Advance Ruling in the case of Societe Generate, reported as ABC, In re given under the DTAA between India and France, is bad in law in view of the express provisions of Section 245S and, therefore, void ab initio.

(2). That, without prejudice to ground No. 3(a) above, the learned CIT(A), without considering the elaborate submissions made in the. course of hearing of the appeal, erred in directing the AO to apply the tax rate applicable to foreign companies against the express provisions of Article 24 of the DTAA between India and Netherlands dt. 27th March, 1989 [(1989) 177 ITR (St) 72] read with Section 90 of the Act and Circular No. 333. dt. 2nd April, 1982 [(1982) 137 ITR (St) 1] issued by the CBDT.

(3) That, in any view of the matter, and without prejudice to grounds 3(a) and 3(b) above, the learned CIT(A) completely disregarded the specific direction given by the Hon'ble CBDT in the appellant's own case that the appellant shall be taxed at the rates applicable to domestic companies for the concerned assessment years read with the provisions of Article 25 of the DTAA between India and Netherlands.

(4) That, in view of the impugned issue decided in favour of the appellant's own case for asst. yr. 1996-97 by the Hon'ble Tribunal in its order dt. 30th March, 2001, the learned CIT(A) erred in taking a contrary view overruling the Tribunal decision considering the Explanation to Section 90(2) of the Act, inserted by the Finance Act, 2001."

39. The relevant facts relating to this issue are that the AO had levied tax in this case at the rates applicable to domestic companies. However, in course of appellate proceedings before the CIT(A) against the assessments made by the AO, it was felt that the rate of tax applicable in the case of the assessee was as applicable to foreign companies. The CIT(A) had accordingly issued a show-cause notice for enhancement to the assessee. Objections were filed by the assessee to the proposed action. It was claimed by the assessee that the issue had been considered by the Tribunal in assessee's own case in ITA No. 692/Cal/2000, dt. 30th March, 2001, and that for asst. yr. 1991-92, the rate of tax was charged as applicable to domestic companies. The CIT(A) has referred to the decision of the Tribunal in favour of the assessee, but has pointed out that after the decision of the Tribunal, there has been amendment by the Finance Act of 2001, in Section 90 of the IT Act, 1961, by virtue of which an Explanation to Section 90(2) was added. The CIT(A) has on the basis of the said Explanation, which is applicable retrospectively with retrospective effect from 1st April, 1962, held that the assessee was liable to tax at the rates applicable to foreign companies.

40. The learned counsel for the assessee contended that the CIT(A) was not justified in invoking his powers under Section 251 insofar as the issue was covered by the CBDT Instruction No. 500/45/94-FTD, dt. 21st Nov., 1994 and also the decision of the Tribunal in the assessee's own case for the asst. yr. 1996-97 (supra). It was contended that the appeal of the assessee before the CIT(A) was in regard to the income assessed and, therefore, he had no power to disturb the rate of tax levied by the AO. The learned counsel invited our attention to Article 24 of the DTAA which provides for non-discrimination of taxation on PE with the taxation on enterprises of that State. Since the Indian banks were paying tax at the rates applicable to domestic companies, the appellant could not be subjected to tax at a higher rate than applicable to Indian companies, it was contended. In this connection reference was made to the decision of the Tribunal in the assessee's own case for asst. yr. 1996-97 (supra) where the issue has been decided in favour of the assessee.

41. Our attention was also invited to D.O. No. 500/45/94-FTD, dt. 21st. Nov., 1994, issued by the CBDT addressing the Chief CIT-II, whereby the Board expressed the view that the assessee-bank was liable to tax at the same rate as applicable to Indian companies. The learned counsel further pointed out that the said letter has been modified by the Board vide subsequent letter dt. 24th March, 2000. It has been clarified therein that action could be taken by the AO for application of higher rate of tax in respect of the respective assessment years barring the years covered by the aforementioned letter dt. 21st. Nov., 1994. Our attention was invited to Article 25 of DTAA which provides for mutual agreement procedure in the event of any dispute relating to taxation contrary to the provisions of the Convention. Sri Dastur pointed out that the D.O. No. 500/45/94-FTD, dt. 21st Nov., 1994, was issued by the Board in response to reference from Embassy of Netherlands and, therefore, by virtue of the provisions of DTAA Article 25, any decision reached after following the procedure is binding upon both the parties and in the event of any conflict with the domestic law of the State, such an agreement would prevail. The learned counsel pointed out that reference for mutual agreement is required to be made to the competent authority and the competent authority is defined to mean the Central Government or any authorized representative of the Central Government. Since the CBDT is authorized to issue instructions, the circular issued by it relating to the rate of tax applicable in the case of the appellant has the effect of mutual agreement within the meaning of Article 25 of the DTAA, it was contended.

42. Sri Dastur, as an alternative to the aforementioned argument, contended that in any case the circulars of the Board are binding upon the Revenue authorities working under their jurisdiction. Relying upon the decision of the Supreme Court in the case of Ellerman Lines Ltd. v. CIT , it was contended that even the letters issued by the Board are considered as circulars having a binding force under Section 119 of the IT Act, 1961. It was further contended that the withdrawal of the circular issued by the Board is effective prospectively and not retrospectively. In this connection reliance was placed on the decision of Bombay High Court in the case of Unit Trust of India and Anr. v. P.K. Unny, ITO and Ors. . The learned counsel further invited our attention to the decision of the Supreme Court in the case of UCO Bank v. CIT in

support of the contention that the CBDT has the power to issue circulars having effect of relaxing the rigour of law and also providing of uniform application of law consonant with concept of income. Such circulars are not to be treated as inconsistent with provisions of the statute. Their Lordships have further held that the circulars issued by the Board are binding on the parties. Reference was also made to Circular No. 333, dt. 2nd April, 1982, by virtue of which the CBDT has clarified that in the event of conflict between the provisions of the IT Act, 1961, and the provisions of DTAA, the provisions of DTAA would prevail over the provisions of the IT Act. According to the learned counsel for the assesses, Explanation to Section 90 incorporated by the Finance Act, 2001, with retrospective effect from 1st April, 1962, is inapplicable in view of the clarification of the CBDT relating to the rate of tax chargeable in the case of the appellant.

43. Sri Dastur further contended that, assuming that the Explanation to Section 90 is applicable in contrast to the circulars of the Board, the said Explanation is inapplicable in view of the fact that the foreign company cannot fulfill the condition of making prescribed arrangement for declaration and payment within India, of the dividends payable out of its income in India. Our attention was also invited to Rule 27 of IT Rules, 1962, in support of the above submission. The learned counsel contended that the Explanation does not make any sense insofar as the prescribed arrangement for declaration and payment within India of the dividends payable out of its income in India cannot be fulfilled. Sri Dastur contended that the CIT(A) has enhanced the rate of tax without the aid of the Explanation when the Tribunal in assessee's own case for asst. yr. 1996-97 (supra) had decided the issue in favour of the assessee. Sri Dastur further contended that the reference to the decision of the Authority for Advance Ruling was misplaced as the said decision has been set aside by the Hon'ble Supreme Court in the case of Societe Generale v. CIT . It was pointed out that the Tribunal in assessee's own case has decided the issue in favour of the Revenue in respect of Article 24(1) of the DTAA. So, however, the claim of the assessee under Article 24(2) has been upheld. It was, accordingly, pleaded that the decision of the CIT(A) in regard to the application of higher rate of tax in the case of appellant may be quashed.

44. The learned Departmental Representative, on the other hand, contended that the issue relating to the rate of tax is to be decided in the light of the Explanation to Section 90(2) inserted by Finance Act, 2001, with retrospective effect from 1st April, 1962. It is well settled law, according to the learned Departmental Representative, that in the event of conflict between a treaty and the statutory law, the statutory law will prevail. It was further contended that Section 90 is an enabling provision for entering into agreements with other countries for double taxation avoidance, etc. It was contended that the CIT(A) exercises his powers co-terminus with the AO, as held by their Lordships of the Supreme Court in the case of CIT v. Kanpur Coal Syndicate and, therefore, the CIT(A) had the power to enhance the rate of tax applicable in the case of the assessee. Referring to the contention on behalf of the assessee that the taxation of the appellant was governed by the CBDT circulars, it was contended that the letters issued by the Board do not partake the character of circulars. In this connection, reliance was placed on the decision of the Supreme Court in the case of CIT v. Anjum M.H. Ghaswala and Ors. and that of the Delhi High Court in the case of Geep Industrial Syndicate Ltd. v. CBDT . It was further contended that the circulars of the Board generally indicate the source of power. But in the letters issued by the CBDT expressing an opinion, no source is mentioned and as such these letters do not have the force of circulars issued by the Board. Reliance has been placed on the decision of the Supreme Court in the case of Kerala Financial Corporation v. CIT . It was pointed out that the

decision of the Bombay High Court in the case of Unit Trust of India and Anr. v. P.K. Unny, ITO and Ors. (supra) was relating to a different issue and the observations at best can be taken as obiter and not ratio decidendi. In any case, the decision of the Supreme Court in the case of CIT v. Anjum M.H. Ghaswala and Ors. (supra) prevail over the decision of the Bombay High Court. Referring to the non-discriminative clause under Article 24 of DTAA, it was contended that non-discriminative clause applies amongst the equals. In regard to Article 25, the learned Departmental Representative contended that the mutual agreement has got to be arrived at by following a procedure and reference has got to be made with competent authorities. Mere letter of the CBDT seeking opinion about the applicability of the rate of tax does not take the character of mutual agreement.

45. In counter-reply, the learned counsel for the assessee relied upon the decision of the Calcutta Bench of the Tribunal in the case of Dy. CIT v. ITC Ltd. (2002) 76 TTJ (Cal) 323 : (2002) 82 ITD 239 (Cal) at p. 245 in support of the contention that in the event of conflict between the provisions of DTAA and the IT Act, the provisions of the DTAA shall prevail. Reference was also made to Section 90(2) of the IT Act, 1961, which was inserted by the Finance (No. 2) Act, 1991, w.e.f. 1st April, 1972, which clearly provides that in the event of conflict between the provisions of the Act and the DTAA, the provisions more beneficial to the assessee shall apply. The learned counsel also relied upon the decision of the Andhra Pradesh High Court in the case of CIT v. Visakhapatnam Port Trust in support of the contention that the mutual agreements under the DTAA have a binding force. Reliance was also placed on the decision of the Supreme Court in the case of CIT v. Elphinstone Spg. & Wvg. Mills Co. Ltd. in support of the contention that if the legislature uses inappropriate language in a Statute, such provisions of law are ineffective. The decisions cited on behalf of the Revenue, according to the learned counsel, are distinguishable on facts. It was, accordingly, pleaded that the appeal of the appellant on this ground may be accepted.

46. We have given our careful consideration to the rival contentions. The issue relating to the applicability of rate of tax in the case of the assessee had come up for consideration of the Tribunal in the assessee's own case for asst. yr. 1996-97 (supra). The Tribunal vide order, dt. 30th March, 2001, in para 23 relating to applicability of Article 24(1) held--"We are of the opinion (as discussed above) that the assessee-company cannot be considered to be in the same circumstances as an Indian company in view of the fact that the scope of taxation of the Indian company is wider enough than that of a non-resident company like the assessee." However, the contention on behalf of the assessee was accepted to be covered under Article 24(2) of DTAA. Para 28 of the order of the Tribunal is quoted as under :

"28. Taking into consideration the different aspects of the case, we are finally of the opinion that by virtue of Article 24(2) of the DTAA between India and Netherlands, the assessee-company cannot be subjected to taxation in a less favourable manner than an Indian banking company. We have already noted above that at least some of the private Indian banks are subjected to the lower rate of tax (@ 46 per cent) applicable to the domestic companies. Furthermore, the assessee-company itself is being subjected to this lower rate of tax by virtue of the non-discrimination provision in the DTAA right from the asst. yr. 1991-92 onwards. There is no plausible reason to depart from this accepted position when no new facts in this regard have been discovered. The AO himself allowed the lower rate in the assessment order. We feel that the CIT(A) did not have any occasion to disturb the same by directing to apply the higher rate and in disturbing the position accepted even by the CBDT in that way. Finally, therefore, we knock down the enhancement, as directed by the CIT(A) in this case and, on the other hand, order that the rate of tax as considered in the assessment be adopted."

47. The decision of the Tribunal has been arrived at after consideration of the detailed arguments advanced on behalf of the assessee which have been reiterated before us. We would have no difficulty in following the elaborate decision of our co-ordinate Bench, but for the amendment in Section 90 of the IT Act, 1961, by the Finance Act, 2001, with retrospective effect from 1st April, 1962. We, therefore, do not consider it necessary to deal with the contentions advanced on behalf of the assessee without taking into account the above amendment in Section 90. We consider it necessary to examine the effect of the amendment of Section 90 in regard to the application of rate of tax.

48. It will be useful to quote Section 90 as under :

"90(1). The Central Government may enter into an agreement with the Government of any country outside India -

(a) for the granting of relief in respect of income on which have been paid both income-tax under this Act and income-tax in that country, or

(b) for the avoidance of double taxation of income under this Act and under the corresponding law in force in that country, or

(c) for exchange of information for the prevention of evasion or avoidance of income-tax chargeable under this Act or under the corresponding law in force in that country, or investigation of cases of such evasion of avoidance, or

(d) for recovery of income-tax under this Act and under the corresponding law in force in that country, and may, by notification in the official gazette, make such provisions as may be necessary for implementing the agreement.

(2) Where the Central Government has entered into an agreement with the Government of any country outside India under Sub-section (1) for granting relief of tax, or as the case may be, avoidance of double taxation, then, in relation to the assessee to whom such agreement applies, the provisions of this Act shall apply to the extent they are more beneficial to that assessee."

The following Explanation was inserted by the Finance Act, 2001, with retrospective effect from 1st April, 1962 :

"Explanation : For the removal of doubts, it is hereby declared that the charge of tax in respect of a foreign company at a rate higher than the rate at which a domestic company is chargeable, shall not be regarded as less favourable charge or levy of tax in respect of such foreign company, where such foreign company has not made the prescribed arrangement for declaration and payment within India, of the dividends (including dividends on preference shares) payable out of its income in India."

49. Before considering the claim of the assessee in the light of the amendment of Section 90, with retrospective effect from. 1st April, 1962, we consider it useful to keep in mind the applicability of the Indian tax laws vis-a-vis DTAA with the foreign country. In this connection reference to the decision of the Hon'ble Supreme Court in the case of Gramophone Co. of India Ltd. v. Birendra Bahadur Pandey and Ors. is relevant. In this case, their Lordships of the Supreme Court held that in the event of conflict between international law, the Court must follow municipal law. The relevant para 5 is quoted hereunder for the sake of reference :

"5. There can be no question that nations must march with the international community and the municipal law must respect rules of international law even as nations respect international opinion. The comity of nations requires that rules of international law may be accommodated in the municipal law even without express legislative sanction provided they do not run into conflict with Acts of Parliament. But when they do run into such conflict, the sovereignty and the integrity of the Republic and the supremacy of the constituted legislature in making the laws may not be subjected to external rules except to the extent legitimately accepted by the constituted legislatures themselves. The doctrine of incorporation also recognizes the position that the rules of international law are incorporated into national law and considered to be part of the national law, unless they are in conflict with an Act of Parliament. Comity of nations or no, municipal law must prevail in case of conflict. National Courts cannot say "yes" if Parliament has said "no" to a principle of international law. National Courts will endorse international law but not if it conflicts with national law. National Courts being organs of the National State and not organs of international law must perforce apply national law if international law conflicts with it. But the Courts are under an obligation within legitimate limits, to so interpret the municipal statute as to avoid confrontation with the comity of nations or the well established principles of international law. But if conflict is inevitable, the latter must yield,"

50. Section 90 of the IT Act empowers the Central Government to enter into an agreement with the Government of any country outside India for granting of relief or for avoidance of double taxation of income, etc. Thus, the source of DTAA with Netherlands is Section 90 of the IT Act, 1961. Section 90 has been quoted in para 48 above.

51. It is noteworthy that Sub-section (2) of Section 90 provides for application of beneficial provisions of the agreement in contrast to the contrary provisions of the IT Act, 1961. It has, however, to be borne in mind that in the event of there being no conflict between the provisions of the DTAA and the IT Act, 1961, the effect shall have to be given to the provisions of the IT Act, 1961. It is only when there is a conflict between the provisions of the agreements in contrast with the provisions of the IT Act, 1961, that the beneficial treatment is to be given as per Section 90(2) of the IT Act, 1961. In this connection, circular of the CBDT, being No. 333, dt. 2nd April, 1982, also clarifies the position of law, which is quoted hereunder :

"Subject : Conflict between the provisions of the IT Act, 1961, and the provisions of the DTAA--Clarification.

It has come to the notice of the Board that sometimes effect to the provisions of DTAA is not given by the AOs when they find that the provisions of the agreement are not in conformity with the provisions of the IT Act, 1961.

2. The correct legal position is that where a specific provision is made in the DTAA, that provision will prevail over the general provisions contained in the IT Act, 1961. In fact the DTAAs which have been entered into by the Central Government under Section 90 of the IT Act, 1961, also provide that the laws in force in either country will continue to govern the assessment and taxation of income in the respective country except where provisions to the contrary have been made in the Agreement.

3. Thus, where a DTAA provides for a particular mode of computation of income, the same should be followed, irrespective of the provisions in the IT Act. Where there is no specific provision in the agreement, it is the basic law, i.e., the IT Act, that will govern the taxation of income."

52. As already pointed out, an agreement for avoidance of double taxation and prevention of fiscal evasion with Netherlands was executed between the Republic of India and the Kingdom of Netherlands which was notified vide Notification No. 382(E), dt. 27th March 1989, and amended by Notification No. SO 693(E), dt. 30th Aug., 1999. This agreement is available in (1989) 177 ITR (St) 72. The Notification gives the source of the agreement, i.e., Section 90 of the IT Act, 1961, and similar provision under the Companies Profits (Surtax) Act and WT Act. Thus, it is evident that the DTAA derives its source from the IT Act, 1961, itself. It overrides the provisions of the IT Act, 1961, within the limits provided under the said Act. The limit provided under the Act, as pointed out earlier, is that in the event of conflict between the provisions of the DTAA and the provisions of the IT Act, the beneficial provision of the Act shall prevail in regard to the taxation of the subjects. It thus becomes abundantly clear that when there is no conflict between the DTAA and the IT Act, 1961, in regard to any aspect of the matter, the provisions of the IT Act, 1961, shall have to be implemented with full force. Section 90 was amended, as pointed out earlier, by the Finance Act, 2001 with retrospective effect from 1st April, 1962, by incorporation of the Explanation which has been quoted in para 48 above.

At this stage it will be relevant to refer to Article 24 of the DTAA, which reads as under :

"Article 24-Non-discrimination - 1. Nationals of one of the States shall not be subjected in the other State to any taxation or any requirement connected therewith, which is other or more burdensome than the taxation and connected requirements to which nationals of that other State in the same circumstances are or may be subjected. These provisions shall, notwithstanding the provisions of Article 1, also apply to persons who are not residents of one or both of the States.

2. Except where the provisions of para 3 of Article 7 apply, the taxation on a permanent establishment which an enterprise of one of the States has in the other State shall not be less favourably levied in that other State than the taxation levied on enterprises of that other State carrying on the same activities.

3. The provisions of para 2 shall not be construed as obliging one of the States to grant to residents of the other State any personal allowances, reliefs and reductions for taxation purposes on account of civil status or family responsibilities which it grants to its own residents.

4. Except where the provisions of para 1 of Article 9, para 9 of Article 11, or para 9 of Article 12 apply, interest, royalties and other disbursements paid by an enterprise of one of the States to a resident of the other State shall, for the purpose of determining the taxable profits of such enterprise, be deductible under the same conditions as if they had been paid to a resident of the first-mentioned State. Similarly, any debts of an enterprise of one of the States to a resident of the other State shall, for the purpose of determining the taxable capital of such enterprise, be deductible under the same conditions as if they had been contracted to a resident of the first-mentioned State.

5. Enterprises of one of the States, the capital of which is wholly or partly owned, controlled, directly or indirectly, by one or more residents of the other State, shall not be subjected in the first-mentioned State to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which other similar enterprises of the first-mentioned State are or may be subjected."

53. The Tribunal in the assessee's own case for asst. yr. 1996-97 (supra) has held that Article 24, para 1 is not applicable in the case of the appellant. However, the Tribunal has expressed the view that Article 24(2) applies in the case of the appellant. However, Explanation to Section 90 specifically provides that the charge of tax in respect of the foreign company at the rate higher than the rate at which a domestic company is chargeable shall not be regarded as less favourable charge. In the DTAA, there is no definition of "less favourable charge". Therefore, the Explanation to Section 90 cannot be said to be in conflict with the provisions of the DTAA. On the facts and in the circumstances of this case, there is no escape from the conclusion that there is no conflict between the provisions of the DTAA and the IT Act, 1961, in regard to the non-discrimination.

54. As has been pointed out earlier, in the provisions of DTAA, incorporation of specific provisions contrary to the provisions of the IT Act, 1961, are to prevail insofar as such incorporation is authorized under the IT Act, 1961 itself. However, in regard to the subsequent amendments, the only requirement is to notify the; amendments to the respective countries and in the event of there being no conflict, the amended provisions shall have to be given effect to. In this connection, it will be relevant to refer to Article 2, para 4 of the DTAA which reads as under :

"4. The Convention shall apply also to any identical or substantially similar taxes which are imposed after the date of signature of the Convention in addition to, or in place of, the existing taxes. The competent authorities of the States shall notify to each other any substantial changes which have been made in their respective taxation laws."

(Emphasis, italicised in print, supplied)

55. It is thus evident that even the DTAA recognizes the fact that the amendments effected by the respective legislatures after the execution of the DTAA are not affected insofar as they are not repugnant to the specific provisions of the DTAA. In this view of the matter, the amendment in Section 90 is applicable in this case with retrospective effect insofar as it is not in conflict with the provisions of DTAA.

56. The contention advanced on behalf of the assessee that the said Explanation to Section 90 is unimplementable because of inappropriate language, does not appeal to us. The Explanation in our view provides for two eventualities. One is the charge of tax in respect of a foreign company vis-a-vis an Indian company, (i.e., a domestic company). The second category as per Explanation is the foreign company vis-a-vis the domestic company other than Indian company. It is noteworthy that the domestic company is defined under the Finance Act. For the sake of reference we may quote the definition of the 'domestic company' as per the Finance (No. 2) Act, 1996.

"'domestic company' means an Indian company, or any other company which, in respect of its income liable to income-tax under the IT Act for the assessment year commencing on the 1st April, 1996, has made the prescribed arrangements for the declaration and payment within, India of the dividends (including dividends on preference shares) payable out of such income in accordance with the provisions of Section 194 of the Act."

(Emphasis, italicised in print, supplied)

Thus, even under the Finance Act the domestic company is recognized as Indian company and any other company having made arrangement for declaration of dividends payable on such income. We, therefore, do not find the language of the Explanation to Section 90 as inappropriate. Moreover, insofar as there is no doubt about the category of the foreign company vis-a-vis the Indian company having been specified in the Explanation, one need not ascertain as to whether in any case the second category of the companies would at all exist. We, therefore, do not find merit in the contentions advanced on behalf of the assessee in this regard.

57. The contention advanced on behalf of the assessee that the CIT(A) was not justified in ignoring the decision of the Tribunal for asst. yr. 1996-97 (supra) is also not well-founded. The CIT(A) has decided this issue in asst. yr. 1993-94, and this order has been followed in other years. The relevant portion of the order is reproduced hereunder :

"4. I have considered the submissions of the appellant. The Hon'ble Tribunal Calcutta, in their order in ITA No. 692/Cal/2000, dt. 30th March, 2001, have decided that the remuneration payable to expatriate offshore as well as the amount of income-tax paid (TDS) in respect of the remuneration paid to the expatriates, is an allowable deduction under Section 37(1) of the IT Act. However, it is a common ground that the net offshore remuneration has not been booked in Indian books of account maintained by the appellant for the previous year relevant to asst. yr. 1993-94, and that, nor the amount of tax payable on the remuneration to the expatriates offshore has been paid or deducted during the relevant previous year as required under Chapter XVII-B of IT Act. In fact, admittedly the amount of tax (TDS) has been paid in the subsequent previous year ended 31st March, 1995, relevant to asst. yr. 1995-96. As per the provision of Section 40(a)(i) and proviso thereto, any sum chargeable under the IT Act which is payable outside India on which tax has not been paid or deducted under Chapter XVII-B, shall not be deducted in computing the income chargeable under the head "Profits and gains of business or profession". It is further provided that "where in respect of any such sum, tax has been paid or deducted under Chapter XVII-B in any subsequent year, such sum shall be allowed as deduction in computing the total income of the previous year in which such tax has been paid or deducted". In view of the express provision of Section 40(a)(i), restricting the allowance for deduction under certain circumstances, which are applicable to the facts of the appellant's case, the claim for deduction in respect of remuneration paid to the expatriates offshore and TDS thereof, cannot be allowed in the asst. yr. 1993-94. The order of the AO disallowing the aforesaid amount is, therefore, confirmed and the appellant's grounds of appeal in this regard are dismissed.

5. During the course of examination of the order of the AO, it was found that the appellant's total income was charged to tax at the rate applicable to a domestic company instead of applying higher rate of tax since the appellant was a foreign company and being assessed as such. Therefore, vide letter No. 79/A-ii/96-97/608, dt. 19th July, 2000, the appellant was asked to show cause as to why the assessee-bank should not be taxed at a higher rate as is applicable to a foreign company. The appellant in response to the show cause dt. 19th July, 2000, filed a written submissions through letter dt. 24th July, 2000. The submission so made are reiteration of the detailed submissions made before CIT(A) during appeal proceedings for the year 1996-97 with regard to a similar show-cause notice issued to the appellant. The CIT(A) rejected the appellant's contention raised in the aforesaid submission and held in his order in appeal No. 88/A-ii/1999-2000 for the asst. yr. 1996-97 that "while giving effect to this order, the AO is directed to recalculate the tax in accordance with the provision of the Finance Bill relating to the asst. yr. 1996-97 at the rate chargeable to foreign companies". This order of the CIT(A) was set aside by Hon'ble Tribunal in ITA No. 692/Cal/2000, dt. 30th March, 2001, on the following grounds :

Taking into consideration the different aspects of the case, we are finally of the opinion that by virtue of Article 24(2) of the DTAA between India and Netherlands the assessee-company cannot be subjected to taxation in a less favourable manner than an Indian banking company. We have already noted above that at least some of the private Indian banks are subjected to the lower rate of tax (@ 46 per cent) applicable to the domestic companies. Furthermore, the assessee-company itself is being subjected to this lower rate of tax by virtue of non-discrimination provision in the DTAA right from the asst. yr. 1991-92 onwards. There is no plausible reason to depart from this accepted position when no new facts in this regard have been discovered. The AO himself allowed the lower rate in the assessment order. We feel that the CIT(A) did not have any occasion to disturb the same by directing to apply the higher rate and in disturbing the position accepted even by the CBDT in that way. Finally, therefore, we knock down the enhancement, as directed by the CIT(A) in this case and, on the other hand, order that the rate of tax as considered in the assessment be adopted.'

6. However, the Finance Act, 2001, has inserted an Explanation to Section 90(2) of the Act, with retrospective effect from 1st April, 1962. The said Explanation is produced below :

"For the removal of doubts, it is hereby declared, that the charge of tax in respect of foreign companies at a rate higher than the rate at which a domestic company is chargeable, shall not be regarded as less favourable charge or levy of tax in respect of such foreign companies, where such foreign companies has not made prescribed arrangement for declaration and payment within India of dividends (including the dividends on preference share) payable out of its income in India."

It is evident that the Explanation effectively seeks to override non-discrimination article of the DTAA with retrospective effect. The Explanation inserted is clarificatory in nature and retrospective in operation and in view thereof, the decision of Tribunal (supra) relied upon by the appellant on this issue is no longer valid. Accordingly, relying on the order of the CIT(A) for the asst. yr. 1996-97 and on consideration of the Explanation to Section 90(2) of the IT Act as discussed above, I direct the AO to recalculate the tax in accordance with the provisions of Finance Act relating to the asst. yr. 1993-94 at the rate chargeable to foreign companies,"

It is evident from the above decision of the CIT(A) that he has decided the issue on the basis of the amendment of Section 90 and after taking into account the decision of the Tribunal in the assessee's own case for the asst. yr. 1996-97 (supra).

58. That leaves us to consider the effect of the letters issued by the CBDT in regard to the taxation of the appellants. The CBDT had issued the two letters, one dt. 21st Nov., 1994 and another dt. 24th March, 2000. These are reproduced hereunder :

Letter dt. 21st Nov., 1994 :

"Sub : Taxation of ABN--AMRO Bank-Ref. From Embassy of Netherlands.

Please refer to your letter D.O. No. CC-11/HQ Asstt. 4 Misc./93-94/Vol-IV/504, dt. 29th July, 1994, on the above subject. The matter has been looked into and the Board is of the opinion that the tax rate applicable in the case of ABN AMRO Bank would be the same as for an Indian company, at the relevant tax rates applicable for the concerned assessment years."

Letter dt. 24th March, 2000 :

"Subject : Taxation of M/s ABN Amro Bank at the rates as applicable to nonresident companies as per letter No. F.No. 500/5/99-FTD, dt. March 1999-Matter reg.

I am directed to refer to your letter No. CC/HQ-II/Asstt. 4/Misc/1999-2000/35, dt. 7th April, 1999. It is clarified that M/s ABN Amro Bank should be taxed at the rates applicable to foreign companies under the respective Finance Acts. The AOs may be instructed to take action accordingly except for the years covered by Board's letter dt. 21st Nov., 1994."

59. It is evident from the letter dt. 24th Nov, 1994, that the CBDT was of the view that the tax rate applicable in the case of the appellants would be the same as applicable to Indian companies. However, this opinion was changed before the law was amended vide letter dt. 24th March, 2000 referred to above. We have referred to the contentions advanced on behalf of the assessee in regard to these two letters issued by the CBDT. It is evident from the contents of the letters that the opinion of the Board is expressed in the aforementioned letters. If the law were not amended, perhaps we would have no difficulty in holding that the AO could not have overlooked the opinion of the Board in regard to the taxation of the appellants. So, however, the law has been amended retrospectively. Therefore, the only issue that requires to be considered is as to whether the circular of the CBDT prevails over the statutory law passed by the, supreme legislature. The CBDT is the creation of statute. The instructions issued under Section 119 of the IT Act, 1961, is under the delegated power by the Parliament. Therefore, it is futile to suggest that the CBDT circulars would prevail over the conscious amendment of the law by the legislature which overrides the law prevalent before the amendment including the CBDT circulars. Their Lordships of the Supreme Court in the case of State Bank of Travancore v. CIT held that the

circulars issued by the Board would be binding on all officers and persons employed in the execution of the Act, but no instructions or circular can go against the provisions of the Act. In the case of State of Madhya Pradesh and Anr. v. G.S. Dall & Flour Mills , their lordships of the Supreme Court held that

executive instructions can supplement a statute or cover areas to which the statute does not extend. But they cannot run contrary to the statutory provisions or whittle down their effect. In the case of Kerala Financial Corporation v. CIT (supra), their Lordships of the Supreme Court held that the circular of the Board issued under Section 119 cannot override or be detracted from the Act, inasmuch as what Section 119 has empowered is to issue orders, instructions or directions for the proper administration of the Act or for such other purposes specified in Sub-section (2) of that section. Such an order, instruction or direction cannot override the provision of the Act; that would be destructive of all the known principles of law as the same would really amount to giving power to a delegated authority to even amend the provision of law enacted by Parliament. This principle has been further reiterated in the case of Shanmuga Traders v. State of Tamil Nadu . In the case of Union of India v. M.

Bhaskar, , their Lordships held that there is no

dispute in law that statutory provision cannot be changed by administrative instructions.

60. Thus, from the decisions of the Supreme Court referred to above, it becomes abundantly clear that when the law is amended, any circular issued earlier automatically gets superseded. Since in this case the law was amended retrospectively, the letters issued by the Board, even assuming that they have the effect of circulars issued under Section 119 of the IT Act, 1961, are ineffective and they have to give way to the law passed by the supreme legislature. It may be pertinent to mention that their Lordships of the Delhi High Court in the case of National Thermal Power Corporation Ltd. v. Union of India and Ors. held that the opinion of the Board expressed in its administrative capacity can under no circumstances be binding on the appellate authorities or the High Courts on a reference.

61. In the case of CIT v. Swedish East Asia Co. Ltd. , their Lordships of the Calcutta High Court held that when the section is clear, one cannot take aid of the circulars to interpret the law. This view is in consonance with the view expressed by their Lordships of the Supreme Court in the case of State Bank of Travancore (supra).

62. We may further refer to the observations of Sri K. Srinivasan, author of the book on DTAA contained in para 7.2 of the book as under :

"7.2. While a treaty may supersede the existing law insofar as its specific terms are concerned, its scope cannot be obviously widened by provisions covering future enactments, for no sovereign legislature will ever agree to be eternally bound by such executive stipulations. There is nothing in law preventing the legislature from revising its own views and amending the existing enactments. A treaty cannot afford protection against such subsequent changes in law. However, all that is required for revision of a treaty is the prescribed notice. Whenever the law undergoes any modification that may affect the terms of a treaty, the administration may have to give due notice to the concerned countries immediately to avoid giving any cause for a grievance. Courts have held in the UK that any unilateral legislation enacted after a treaty has come into force will override the treaty, whereas if it had been enacted earlier, its effect would have been limited by the treaty provisions--CIR v. Collco Dealings Ltd. (1960) 39 Tax Cases 509, concerning UK anti-avoidance legislation conflicting with the earlier Irish double tax avoidance agreement and Woodend Rubber Co. v. CIR (1970) 2 WLR 10, concerning discriminatory legislation in Ceylon (Sri Lanka) conflicting with the earlier UK-Ceylon treaty."

63. In the light of the above position of law, we are of the view that the Explanation to Section 90 is attracted in this case and the letters issued by the CBDT have been superseded by the said Explanation w.e.f. 1st April, 1962. We, accordingly, uphold the decision of the CIT(A) in regard to the applicability of the rate of tax as applicable in the case of foreign companies in the case of the appellant. Before parting with this issue we would like to point out that Article 25 of the DTAA is not attracted in this. The said article is reproduced hereunder :

"Article 25 - Mutual agreement procedure 1. Where a person considers that the actions of one or both of the States result or will result for him in taxation not in accordance with the provisions of this Convention, he may, irrespective of the remedies provided by the domestic law of those States, present his case to the competent authority of the State of which he is a resident or, if his case comes under para 1 of Article 24, to that of the State of which he is a national. The case must be presented within three years from the first notification of the action resulting in taxation not in accordance with the provisions of the Convention.

2. The competent authority shall endeavour, if the objection appears to it to be justified and if it is not itself able to arrive at a satisfactory solution, to resolve the case by mutual agreement with the competent authority of the other State, with a view to the avoidance of taxation which is not in accordance with the Convention. Any agreement reached shall be implemented notwithstanding any time limits in the domestic law of the States.

3. The competent authorities of the States shall endeavour to resolve by mutual agreement any difficulties or doubts arising as to the interpretation or application of the Convention. They may also consult together for the elimination of double taxation in cases not provided for in the Convention.

4. The competent authorities of the States may communicate with each other directly for the purpose of reaching an agreement in the sense of the preceding paras. When it seems advisable in order to reach agreement to have an oral exchange of opinions, such exchange may take place through a Commission consisting of representatives of the competent authorities of the two States."

We admit our failure to appreciate as to how a letter written to the CBDT seeking opinion about the rate of tax chargeable in the case of the appellant fits in within the framework of reference under Article 25 of the DTAA. We find no merit in the contention in this regard advanced on behalf of the appellants.

64. For asst. yrs. 1997-98 and 1998-99, the common grounds of appeal relating to rate of tax are as under :

"1a. That, on the facts and in the circumstances of the case, the learned CIT(A) erred in upholding the action of the AO of charging tax at a higher rate (55 per cent) applicable to foreign companies instead of the tax rate applicable to domestic companies (43 per cent) as claimed by the appellant.

1b. That, without prejudice to ground la above, the learned CIT(A) without considering the elaborate submissions made in course of hearing of the appeal, erred in confirming the action of the AO in applying the tax rate applicable to foreign companies against the express provisions of Article 24 of the DTAA between India and Netherlands, Notification No. G.S.R. 382(E), dt. 27 March 1989, [(1989) 177 ITR (St) 72] read with Section 90 of the Act and Circular 333, dt. 2nd April 1982, [(1982) 137 ITR (St) 1] issued by the CBDT.

1c. That, in any view of the matter, and without prejudice to grounds 1a and 1b above, the learned CIT(A) completely disregarded the specific direction given by the Hon'ble CBDT in the appellant's own case that the appellant shall be taxed at the rates applicable to domestic companies for the concerned assessment years read with the provisions of Article 25 of the DTAA between India and Netherlands.

1d. That, in view of the impugned issue decided in favour of the appellant's own case for asst. yr. 1996-97 by the Hon'ble Tribunal in its order, dt. 30th March 2001, the learned CIT(A) erred in taking a contrary view overruling the Tribunal decision considering the Explanation to Section 90(2) of the Act inserted by the Finance Act, 2001."

65. Our decision in regard to the issue of rate of tax for asst. yrs. 1992-93, 1993-94 and 1994-95 shall apply to asst. yrs. 1997-98 and 1998-99 mutatis mutandis.

Asst. yr. 1994-95 :

66. The only other ground that remains to be considered for asst. yr. 1994-95 is ground No. 3 which reads as under :

"3. That, on the facts and in the circumstances of the case, the learned CIT(A) erred in enhancing the assessment by an amount of Rs. 9,57,58,904 representing the operational loss arising to the appellant on account of transactions in securities merely for the reasons that appellant was pursuing the matter in suit which was pending disposal before the Court, disregarding the appellant's submissions, inter alia, that pendency of the suit was not relevant for disallowance of the claim."

67. The relevant facts relating to this issue are that the assessee had received a sum of Rs. 10 crores from Punjab Housing Board (in short 'PHB') for investments in bonds generating agreed rate of return at 17 per cent The assessee had issued a cheque for Rs. 9.76 crores dt. 9th March, 1992 in favour of Andhra Bank, Fort Branch, Mumbai, purportedly for investment in the purchase of NPC Bonds. The said cheque was encashed by the bank on the same day. Sri N.K. Agarwal, the broker, through whom the investment was made, failed to deliver the 17 per cent NPC Bonds in spite of repeated reminders. On 18th March, 1992, Sri N.K. Agarwal delivered original letter of allotment covering 1 lakh 9 per cent tax-free secured redeemable non-convertible bonds of Rs. 1,000 each fully paid-up (6th 'A' series) Railway Bond 1991-92 issued by the Indian Railway Finance Corporation Ltd. (IRFC). It is the claim of the assessee that the delivery of IRFC Bonds was accepted from Sri N.K. Agarwal on the understanding that the same would be held as alternate security pending delivery of 17 per cent NPC Bonds. The assessee sought information from Andhra Bank about the non-delivery of NPC Bonds vide letter dt. 18th June, 1992. The Andhra Bank vide letter, dt. 22nd June, 1992 informed the assessee that the amount received from Sri N.K. Agarwal was credited in the account of Sri Hitendra Dalal, the broker, as per the instructions of Sri N.K. Agarwal. The assessee had lodged the IRFC Bonds with Indian Railway Financial Corporation Ltd. to register the same in the name of the assessee. However, IRFC refused to register the bonds in favour of the appellant on the ground that the said bonds have already been registered in the name of Standard Chartered Bank. The assessee filed an appeal to the Company Law Board against the refusal of the IRFC for registering the IRFC Bonds. The appeal of the assessee was dismissed by the Company Law Board vide order dt. 25th Aug., 1994. The assessee appealed to the Delhi High Court. However, the appeal was transferred to the Special Court and the said Court also dismissed the appeal of the assessee on 31st March, 1998.

68. In the previous year relevant to the asst. yr. 1994-95, the assessee settled the claim of the PHB by returning the principal along with 17 per cent interest. It may be pertinent to mention that the assessee had returned a sum of Rs. 24,41,096 to PHB out of Rs. 10 crores at the time of issuing the cheque in favour of the Andhra Bank for Rs. 9,75,58,904. Subsequently, in March, 1992, a sum of Rs. 18 lakhs received from Sri N.K. Agarwal was also refunded to PHB. The balance of Rs. 9,57,58,904 and the interest @ 17 per cent for six months was refunded to the PHB on 7th July, 1993. Whereas the interest paid to the PHB was claimed as a deduction separately as interest under the head "Business income", the sum of Rs. 9,57,58,904 paid to the PHB was claimed as "loss in business". The AO denied the claim of the assessee. The CIT(A) has also confirmed the disallowance.

69. The learned counsel for the assessee contended that the assessee had suffered business loss and as such was entitled to deduction in respect of the same. It was pointed out that the assessee had also written letter to the RBI sometime in April, 1993, but they had refused to interfere vide its letter dt. 11th May, 1993. The assessee was also refused the permission to open a branch till the dispute with Andhra Bank was settled. In March, 1995, the assessee instituted a suit against the Andhra Bank and Sri N.K. Agarwal for the recovery of the principal amount along with interest. The suit has been transferred to the Special Court. According to the learned counsel, since the settlement with the PHB was made on 7th July, 1993, i.e., in the previous year relevant to asst. yr. 1994-95, the loss suffered by the assessee falls within the previous year and, accordingly, allowable as a business loss. It was stated by the learned counsel that the interest paid to PHB has been allowed as a deduction. The learned counsel pointed out that in order to avoid adverse publicity, the assessee in the business interests considered it prudent to settle the claim with the PHB. Our attention was invited to the decision of the Supreme Court in the case of CIT v. Nainital Bank Ltd. where the jewellery pledged with the bank had been stolen. Though the bank was not legally bound to compensate the borrowers for the loss of jewellery, it was decided to do so in the interests of business. Such expenditure incurred by the assessee was held to be allowable as business loss. Reference was also made to the CBDT Circular No. 35D, dt. 24th Nov., 1965 in support of the contention that the loss incidental to business is to be allowed in the year in which it was discovered. Reference was also made to the decision of the Gujarat High Court in the case of Dinesh Mills Ltd. v. CIT in

support of the contention that the loss suffered by the assessee in the course of business was allowable. It was, accordingly, pleaded that the deduction for a sum of Rs. 9,57,58,904 may be allowed.

70. The learned Departmental Representative, on the other hand, contended that the assessee was not entitled to deduction insofar as the claim of the assessee was sub judice. There might be a possibility of loss to the assessee. But deduction is not allowable on mere possibility. It was further contended that the decisions relied upon by the learned counsel for the assessee are distinguishable on facts. The facts and circumstances of this case clearly reveal that the assessee had not suffered the loss in the year under appeal and, therefore, no deduction was permissible.

71. We have given our careful consideration to the rival submissions. The assessee is engaged in the business of accepting deposits, giving loans, discounting/collection of bills, issue of letter of credit, guarantee, executing forward transaction in foreign currencies for importers/exporters, money market lending/borrowings, investment in securities, etc. The assessee received a sum of Rs. 10 crores from PHB in the course of business for purposes of investment with assured return of interest at 17 per cent. Sum of Rs. 42,41,096 (Rs. 24,41,096 + Rs. 18,00,000) had been returned to PHB out of 10 crores investment. The assessee had made investment in the course of its business with Andhra Bank through Sri N.K. Agarwal, a broker. It is the claim of the Andhra Bank that the amount received from Sri N.K. Agarwal on behalf of the appellant was credited in the account of Sri Hitendra Dalai as per instructions of Sri N.K. Agarwal. However, it is the claim of the assessee that no such instructions were issued and that the cheque paid in the name of Andhra Bank was issued for the purchase of NPC Bonds on behalf of PHB. This fact is disputed by the Andhra Bank. Even on the basis of the disputed facts it is evident from the material available on record that the assessee could not retrieve the investment of Rs. 9,57,58,904. The Revenue is not disputing this fact. The dispute, however, is only as to whether the non-receipt of NPC Bonds for the amount of Rs. 9,57,58,904 amounts to loss incurred by the appellant and if so, which is the relevant year for allowance of deduction. There are two aspects of the issue involved. One aspect is whether the assessee has suffered the loss. Second aspect is, in any case, whether the loss has been incurred in the year under appeal by reason of refund of principal and interest to the investor, PHB. We first propose to deal with the second aspect. As is evident from the facts, the assessee had received the amount from PHB on 28th Feb., 1992. The assessee had received IRFC Bonds from Sri N.K. Agarwal in March, 1992, as indicated in the decision of the Company Law Board, Northern Region, New Delhi, placed on record. These bonds had been lodged with IRFC. It was in June, 1992, that the assessee was informed that the original bonds had already been transferred in favour of the Standard Chartered Bank. So, if at all the assessee can be said to have lost the investment made through Sri N.K. Agarwal, its discovery could be said to be on receiving the information from IRFC in June, 1992. The said date falls in asst. yr. 1993-94. We are dealing with asst. yr. 1994-95. In asst. yr. 1994-95, the assessee has settled the claim with PHB by repaying the investment along with 17 per cent interest on such investment. The claim of the assessee is that the investment had been made on behalf of the PHB and that it had no legal obligation to refund the investment to the PHB. However, the refund was made as a matter of business prudence and, accordingly, the expenditure so incurred was allowable as a deduction for computing the business profits, it was contended.

72. In our considered view, the assessee had received the amount from PHB for the purpose of investment in specific bonds, not necessarily NPC Bonds. The assessee had made investments in the course of its business. Though the investment made by PHB with appellants and the investment made by the appellant with Andhra Bank are related, yet they are not part of the same transaction. The assessee has received money for the purpose of investment which is the business of the assessee. The investor had been assured the return of 17 per cent per annum. In turn, the assessee made investment in the course of its business. The possibility of loss of investment is part of the business of the assessee. The assessee had accepted IRFC Bonds from Shri N.K. Agarwal. However, PHB was not a party to such transaction or acceptance of the bonds. In the petition filed with the Company Law Board regarding transfer of IRFC Bonds, PHB is not a party. It thus becomes abundantly clear that the investment made by the assessee with the Andhra Bank was not as agent of PHB but as an independent business investment. Andhra Bank has claimed that the cheque was issued with clear instructions to be credited to the account of Sri Hitendra Dalai. In view of the disputed facts one cannot come to the conclusion that the assessee has lost the money. In any case, even if it is assumed that the assessee has suffered any loss, it is not on account of refund of money to the PHB but on account of investment made by the assessee-bank. As already pointed out, the fact that Sri N.K. Agarwal had not made investment for the purchase of NPC Bonds as per the purported instruction by the assessee was known to the assessee in the preceding year, i.e., in the asst. yr. 1993-94. The assessee had pursued the matter with Sri N.K. Agarwal and Andhra Bank and finally a suit was instituted against Andhra Bank and Sri N.K. Agarwal sometime in 1995. Therefore, it cannot be said with certain amount of certainty that the assessee has suffered the loss as yet. In any case, the claim does not fall in the year under appeal. Even if the loss is to be taken at the time of its discovery, that is when Shri N.K. Agarwal did not deliver the NPC Bonds or when IRFC Bonds were refused to be registered in the name of the assessee, even then the loss falls in asst. yr. 1993-94. However, assessee is to claim the loss only after losing the reasonable hope of recovery, the loss can be considered only in the event of the decision in the suit instituted against Sri N.K. Agarwal and Andhra Bank. This may be explained with an example. In the case of a trader, the assessee supplying goods to party 'A' may find it difficult to make recovery on account of the sale price of the goods. The assessee without making any efforts for recovering the amount cannot be said to have suffered the loss unless all reasonable means are exhausted for the recovery of the sale price. In this case, Sri N.K. Agarwal is stated to be the agent for Andhra Bank and the receipt of money has been pursued through Sri N.K. Agarwal, as admitted by Andhra Bank. The dispute is about the nature of the instructions received from the assessee regarding the investments. The suit has been instituted and there is still reasonable hope of recovery of the amount. The loss in the year under appeal cannot be said to have been incurred by the assessee notwithstanding the fact that there is a possibility of loss. Mere possibility of the loss may not be equivalent to the actual lose of money. Taking the totality of the facts and circumstances of the case into consideration, we are of the view that the refund of money to the investor, viz., PHB, of Rs. 9,58,57,904 is refund of the investment in the course of business and it does not amount to a loss suffered by the assessee in the course of business. This view gets further strength from the fact that the assessee paid interest of 17 per cent to the PHB along with the refund of the principal. It is unimaginable that the assessee-bank would have agreed not only to refund the principal amount to PHB but had also agreed to pay interest @ 17 per cent to the said Board as a matter of business prudence when according to the assessee they were not obliged to even return the investment to PHB. Facts and circumstances of this case clearly indicate that the refund to PHB was of their investment with the appellants and payment of interest on such investment was rightly allowed as expenditure incurred for purposes of business. It is like purchases being made from 'A' and the goods having been sold to 'B'. If B' does not pay the price of the goods, it may amount to loss suffered by the assessee. But the payment to 'A' for the goods supplied will not amount to loss to the assessee though the loss to the assessee on account of B's refusal to pay relates to the goods supplied by 'A'. Similarly, in this case, PHB made investment with the appellants. If at all the assessee has suffered a loss in the course of its business of making the investment, refund of money belonging to PHB plus interest cannot be said to be loss to the assessee. The event of refund to PHB is not the occasion of loss. We, accordingly, hold that the loss, if any, suffered by the appellants on account of investments does not relate to the year under appeal. We, accordingly, hold that in view of the disputed facts, it cannot be said that the assessee has suffered the loss. The refund of principal and interest to the investor-PHB in any case is not the event of loss. We also hold that, in any case, the loss does not pertain to the year under appeal. We, however, make it clear that our decision for the year under appeal relating to the disallowance of loss of Rs. 9,57,58,904 is without prejudice to the right of the assessee to claim the loss, if any, in which it can be said to have been incurred.

73. Before parting, we may point out that the assessee had filed application dt. 10th March, 2003 on 11th March, 2003 with the Registry raising the following additional ground of appeal for asst. yr. 1993-94 :

"In the event of the appellant's claim for operational loss on securities amounting to Rs. 9,57,58,904 is not allowed in the asst. yr. 1994-95, the same ought to be considered and allowed in the asst. yr. 1993-94."

The hearing of appeal for asst. yr. 1993-94 was concluded on 6th March, 2003, along with appeals for asst. yrs. 1992-93 and 1995-96. The filing of additional ground of appeal after concluding the hearing and subsequent to the date of hearing is inconsequential and, accordingly, does not require any consideration. It may also be pertinent to mention that the assessee has filed a suit against Andhra Bank and Sri N.K. Agarwal and facts stated by the assessee are disputed. Therefore, whether the assessee has incurred the loss or not is dependent on the outcome of the suit. In such circumstances the claim of the assessee that the loss should be considered in asst. yr. 1993-94 is premature in any case.

74. In the result, the appeals of the assessee for asst. yrs. 1992-93 to 1995-96 are partly allowed.

Pramod Kumar, A.M.

75. I have carefully gone through the order proposed by the learned Vice President but as I am unable to persuade myself to agree with certain conclusions arrived at therein I proceed to place on record my dissenting views.

76. The facts of this case and the developments giving rise to this litigation have been rather comprehensively set out in the learned Vice President's draft, and, for the sake of brevity I need not repeat the same. I would, therefore, come directly to the areas of disagreement which are primarily on the legal principles.

A: On the scope of proviso to Section 40(a)(i) :

77. In paras 24 and 27 of his draft, the learned Vice President has, inter alia, observed as follows :

"It is evident from the above that the salary paid to expatriate employees is net of taxes. The assessee had neither paid nor deducted taxes in asst. yrs. 1992-93 to 1994-95. However, in the asst. yr. 1995-96, the assessee has paid the tax deductible at source. Therefore, in principle the assessee would be entitled to deduction in respect of the tax component of the salary also if the salary is found to be deductible as per directions of the Tribunal for the asst. yr. 1996-97 (supra) which has been adopted by us. So however, no deduction will be permissible in asst. yr. 1992-93 to 1994-95 by operation of Section 40(a)(i) of the IT Act, 1961. The claim for the said assessment years shall have to be disallowed for the reasons of non-deduction of tax. So, however, the deduction shall have to be considered for the asst. yr. 1995-96 as per proviso to Section 40(a)(i)"

"In principle, the claim of the assessee has got to be considered in the assessment year to which the claim pertains to. It is only when the claim is considered and found allowable but for provisions of Section 40(a) that the same can be allowed in the year of payment. Since the claim for asst. yrs. 1990-91 and 1991-92 is not established to have been made and considered in earlier years, the benefit is not permissible in asst. yr. 1995-96 merely because the tax has been paid in the year under appeal. The benefit of the proviso to Section 40(a)(i) is thus not available to the assessee for which no claim is made in the respective assessment years."

78. In my considered view, however, in cases where deduction in respect of sums paid to non-residents is claimed in the year in which the relevant tax deduction at source obligations are discharged, and such an year is subsequent to the year to which relevant expenses pertain, it is not sine qua non that the assessee should have first claimed the deduction in the year to which it pertains and the deduction should have been rejected by the AO under Section 40(a)(i). I am, therefore, unable to subscribe to the aforesaid proposition laid down in learned Vice President's proposed draft.

79. I may reproduce the contents of Section 40(a)(i) for ready reference :

"Notwithstanding anything to the contrary in Sections 30 to 38, the following amounts shall not be deducted in computing the income chargeable under the head 'Profits and gains of business or profession',--

(a) in the case of any assessee

(i) any interest (not being interest on a loan issued for public subscription before the 1st day of April, 1938), royalty, fees for technical services or other sum chargeable under this Act, which is payable outside India, on which tax has not been paid or deducted under Chapter XVII-B :

Provided that where in respect of any such sum, tax has been paid or deducted under Chapter XVII-B in any subsequent year, such sum shall be allowed as a deduction in computing the income of the previous year in which such tax has been paid or deducted...."

80. A plain reading of the above legal provision makes it clear that so far as payments outside India are concerned, these payments are not allowed as a deduction unless the tax deduction at source obligations, if any, in respect of the same, are duly discharged by the assessee. It further provides that in cases in which such tax deduction at source obligations are discharged in a year subsequent to the year to which the payments pertain to, the related payments are allowable as deductions in the year in which the tax deduction at source obligations are so discharged. There is no suggestion, however, to the effect that the proviso to Section 40(a)(i) will only come to the play when the assessee has claimed the deduction in the year to which the expense pertains and such a claim was rejected under Section 40(a)(i). In the absence of any such limitation having been specifically placed on the scope of proviso to Section 40(a), in my considered view, it is not open to us to infer or assume such restrictions which are not supported by the words of the statute. Even if these restrictions be said to be desirable for proper working of the section, it is not open to us to supply the casus omissus. In the case of Tata Tea Limited v. Jt. CIT (2003) 78 TTJ (Cal) 646 : (2003) 87 ITD 351 (Cal), to which both of us were parties, it was observed that "casus omissus, which broadly refers to the principle that a matter which has not been provided in the statute but should have been there, cannot be supplied by us, as, to do so will be clearly beyond the call and scope of our duty which is only to interpret the law as it exists." As Rowlatt, J. has said, in Cape Brandy Syndicate v. IRC (1921) 1 KB 64, "In a taxing statute, one has to look merely at what is clearly said; there is no room for any intendment...". The temptation of resorting to a rather creative process of an aggressive interpretation of statutes, which allows us to read between the lines, therefore, must be resisted. Even as I say so, I am also of the view that, in any event, there is nothing between the lines to justify such an interpretation either. I am of the considered view that, in any event, it can be nothing short of a meaningless ritual for an assessee to claim a deduction knowing well that the same is specifically inadmissible in view of the provisions of Section 40(a)(i), or, for that purpose, for the AO or the appellate authorities to adjudicate on the academic questions of allowability of such a deduction on merits when the same is clearly not admissible in view of specific provisions of Section 40(a)(i). By the virtue of Section 40(a)(i), in my considered view, deductions in respect of payments made outside India, involving tax deduction at source obligations by the payee, are admissible in the year in which such tax deduction at source obligations have been discharged, and this principle operates de hors the method of accounting employed by the assessee. For all these reasons, in my considered view, it is not a condition precedent for admissibility of deduction under proviso to Section 40(a)(i) that the assessee should have first claimed the deduction in the year to which it pertains and that deduction should have been rejected by the AO only on the ground that the tax deduction at source obligations in respect of the same have not been discharged by the assessee.

81. It is interesting to note that the provisions of Section 40(a)(i) are disabling provisions as well as enabling provisions. While Section 40(a) lays down the restrictions on deductibility of certain expenses, proviso to Section 40(a)(i) lays down the conditions in which such an expense is to be allowed.

82. Normally, proviso to a section sets out an exception to the scope of section. It carves out an area, out of the area covered by the scope of the section, and takes it away from applicability thereof. As Lush J said, "When one finds a proviso to a section, the natural presumption is that, but for the proviso, the enacting part of section would have included the subject-matter of the proviso." As Lord Macnaghaten observed, 'the proviso may be a qualification of the preceding enactment which is expressed in terms too general to be accurate'. No doubt that, more often than not, it is somewhat alien to the proper function of a proviso to read it as providing something by way of an addendum or dealing with a subject which is not directly relevant to the section of which it is a proviso. In other words, normally a proviso operates as an exception, rather than as a substantive provision. However, as was observed by the Hon'ble Supreme Court in the case of CIT v. Jagannath Mahadeo Prasad "where the language is quite clear and no other view is possible, it is futile to go into the question whether the proviso to Section 24(1) operates as a substantive provision or only by way of an exception to Section 24(1)". The words of proviso to Section 40(a)(i) also being clear and being free from any ambiguity, and in view of the principle so laid down by the Hon'ble Supreme Court in the case of Jagannath Mahadeo Prasad (supra), this proviso is to be viewed as a substantive provision and as, to repeat my words in the preceding para, an enabling provision.

83. In the light of the above discussions and in view of the fact that the learned Vice President has confirmed the disallowance of remuneration and tax in respect of 1990-91 and 1991-92 only on the ground that the assessee had not made claim for deduction thereof in the respective years, I dissociate myself from this conclusion arrived at by the learned Vice President. In my considered view, therefore, the deduction of remuneration and tax in respect of 1990-91 and 1991-92 is to be allowed in the asst. yr. 1995-96, i.e., the year in which the assessee has duly discharged the tax deduction at source obligation in respect of the same.

B : Deductibility of interest under Section 201(1A)

84. In para 28 of the proposed draft, learned Vice President has observed as follows :

"That leaves us to consider the interest paid by the assessee under Section 201(1A). Before proceeding to consider this issue, we would make it clear that for asst. yrs. 1992-93 to 1994-95 interest paid by the assessee was neither claimed in the course of assessment proceedings nor in the grounds of appeal before the CIT(A) or before us. The claim has, however, been made in the asst. yr. 1995-96. Thus, at the very outset the claim of interest pertaining to period falling in 1990-91 to 1994-95 is disallowable in any case for the reason that no such claim has been made for the relevant years."

In my considered view, however, since the aforesaid interest was in the nature of employee cost and since it was paid in the previous year relevant to the asst. yr. 1995-96, the same should be allowed as a deduction in the asst. yr. 1995-96. It is also to be noted that the liability to pay even the remuneration was not debited in the books of account in India, as evident from the contents of para 9 of learned Vice President's draft, and yet the same was held to be allowable as a deduction in computing income attributable to Indian PE. By the same logic, merely because relevant interest expenses were not claimed as a deduction by showing the same in the books of account for the relevant years, cannot come in the way of allowing interest expenses as a deduction for the present year. On the facts of the present case, interest levy under Section 201(1A) is an integral part of the remuneration paid to expatriates, since such remuneration is paid on 'net of tax basis' and interest under Section 201(1A) will have the same character as the tax paid on such salaries which is undoubtedly the character of salaries or cost of employment. As a corollary to the remuneration itself having been held to be an allowable deduction, the tax paid in connection with such remuneration as also interest paid in connection with such taxes is also required to be treated as an 'allowable deduction'.

85. In para 34 of the proposed order, learned Vice President has further observed that :

"...It may also be pertinent to mention that income-tax paid by the assessee does not qualify for deduction as such. This view is supported by the decision of the Supreme Court in the case of Smt. Padmavati Jaikrishna v. Addl. CIT . In the case of East India Pharmaceutical Works Ltd v. CIT , Their Lordships of the Supreme Court held that the interest paid on the overdrafts utilized for payment of income-tax is also not allowable as a deduction as it is not an expenditure laid down wholly and exclusively for the purposes of business as contemplated by Sub-section (1) of Section 37 of the IT Act, 1961. On the basis of the above principles of law, the interest paid by the assessee as 'an assessee-in-default' of tax is not exigible for deduction as expense incurred for purposes of business. The decisions relied upon by the learned counsel for the assessee are accordingly inapplicable to the facts of this case." [The expression "interest paid by the assesses as 'an assessee-in-default' of tax" refers to interest paid by the assesses under Section 201(1A) of the Act]

However, in my considered view, interest paid by the assessee on the facts of this case is in the nature of a compensatory levy and part of the employee cost. I am also of the view that since the interest in question is not in respect of taxes on income of the assessee, but in respect of employee tax liability which is in the nature of 'employee cost' for the assessee, Hon'ble Supreme Court's judgments in the cases of Smt Padmavati Jaikrishna v. Addl. CIT and East India Pharmaceutical Works Ltd v. CIT

are not relevant in the present context.

86. In the proposed order, the learned Vice President has declined the claim by observing that income-tax does not constitute an admissible deduction and since interest in question is paid in connection with income-tax, the interest paid on account of delay in deposit of tax deducted at source also cannot be allowed as a deduction. Interestingly, however, in the proposed order, the learned Vice President himself has allowed the deduction on account of tax deductible at source from salaries to expatriates. In doing so, in paras 24 to 26 of the learned Vice President's draft, it has been observed that :

"It is evident from above that the salary paid to expatriate employees is net of taxes.... We... direct the AO to consider the claim of the assessee in regard to remuneration and the taxes paid relating to the asst. yrs. 1992-93 to 1995-96 in the asst. yr. 1995-96 in accordance with the directions contained in this order."

Once we hold that the taxes deducted at source, which were borne by the assessee as an employee cost and on account of expatriate salaries being on 'net on tax basis', constituted admissible deduction, it cannot be open to us to hold that interest payable in connection with such taxes deductible at source will not be deductible on the ground that tax itself is not an allowable deduction. To me, there appears to be an inherent contradiction in this stand; either income-tax deductible at source is an allowable deduction or it is not, but once on the facts of a case, it is held that it is an allowable deduction, and rightly so, the interest on delayed deposit of such tax cannot be declined deduction on the ground that income-tax deductible at source is not an allowable deduction. In any case, income-tax paid by the assessee, in discharge of tax liability of the employees and on account of assessee paying salaries to related employees on 'net of tax basis', is nothing but an expense in the nature of, what is usually termed as, 'employee cost'. Such an expense is incurred to earn the income, and is, therefore, an admissible deduction.

87. In Smt. Padmavati Jaikrishna's case (supra) relied upon by the learned Vice President, Hon'ble Supreme Court had, inter alia, observed that "we are inclined to agree with the High Court that so far as the meeting of the liability of income-tax and wealth-tax is concerned it was indeed a personal one and payment thereof cannot at all be said to be expenditure laid out or expended wholly and exclusively for the purpose of the earning the income" and that "the test to apply is that the expenditure should be wholly and exclusively for the purpose of earning the income". In coming to the conclusion that the interest paid on overdraft to pay income-tax dues does not constitute an admissible deduction under Section 57(iii), Their Lordships took note of the legal position that "the expenditure to be deductible ... must be laid out or expended wholly and exclusively for the purpose of making or earning such income..." as also the finding that "the expenditure in this case was to meet the personal liability of payment of income-tax and wealth-tax" which was obviously not to earn income. To my understanding, the principle that could be said to emerge from this judgment is that only such expenses can be allowed as a deduction which are incurred to earn that income, but then income-tax is certainly not 'to earn an income', and, therefore, rightly inadmissible as a deduction. In the case of East India Pharmaceutical Works (supra) relied upon by the learned Vice President, Hon'ble Supreme Court has simply followed this principle and observed that "as has been already noticed in Smt. Padmawati's case (supra), this Court had affirmatively held that, meeting the liability for income-tax was a personal liability and such expenditure can never be held to be wholly and exclusively for the purpose of earning income." . On the facts of the present case, however, none of these judgments have any application. It is not in dispute that the assessee has paid the salaries to expatriates on net of tax basis, and, therefore, tax paid on behalf of such employees is an integral part of the employee cost which cannot but be said to be in the nature of expenses, to use the terminology employed by the Hon'ble Supreme Court, "wholly and exclusively for the purpose of earning income". On the present set of facts, therefore, interest paid on account of delay in depositing the taxes deductible at source is an admissible deduction, and learned Vice President's reliance on Hon'ble Supreme Court's judgments in the cases of Smt. Padmavati Jaikrishna (supra) and East India Pharmaceutical Works (supra) does not appear to be wholly justified.

88. In his proposed order, learned Vice President has stated that "Since the income of the expatriate employees is liable to tax, the assessee would be obliged to file the returns of income and discharge the obligations which, but for the agreement of employment with the assessee, expatriate employees had to discharge." In my view, we have no basis for arriving at this conclusion, nor is it anyway relevant in deciding the deductibility of interest paid on delayed deposit of taxes deductible at source.

89. It cannot also be in dispute that the interest under Section 201(1A) is compensatory, and not penal in nature. Articulating the views of Kolkata 'C' Bench in the case of ITO v. Titagarh Steels Ltd. (2001) 73 TTJ (Cal) 297 : (2001) 79 ITD 532 (Cal), and dealing with a case in which the assessee had, inter alia, paid interest under Section 201(1A) for delayed deposit of taxes deducted at source, I had observed as follows :

"... the first and foremost consequence is that the tax deductor has to make good the shortfall in tax deduction and the tax deductor also has to compensate the Revenue by way of interest for the period of late realization of this tax to the Revenue authorities. These provisions, contained in Section 201(1) and Section 201(1 A), are set out in Chapter XVII-B titled as 'Collection and Recovery of Tax'. The next set of consequences are contained in Section 271C and Section 276B, covered by Chapter XXI--'Penalties Imposable' and Chapter XXII--'Offences and Prosecutions' respectively....".

90. In the case of Mahalakshmi Sugar Mills Co. Ltd. v. CIT , Hon'ble Supreme Court has, while dealing with the levy of interest on cess, observed that "In truth, the interest provided for under Section 3(3) is in the nature of compensation paid to the Government for delay in the payment of cess. It is not by way of penalty. The provision for penalty as a civil liability has been made under Section 3(5) and for penalty as a criminal offence under Section

4." Their Lordships were thus of the opinion that a compensatory levy of interest is a deductible expenditure. In view of Tribunal's decision in the case of Titagarh Steels Limited (supra), interest levy under Section 201(1) is a compensatory levy, and, therefore, the same constitutes an admissible deduction. The circumstances leading to this levy may be such as to invite a penal action but then what is material in the present context is the precise nature of deduction being claimed, and no further. It may be recalled that in Mahalakshmi Sugar Mills Co Ltd's. case (supra), Their Lordships had further observed as follows :

"In our opinion, the interest paid under Section 3(3) of the Cess Act cannot be described as a penalty paid for an infringement of the law. As that is the only ground on which the Revenue resists the claim of the assessee to a deduction of the interest under Section 10(2)(xv) of the Indian IT Act, 1922, the assessee is entitled to succeed. There is no dispute that the payment of interest represents expenditure laid out wholly or exclusively for the purpose of the business. There is also no dispute that it is in the nature of revenue expenditure."

In the case of Prakash Cotton Mills (P) Ltd. v. CIT , Their Lordships of Hon'ble Supreme Court have observed that "The decision of this Court in Mahalakshmi Sugar Mills Co. Ltd. and the decision of the Division Bench of the Andhra Pradesh High Court in CIT v. Hyderabad Allwyn Metal Works Ltd. with the view of which we are in complete agreement, are in our opinion, decisions which settle the law on the question as to when an amount paid by an assessee as interest or damages or penalty could be regarded as compensatory (reparatory) in character as would entitle such assessee to claim it as an allowable expenditure under Section 37(1) of the IT Act".

91. In view of the reasons stated above, I am unable to concur with the learned Vice President that the interest paid by the assessee under Section 201(1A) of the Act is not eligible for deduction as expenses incurred for the purposes of business. In my view and on the facts of this case, the interest paid under Section 201(1A), being an integral part of the cost of employees--as payment on account of compensatory levy for delayed deposit of taxes which the assessee was under an obligation to pay on behalf of the employees--, is in the nature of expenses incurred for the purposes of the business and for earning the income, and, is, therefore, admissible as a deduction under Section 37(1) of the Act.

C : Deducibility of operational loss

92. As far as this claim of deduction of Rs. 9,57,58,904 is concerned, this claim was originally allowed by the AO but, in the course of first appellate proceedings and vide para 8 of the impugned order, CIT(A) made this disallowance by observing as under :

"I find that this claim of loss relates to the transactions with regard to scam period in respect of shares and securities and the matter is at present sub judice and is pending with Special Court set up by the Government to decide scam related issues.

Keeping in view the fact that the matter is still sub judice and the Court is yet to give finding with regard to this scam and the loss incurred was not business loss, this loss of Rs 9,57,58,904 cannot be allowed to the appellant. The AO is directed to give effect to this order enhancing the income of the appellant to this extent"

Aggrieved by the enhancement so made by the first appellate authority, assessee is in appeal before us.

93. In order to appreciate the nature of this loss in correct perspective, it may also be useful to understand the nature of transaction as also modus operandi of the broker.

94. As evident from the document placed before us at p. 47 of the paper book, the assessee received a sum of Rs. 10 crores from Punjab Housing Board (PHB, in short), for investment by the assessee, for a period of 180 days subject to the condition that the money is to be invested in Government securities, UTI or tax-free bonds, that a return of 17 per cent minimum will be guaranteed, that all services were to be rendered in Chandigarh, and that in case of emergency, money may be made available to PHB with whatever returns that becomes due at that time. It was in the course of investment of money so received by the assessee that on 9th March, 1992, it issued a cheque of Rs. 9,75,58,904 to Andhra Bank for purchase of 17 per cent NPC Bonds @ 'Rs 97 per bond plus accrued interest' and handed over a payment advice and the cheque, cheque forming part of the payment advice, to a broker by the name of Shri. N.K Agarwal. At this stage, I must clarify as to the present practice of issuance of 'payment advice-cum-cheque'. With the changes in the Indian banking practices brought about mainly by the multinational banks, it is no longer a cheque book which is used by the large corporate account holders, involving issuance of large number of cheques, or the banks. These cheque books are now replaced by packets of perforated computer friendly forms, used as a continuous computer stationery, issued by the banker to its important clients and, of course, for its own purposes. These pre-numbered advices are in two parts and can be separated by tearing off at the perforated points. The top portion contains the kind of details of the person issuing the cheques as a letter-head would contain, and has columns for the name and address of the person to whom cheque is issued, details of payment, and details of purposes for which it is issued. The bottom portion is a form for the cheque itself. These forms are computer friendly and, while processing the payment, while details of payment are printed on the top portion, the details necessary for cheque are printed on the bottom portion. Upon signing, the top portion is used as a payment advice, while bottom portion, on being removed from the aforesaid advice, works as a cheque itself. A typical example of such a practice is reflected by the copy of payment advice-cum-cheque in question issued to Andhra Bank, a copy of which is placed before us at p. 49 of the paper book. Even a cursory look of the above payment advice-cum-cheque clearly demonstrates the fact that the payment advice and the cheque are composite instruments in this case, although, for banking purposes, one has to tear off the cheque and process it for payment. The cheque portion appears to be in favour of Andhra Bank, but then it's a fairly well-known fact that the modus operandi of many security scams was that cheques issued in the name of banks were used, as a part of normally acceptable practice, to credit the accounts of certain brokers as maintained in those banks. It was, inter alia, this vulnerable practice in the banking industry which proved to be a fertile ground for ingenious and unscrupulous scamsters.

95. It is not in dispute in the present case that it was this payment advice-cum-cheque which was handed over by the assessee to the broker, and this fact is also evident from acknowledgment on copy of the payment advice-cum-cheque placed before us at p. 49 of the paper book. What has apparently been done by someone in this case is that he removed the top portion of payment advice-cum-cheque, ignored its contents altogether, and used the bottom portion, i.e., the cheque, for affording credit to the account of one Hiten Dalal, one of the central characters in several cases of security scams in this country. This exercise, in our considered view, is nothing short of a fraud within meanings of Section 17 of the Indian Contracts Act, 1872, which describes fraud as, inter alia, active concealment of a fact by one having knowledge or belief of the fact. Now, it cannot be in dispute that the person who received the payment advice-cum-cheque was aware that the cheque in the name of Andhra Bank was specifically for the purpose of purchase of NPC Bonds in the name of PHB, but he actively conceals this fact by removing the top portion of 'payment advice-cum-cheque' and uses only the cheque portion for an unauthorized credit to the account of Hiten Dalai. As an agent of the PHB, which the assessee clearly was while making investment specifically on behalf of this principal, the assessee was bound to conduct the business of the principal as per directions given by the principal, or, in the absence of such instructions, according to the normal usage. Subsequent to this transaction, the assessee has been able to realize IRFC Bonds valued at Rs. 9,57,58,904 as also a sum representing the difference in value of NPC Bonds vis-a-vis the IRFC Bonds, on 18th March, 1992, but even the IRFC Bonds could not be transferred to the assessee-bank as the same were already sold to Standard Chartered Bank. The assessee carried the matter before the Company Law Board but without any success. As evident from p. 1 of CLB's order, dt. 25th Aug., 1994, marking attendance of Shri Manmohan and Shri C.M. Oberoi, Advocates representing PHB, PHB was also represented before the CLB. This CLB order, at p. 2, specifically observes as follows :

"In accordance with the instructions of NKA (i.e., the broker), ABN Amro Bank, (i.e., appellant before us) issued an account-payee cheque/pay order in favour of Andhra Bank, Fort Branch, Bombay, for the above said amount, with an attached memorandum stating that it represents the cost of 17 per cent NPC Bonds purchased on behalf of petitioner's customer, PHB."

In my view, receipt of Rs. 10 crores from PHB and issuance of cheque for purchase of 17 per cent NPC Bonds are integral parts of the same transaction. It is also important to bear in mind the fact that the amount that the assessee-bank was unable to invest in the NPC Bonds was duly refunded to the PHB. In case receipt of Rs. 10 crores from PHB and Investment in 17 per cent NPC Bonds are to be treated as unconnected transactions, the refund of Rs. 24,41,096 to PHB remains unexplained, which represents the difference of amount received for investment minus the amount invested in 17 per cent NPC Bonds. The assessee-bank had also refunded Rs. 18 lakhs to PHB and this amount was received from N.K. Agarwal, being difference between the market value of NFC Bonds and IRFC Bonds, at the time of handing over IRFC Bonds in substitution of NPC Bonds. All these factors indicate that receipt of Rs. 10 crores from PHB, and investment in NFC Bonds are interconnected and integral part of the transaction entered into by the assessee-bank. While making this purchase of 17 per cent NPC Bonds, assessee was not making an investment in the course of its business, but making an investment specifically on behalf of the constituent, i.e., PHB as an agent. It would also appear to us that the assessee acted in the manner in which a normal prudent person would have acted by issuing the cheque in the name of Andhra Bank with specific instructions to use the proceeds of this cheque for buying the securities in question. The loss suffered by the assessee in such a situation, i.e., acting as an agent of PHB and while conducting the business in a bona fide manner, prima facie is on account of the principal, i.e., PHB. In our considered view, therefore, no loss was incurred by the assessee as such on his account, but on account of its client, i.e., PHB, specifically on whose behalf and specifically in whose name, the assessee was trying to acquire securities. Yet the assessee agreed to bear this loss by making good the loss caused to PHB, not because the assessee had a legal duty to do so but, as I find, because of commercial expediency. One important factor contributing to this commercial expediency appears to be that the RBI declined to issue a licence for opening a new branch office at Chennai. The RBI in its letter dt. 16th June, 1993, a copy of which was placed before us at p. 58 of the paper book, stated that "issue of a licence to your bank for opening a branch in Madras has again been decided to be kept in abeyance till such time as the dispute on securities transactions between your bank and Andhra Bank is resolved". Within three weeks of this communication, the assessee-bank entering into settlement with PHB, also, in a way, indicates the factors influencing the assessee-bank's decision to bear the loss. Let us see this from the point of view of a large multinational bank that this assessee admittedly is. In case such an assessee has to choose between bearing a loss of Rs. 9.57 crores or losing the opportunity to operate business in a major Indian metropolitan city like Chennai, the odds are that the commercial expediency may persuade the assessee to opt for losing only Rs. 9.57 crores. In other words, commercial expediency of bearing this loss, which is surely best judged by the assessee himself, cannot be simply rejected as improbable. In this view of the matter, I am of the considered opinion that there is no material to reject assessee's claim that the payment made to PHB was justified on the grounds of commercial expediency.

96. There is one more aspect to the matter, and, that is pertaining to the importance of assessee's credibility in its customers and prospective customers. There are occasions when, to protect its reputation and credibility, a bank has to bear a loss which, strictly speaking, is not even its loss. One such situation was dealt by with Their Lordships of Hon'ble Supreme Court in the case of CIT v. Nainital Bank Ltd . Their Lordships were in seisin of a case in which certain amount of cash and 'a large quantity of jewellery pledged with the bank by its constituents' were stolen by dacoits on 11th June, 1951, from the premises of the bank. As far as loss of jewellery belonging to the customers was concerned, the bank has settled these claims with the customers. The loss was thus borne by the assessee-bank, even though the bank was not under any legal or contractual obligation to bear such loss. The amount so paid was, however, disallowed by the Revenue on the ground that the assessee-bank did not have any liability to settle the claim. When the matter finally reached the Hon'ble Supreme Court, Revenue contended that the loss incurred by the bank was under no legal liability to pay to the constituents the value of the jewellery pledged. Revenue also pointed out that the bank was, as a pledgee, a bailee of the jewellery and was in law required to take as much care of the pledged jewellery as a person of ordinary prudence would take under similar circumstances of his own jewellery of the same bulk, quantity and value, and the bank having provided an adequate number of watchmen, it was not liable for the loss of the property pledged. It was in this backdrop that Their Lordships observed that, "Granting that, on proof that it had taken as much care of the jewellery pledged with it as it would have taken if it belonged to it, the bank could enforce its rights and recover the full amount due from the constituents, the question still remains whether in admitting liability for the purpose of the business." and thus answered the question posed to themselves :

"... The credit of a banking business is very sensitive : it largely thrives upon the confidence which its constituents have in its management. To maintain that confidence the management has often to make concessions and thereby to preserve the goodwill of the business and its relations with the clientele. The bank could have, if so advised, taken its stand strictly on its legal obligations, and could have recovered the amounts due by the constituents at the same time denying liability to make any compensation for the loss of jewellery pledged with it. But such a stand might very well have ruined its business, especially in the rural areas in which it operated. The bank had evidently two courses open : to enforce its light strictly according to law, and thereby to lose the goodwill it had built up among the constituents, or to compensate the constituents for loss of their jewellery, and maintain its business connections and goodwill. In choosing the second alternative, in our judgment, the bank laid out expenditure for the purpose of its business. Paying to the constituents the price of the jewellery stolen in a robbery or a burglary was, therefore, expenditure for the purpose of the business. There can be no doubt that the expenditure was wholly and exclusively in the interest of the business. The expenditure was laid out for no other purpose."

(emphasis by underlining, italicised in print, supplied by me)

97. Applying the principle laid down by the Hon'ble Supreme Court in the case of Nainital Bank (supra), it would appear that the assessee-bank had evidently two courses open : to enforce its right strictly according to law, and thereby to lose the goodwill it had built up among the constituents, or to compensate the constituent for the loss suffered in the securities scam, and maintain its business connections and goodwill. In choosing the second alternative, as held by the Hon'ble Supreme Court, the assessee-bank laid out expenditure for the purpose of its business. Accordingly, the payment of Rs. 9,57,58,904 made by the assessee-bank to the PHB is, in my considered view, bona fide business expenditure eligible for deduction under Section 37(1) of the Act.

98. As for the Revenue's contention that the loss is not yet final and there is still a possibility of assessee-bank's being able to recover the disputed amount from Andhra Bank, N.K. Agarwal or Hiten Dalai, I find no substance in this contention either. First of all, this argument proceeds on the fallacy that it is the loss incurred on behalf of PHB which is being claimed as deduction, whereas, in my view, it is the payment to PHB, which is a payment warranted on account of commercial expediency rather than contractual obligations, which is being claimed as a deduction. Secondly, assuming that such a possibility may have any relevance in this matter, even the 'possibility' of recovery has to be a reasonable possibility, i.e., what a reasonable person would expect in the given circumstances. The material on record, in my understanding, indicates that the assessee-bank has been taken for a ride by unscrupulous operators, misusing the loopholes in the system, and exploiting the fact that transactions involving such huge amounts were entered into, perhaps as a normal course in the banking industry, without taking highest degree of safety measures and incorporating checks and balances as such, and but for this laxity inherent in the normal banking practices, scams of the kind which have become somewhat common in the recent past could not have taken place. Learned CIT(A) has made this enhancement merely on the basis that the matter is still pending before the Special Courts set up for dealing with security scam cases. But then this fact, by itself, cannot imply that there are reasonable prospects of recouping the loss, because, it is also a well-known fact, perhaps as equally well known as the fact about existence of these special Courts itself, that the claims on these scamsters are several times the value of their known assets. This money does not also appear to be recoverable from Andhra Bank also as in response of RBI's letter dt. 16th June, 1993, a copy of which was placed before us at p. 58 of the paper book, stating "issue of a licence to your bank for opening a branch in Madras has again been decided to be kept in abeyance till such time as the dispute on securities transactions between your bank and Andhra Bank is resolved", the assessee-bank has clearly given more importance to the licence for Chennai branch rather than claim, whatever be its merits, on Andhra Bank. Keeping all these factors in mind, I am inclined to share the assessee's perception that there is no reasonable hope of recovery of this amount. There is no material before us to doubt or dispute the assessee's perception that the money so refunded to PHB constitutes a loss, and is, accordingly, booked as an expenditure, that the same is beyond reasonable hope of recovery, and that the chances of recouping the loss are too remote to affect the accounting treatment of the loss. The objection raised by the Revenue is thus, in my considered view, not maintainable.

99. For the reasons set out above, I am of the considered view that the CIT(A) indeed erred in making enhancement of Rs. 9,57,58,904 on account of operational loss. The appellant, therefore, deserves to succeed on this issue as well.

100. Save as otherwise specified hereinabove, I am in considered agreement with the conclusions arrived at by the learned Vice President and, I respectfully, endorse the same.

REFERENCE UNDER SECTION 255(4) OF THE IT ACT, 1961

Pramod Kumar, A.M.

101 A consolidated order in the case of above four appeals for the asst. yrs. 1992-93 to 1995-96 was proposed by the Vice President. However, the AM has expressed his reservations on some of the issues relating to the asst. yr. 1995-96. The AM has agreed with the proposed order in respect of which no specific reservations have been expressed in the dissenting order. Therefore, whereas the appeals for the asst. yrs. 1992-93 to 1994-95 are disposed of by way of the consolidated order, a reference is made to the Hon'ble President for nomination of Third Member in order to resolve the points of difference amongst the members of the Bench for the asst. yr. 1995-96. The points of difference are as under:

(a) Whether or not, on the facts and in the circumstances of the case, the assessee is entitled to deduction of tax component of salary of expatriate employees, relating to asst. yrs. 1990-91 and 1991-92, in the asst. yr. 1995-96 i.e. the year in which the tax has been paid by the assessee.

(b) Whether or not, on the facts and in the circumstances of the case, the assessee was entitled to deduction of interest levied under Section 201(1A).

(c) Whether or not, on the particular facts and in the particular circumstances of this case, the assessee was entitled to deduction on account of operational loss of Rs. 9,57,58,904.

102. It is, therefore, requested that the Hon'ble President may kindly nominate a Third Member for a decision in regard to the points of difference referred to above.

M.A. Bakshi, Vice President

103. A consolidated order in the case of all the above four appeals for asst. yrs. 1992-93 to 1995-96 was proposed by the Vice President. However, the AM has expressed his reservations in respect of some of the issues all relating to asst. yr. 1995-96. The AM has agreed with the proposed order in respect of which no specific reservation has been expressed in the dissenting order. Therefore, whereas the appeals of the assessee for asst. yrs. 1992-93 to 1994-95 are disposed of by the consolidated order, a reference is made to the Hon'ble President for nomination of the Third Member in order to resolve the points of difference amongst the members of the Bench for asst. yr. 1995-96. The points of difference are identified as under:

104. Tax component in respect of expatriate employees for asst. yrs. 1990-91 and 1991-92 :

In paras 24 to 27, the Vice President in his proposed order has held that in principle the assessee is entitled to deduction of tax component of salary relating to expatriate employees in asst. yrs. 1992-93 to 1994-95 but for the operation of the provisions of Section 40(a)(i) the deduction is not permissible in such year the tax not having been paid by the assessee. However, since the payment of tax has been made in asst. yr. 1995-96, the Vice President has, accordingly, allowed the deduction of the entire claim pertaining to asst. yrs. 1992-93 to 1995-96 in asst. yr. 1995-96.

104.1 In asst. yr. 1995-96, the assessee had also claimed deduction in respect of tax component of salary of the expatriate employees pertaining to assessments for 1990-91 and 1991-92. The said assessment years were not in appeal before the Tribunal. The Vice President in para 27 of the order has held that the assessee not having claimed any deduction in respect of the tax component of salary in the asst. yrs. 1990-91 and 1991-92 either before the AO or before any other authority, the mere fact that the tax has been paid in asst. yr. 1995-96 does not entitle the assessee to claim deduction in the year of payment, i.e. in asst. yr. 1995-96 when the assessee is following the mercantile system of accounting.

104.2 On the other hand, the AM in the dissenting order has held that the assessee would be entitled to deduction in respect of tax component of the salary for asst. yrs. 1990-91 and 1991-92 paid in asst. yr. 1995-96 notwithstanding the fact that no claim was either made in asst. yrs. 1990-91 or 1991-92 by the assessee before any authority. According to the AM, Section 40(a)(i) permits deduction in the year of payment. Therefore, the omission of the claim in relevant years, i.e. in asst. yrs. 1990-91 and 1991-92 is of no consequence. Hence the point of difference :

"Whether the assessee is entitled to deduction of tax component of salary of expatriate employees relating to asst. yrs. 1990-91 and 1991-92 in asst. yr. 1995-96 in which the tax has been paid by the assessee, not claimed in the respective assessment years before any authority."

105. Interest paid by the assessee as a defaulter of non-payment of tax deductible at source :

In the order proposed by the Vice President, the assessee has been held to be entitled to deduction on account of remuneration paid to the expatriate employees including the taxes payable on such remuneration. The assessee had committed a default in discharging its obligation of deduction of tax and payment to the Government in respect of the salaries paid to expatriate employees. As a result of the default committed by the assessee of non-deduction and non-payment of TDS, the assessee had to pay interest under Section 201(1A) of the IT Act, 1961. The interest was paid in the previous year relevant to the asst. yr. 1995-96 and the assessee claimed deduction in respect of such interest paid as an expenditure incurred for purposes of business. The Vice President has drawn a distinction between the cost of employment which includes the remuneration, taxes, interest etc. on behalf of the employees on the one hand and the assessee's statutory obligation to deduct and pay taxes on the other hand. The Vice President has expressed the view that, whereas the assessee is entitled to deduction on account of remuneration as well as taxes and interest in respect of such taxes as cost of employment, no deduction would be permissible to the assessee in respect of the interest payable as an assessee-in-default for its failure to discharge the statutory obligation of non-deduction of tax and payment of the same to the Government in contrast to the obligation of the assessee as an employer.

105.1 The AM in his dissenting order has expressed the view that the interest charged under Section 201(1A) is part of the cost of employment to the assessee and, accordingly, is permissible as a deduction. Hence the dispute is identified as under :

"Whether interest paid by the assessee as an assessee-in-default qualifies for deduction as cost of employment to the assessee."

106. Business loss :

The assessee had claimed deduction on account of sum of Rs. 9,57,58,904 refunded to the Punjab Housing Board (PHB) on account of the investment made by them. Deduction of interest @ 17 per cent was also separately claimed. The AO had allowed both the deductions. The CIT(A) had enhanced the income of the assessee by disallowing the deduction on account, of refund to PHB of Rs. 9,57,58,904. On appeal, the Vice President expressed the view that the assessee is not entitled to deduction on account of refund to PHB as that was not the event of loss. The Vice President has also pointed out that facts relating to the loss are disputed by the parties and the matter is sub-judice. The Vice President in his proposed order has given liberty to the assessee to claim the loss as and when it is established to have been incurred.

106.1 The AM in his dissenting order has disagreed with the view and on the reasons recorded in the order held that the assessee is entitled to deduction. Hence the difference on the following point :

"Whether the assessee is entitled to deduction of Rs. 9,57,58,904 on account of payment to Punjab Housing Board in respect of investment made by them with the assessee notwithstanding the fact that facts relating to loss of investment are disputed and the issue is sub-judice."

107. It is, therefore, requested that Hon'ble President may nominate a Third Member for a decision in regard to the points of difference referred to above.

R.P. Garg, Vice President

A reference under Section 255(4) of the IT Act, 1961, was made by the President, Tribunal, for my opinion as Third Member on the following points of difference arising out of the appeal for the asst. yr. 1995-96 :

"(a) Whether or not, on the facts and in the circumstances of the case, the assessee is entitled to deduction of tax component of salary of expatriate employees, relating to asst. yrs. 1990-91 and 1991-92, in the asst. yr. 1995-96, i.e., the year in which the tax has been paid by the assessee.

(b) Whether or not, on the facts and in the circumstances of the case, the assessee was entitled to deduction of interest levied under Section 201(1A).

(c) Whether or not, on the particular facts and in the particular circumstances of this case, the assessee was entitled to deduction on account of operational loss of Rs. 9,57,58,904."

108. The questions referred were not depicting the real controversy and there was also confusion about the assessment year of reference. As regards question (a) above, the reference was only for allowability of the tax component on the salary of expatriate employees deducted at source, whereas the difference between the two Members was covering both the tax component as well as salary payment to the expatriate employees, and question (c) was arising out of the appeal proceedings for the asst. yr. 1994-95 whereas in the reference it is stated to be arising out of asst. yr. 1995-96. Therefore, a revised reference was directed by the President with the following questions :

Asst yr. 1995-96

"(a) Whether or not, on the facts and in the circumstances of the case, the assessee is entitled to deduction of tax component and salary of the expatriate employees relating to asst. yrs. 1990-91 and 1991-92, in the asst. yr. 1995-96, namely, the year in which the tax has been paid by the assessee.

(b) Whether or not, on the facts and in the circumstances of the case, the assessee was entitled to deduction of interest levied under Section 201(1A)."

Asst. yr. 1994-95

"(c) Whether or not, on the particular facts and in the particular circumstances of this case, the assessee was entitled to deduction on account of operational loss of Rs. 9,57,58,904."

109. The assessee is a bank, incorporated in Netherlands with limited liabilities having its original office at Singapore. It has branches in India at Mumbai, Kolkata and New Delhi and is registered as a Scheduled Bank in terms of Schedule II of the Reserve Bank of India (RBI) Act, 1934. Its main activity comprised of accepting deposits, giving loans, discounting of the collection of bills, issue of letter of credit/guarantees, executing forward transactions in foreign currencies for importers/exporters, money market lendings/borrowings, investment in securities, etc., in terms of existing rules and regulations governing such transactions.

110. There exists an agreement for Avoidance of Double Taxation between India and Netherlands (DTA in short), Article 7 of which provides for taxation in India on a foreign enterprise in respect of profit attributable to its permanent establishments (PE in short) and since ABN AMRO was having a PE in India, it is being subjected to tax in India.

111. Four years' appeals for asst. yrs. 1992-93, 1993-94, 1994-95 and 1995-96 came up before the Tribunal simultaneously and there struck a difference of opinion between the two Members while disposing of the appeals for asst. yr. 1994-95 in ITA No. 106/Kol/2001 and asst. yr. 199.5-96 in ITA No. 496/Cal/1999 and the point of difference is referred to above in para 2.

112. The assessee has not deducted tax in. respect of the remuneration paid to its expatriate employees on the prescribed dates as required under Section 192 of the Act. The CBDT, in order to encourage the compliance in respect of TDS, issued Circular No. 685, dt. 20th June, 1994, providing exemption from penalty and prosecution to those employers who paid the tax deducted/deductible at source at a specified date. By another Circular No. 686, dt. 12th Aug., 1994, the Board has also clarified that the assessments of the employees in respect of whom payments of short deduction and interest thereon are made by the employer in pursurance of Circular No. 685, dt. 20th June, 1994, will not be responsible or otherwise disturbed merely on account of the excess salary payment now disclosed by the employer. The assessee took shelter under the said circular and paid a sum of Rs. 2,06,54,499 for previous years starting from asst. yr. 1990-91 to asst. yr. 1995-96. The P&L a/c of the assessee for asst. yr. 1995-96 was debited with the sum of Rs. 2,06,54,499. It was, however, added back and a deduction of only of Rs. 89,04,276 was claimed on account of remuneration including Rs. 52,35,222 paid in Netherland, TDS and interest pertaining to the asst. yr. 1995-96.

113. For asst. yrs. 1990-91 and 1991-92, it seems that the remuneration has not been claimed as a deduction and seemingly no reasons are on record as to why it was not claimed in those years. In the asst. yr. 1992-93, the assessee made claim before the AO for remuneration and tax deducted at source in respect of expatriate employees having rendered services in India for which the payment has been made abroad amounting to Rs. 23,87,325. By another letter, the assessee claimed the tax deducted at source paid in pursuance to the Board's Circular amounting to Rs. 29,86,963. A similar claim was made for asst. yrs. 1993-94 and 1994-95. During the assessment proceedings for asst. year 1995-96, the assessee also claimed deduction of entire amount of Rs. 2,06,54,499 being the tax and interest for all the years starting from asst. yr. 1990-91 to 1995-96. The position of payment of TDS, interest and offshore remuneration paid in Netherlands and claimed as deduction is as under :

Details Asst. yr. Asst. yr. Asst. yr. Asst. yr. Asst yr. Asst. yr. Total

90-91 91-92 92-93 93-94 94-95 95-96 Tax (As TDS 3,61,635 10,54,924 29,86,963 49,44,312 35,86,312 36,15,895 1 ,65,50,510

arrears)

Int. U/S 201 2.45,859 5,80.300 12.19,063 13,24,577 6,81.031 53,159 41,03,989

Sub Total 6,07,494 16,35,224 42,06,026 62,68,889 42,67,812 36,69,054 2 ,06,54,499

Net Offshore 3,27,276 9,10,803 23,87,325 61,90,206 47,16,025 52,35,222 1 ,97,66,857

remuneration paid

in Netherlands

Total 934,770 2.546,027 6,593,351 12.459.095 89.83,837 89,04,276 4 ,04,21,356

114. The AO, however, disallowed the claim of the assessee for offshore remuneration in asst. yrs. 1992-93 to 1994-95 by observing that the decision of Supreme Court in the case of Kedarnath Jute Mfg. Co. Ltd. v. CIT was not applicable; that the salary was paid to the expatriate employees rendering services in India by the head office of the bank and the same has not been debited to the accounts of the bank in India and that the tax borne by the assessee-bank on salary paid to the expatriate offshore the payment has been made only in the subsequent year. He, therefore, disallowed both the payment of salary by the head office as well as the tax deducted at source and interest thereon and paid in the asst. yr. 1995-96 by stating that TDS for earlier years was not covered by Section 43B as if was not a regular payment of tax or Government dues, that the amount has been paid under Amnesty Scheme and, therefore, it is not allowable and that the amount does not pertain to the year under consideration and further that the remuneration and TDS paid by the assessee for the earlier years have not been included in the income of the concerned employees for their income-tax purpose in India for which the assessee is liable and also that the interest on TDS is not a business expenditure and it does not pertain to the year of assessment.

115. The claim of Rs. 89,04,296 in asst. yr. 1995-96 being remuneration, TDS and interest pertaining to the (sic) was also disallowed by the AO by further observing that the assessee has not given the details as to how much of such remuneration has already been claimed as expenditure by any other office of the assessee because the assessee cannot be allowed the same expenditure twice, once in another country and again in India. The assessee has not given details of services rendered, place of service rendered and terms of agreement regarding such employees/offshore expatriates and that the assessee was allowed head office expenses @ 5 per cent of taxable income in India and, therefore, such expenditure including the remuneration under consideration has merged with head office expenses and, therefore, it is treated as allowed by way of head office expenses. He also stated that the aforesaid reasons for not allowing offshore expatriates remuneration applies to interest, TDS and remuneration paid for earlier years as well.

116. The CIT(A) confirmed the disallowances by agreeing with the AO for the disallowance of Rs. 89,04,296 in asst. yr. 1995-96, he also agreed with the AO for the disallowance of the entire deduction of tax of Rs. 2,06,54,499 being the tax and interest on offshore remuneration of the expatriate employees for all the assessment years including the current assessment year. He observed that the CBDT had launched a scheme whereby TDS by defaulters for not deducting tax in respect of salary and remuneration paid to expatriate employees abroad could be paid by the employer and the assessee had taken advantage of this scheme and paid tax and interest due thereupon for several assessment years with respect to payment made to its expatriate employees to save itself from the rigour of prosecution, although in other sense of the term, these taxes were due and collectible from the expatriate employees from whom the assessee-company in earlier years had failed to collect taxes in accordance with the Indian law and pay the same. He further observed that even now these taxes have been paid purely on behalf of the expatriate employees and if there is any liability for payment of the same to the bank it rests on those expatriate employees and, therefore, the assessee cannot say that this should be treated as revenue expenditure. He further held that the taxes paid by the assessee-company because of their own fault in not collecting taxes from its expatriate employees in time and depositing the same with the Government of India, cannot be allowed as a revenue expenditure.

117. The matter came up before the Tribunal. Insofar as the claim for remuneration in the appeals for asst. yrs. 1992-93 to 1994-95 is concerned, both the members agreed that the remuneration paid to the expatriate employees rendering whole-time service in India throughout the accounting year has to be accepted as allowable deduction in computing the profits of the PE subject however with a rider that such payment is not taken into account in working out the deduction under Section 44C and once the AO is satisfied that the assessee is entitled to deduction in respect of remuneration, the claim of the assessee shall have to be dealt with in accordance with Section 40 of the Act. The aforesaid directions were also stated to be valid for offshore remuneration pertaining to the asst. yrs. 1992-93, 1993-94, 1994-95 and 1995-96 with a direction that if after verification the AO comes to the conclusion that the assessee has not taken the amount of remuneration in respective assessment years into consideration in working out the deduction under Section 44C, the claim would in principle be permissible in the respective assessment years. So, however, deduction has got to be allowed as already pointed out in accordance with Section 40(a) read with the proviso. The tax not having been deducted at source in the respective assessment years but having been paid in asst. yr. 1995-96, the deduction in respect of remuneration is allowable in the year of payment, i.e., asst. yr. 1995-96. This would take care of part of the additional ground raised before the Tribunal by the assessee in asst. yr. 1995-96 whereby the deduction in respect of the offshore remuneration and tax component pertaining to asst. yrs. 1992-93 to 1994-95 is claimed as deduction in asst. yr. 1995-96. For asst. yr. 1995-96, tax has been paid by the assessee in the same assessment year and, therefore, the prohibition under Section 40(a) is not attracted. The claim of the assessee was directed to be considered accordingly.

118. The objection of the Revenue about the assessee having failed to establish as to whether the services have been rendered by the expatriate employees in regard to the PE of the assessee in India was found untenable with the observation that if the employees have not rendered services in India for which the remuneration had been received abroad, then how was it that the assessee was under an obligation to deduct tax from their remuneration and that the very fact that the assessee has accepted its obligation to deduct taxes from salary paid to the expatriate employees was sufficient to infer that services had been rendered in India. Similarly, the objection of the Revenue that the taxes have been paid on behalf of the expatriate employees and not as tax deducted at source was also found untenable in view of the provisions of Section 199 providing that any deduction made in accordance with the provisions of Section 192 and paid to the Central Government is to be treated as a payment of tax on behalf of the person from whose income deduction is made under Section 205 of the IT Act. There is a bar for the Revenue to demand tax from the assessee to the extent the amount has been deducted from the income. It was, therefore, observed that the tax deducted at source by the assessee and paid to the Government is to be treated as fine paid on behalf of the expatriate employees.

119. As regards tax deducted at source in respect of remuneration paid outside India to expatriate employees, the Tribunal held that in principle, the assessee would be entitled to deduction in respect of tax component of the salary also if the salary is found to be deductible as per the directions of the Tribunal for asst. yr. 1996-97 and, accordingly, no deduction would be permissible in asst. yrs. 1992-93 to 1994-95 by operation of Section 40(a)(i) of the IT Act and the claim for the said assessment year, shall have to be disallowed for the reason of non-deduction of tax but allowed the same in asst. yr. 1995-96. Both the Members, therefore, held that subject to verification, the claim of remuneration and tax deducted has not been taken into account under Section 44C in regard to expatriate employees, the deduction relating to asst. yrs. 1992-93 to 1994-95 would be permissible in asst. yr. 1995-96 as per the proviso to Section 40(a)(i) of the Act.

120. In Asst. yr. 1995-96, the assessee had also claimed a deduction for remuneration and tax paid for asst. yrs. 1990-91 and 1991-92. The Vice President (JM) held that no evidence has been placed on record to establish that the assessee at any stage made the claim for deduction in the said assessment year and in principle, the claim of the assessee has got to be considered in assessment year to which the claim pertains. It is also observed that it is only when the claim is considered and found allowable but for provisions of Section 40(a) that the same cannot be allowed in the year of payment and since the claim for asst. yrs. 1990-91 and 1991-92 is not established to have been made or considered in earlier year, the benefit according to him, is not permissible in asst. yr. 1995-96 merely because tax has been paid in the year under appeal. According to him, the benefit of the proviso to Section 40(a)(i) is not available in the absence of claim made in the respective assessment years. He, accordingly, upheld the disallowance pertaining to asst. yrs. 1990-91 and 1991-92 in regard to the remuneration and tax component in asst. yr. 1995-96. The AM, on the other hand, held that the assessee would be entitled to deduction in respect of the tax component and the salary for asst. yrs. 1990-91 and 1991-92 in asst. yr. 1995-96 notwithstanding the fact that no claim was ever made in asst. yrs. 1990-91 or 1991-92 by the assessee before the AO. According to him, Section 40(a)(i) permits deduction in the year of payment and, therefore, the omission to claim in the relevant year is of no consequence. This is the first point of difference between the two Members.

121. The learned counsel of the assessee submitted that there is no warrant in imposing the restriction for the allowability of remuneration and tax deducted at source on the ground that it was not claimed in the respective assessment years as a deduction. He referred to the proviso to Section 40(a)(i) and submitted that, where the tax has been deducted or paid in the subsequent year, then such sum shall be allowed as a deduction in computing the income of the previous year, such tax has been paid and since the tax has been paid in the year under consideration, the deduction is to be allowed and it is so held by both the JM and the AM insofar as the claim for asst. yrs. 1992-93 to 1994-95 is concerned. The learned Departmental Representative, however, supported the orders of the Departmental Authorities and the view taken by the JM.

122. I have heard the parties and considered their rival submissions. There is no dispute as to the allowability of the remuneration and tax deducted/deductible at source as revenue expenditure. Both the Members have agreed on this point and in fact, as aforesaid have allowed similar deduction for payment of remuneration relating to asst. yrs. 1992-93 to 1994-95. A sum chargeable under this Act (remuneration in this case) which is payable either outside India or in India to a non-resident, is not allowable as a deduction because of the provisions of Section 40(a)(i) if the tax has not been deducted or after deduction has not been paid before the expiry of the time prescribed under Sub-section (1) of Section 200 and in accordance with the other provisions of Chapter XVII-B of the Act. When a deduction is not allowable because of the statutory provisions, it would make no difference whether the same was claimed or not by the assessee. Because of the proviso to Section 40(a)(i) such sum has to be allowed as a deduction in computing the income of the previous year in which such tax deducted at source has been paid in subsequent year.

123. Section 40(a)(i) reads as under :

"40. Notwithstanding anything to the contrary in Sections 30 to 38, the following amounts shall not be deducted in computing the income chargeable under the head "Profits and gains of business or profession",--

(a) in the case of any assessee :

(i) any interest (not being interest on a loan issued for public subscription before the 1st day of April, 1938), royalty, fees for technical services or other sum chargeable under this Act, which is payable,--

(A) outside India; or

(B) in India to a non-resident, not being a company or to a foreign company,

on which tax is deductible at source under Chapter XVII-B and such tax has not been deducted or, after deduction has not been paid during the previous year, or in the subsequent year before the expiry of the time prescribed under Sub-section (1) of Section 200 :

Provided that where in respect of any such sum, tax has been deducted in any subsequent year or, has been deducted in the previous year but paid in any subsequent year after the expiry of the time prescribed under Sub-section (1) of Section 200 such sum shall be allowed as a deduction in computing the income of the previous year in which such tax has been paid."

124. On a bare reading of the aforesaid provision, it is evident such sum shall be allowed as a deduction in computing the income of the previous year in which such tax has been paid if tax has been deducted in any subsequent year or, has been deducted in the previous year but paid in any subsequent year after the expiry of the time prescribed under Sub-section (1) of Section 200. No restriction is placed for allowability of deduction of the remuneration paid in the subsequent year that it should have been claimed in the earlier year. As aforesaid, it will also not stand to logic that when a deduction is not allowable under a particular provision of the Act, in this case Section 40 of the Act, that the assessee should make a claim and that should be rejected at the first instance in the relevant year. The proviso does not contemplate any such restriction. On the contrary it would be futile rather exposing the assessee to penal consequences if he made a wrong claim which is not allowable due to specific prohibition. Such a restriction, therefore, cannot be read in the language of Section 40(a)(i) of the Act nor could it be inferred so. The deduction for asst. yrs. 1990-91 and 1991-92 has also to be allowed similarly as an admissible deduction with similar direction as were given for allowing the claim for asst. yrs. 1992-93 to 1994-95.

125. Second difference is with regard to allowability of interest paid under Section 201(1A). As aforesaid, the assessee had also claimed interest paid by the assessee as a defaulter of non-payment of tax deductible at source. Here, the Vice President (JM) held that the assessee had committed a default in discharge of its obligation of deduction of tax and payment to the Government in respect of salary paid to expatriate employees as a result of which it had to pay interest under Section 201(1A) of the Act. No deduction according to him, would be permissible to the assessee in respect of interest payable as an assessee-in-default for its failure to discharge its statutory obligation of non-deduction of tax and non-payment thereof to the Government in contrast to the obligation of the assessee as an employer. The AM, on the other hand, expressed an opinion that interest charged under Section 201(1A) is part of the cost of employment to the assessee and, accordingly, on the same parity of reasoning of allowability of the remuneration and taxes, the interest, would also be permissible deduction.

126. As regards this claim, the assessee's contention is that interest for the late payment of TDS imposed under Section 201(1A) relating to the deduction for all the asst. yrs. 1990-91 to 1994-95, is part of the remuneration, that it is therefore, an additional cost and would be allowable on the same reasoning as a salary payment is allowable. The learned counsel of the assessee also submitted that it is compensatory in nature and should be allowed as a deduction. Interest, according to him, would partake the character of the original sum which is paid late and when the tax deducted at source itself is an allowable deduction, the interest cannot be disallowed. The liability for the interest has arisen in asst. yr. 1995-96 and, therefore, it should be allowed as a deduction. He also referred to the decision of the Tribunal in the case of ITO v. Titagarh Steels Ltd. (2001) 73 TTJ (Cal) 297 : (2001) 79 ITD 532 (Cal) wherein it is held that interest is compensatory and not penal in nature. The decision of the Supreme Court in the case of Harshad Shantilal Mehta v. Custodian and Ors. is also relied upon. The learned Departmental Representative, on the other hand, supported the orders of the Revenue authorities and submitted that interest is for the delay in discharging the statutory obligation of the assessee for payment of tax and, therefore, would not be an allowable deduction.

127. The parties were heard and their arguments were considered. The term 'tax' has been defined in the DTA vide Article 3(d) of the DTA to mean Indian tax or Netherlands tax as the context requires, but does not include any amount which is payable in respect of any default or omission in relation to the taxes to which this convention applies or which represents a penalty imposed relating to this tax. By this definition, the interest paid cannot be treated or equated to a tax payment. Tax deducted at source is the liability of the assessee under Section 192/195 of the Act. It was to be deducted by it at the time of payment of salary to the expatriate employees. The assessee committed a default and an omission in relation to the tax by not deducting the same within the prescribed time under the IT Act. The interest was thus payable for that default or omission in relation to the tax deducted at source. Therefore, on a combined reading of the definition of tax in Article 3(d) of the DTA in conjunction with the provisions of Sections 192 and 195 of the Act, the interest, in my opinion, would not be an allowable deduction. It has nothing to do with carrying on the business of the assessee. It may be that the tax was deducted for and on behalf of the employees but it was an obligation of the assessee itself under the IT Act, 1961, to deduct the tax within the prescribed time and, therefore, it was a personal liability of the assessee-bank. In the decision of Jubilee Investments & Industries Ltd. v. Asstt. CIT and Ors. , the Calcutta High Court dealt with the scope of levy of penalty under Section 221 of the Act for failure to deposit the tax deducted at source in time and in that connection, the Calcutta High Court observed that when the assessee is found to be in default in depositing the amount of TDS within the time prescribed, he is liable to pay interest as well as he is liable to pay penalty and the fact that he has suffered loss or financial stringency and, therefore, could not deposit the amount in time has nothing to do with the liability to deposit TDS.

128. Besides the statutory obligation to deduct tax from the remuneration and pay to the Government, the assessee in the present case has undertaken to pay the tax on behalf of the employees and having not paid it failed to discharge the obligation it had which but for such an agreement of employment the expatriate employees had to discharge. The assessee has not discharged its obligation on behalf of the expatriate employees insofar as the taxes have not been paid as it had neither filed the return nor was there any assessment made. The interest liability in any case is not upon the employees. It was on the assessee itself for not complying with the statutory obligation to deduct the tax which was its own liability under the Act because of the provisions of Sections 192 and 195. This obligation is independent of the obligation of the assessee as an agent of the expatriate employees. Therefore, in my opinion, the payment of interest does not partake the character of the remuneration package in respect of the expatriate employees. The decisions referred to in the case of Mahalaxmi Sugar Mills Co. Ltd. v. CIT and in the case of Prakash

Cotton Mills (P) Ltd. v. CIT , in the case of CIT v. Ahmedabad Cotton Mfg. Co. Ltd. and Ors. would have no application as these cases were under a different statute dealing with payment of cess and assessee's liability under contractual obligations. Allowability of interest for non-payment of income-tax came for consideration in cases under the income-tax and non-allowability of interest as a deduction gets support from the two decisions of the Supreme Court in the case of Smt. Padmavati Jaikrishna v. Addl. CIT . In the case of Padmavati Jaykrishna (supra), the payment of interest was to the Department on late payment of tax and annuity deposit and in that context the Supreme Court held that in the case where the interest was paid on the amount borrowed to pay taxes and annuity deposit the assessee was meeting the liability for income-tax and annuity deposit, it was a personal one and the dominant purpose for paying annuity deposit was not to earn income but to meet the statutory liability for making the deposit. The expenditure was not, therefore, wholly and exclusively for the purpose of earning income. Similarly, in this case, the liability to deduct tax and pay the same to the Government was personal one imposed under the IT Act on the payer of the salary and, therefore, interest paid by the assessee for the delayed payment thereof would also be a personal liability of the assessee-bank and failure to discharge that liability in time would not entitle the assessee to claim the deduction for such interest payment.

129. In the case of East India Pharmaceutical Ltd. v. CIT , the interest was paid on the overdraft which was utilized for payment of income-tax and it was held to be not allowable as an expenditure wholly and exclusively laid out for the purpose of business. Again in the case of Bharat Commerce & Industries Ltd. v. CIT , the Supreme Court held that when interest is paid for committing the default in respect of statutory liability to pay advance tax, the amount paid and expenditure incurred in that connection is in no way connected with the preserving or promoting the business of the assessee. Their Lordships held that interest levied on the assessee under Section 139 of the IT Act, 1961, for delay in filing the return and under Section 215 for the failure to pay advance tax upto the statutory percentage are not allowable deduction as business expenditure under Section 37 of the Act.

130. It might be true that the payment of salary and the liability for payment of tax thereon are part of the pay package or employment cost of the assessee and that they are in the nature of expenses wholly and exclusively for the purpose of business of the assessee but a part of that liability has partaken a character of a statutory liability. That part is, that as an employer the assessee was under an obligation under Sections 192 and 195 of the Act to deduct the tax and deposit the same with the Government of India. This statutory liability was a personal liability of the assessee and on failure to deduct that tax, the assessee becomes an assessee-in-default. Interest is paid for the failure of discharging that liability under the Act. The interest, therefore, was levied upon the assessee for the failure in discharging a personal liability and, therefore, cannot be allowed as a deduction. The fact that such tax deducted at source would ultimately be adjusted against the liability of the payee in computing its income-tax liabilities does not, in my opinion, convert the liability of the assessee and consequently, in my opinion, the payment of interest under Section 201(1A) cannot be allowed as a deduction.

131. The third difference is regarding the allowability of an amount of Rs. 9,57,58,904 being the operational loss claimed to have arisen on account of transaction in securities and is arising in the appeal for asst. yr. 1994-95. The assessee had claimed deduction of Rs. 9,57,58,904 being the amount refunded to the Punjab Housing Board (PHB) on account of the investment made by them. The payment of interest at the rate of 17 per cent was also claimed separately. The AO allowed both the deductions but the CIT(A) enhanced the income of the assessee by disallowing the deduction for the refund of Rs. 9,57,58,904. The facts of the case are that the assessee received a sum of Rs. 10 crores from PHB, for investment by the assessee, for a period of 180 days subject to the condition that the money was to be invested in any Government securities, UTI or tax-free bonds which can give with a minimum guaranteed return of 17 per cent and that in case of emergency, money be available to PHB with whatever returns that becomes due at that time. No specific directions were there to invest the money in specific securities. It was in the course of investment of this money received, the assessee issued a cheque of Rs. 9,75,58,904 on 9th March, 1992, to Andhra Bank for purchase of 17 per cent NPC Bonds @ Rs. 97 per bond plus accrued interest and handed over a payment advice and the cheque, to a broker Shri N.K. Agarwal. As Shri. N.K. Agarwal failed to deliver the said 17 per cent NPC Bonds, the assessee sought information from Andhra Bank who vide their letter dt. 2nd June, 1992 informed that the amount received was credited in the account of Shri Hiten Dalai, as per the instructions of Shri. N.K. Agarwal.

132. With the advent of 'payment advice-cum-cheque' in the Indian banking, it is no longer a cheque book which is used by the large corporate account-holders. These cheque books are now replaced by packets of perforated computer friendly forms, used as a continuous computer stationery. These are numbered advices. These are in two parts and can be separated by tearing off at the perforated points--the top portion containing the details of the person issuing the cheques like a letterhead, with columns for the name and address of the person to whom cheque is issued, details of payment, and details of purposes for which it is issued; the bottom portion being a form for the cheque itself. These forms are computer friendly and, while processing the payment, the details of payment are printed on the top portion, and the details necessary for cheque are printed on the bottom portion. The top portion is used as a payment advice, while bottom portion, on being removed from the aforesaid advice, works as a cheque itself. This was the system for the transaction with Andhra Bank. The cheque portion appeared to be in favour of Andhra Bank but the top portion was used, as a part of normally acceptable practice, to credit the accounts of Hiten Dalai, one of the central characters in several cases of security scams in this country.

133. Thereafter it seems that the alternative security in the form of original letter of allotment covering 1 lakh 9 per cent tax-free secured redeemable non-convertible bonds of Rs. 1,000 each fully paid-up (6A series) Railway Bonds 1991-92 issued by Indian Railway Finance Corporation Ltd. (IRFC in short) were offered by the said Shri N.K. Agarwal. The assessee accepted the delivery though on the understanding that the same would be held as a security pending delivery of the originally contemplated purchase of 17 per cent NPC Bonds. When sent for the registration of these 1 lakh IRFC Bonds in favour of the assessee it was, however, refused on the ground that the said bonds have already been registered in the name of Standard Chartered Bank. The assessee made an appeal against the refusal but the same was dismissed by the Company Law Board vide order dt. 25th Aug., 1994. The assessee thereafter filed an appeal to the Delhi High Court and that was transferred to Special Court and there also it was dismissed on 31st March, 1998. In the meantime, the assessee, it seems, settled the claim of PHB by returning the balance principal of Rs. 9,57,58,904 on 7th July, 1993 along with 17 per cent interest in the year under consideration, i.e., after adjusting the sum of Rs. 24,41,096 returned at the time when it issued a cheque in favour of Andhra Bank for the purchase of NPC Bonds for Rs. 9,57,58,904 in March, 1992, and a sum of Rs. 18 lakhs received from Shri N.K. Agrawal refunded to PHB thereafter. This payment of Rs. 9,57,58,904 and 17 per cent interest payment was claimed as a loss.

134. The Vice President (JM) held that the assessee had made the investment in the course of its business with Andhra Bank through the broker Shri N.K. Agarwal. Andhra Bank credited the amount received through Shri N.K. Agarwal in the account of Shri Hiten Dalai as per the instructions of Shri N.K. Agarwal. The claim of the assessee, on the other hand, is that no such instructions were issued by the assessee and the cheques paid in the name of Andhra Bank were issued for the purchase of NPC Bonds on behalf of the PHB. This fact is disputed by Andhra Bank. According to him, if at all the assessee can be said to have lost the investment made through Shri N.K. Agarwal, its discovery was on receiving the information from IRFC in June, 1992, informing that IRFC Bonds have already been transferred in the name of Standard Chartered Bank. The said date, according to him, fell in asst. yr. 1993-94. The Vice President (JM) held that refund to PHB was of their investment with the assessee and the payment of interest on such investment was rightly allowed as an expenditure incurred for the purpose of business. It is, according to him, like purchases being made from A and goods having been sold to B and if B does not pay the price of the goods, it may amount to loss suffered by the assessee but the payment to A for the goods supplied will not amount to loss to the assessee though the loss to the assessee on account of B's refusal to pay relates to the goods supplied by A. According to him, in view of the disputed facts, it cannot be said that the assessee had suffered a loss. He further observed that the refund of principal and interest to the investor, PHB, in any case is not an event of loss. He, therefore, held that loss does not pertain to the year under appeal. He, however, made it clear that this decision is without prejudice to the right of the assessee to claim the loss, if any, (in the year) in which it can be said to have been incurred.

135. The AM, however, held that the assessee is entitled to deduction and, according to him, the decision of the Supreme Court in the case of CIT v. Nainital Bank under which the assessee had two options--(i) to enforce its right strictly in accordance with law and thereby to lose the goodwill it had built up among the constituents, and (ii) to compensate the constituent for the loss suffered in the securities scam, and maintain its business connections and goodwill. In choosing the second alternative, as held by the Supreme Court, the assessee-bank, according to the AM, laid out expenditure for the purpose of its business and consequently, it would be a bona fide business expenditure eligible for deduction under Section 37(1) of the Act. As regards the finality of the dispute pending with Andhra Bank, N.K. Agarwal and Hiten Dalai, he observed that firstly there is a fallacy that it was the loss incurred on behalf of PHB which is being claimed as deduction. According to him it was the payment to PHB, which was warranted on account of commercial expediency rather than contractual obligations, which is being claimed as a deduction. Secondly, on assuming that such a possibility may have any relevance in this matter, he observed that even the 'possibility' of recovery has to be a reasonable possibility, i.e., what a reasonable person would expect in the given circumstances. The material on record, in his understanding, indicates that the assessee-bank has been taken for a ride by unscrupulous operators, misusing the loopholes in the system, and exploiting the fact that transactions involving such huge amounts were entered into, perhaps as a normal course in the banking industry, without taking highest degree of safety measures and incorporating checks and balances as such, and but for this laxity inherent in the normal banking practices, scams of the kind which have become somewhat common in the recent past could not have taken place. The fact that the matter is still pending before the Special Courts set up for dealing with security scam cases, by itself, cannot imply that there are reasonable prospects of recouping the loss, because, it is also a well-known fact, perhaps as equally well-known as the fact about existence of these Special Courts itself, that the claims on these scamsters are several times the value of their own assets. This money does not also appear to be recoverable from Andhra Bank also as in response of RBI's letter dt. 16th June, 1993, stating "issue of a licence to assessee-bank for opening a branch in Madras had again been decided to be kept in abeyance till such time as the dispute on securities transactions between assessee-bank and Andhra Bank is resolved", the assessee-bank has clearly given more importance to the licence for Chennai branch rather than claim, whatever were its merits, on Andhra Bank. The assessee's perception, according to him, was that there was no reasonable hope of recovery of this amount and there is no material to doubt or dispute that the money so refunded to PHB, according to him, constitutes a loss, and is, accordingly, booked as an expenditure, that the same is beyond reasonable hope of recovery, and that the chances of recouping the loss are too remote to affect the accounting treatment of the loss.

136. The assessee's contention is that it was a business loss. It approached the RBI in April, 1993, but they refused to interfere in the matter. The assessee was also refused permission vide RBI letter dt. 16th June, 1993, to open a branch until the dispute with Andhra Bank was settled. The assessee's main claim is that the matter was settled with PHB on 7th July, 1993 and that date falls within the previous year relevant to the asst. yr. 1994-95 and, therefore, it is allowable as a deduction. It was also submitted that in order to avoid adverse publicity, the assessee in the business interests considered it prudent to settle the claim and, therefore, in view of the decision of Supreme Court in the case of Nainital Bank (supra), it is an allowable business loss. Reference was also made to CBDT Circular No. 35D wherein the loss incidental to business is advised to be allowed in the year in which it was discovered. Reference was also invited to the decision of Gujarat High Court in the case of Dinesh Mills Ltd. v. CIT . He also referred to the decision of the Tribunal in the case of Cama Motors (P) Ltd. v. IAC (1987) 29 TTJ (Ahd) 452 : (1987) 21 ITD 640 (Ahd) allowing the claim of the assessee after taking into consideration the decision of Punjab and Haryana High Court in the case of Laxmi Ginning & Oil Mills v. CIT (1971) 82 ITR 958 (P&H). In this case, it is held that the claim should be allowed in the year of theft and if any amount is recovered therefrom, it would be offered to tax. The Revenue's case is that the claim of the assessee was sub judice and it was not allowable on mere possibility of its non-recovery. According to the Revenue, the assessee has not suffered any loss in the year under appeal and, therefore, the deduction was not permissible.

137. The assessee is in the business of arranging investment for its clients. It is true that the assessee was making investment specifically on behalf of PHB and it was bound to conduct the business of the customer as per directions given by him, or, in the absence of such instructions, according to the normal usage. The assessee received a sum of Rs. 10 crores from PHB, for investment by the assessee, for a period of 180 days not necessarily and specifically in the investment of these 17 per cent NPC Bonds but with an understanding and subject to the condition that the money was to be invested in any Government securities, UTI or tax-free bonds with a minimum guaranteed return of 17 per cent. It was also with a further understanding that in case of emergency, money would be made available to PHB with whatever returns that becomes due at that time. It was for the investment of this money received that the assessee issued a cheque of Rs. 9,75,58,904 on 9th March, 1992, to Andhra Bank. It was for the purchase of 17 per cent NPC Bonds @ Rs. 97 per bond plus accrued interest. The assessee arranged investment. It however, fell down. The assessee made another deal though stated to be as a security for the 1st deal in substitute in the form of IRFC Bonds valued at Rs. 9,57,58,904 and also received a sum of Rs. 18 lakhs representing the difference in value of NPC Bonds and the IRFC Bonds, on 18th March, 1992, but even these IRFC Bonds could also not be transferred to the assessee-bank as the same were already sold to Standard Chattered Bank. The assessee pursued both the matters further. The matter of registration was carried to CLB, then to High Court from where it was transferred to Special Court dealing with scam matters and lost finally in 1998 and the matter of N.K. Agarwal (is) stated to be still pending. By the end of previous year relevant to asst. yr. 1994-95 both the matters (were) pending adjudication.

138. In my view, receipt of Rs. 10 crores from PHB and issuance of cheque for purchase of 17 per cent NPC Bonds are two parts of the deal. These receipt of money and investment in bonds are two independent different transactions. The other facts, i.e., refund of unused amount of Rs. 24,41,096 to PHB, receipt of Rs. 18 lakhs from N.K. Agarwal being difference between the market value of IRFC Bonds and alternate investment in IRFC Bonds, though indicate a common thread, i.e., the business of the assessee and its client PHB but all the transactions are independent, one after the other but not as integral part of the same transaction. While making the purchase of 17 per cent NPC Bonds, assessee was making an investment as a businessman though for and on behalf of the customer, i.e., PHB. In my opinion, therefore, the loss was incurred by the assessee as such on its own account, and not on account of its client PHB, on whose behalf and specifically in whose name, the assessee was trying to acquire securities. The assessee stated to have agreed to bear this loss because of commercial expediency and one important factor contributing to this commercial expediency is stated to be that the RBI declined to issue a licence for opening a new branch office at Chennai by its letter dt. 16th June, 1993. It might be a fact that within three weeks of this communication, the assessee-bank entered into settlement with PHB but that does not have any bearing or influencing factor for settling the issue with PHB. RBI's refusal or suspension of decision to issue licence was for the reason that dispute in security investment with Andhra bank was to be settled first. PHB was not in picture at all. Settlement for payment of Rs. 9.57 crores is with PHB and not Andhra Bank. Nainital Bank's case, therefore, is of no help to the assessee, I, therefore, hold that the refund of money to PHB was not a loss to the assessee. Loss, if any, which could be said to have been suffered by the assessee was on account of the decision to invest in NPC Bonds through Shri N.K. Agarwal. Here, the broker Shri N.K. Agarwal had played a mischief and consequently taken that upon himself by offering another security in IRFC Bonds, Andhra Bank has transferred the money on the instructions of Shri N.K. Agarwal, stated to be on behalf of the assessee. That fact is disputed by the assessee. The assessee had not pursued the matter vis-a-vis Andhra Bank. It had carried the matter further accepting the alternative security in the form of IRFC Bonds, the registration for which was refused on the ground that they have already been registered in the name of another bank. The matter of registration of alternative security ended in 1998 whereas the matter vis-a-vis Shri N.K. Agarwal is pending even on date. In these circumstances, in my opinion, there was no loss which can be said to have arisen to the assessee in the year under consideration.

139. In the case of Dinesh Mills Ltd. (supra), the assessee carried on business in textiles. It maintained mercantile system of accounting. It had incurred loss of Rs. 13,40,000 on account of embezzlement by its employee between 29th Jan., 1974, and 26th April, 1976. The assessee discovered the loss during the asst. yr. 1977-78 and claimed the entire loss as deduction in that year. The AO disallowed the claim on the ground that the extent of loss remained indeterminate or unknown during the assessment year in question and the amount of actual loss could be known only when the assessee entered into a compromise decree with the defaulter-employee in the calendar year 1980. The CIT(A) considered the embezzlement in two parts-one which could reasonably be estimated to be recoverable and the other which could not be reasonably expected to be recoverable and ascertained the position at the end of the previous year, i.e., 31st Dec., 1976. He held that the assessee had a reasonable hope of recovery for Rs. 7,20,000 while the balance Rs. 6,20,000 was lost by the assessee for all time to come and granted deduction thereof. The Tribunal accepted that the loss was incidental to the business and upheld the order of the CIT(A). On a reference, the High Court held that in view of the statement made on behalf of the assessee to the effect that no deduction had been allowed in any subsequent year, the assessee would be entitled to deduction of loss during the assessment year in question as this was the year in which the loss on account of embezzlement was, in fact, discovered. It set aside the matter to the Tribunal to ascertain the allowability or otherwise of embezzlement loss in the light of the statement made on behalf of the assessee.

140. In the case of Cama Motors (P) Ltd. (supra), the Ahmedabad Bench of the Tribunal was dealing with a case of expenditure of Rs. 2,87,516 on the purchase of four jeeps, which had been handed over to it on the basis of order placed by the executive engineer directly with the supplier. The assessee claimed that on or about 1st May, 1981, these jeeps were stolen and that it suspected that its sales manager was involved in the theft. On police investigation, the suspect was arrested and the jeeps were recovered from him. The Magistrate, however, found that the jeeps were registered in the names of outsiders, and hence ordered that they might be restored to the registered owners. On appeal by the assessee, the High Court stayed the. Magistrate's order and directed that the jeeps be placed in the custody of the assessee for safe keeping till the final decision by the Court. The High Court also ordered that the vehicles must be kept unused and that the Magistrate should dispose of the case before 31st Dec., 1982. The dispute about ownership remained unsolved even till September, 1986. For the asst. yr. 1982-83, the assessee claimed the amount of Rs. 2,87,516 as a business loss, but the claim was rejected by the IAC and the CIT(A). The High Court held that the four jeeps lying with the company under orders of the Court were not the property of the company. They were not reflected in the closing stock of the company and were undergoing continuous deterioration being subjected to the elements day in and day out. As against this, a sum of Rs. 2,78,516 had gone out of the coffers of the company for purchase of four jeeps which had been handed over to the executive engineer. It was not known as of today what the company would recover as a result of the conclusion of the legal proceedings and when. The alleged accused was absconding. The record did not state anything as to whether any money was recovered from him when his arrest was effected. In case the company recovered anything by the sale of the four jeeps, the amount might not be much because of the considerable erosion in their value after a lapse of time. In these circumstances, the Tribunal held that the claim merited allowance not only on the basis of system of accounting being followed by it, but also on the facts surrounding the claim.

141. In the case of Laxmi Ginning & Oil Mills (supra), a case before the Punjab and Haryana High Court, the assessee sold a certain quantity of oil to a company for a total value of Rs. 26,642. The purchaser-company did not take delivery. The assessee then sold that quantity of oil in the open market at the risk of the purchaser and realized only a sum of Rs. 20,572 incurring a loss of Rs. 9,160 which was debited by him to the "groundnut account" and credited for the "claim in dispute account". The assessee thereafter filed a suit against the company for recovery of the said loss and ultimately obtained a decree in 1962. In the meantime, the assessee claimed the above loss in its return for the asst. yr. 1953-54. The AO disallowed the loss on the ground that the loss debited to the trading account had not been finally settled, the debit created in the groundnut account cannot be allowed and added back the same. CIT(A) and Tribunal upheld the contention of the AO. On a reference, the High Court held that the loss was suffered by the assessee in the accounting year relevant to the asst. yr. 1953-54 and if, as a result of the litigation, it was found entitled to less amount than the amount claimed, the difference could be included in the assessable income of the assessee for the year during which the final decision of the litigation was made. Similarly, if the assessee had been successful in obtaining the entire amount of the loss from the company, the amount could be included in the income of the assessee for the year during which the amount was actually recovered. The pendency of litigation about the loss suffered cannot militate against the fact that the loss was suffered by the assessee during the accounting year relevant to the asst. yr. 1953-54 when the company did not take delivery and the assessee had sold the goods in the open market for a lesser amount. All these cases could have helped the assessee in the present case if the claim was made in the appeal for asst. yr. 1993-94 when the assessee got the information that the cheques issued for investment in NPC Bonds were diverted to the account of Shri Hiten Dalal or when the alternative security in IRFC Bonds was found to be registered in some other bank's name. Both these dates were falling in asst. yr. 1993-94 and consequently, the assessee cannot claim the loss in the year under consideration even on the basis of the three decisions referred to above. In view of the above, in my opinion, the CIT(A) was right in disallowing the claim of the assessee.

142. The matter will now go to the Division Bench which heard the appeals for passing a majority order.

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TAX India has witnessed a surfeit of judicial verdicts on the concept of Permanent Establishment. The outcome of the rulings by Appellate Tribunal, Authority for Advance Rulings and the Apex Court has irrigated the ground for a sturdy and comprehensive sketch on the applicability and upshot of attraction of Permanent Establishment in India. The application facet of Permanent Establishment is the key debate in all the decisions, while the attribution of profits to the Permanent Establishment has been given the take away mention.

Permanent Establishment is defined under Income Tax Act to include a fixed place of business through which the business of the enterprise is wholly or partly carried on. The definition is in sync with the Fixed Place Permanent Establishment as set in the Double Taxation Avoidance Agreements.

According to the domestic law, the taxation of business profits of non-residents in India is kicked off with a business connection in India. The inference of business connection in India as per the Income Tax Act is quite wide and would lead to deeming the Income ‘to accrue or arise’ for the foreign enterprise in India. The existence of Permanent Establishment in India neither means that there is business connection for the foreign enterprise in India nor that there is Income deemed to accrue or arise in India. Permanent Establishment in India would mean an outcrop of the foreign enterprise in India and is specifically defined in the Double Taxation Avoidance Agreements. Article 7 of the Double Taxation Avoidance Agreements stipulates that only the profits directly or indirectly attributable to the Permanent Establishment in India would be taxed in India. Hence the Permanent Establishment that generates income with a business connection in India will be taxable in India. The Permanent Establishment of the foreign enterprise in India may use its assets and resources to earn income both in India and outside India, but only the segment of Income that relates to the business connection in India is taxed.  In the absence of business connection in India, the Permanent Establishment would just be a taxable entity and not a tax paying entity. The meaning of business connection in the domestic law would be a blend of Fixed Place Permanent Establishment and Agency Permanent Establishment as set in the Double Taxation Avoidance Agreements.

The Double Taxation Avoidance Agreements entered into by India perceive the following main types of Permanent Establishment (PE) for a foreign enterprise in India :

• • Fixed Place PE

  • Agency PE

  • Service PE

The following sections will elucidate the applicability conditions and attraction principles as endorsed by the judicial findings.

Fixed Place PE

Article 5 (1) of Double Taxation Avoidance Agreements of India provide the rudimentary substance of Fixed Place PE. The two requisites to pull in Fixed Place PE for a foreign enterprise in India are :

• • Fixed Place of Business

• Business of the foreign enterprise is wholly or partly carried on

The above requisites can be examined using the following two tests:

Geographic Test

The business of the enterprise needs to be performed from an identifiable place in Indian territory. For example Machinery installed for operations in India by the foreign enterprise would constitute a fixed place of business for the foreign enterprise in India. Any building, premises or installations in India through which the business of the foreign enterprise is carried out and which is not a temporary facility would satisfy the geographic condition for Fixed Place PE. The regular conduct of business for a considerable period of time would negate the temporary tag for the business. The Double Taxation Avoidance Agreements of India state the specific time period to be examined in case of installations or structures used for exploration or exploitation of natural resources, building site or construction, installation or assembly project. The attraction of PE for the foreign enterprise is from the first day of commencement of such business in India that constitutes the PE.

Test of Right of Usage

The foreign enterprise must be able to carry on the business at ‘the place’, as a matter of right. The inference here is that, the business is carried out at the place with the normal right to use the premises or facility. There need not be a formal written accord for the usage of place from any other party, but the access and usage of place must be at the sole discretion and disposal of the foreign enterprise for satisfying the test of Right of Usage.

The judicial discussion on Fixed Place PE has been recapitulated under the above mentioned tests, as given below:

Income Tax Appellate Tribunal (“ITAT”) in case of Galileo International Inc (2007-TIOL-447-ITAT-DEL)

Galileo International Inc, USA provided airline reservation system services for airlines in relation to the Indian customers through the travel agents in India. Galileo International Inc provided these services by establishing computerized reservation and ticketing system in India through a distributor, at the premises of the travel agents. The computerized system in the premises of the travel agents was managed, controlled and made functional through the master computer system in USA by Galileo International Inc. Galileo International Inc was remunerated by the airlines for the reservation and ticketing system services provided. The ITAT held that a part of the entire system for earning revenue by Galileo International Inc is located in India. Further, without the computers and the network installed at the travel agent’s premises by Galileo International Inc, it was not possible for the reservation process to be completed. Hence, the computer reservation system installed at the travel agent’s premises would constitute Fixed Place PE for Galileo International Inc. in India.

Geographic Test

The computer system for reservation and ticketing established in the premises of travel agents in India is an identifiable place of business in India which contributes to the process of generating income for Galileo International Inc.

Test of Right of Usage

The computer reservation system at the travel agent’s place was exclusively controlled by Galileo International Inc from USA through the master computer system.

ITAT in case of Rolls Royce Plc (2007-TIOL-408-ITAT-DEL)

Rolls Royce Plc, UK supplied engines and spare parts to the Indian customers and had made an agreement with its subsidiary in India, Rolls Royce India Ltd. The Indian subsidiary also performed the marketing and liaison function for Rolls Royce Plc. The premises of Rolls Royce India Ltd. was held to be a Fixed Place PE for Rolls Royce Plc in India.

Geographic Test

The premises of the subsidiary in India operated like a marketing office for securing orders from Indian customers.

Test of Right of Usage

No formal right is required for the usage of premises of Indian subsidiary to perform the marketing function. In this case, though Rolls Royce Plc does not directly use the premises of the subsidiary for its business, the function of securing sales orders of Rolls Royce Plc products happens from the premises of the subsidiary.

ITAT case of Motorola Communications Inc (2005-TIOL-103-ITAT-DEL-SB)

Motorola Communications Inc, USA carried out the installation of telecommunication systems in India through its subsidiary in India. The employees of Motorola Communication Inc visited the premises of the subsidiary for facilitating the work of both Motorola Communication Inc and its subsidiary.

Test of Right of Usage

The location through which the business is performed by the employees of Motorola Communication Inc, if used as a matter of right with the power of disposal, would constitute a Fixed Place PE of Motorola Communication Inc in India. But the Fixed Place PE would be negated as the activities carried out by the employees are preparatory or auxiliary in character, specifically excluded by the Double Taxation Avoidance Agreement.

ITAT in case of Western Union Financial Services Inc (2006-TIOL-58-ITAT-DEL)

Western Union Financial Services Inc, USA, engaged in money transfer business, appointed agents in India for liaison and related activities. The agents operated from their premises with the display to demonstrate the agency of Western Union Financial Services. The premises of agents were held not to constitute a Fixed Place PE of Western Union Financial Services Inc.

Geographic Test

Western Union Financial Services Inc did not have a sales outlet in India in the premises of the appointed agents and hence, the premises of the agents will not be a projection of the business space of Western Union Financial Services in India.

Test of Right of Usage

The employees of Western Union Financial Services Inc could not use and access the premises of the agents as a matter of right or in other words, the premises of the agents were not at the disposal of Western Union Financial Services Inc.

Supreme Court in case Morgan Stanley & Co. Inc (2007-TIOL-125-SC-IT)

Morgan Stanley & Co. Inc, USA a financial services MNC, outsourced the processing work to its associated enterprise in India namely, Morgan Stanley Advantages Services Pvt. Ltd. The Supreme Court upheld the ruling of the Authority for Advance Rulings, that there is no Fixed Place PE for the US company in India.

Geographic Test

The Apex Court analyzed whether the back office operations would come within the ambit of ‘place of business of the enterprise’. The Supreme Court has differentiated the main functions carried out by Morgan Stanley & Co. Inc which constituted its business and the data processing and other back office function carried out by the Indian subsidiary. Back office function is separate from the business of the foreign enterprise and thus no business is carried out by Morgan Stanley & Co. Inc in India through its associated enterprise in India.

Agency PE

Agency PE is attracted for a foreign enterprise in India if the agent appointed by the foreign enterprise in India is a dependent agent. The agent who is dependent and performs the following functions will be considered as a PE of the foreign enterprise:

• • Exercises an authority to conclude contracts on behalf of the foreign enterprise.

  • Secures orders wholly or almost wholly for the foreign enterprise.

  • Maintains the stock of goods or merchandise from which the agent regularly delivers on behalf of the foreign enterprise.

The above functional requisites for the Agency PE can in principle be captured in the ‘binding test’ and ‘dependency test’ for the agent of the foreign enterprise in India.

Binding Test

If the action of the agent who is found to be a dependent agent after applying the dependency test, like securing orders, legally bind the foreign enterprise to perform the contract in India and the final decision to perform or not does not lies with the principal, the agent can be considered to be a PE of the foreign enterprise in India. The aspect of conclusion of contracts would have to be seen from the point of view of performing all the actions necessary for the conclusion of contracts, though the actual signing of the contract may be performed by the foreign enterprise outside India.

Dependency test

The dependency Test is to corroborate whether the agent is dependent legally and economically on the foreign enterprise for the conduct of business. The agent who is found to be a dependent agent after applying the dependency test and who performs any of the three requisite functions for attracting the Agency PE as mentioned above would be considered as the PE of the foreign enterprise in India.

Legal dependence

The legal dependence is reflected by the facts of arrangement or agreement between the foreign enterprise and the agent. If the risk and return of the business done by the agent fully accrue to the agent, then the agent can be deemed to be an independent agent.  The act of the agent with autonomous decisions in the normal course of business and remuneration for the services at arm’s length by the foreign enterprise would strengthen the claim of the agent as an independent agent.

Economic dependence

The agent if earns the major portion (say more than 75 percent) income from other than the relevant foreign enterprise, it would cement the fact that, the agent does not act ‘wholly and exclusively on behalf of the foreign enterprise’. Economic independence signify the business relationship with its principal (here the foreign enterprise) and the consequent dependency for the functioning of business of the agent. For example, if the foreign enterprise is the only customer the agent serves as part of its agency business, then it would be deemed that the agent is economically dependent on the foreign enterprise. If the agent’s activities are not wholly or exclusively devoted to the foreign enterprise and the agent’s services are being remunerated at arm’s length, then the agent would be considered as an independent agent.

The judicial discussion on Agency PE has been recapitulated under the above mentioned tests as given below:

ITAT in the case of Galileo International Inc

The distributor in India through which Galileo International Inc, USA provided airline reservation system services, was held to be a dependent agent of Galileo International Inc and hence, an Agency PE for Galileo International Inc in India.

Binding Test

The distributor was found to have the authority to bind Galileo International Inc in relation to the contract made by the distributor with the travel agents for the usage of the airline reservation system.

Dependency Test

Legal dependence

The distributor could do the business of providing the airline reservation services only with the full support and control from Galileo International Inc.

Economic dependence

The distributor was found to provide the airline reservation services only on behalf of Galileo International Inc in the course of its business.

ITAT in case of Rolls Royce Plc

Rolls Royce India Ltd. was held to be an Agency PE for Rolls Royce Plc in India.

Dependency Test

Economic dependence

Rolls Royce India Ltd was found to have habitually securing orders wholly for Rolls Royce Plc from the Indian customers.

ITAT in case of Western Union Financial Services Inc

The ITAT framed three requisites for establishing an agent as an independent agent:

• • He should be acting in the ordinary course of his business;

  • His activities should not be devoted wholly or almost wholly on behalf of the foreign enterprise for whom he is acting as an agent;

  • The transactions between the foreign enterprise and the agent should be at arm's length.

Dependency Test

Legal dependence

The concept of “ordinary course of business” was given a wider meaning by the ITAT by stating that the Non-Banking agents like Department of Posts and tour operators appointed by Western Union Financial Services Inc for money transfer business, though not directly engaged in such money transfer business, performs those money transfer functions which are conducive to their main business. Hence agents can be considered as acting in the ordinary course of their business. Further, the tax authorities could not provide any material to prove that the compensation to the agents by Western Union Financial Services Inc had to be higher and that the compensation was not at arm’s length.

Economic dependence

The activities of the agents like Department of posts are so large and wide that it can not be said that they are dependent on Western Union Financial Services Inc for their earnings or revenues. Hence the agents are to be treated as independent agents.

Supreme Court in case Morgan Stanley & Co. Inc

The Apex Court held that the unit in India which performed the back office services would not constitute an Agency PE for Morgan Stanley & Co. Inc in India.

Binding Test

Morgan Stanley Advantages Services Pvt. Ltd. did not have the authority to enter into contracts or bind Morgan Stanley & Co. Inc with any contracts, in India.

Service PE

Service PE is attracted by the foreign enterprise in India if the employees of foreign enterprise furnish or perform services in India, other than services covered under Royalties or Fees for Technical Services, for a specified period of time. “Furnishing of Services” is the most important check for attraction of Service PE. For example in Indo- US Double Taxation Avoidance Agreement, the specified period is ninety days within any twelve-month period. The employment lien with the foreign enterprise has to be established for the employees providing services, to constitute a Service PE.

Supreme Court in case Morgan Stanley & Co. Inc

Morgan Stanley & Co. Inc sends its employees to its associated enterprise in India namely, Morgan Stanley Advantages Services Pvt. Ltd for undertaking stewardship activities which included activities performed to monitor the quality and confidentiality of the outsourcing work. Further, Morgan Stanley & Co. Inc also sends its employees on deputation for different periods, even extending more than one year at the request of Morgan Stanley Advantages Services Pvt. Ltd. The deputed employees had a lien on his employment with Morgan Stanley & Co. Inc by virtue of which Morgan Stanley & Co. Inc retained control over the employee’s terms and employment.

Activities which will attract Service PE

The Supreme Court ruled that the stewardship activities constituted activities to protect the internal interests of Morgan Stanley & Co. Inc in relation to the quality and confidentiality of work done and do not include ‘furnishing of services’ to the Indian associated enterprise. Since no services were rendered through stewardship activities, there would be no Service PE for Morgan Stanley & Co. Inc in relation to its employees performing stewardship activities.

The Apex Court noted that employees deputed by Morgan Stanley & Co. Inc for more than the specified period of time as given in the Indo- US Double Taxation Avoidance Agreement would attract Service PE in India and thus Morgan Stanley Advantages Services Pvt. Ltd. would be the Service PE for Morgan Stanley Inc in India. It is interesting to note that the Indian company is referred as the Service PE by the Supreme Court and not the employees of the foreign enterprise.

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Under section 5 of the Income Tax Act, a foreign company or any other non-resident person is liable to tax on income which is received or is deemed to be received in India by or on behalf of such person, or income arises or is deemed to accrue or arise to it in India. Section 9 thereafter specifies certain types of income that are deemed to accrue or arise in India. Some of the important concepts which needed to be understand which are related to the international taxation such as country of residence where the person is tax resident under the relevant tax laws of any country is called the country of residence. Country of source where the person earns income or where the income accrues or arises is the country of source. Country of payment is a country from which the person makes the payment. Where exactly is the tax base for Government of different countries to charge tax. There can only 2 bases for levy of income-tax one is on the bases of residence and other is on the bases of income. For the levy of income-tax, Indian Government can tax the global income of Indian tax residents or the Indian accrued income of tax non-residents of India. Governments cannot tax foreign sourced income of non-residents. There has to be a nexus between the country & its residents or the country & income sourced in that country. Unless & until, there is a nexus between any one of the two, Governments do not have a base/ jurisdiction for taxation.

Sec. 92 F The section says about permanent establishment. "It includes fixed place of business through which the business of the enterprise is wholly or partly carried out.” Article 5 of OECD & UN model conventions also provide for an inclusive definition of the term permanent establishment i.e. "it includes a place of management, a branch, an office, a factory, a workshop and ...".The international consensus has been that the profits should be attributed to a PE on the basis of the "separate enterprise" concept, and the application of the arm's length principle. This is currently encapsulated in Article 7(1) and (2) of the OECD Model Tax Convention. 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. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State, but only so much of them as is attributable to that permanent establishment. Where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits 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.”.

Section 9 (i) of the Act explains business connection. It says it includes "any business activity carried out through a person who, acting on behalf of the non-resident has and habitually exercises in India, an authority to conclude contracts on behalf of the non-resident, Provided that such business connection shall not include any business activity carried out through a broker, general commission agent or any other agent having an independent status, if such broker, general commission agent or any other agent having an independent status is acting in the ordinary course of his business, further where such broker, general commission agent or any other agent works mainly or wholly on behalf of a non-resident (hereafter in this proviso referred to as the principal non-resident) or on behalf of such non-resident and other non-residents which are controlled by the principal non-resident or have a controlling interest in the principal non-resident or are subject to the same common control as the principal non-resident, he shall not be deemed to be a broker, general commission agent or an agent of an independent status.

 Sec. 90 (1) of the Act gives power to the Government to enter into an agreement with the Government of any country outside India for granting relief in respect of double taxation, Since different incomes will have different ways of determining the location of source; different categories have been listed. For e.g.: royalty, interest, dividend, fees for technical services, rental income, etc. Under the DTA, it is necessary to determine the country of source of income. Since different incomes will have different ways of determining the country of source; different categories are useful to determine the source. The house property income is sourced in the country where the property is situated. The dividend income is sourced where the company distributing the dividend is resident. Salary income is taxable where services are performed. Thus for determining the location or the country of source, the Categorisation is useful. Under the domestic law, Categorisation is useful for computation. Different categories of income may have different computation provisions.

Section 245 N of the Act helps in avoiding controversies & litigation at a later stage i.e. after the financial transaction is undertaken. In the past, AAR i.e Authorities of Advance Ruling has given several rulings. Unfortunately, with due respect, these rulings have put precedents that differ from the Tribunal, High Court or the Supreme Court decisions. There are also tax heaven countries which are a country which does not charge tax to its residents or charges lower rates of tax. These countries sign the DTAAs with other countries in such a way, that there may not be any tax payable by the assessee in any country. Therefore, a lot many numbers of companies structure their investments so that they are outside the purview of any tax jurisdiction. Countries like Isle of Man, Cayman Islands, Mauritius, Cyprus, Malta, Singapore, etc. are examples such tax heavens because of which there is much of treaty shopping or treaty abuse happen treaty shopping is nothing but shopping of the DTAA. Companies may take the benefit of the most beneficial DTAA. Generally, a treaty shopping arises when a resident of a State other than Contracting States of a tax treaty attempts to capitalize on benefits of the treaty by setting up a company with no economic substance or conducting a bogus transaction. A good example of treaty shopping is that of Malaysia-Korea, India- Mauritius, etc.Treaty shopping can occur in the following two ways: 1) A taxpayer of a country that has no treaty with the a particular country say India seeks the coverage of a favorable treaty,or2) A taxpayer of India treaty partner, prefers the treaty of another country. Round tripping is also one of the methods by which the companies take disadvantages of the treaty it is the act of moving funds outside the country & then channelising them back in the country to change the actual character of funds. Funds earned through illegal sources, etc. may be sent abroad & reinvested in the same country as legal funds. Companies use round tripping for changing the character of domestic funds into foreign funds or illegal funds into legal funds. There are also various hybrid entities which are the different forms of entities say, for example, India gives the status of the firm as a tax resident. It taxes the firm on its income & the income of the firm is exempt in the hands of the partners. In some countries, taxation is transparent i.e. it may not tax the income of the firm in the hands of the firm but it may tax the partners individually on income earned through the firm. There are also several other entities like US LLP, UK LLP, Dutch CV, German KG * Co., trust, partnership, co-operative societies, venture capital funds & collective investment vehicles, etc.; taxation of which may be separate in separate countries. This may give rise to conflict in classification of cross border scenario. Hybrid entities may also give rise to complication in application of treaty provisions. Also there is tax sparing ,developing countries often attempt to attract foreign investors with incentives in the form of reduced rates of taxation or, in some cases, the exemption of certain types of income from tax. In order to preserve the resultant investment revenues to the developing country, the country of residence of the investor (that is, the developed country) "spares" the tax that it would normally impose on the low-taxed or untaxed income earned by its resident abroad by granting foreign tax credits equal to, or possibly greater than, the tax that would otherwise have been eligible in the developing country. Tax sparing is intended to promote economic development among developing nations by ensuring that tax incentives offered to foreign investors by these countries were not eroded through the tax treatment of the income from the advantaged activities in the investor's country of residence.

 Underlying Tax Credit is also a concept available in residence country for taxes paid by subsidiaries of companies in foreign countries. The above can be explained with the help of following example, say for e.g.: Company A in India has a wholly owned subsidiary in a foreign country. During the year, foreign subsidiary earns a profit of $ 1,000. Assuming tax rate in foreign country is 35 %, foreign subsidiary is liable to pay $ 350 in foreign country itself & shall remit the balance $ 650 in India. Foreign subsidiary will also have to pay a dividend distribution tax on this, say 15 % i.e. $ 97.5 on $ 650.In India, Co. A will be taxed on its overseas subsidiary's profit. Since corporate taxes in India is, say we assume 30 %, then this translates to a tax of $ 300. But since a tax greater than this has been paid in the foreign country, no taxes are paid in India. In effect, Co. A has paid a tax of 44.75 % ($ 350 + $ 97.50) & tax credits of $ 147.5 is lost. Pooling of foreign tax credits is also done if however India would have permitted pooling of foreign tax credit, then even $ 147.5 would have been available as credit. Many international treaties signed provide for underlying & pooling tax credits.

There is a Non-Discrimination Clause in Article 24 of OECD & UN Model Convention provide for subjecting the residents of one country to taxation & requirement connected therewith in other country similar to that of the residents of that other country i.e. the taxation & connected requirements should not be more burdensome than subjected to residents of that other country.

Many persons were using the provisions of treaties to their own benefits. Some persons have even misused the treaty provisions by forming conduit, shelf, offshore companies or SPVs i.e. Special Purpose Vehicles. Limitations on benefits provisions generally prohibit third country residents from misusing treaty benefits. For example, a foreign corporation may not be entitled to a reduced rate of withholding unless a minimum percentage of its owners are citizens or residents of the treaty country. Article 23 of the UK - USA treaty provides for limitation of benefits clause. Recently Indo-Singapore treaty was amended to insert the limited version of limitation of benefits clause. Indian tax authorities are also trying to re-negotiate tax treaties with UAE, Cyprus, and Mauritius to insert this limitation of benefits clause. Also there are Mutual Agreement Procedure (MAP) under Article 25 of the OECD & UN Model Convention state that where a person considers that the actions of his domestic country or the other country shall result in taxation not in accordance with the treaty provisions, irrespective of the remedies provided by the domestic law of those states, he can present his case to the competent authority in the country of his residence. The competent authority of residence country shall verify the arguments stated whether the arguments are justified & if the case of unable to arrive at a satisfactory solution as regards elimination of the double taxation or interpretation of tax treaty, competent authorities of both the countries shall resolve the difficulties by mutual agreement. Advanced Pricing Arrangements (APA)  can also be entered by the parties an APA is an arrangement between a taxpayer and the tax authority wherein the method of determining the transfer pricing for inter-company transactions are set out in advance. Such programmes are designed to resolve actual or potential transfer pricing disputes in a cooperative manner. The tax payer must submit a formal APA application, tax authorities shall review & evaluate the proposal & then negotiate and execute the APA.

 Withholding tax is additional tax imposed by the country of source when various types of remuneration (dividends, interest, royalties etc.) are paid in favour of non-residents of that country. The principle of a withholding tax is that it is withheld (retained) by the payer and given directly to the taxation authorities. The payee is given only the balance after the withholding tax amount. The primary motivation is to reduce tax evasion or failure to pay. Force of Attraction rule normally applies were business profits are taxed in the country of residence except when the entity functions or performs business in the other country with the help of a dependent agent or a permanent establishment. In such cases, income attributable to the permanent establishment is taxed in the country of source. The Contracting States will attribute to a permanent establishment the profits that it would have earned had it been an independent enterprise engaged in the same or similar activities under the same or similar circumstances. As the name suggests, the force of attraction approach focuses on the actual economic connection between a particular item of income and the permanent establishment. Under the "force of attraction" approach, all domestic sourced income is attributed to the permanent establishment, irrespective of whether the relevant item of income is in fact economically connected with the activity of such a permanent establishment. Controlled Foreign Corporations (CFC) rules is a were income from a foreign source is taxed usually after it is accrued or received as income in the country of residence of the taxpayer. The use of intermediary entities in a tax-free or low-tax jurisdiction enables a tax resident to defer (or avoid) the domestic tax on the income until it is repatriated to the residence state. This tax deferral could lead to an unjustifiable loss of domestic tax revenue.

A CFC is a legal entity that exists in one jurisdiction but is owned or controlled primarily by taxpayers of a different jurisdiction. CFC laws can be introduced to stop tax evasion through the use of offshore companies in low-tax or no-tax jurisdictions such as tax havens. It is rarely illegal to have a financial or controlling interest in a foreign legal entity; however, many governments require taxpayers to declare their interests and pay taxes on them, and CFC laws (combined with a no-tax jurisdiction or a double taxation agreement) sometimes mean that a company is only taxed in one jurisdiction. The CFC rules are designed to stop companies avoiding tax in residence country by diverting income to subsidiaries situated in low tax regimes. Students are requested to read articles, books written by Professor Klaus Vogel, OECD Model Tax Convention & Commentary, UN MTC & Commentary, League of Nations report, Vienna Convention reports, IFA reports, etc. Students are also requested to read the recent AAR & Supreme Court decisions for thorough understanding of International Taxation.

At the end I would like to put forward some of the reforms which I think are needed in India international taxation are :-

1.       A number of Indian companies have established subsidiaries worldwide. These companies, however, do not bring into India their dividends or capital gains from the sale thereof, as that is taxable in the hands of Indian holding companies at the normal rates, of course, subject to the credit of tax paid by them overseas, which at times is lesser particularly in tax heaven countries. With a view to encouraging them to repatriate their earnings into India, the receipt of dividend and capital gains should be tax exempt or at least taxed on a concessional basis in India.

2.       Under the provisions of section 195, any sum payable to a non-resident and chargeable to tax, is subject to a withholding tax by the payer. Though, the deductor or recipient can apply for a lower / nil rate, delays occur in the issuance of such certificates. It would be in fitness of things to provide an option to the deductor to remit 80% of the amount sought to be remitted and to furnish a certificate from the bank for holding 20% of the balance amount as 'good for payment' towards the tax liability, which may be paid later to the extent ultimately determined payable.

3.       Under the existing provisions, a person is eligible for tax credit paid outside India in respect of doubly taxed income, equivalent to the tax at the Indian rate of tax or the rate of tax of the said country, which ever is lower. In all fairness there should be a consolidation of tax liability and in case the tax paid to the foreign country on income from outside sources is more than what it would be payable in India, the assessee should be eligible for tax credit deduction in respect of the excess part of the tax liability as well, as is in vogue in many other countries.

4.       In today's competitive environment many countries including Netherlands, Singapore, Luxembourg, Ireland, Spain, Austria have redesigned their taxation laws, to have low tax preferred jurisdiction with a view to attracting outbound investments. This is what we normally call 'participation exemption'. At a time when we are restructuring our fiscal Statutes and enacting altogether new Income Tax law, I feel it would be appropriate to introduce the said concept of 'participation exemption' on the lines of provisions prevalent in other countries.

5.       Dividend Distribution Tax (DDT) needs to be brought within the ambit of DTAA to enable the overseas holding companies, having their subsidiaries in India, to offset the distribution taxes paid in India from tax payable by them in their respective countries. It is equally important to reduce the rate of Dividend Distribution Tax.

6.       The present provision which requires the taxpayer to take the arithmetic mean of prices may be modified to use other statistical methods such as median of prices. Our law should be flexible enough to adapt with the emerging developments in the Group's business, taking into consideration the enterprise's perception of the risks of adverse tax assessment, as also considering both planning opportunities and risk management and weighing effective tax rate optimization against fiscal authority challenges and the cost compliance. Further, the provisions with regard to penalties need a relook.

7.       The issue of ESOPs has assumed added significance in the recent past particularly for the IT and knowledge based industries. We have to ensure that FBT on ESOPs is eligible for tax credits under the DTAA and overseas stock exchanges are recognized on selective basis at par with our recognized stock exchanges for ESOPs valuation purposes.

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Service Permanent Establishment - OECD, UN and Indian Approach

Introduction

The concept of Permanent Establishment (PE) is a fundamental idea, which is intrinsic to double taxation agreements. The very existence of a PE, only determines the right of a contracting state to tax the profits of an enterprise of the other contracting state. There are three major types of PE which usually exist in double tax treaties:

Fixed PE

Agency PE

Service PE

This article looks at the Service PE concept in the UN Model Convention (MC), OECD MC and Indian tax treaties.

UN Approach

The concept of Service PE exists in Article 5 of UN MC. UN MC, which favors source based taxation, though does not specifically use the expression “Service PE”, but it’s Article 5(3) (b), which deals with the concept of Service PE reads as under;

“The furnishing of services, including consultancy services, by an enterprise through employees or other personnel engaged by the enterprise for such purpose, but only if activities of that nature continue (for the same or a connected project) within a Contracting State for a period or periods aggregating more than six months within any twelve –month period”

Developing and emerging economies, which are predominantly capital importing nations, generally try and negotiate Service PE clause in bilateral treaties, so as to tax profits of foreign enterprises operating within their territories, even in circumstances where no Fixed or Agency PE exists.

Indian Tax Treaties

India’s tax treaties are a combination of both OECD and UN MC. India does not follow a uniform definition of PE in its treaties, but is understandably more inclined towards UN approach, with emphasis on source taxation. In fact in certain treaties, for example, the one with United Kingdom, the definition of service PE is even wider than the one in UN MC. There is also a Service PE clause incorporated in the India-US Double Taxation Avoidance Agreement, even though no such concept exists in the US MC.

In recent years, most of the global businesses have entered India to profit from the growing market by way of joint ventures, liaison offices, representatives, branches, agents and also incorporation. This has resulted in spate of tax litigation, especially around the concept of permanent establishment, with the revenue taking a tough stance (fairly or unfairly) to protect and increase its tax coffers.

Indian Service PE

Service PE is attracted by the foreign enterprise in India, if the employees of the foreign enterprise furnish or perform services in India, other than the services covered under royalties or fee for technical services, for a specified period of time. “Furnishing of services”, and the time factor, are the most important check for attraction of Service PE.

There have been some landmark judgments on the Service PE concept in recent years. Two of those rulings are discussed below.

DIT Vs Morgan Stanley & Co

In this case, the Supreme Court of India had to determine, whether the deputation of employees by Morgan Stanley (MS), to its Indian affiliate Morgan Stanley Advantage Services Private Limited (MSAS), constituted a Service PE. Admittedly MS used to depute its employees to Indian Affiliate for a period exceeding one year. Supreme Court held, that though the US Company had no fixed PE in the country, but deputation of its employees for a period exceeding 90 days, as provided in the India-US Treaty, would attract Service PE in India, and thus MSAS would deem to be the Service PE of MS in India. The court held MSAS, the Indian Affiliate as the Service PE, and not the employees of MS.

Linklaters LLP Vs ITO

A recent ruling by the Mumbai Income Tax Appellate Tribunal has held Linklaters, a UK based global law firm, of having a Service PE in India. The Tribunal had to interpret the India-UK Article 5 dealing with PE, to arrive at the above conclusion. As per the Service PE clause in the treaty, a Service PE is deemed to exist, if there was any furnishing of services including managerial services through the employees or other personnel in the host country for a period exceeding 90 days in case of unassociated enterprise or 30 days in case of associated enterprise, within any twelve-month period.

Admittedly, several partners of the law firm visited India frequently for work, thus satisfying the above criteria. The Tribunal ruled, that the non-resident firm had a Service PE in India in light of above circumstances. The Tribunal also observed, that in order to constitute Service PE, permanence test need not be satisfied.

OECD Approach

Historically OECD has always expressed its preference for residence taxation and given justification for not including Service PE, but it now recognizes the growing role of developing nations, which is reflected in its commentary on Article 5. Though the 2008 update to the OECD Model did not change the definition of PE, but it did add in the commentary an alternative provision for states wishing to include it in their double tax conventions.

The Linklaters judgment is contrary to the OECD principle that a Service PE should not exist if the services are rendered outside the source country. In Linklaters, the services, which were rendered in UK, but utilized in India, were held to be taxable in India. The Tribunal also deviated from the OECD approach on partnership taxation and territorial nexus in the above ruling.

OECD has also stipulated, that Service PE should only exist in case of services provided to third parties only, but in the Indian treaties, Service PE is also deemed to exist even in case of services to associated enterprise.

Conclusion

It is crucial for multinational enterprises to carefully plan the movement of its employees and personnel’s across territories, so as to avoid giving rise to Service PE, especially in jurisdictions which have incorporated Service PE clauses in their double tax treaties. It is not necessary that deputation of employees would always give rise to Service PE unless there is furnishing of services through those employees.

With the labour becoming so mobile, it is likely that more nations would prefer having Service PE clause in their treaties. But on the contrary, it is possible, that with a few developing nations, especially emerging economies, becoming net exporter of capital rather than net importer, the service PE clause might not seem as attractive to them in future, as it seems now.

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SECTION 9

Income deemed to accrue or arise in India

Scope and ambit of ‘business connection’ in the case of a non-resident - The following are illustrative instances of a non-resident having business connection in India:

     -  Maintaining a branch office in India for the purchase or sale of goods or transacting other business.

     -  Appointing an agent in India for the systematic and regular purchase of raw materials or other commodities, or for sale of the non-resident’s goods, or for other business purposes.

     -  Erecting a factory in India, where the raw produce purchased locally is worked into a form suitable for export abroad.

     -  Forming a local subsidiary company to sell the products of the non-resident parent company.

     -  Having financial association between a resident and a non-resident company.

Clarifications regarding applicability of provisions of section 9 in certain specified situations :

1.          NON-RESIDENT EXPORTERS SELLING GOODS FROM ABROAD TO INDIAN IMPORTER - No liability will arise on accrual basis to the non-resident on the profits made by him where the transactions of sale between the two parties are on a principal-to-principal basis.

     If the non-resident makes over the shipping documents to a bank in his own country which discounts the documents and sends them for collection to the bankers in India, who present the sight or usance draft to the resident importer and deliver the documents to him against payment or acceptance by the latter, the non-resident will not be liable to tax on the profit arising out of the sales on receipt basis.

2.          NON-RESIDENT COMPANY SELLING GOODS FROM ABROAD TO ITS INDIAN SUBSIDIARY - In such a case, if the transactions are actually on a principal-to-principal basis and are at arm’s length and the subsidiary company functions and carries on business on its own, instead of functioning as an agent of the parent company, the mere fact that the Indian company is a subsidiary of the non-resident company will not be considered a valid ground for invoking section 9 for assessing the non-resident.

     Where a non-resident parent company sells goods to its Indian subsidiary, the income from the transaction will not be deemed to accrue or arise in India under section 9, provided that (a) the contracts to sell are made outside India, (b) the sales are made on a principal-to-principal basis and at arm’s length, and (c) the subsidiary does not act as an agent of the parent company.

3.          SALE OF PLANT AND MACHINERY TO AN INDIAN IMPORTER ON INSTALMENT BASIS - Where the transaction of sale and purchase is on a principal-to-principal basis and the exporter and the importer have no other business connection, the fact that the exporter allows the importer to pay for the plant and machinery instalments will not, by itself, render the exporter liable to tax on the ground that the income is deemed to arise to him in India.

4.          FOREIGN AGENTS OF INDIAN EXPORTERS - Where a foreign agent of Indian exporter operates in his own country and his commission is usually remitted directly to him and is, therefore, not received by him or on his behalf in India. Such an agent is not liable to income-tax in India on the commission.

5.          NON-RESIDENT PERSON PURCHASING GOODS IN INDIA - A non-resident will not be liable to tax in India on any income attributable to operations confined to purchase of goods in India for export, even though the non-resident has an office or an agency in India for this purpose.

6.          SALES BY A NON-RESIDENT TO INDIAN CUSTOMERS EITHER DIRECTLY OR THROUGH AGENTS - (a) Where non-resident allows an Indian customer facilities of extended credit for payment, there would be no assessment merely for this reason provided that (i) the contracts to sell were made outside India; and (ii) the sales were made on a principal-to-principal basis.

     (b) Where a non-resident has an agent in India and makes sales directly to Indian customers, section 9 of the Act will not be invoked, even if the resident pays his agent an overriding commission on all sales to India, provided that (i) the agent neither performs nor undertakes to perform any service directly or indirectly in respect of these direct sales; (ii) the contracts to sell are made outside India; and (iii) the sales are made on a principal-to-principal basis.

     (c) 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.

     (d) Where a non-resident principal’s business activities in India are not wholly channelled through his agent in India, the assessment in India will be on the sum total of the amount of profit attributable to his agent’s activities in India and the amount of profit attributable to his own activities in India, less the expenses incurred in making the sales.

7.          EXTENT OF THE PROFIT ASSESSABLE UNDER SECTION 9 - If a non-resident has a business connection in India, it is only that portion of the profit which can reasonably be attributed to the operations of the business carried out in India, which is liable to income-tax —Circular : No. 23 [F. No. 7A/38/69-IT (A-II)], dated 23-7-1969.1

Agency engaged in activity of purchase of goods for export - The mere existence of an agency established by a non-resident in India will not be sufficient to make the non-resident liable to tax, if the sole function of the agency is to purchase goods for export—Circular : No. 163 [F. No. 488/23/73-FTD], dated 29-5-1975.

Foreign company engaged in re-insurance with Indian companies - Regarding taxability of a foreign company on its profits of re-insurance with companies in India no uniform principle could be laid down which will be applicable in all cases. The ITOs will have to examine each case in the light of its facts and decide, where tax liability is attracted and what portion of the income from the re-insurance should be assessed—Circular : No. 35(XXXIII-7) of 1956 [F. No. 51(5)-IT 54], dated 3-9-1956.

Pensions received in India from abroad - Pensions received in India from abroad by pensioners residing in this country, for past services rendered in the foreign countries, will be income accruing to the pensioners abroad, and will not, therefore, be liable to tax in India on the basis of accrual. These pensions will also not be liable to tax in India on receipt basis, if they are drawn and received abroad in the first instance, and thereafter remitted or brought to India.

While the pension earned and received abroad will not be chargeable to tax in India if the residential status of the pensioner is either ‘non-resident’ or ‘resident but not ordinarily resident’, it will be so chargeable if the residential status is ‘resident and ordinarily resident’—Circular : No. 4 [F. No. 73A/2/69-IT (A-II)], dated 20-2-1969.

Shares allotted to non-residents in consideration for machinery and plant - Where shares in Indian companies are allotted to non-residents in consideration for machinery and plant, the income embedded in the payments would be received in India as the shares in the Indian companies are located in India and would accordingly attract liability to income-tax as income received in India—Circular : No. 382 [F. No. 484/12/78-FTD], dated 4-5-1984.

Taxation of Business Process Outsourcing Units in India - 1. A non-resident entity may outsource certain services to a resident Indian entity. If there is no business connection between the two, the resident entity may not be a Permanent Establishment of the non-resident entity, and the resident entity would have to be assessed to income-tax as a separate entity. In such a case, the non-resident entity will not be liable under the Act.

2. However, it is possible that the non-resident entity may have a business connection with the resident Indian entity. In such a case, the resident Indian entity could be treated as the Permanent Establishment of the non-resident entity. The tax treatment of the Permanent Establishment in such a case is under consideration in this circular.

3. During the last decade or so, India has seen a steady growth of outsourcing of business processes by non-residents or foreign companies to IT-enabled entities in India. Such entities are either branches or associated enterprises of the foreign enterprise or an independent Indian enterprise. Their activities range from mere procurement of orders for sale of goods or provision of services and answering sales related queries to the provision of services itself like software maintenance service, debt collection service, software development service, credit card/mobile telephone related service, etc. The non-resident entity or the foreign company will be liable to tax in India only if the IT-enabled BPO unit in India constitutes its Permanent Establishment. The extent to which the profits of the non-resident enterprise is to be attributed to the activities of such Permanent Establishment in India has been under consideration of the Board.

4. A non-resident or a foreign company is treated as having a Permanent Establishment in India under Article 5 of the Double Taxation Avoidance Agreements entered into by India with different countries if the said non-resident or foreign company carries on business in India through a branch, sales office, etc., or through an agent (other than an independent agent) who habitually exercises an authority to conclude contracts or regularly delivers goods or merchandise or habitually secures orders on behalf of the non-resident principal. In such a case, the profits of the non-resident or foreign company attributable to the business activities carried out in India by the Permanent Establishment becomes taxable in India under Article 7 of the Double Taxation Avoidance Agreement.

5. Paragraph 1 of Article 7 of the Double Taxation Avoidance Agreement provides that if a foreign enterprise carries on business in another country through a Permanent Establishment situated therein, the profits of the enterprise may be taxed in the other country but only so much of them as is attributable to the Permanent Establishment. Paragraph 2 of the same Article provides that subject to the provisions of Paragraph 3, there shall in each contracting State be attributed to that Permanent Establishment the profits 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. Paragraph 3 of the Article provides that in determining the profits of a Permanent Establishment there shall be allowed as deductions expenses which are incurred for the purposes of the Permanent Establishment including executive and general administrative expenses so incurred, whether in the State in which the Permanent Establishment is situated or elsewhere. What are the expenses that are deductible would have to be determined in accordance with the accepted principles of accountancy and the provisions of the Income-tax Act, 1961.

6. Paragraph 2 contains the central directive on which the allocation of profits to a Permanent Establishment is intended to be based. The paragraph incorporates the view that the profits to be attributed to a Permanent Establishment are those which that Permanent Establishment would have made if instead of dealing with its Head Office, it had been dealing with an entirely separate enterprise under conditions and at prices prevailing in the ordinary market. This corresponds to the “arm’s length principle”. Paragraph 3 only provides a rule applicable for the determination of the profits of the Permanent Establishment, while paragraph 2 requires that the profits so determined correspond to the profit that a separate and independent enterprise would have made. Hence, in determining the profits attributable to an IT-enabled BPO unit constituting a Permanent Establishment, it will be necessary to determine the price of the services rendered by the Permanent Establishment to the Head Office or by the Head Office to the Permanent Establishment on the basis of “arm’s length principle”.

7. “Arm’s length price” would have the same meaning as in the definition in section 92F(ii) of the Income-tax Act. The arm’s length price would have to be determined in accordance with the provisions of sections 92 to 92F of the Act.

8. The CBDT Circular No. 1/2004, dated 2-1-2004 is hereby withdrawn with immediate effect. - Circular No. 5/2004, dated 28-9-2004.

===================================================================================================

BEFORE THE AUTHORITY FOR ADVANCE RULINGS

(INCOME TAX) NEW DELHI

==========

P R E S E N T

Hon’ble Mr. Justice Syed Shah Mohammed Quadri (Chairman)

Mr. K.D. Singh (Member)

Mr. K.D. Gupta (Member)

Tuesday, the First June Two thousand four

A.A.R. NO. 603 OF 2002

Name & address of Sutron Corporation

the applicant 213000 Ridgetop Circle Sterling, Virginia 20166

Commissioner concerned Director of Income-tax

(International Taxation)

New Delhi

Present for the Department Mr. S.M.J.Abidi,

Addl. CIT, Range02

New Delhi

Present for the Applicant Shri O.S. Bajpai, Advocate

R U L I N G

(By Mr. Justice Syed Shah Mohammed Quadri)

.

The applicant, M/s. Sutron Corporation, Virginia, USA, is a non-resident company. In response to the tenders floated in three packages by the Government of Andhra Pradesh, India (for short GOAP) in respect of the project for installation of remote stations (“the project”), the applicant prepared and signed proposals in USA and submitted the same. The GOAP awarded contract for

1

package-2 and package-3 to the applicant. We are not concerned with package 1 which was awarded to some third party. Accordingly, the applicant through its authorized Country Manager (Mr. Naresh Goel) at Hyderabad. entered into two contracts with the “GOAP” – the first on 14.6.2002 for supply installation and commissioning of gauging equipment and associate systems and ancillary services termed as Package-3 and the second on 25.6.2002 for supply of installation and commissioning of Satellite Telemetry and associated systems and ancillary services termed as Package-2. The contracts relate to supply of foreign equipments and providing local material and services including internal insurance, custom clearance, inland transportation, civil and mechanical works, installation, commissioning, acceptance and warranty for two years and annual maintenance for a period of four years for the consideration specified in the contracts. Each contract comprises of two parts (1) supply of goods and erection of three to six specimen remote stations and on the spot training of personnel and (ii) providing local material and services etc. In regard to the first part of the contract, the goods were delivered to the AIR India in USA which was appointed as carriers on the instructions of the GOAP which borne the cost of insurance and freight. The documents of title were sent by Courier to SBH at Hyderabad. In regard to the second part of the contracts, it is

2

stated that a Memorandum of Understanding was executed between the applicant and M/s. Arraycom (India) Limited (for short “Arraycom”) for supplying all local integration material, providing local and other services and also for giving warranty services for the said period of 2 years and AMC services for a total of 4 year for which Arraycom will recover the cost from the applicant. The MOU was submitted along with bid documents to GOAP. The consideration for the first part is payable to the applicant for the both the packages in US dollars in USA and the consideration for the second part is payable in Indian rupees in India. The payment is required to be made by GOAP as follows :

(i) 10% of contract price is to be paid within 30 days of the signing of the contract against Bank Guarantee to be furnished by the applicant company.

(Bank Guarantee is required to be furnished for the entire amount of contract).

(ii) 70% of contract price is to be paid through irrevocable letter of credit which was opened by Government of AP through their Bankers State Bank of Hyderabad, in favour of the applicant’s Bank i.e. Allfirst Bank, Baltimore, USA through Union Bank of California on shipment of goods by the supplier.

(iii) 20% of the contract price is to be paid within 30 days of installation upon issue of acceptance certificate by the purchaster.

(iv) Thus, the entire payment is to be made by transfer of the amount to Allfirst Bank, Baltimore, USA.

It is said that the consideration has been received by the applicant in USA through the applicant’s bankers “Allfirst Bank, 3

Baltimore, USA”. It is claimed that no income/profit accrues/arises or can be deemed to accrue/arise in India and in any event in view of the DTTA no income of the applicant from the said contracts is taxable in India. On these facts, in this application filed under section 245Q(1) of the Income-tax Act (for short “the Act”), the applicant seeks ruling on the following questions:

Q.1. Whether on the facts and circumstances of the case, any income could accrue or arise under the Income-tax Act, 1961 or can be deemed to accrue or arise under the said Act, to the non-resident applicant company in India ?

Q.2. Whether on the facts and circumstances of the case the non resident applicant company can be said to have permanent establishment in India as defined in the Double Taxation Avoidance Agreement (DTAA) with United States of America ?

Q.3. Without prejudice to the foregoing main contentions of the applicant company, if the applicant company is found liable to pay any tax under the Income-tax Act, 1961, what would be the proportion of the net income content in the total receipts ?

Q.4. Whether on the facts and circumstances of the case and without prejudice to the main contention of the non resident applicant company, Is any part of their income liable to tax deduction at source and if yes at what rates.

2. In his comments, the jurisdictional Commissioner, the Director of Income-tax (International Taxation), Delhi, states that: the applicant appointed Mr. Naresh Goel as its Country Manager in India. He collects information about the invitation of tenders by various concerned in India including the Central and the State

4

Governments for supplying data about the environmental monitoring and control systems such as weather, floods, cyclone, forecast system; in response to the tenders floated by GOAP, he submitted proposals which were approved and prepared by the applicant at Virginia, USA; he collects information as to whether the tender is awarded to the applicant and conveys the same to the applicant; he has authorization of the applicant to submit bids and sign contracts with the GOAP after obtaining due approval from them. The applicant has an office for its operations in India and Mr. Goel is the Country Manager for rendering various duties referred to above. Therefore, the applicant has business connection for the purpose of section 9(1)(i) of the Income-tax Act (for short “ Act) and he is also a dependent agent of the applicant within the meaning of Article 5 of the Double Taxation Avoidance Agreement (DTAA) concluded between India and USA. As the applicant has an agent in India, the income, under the contract aforementioned, is deemed to accrue or arise in India under sec. 9(1)(i) of the Act. Further, the applicant has ‘permanent establishment’ in India and a dependent agent – Mr. Naresh Goel. Thus the requirements of Article 5 of DTAA, concluded between Republic of India and the Government of the USA are fulfilled. It is further stated that on the facts stated in the application it is not possible to find out as to what would be the portion of the net

5

income in the total receipts of the applicant which would be taxable and it has to be ascertained on the basis of the facts. Mr. Goel, the Country Manager, entered into agreement with the applicant on December 4, 2000 describing himself an independent consultant and not an employee. He receives a fixed remuneration of $ 3,000 per month for his professional services. He is also paid the following expenses:

Driver $ 125

Local conveyance $ 125

Travelling expenses $ 1000

Communication costs $ 120

Local expenses $ 100

These facts clearly shows that Mr. Goel is not an independent consultant but is only an employee of the applicant. Therefore, while making payments under the contracts, GOAP has to deduct tax @ 48% under section 195 of the Act.

3. Mr. O.S. Bajpai, Advocate who appeared for the applicant submitted, at the outset, that he would not press question Nos. 3 and 4.

With regards to questions No. 1 and 2 he argued that the sale of the machinery and plant is outside India, therefore, no income accrues or arises to the applicant or is deemed to accrue or arise to the applicant under section 9 of the Act; according to Article 7(1) of DTAA, the profit of the applicant would be taxable only in USA and not in India; the applicant has no business connection or

6

permanent establishment in India and the residential address of Mr. Naresh Goel, the Country Manager of the applicant, cannot be treated as permanent establishment. Mr Abidi, Additional Commissioner of the jurisdictional Commissioner submitted that Mr. Naresh Goel is the agent of the applicant in India; he has authority to negotiate and enter into contract and, indeed, he has signed the contracts with GOAP. It is asserted that the applicant has business connection within the meaning of section 9(1)(i) of the Act and also permanent establishment in India within the meaning of Article 7(4) of DTAA. Therefore, requirements of both section 9 as well as of DTAA are satisfied. It is not a case of sale of goods and supplying services but a contract of turnkey project.

4. Before adverting to the rival contentions of the parties, it may be pointed out that the answer to the second question is germane to any ruling on the first question. The present discussion will cover both the questions. In this backdrop, the short question that needs to be addressed is: whether any income/profit accrues or arises, or deemed to accrue or arise to the applicant in India from the sale of machinery/equipment and providing of services under the contracts with GOAP.

5. It will be appropriate to note that section 5 of the Act deals with the scope of total income which forms the subject matter of

7

charge under section 4 of the Act. Sub-section (1) of section 5 speaks of total income of a resident. The topic of total income of any previous year of non-residents is the subject matter of sub-section (2) of section 5 of the Act which provides, inter alia, that all income, from whatever source, which accrues or arises or is deemed to accrue or arise in India in any previous year by or on behalf of non resident will be included in his total income.

6. Ordinarily profits of a business accrues at the place of formation of contract but factors like where the contract is carried out or acts done under the contract have an important bearing on the decision of a question regarding place of accrual of the profit which is no doubt a vexed question. In the case of sale of goods simpliciter, profits arise at the place where the contract of sale is effected. And a contract is made at the place where the offer is accepted. In a case where the contract of sale is made in one place and the sale takes place in another, profits may accrue partly at the place where the contract of sale is made and partly at the place where the sale is effected or the contract is executed.* But in a case where under a contract various obligations are undertaken including sale of goods, profits will accrue/arise where the sale is effected.

________________________________________________________________

* The law and practice of Income-tax” Kanga Palkivala vs. Vyas [9th Edition Vol. I pg. 332] See also “Commissioner of Income-tax, Bangalore v. Union Tile Exporters ( 71 ITR 453)

8

In this case, the contracts are executed in India but goods are delivered to the carrier appointed by the purchaser in USA and consideration for sale, installation of the machinery and for providing service is received by the applicant in USA, no income/profit will accrue/arise to the applicant partly in India. Therefore, neither clause (a) nor clause (b) of sub-section (2), except the deeming provision will apply. We shall advert to the deemed accrual/arising of profits presently.

7. In support of his contention that where the goods are sold outside India, no income can be said to accrue/arise in India, Mr. Vajpai relied on the following decision of the Andhra Pradesh High Court. Additional Commissioner of Income-tax vs.Skoda Export, Praha [172 ITR 358], in that case a Government of India Undertaking(for short “the Undertaking”) entered into two agreements with the non-resident company.The second agreement was in respect of delivery of machinery and equipment F.O.B. European and the time for the fulfillment of the delivery was the date of bills lading. On consideration of the relevant clauses of the agreement the Income-tax Appellate Tribunal held that the sale of machinery took place outside India and no part of the profit arising therefrom could be said to arise in India to the non-resident company. On a reference, the A.P. High Court held that the sale of

9

machinery was not an independent or isolated transaction. It was part and parcel of the business venture or business connection, between the “Undertaking” and the non-resident. It was observed that in such a situation one has to apply the test of predominance and decide where the sale took place. The High Court answered the question thus, “ a combined reading of the clauses of the agreement, we have no doubt that the sale of machinery did take place outside India.

8. Now we shall proceed to consider whether any part of profits can be deemed to accrue to the applicant under sections 5(2)(b) and 9(1)(i) of the Act. It is necessary to clarify here that when income/profit accrues/arises in India, the further question whether it shall be deemed to accrue/arise, does not arise.

9. The provisions of clause (i) of sub-section (1) of section 9 and the Explanation thereto which incorporate the principle of deemed accrual or arising of income, may be referred to here.

“9. (1) The following incomes shall be deemed to accrue or arise in India:-

(i) all income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, [ * ] or

10

through the transfer of a capital asset situate in India.

Explanation – For the purposes of this clause -

(a) in the case of a business of which all the operations are not carried out in India, the income of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India;

(b) in the case of a non-resident, no income shall be deemed to accrue or arise in India to him through or from operations which are confined to the purchase of goods in India for the purpose of export;

(c ) in the case of a non-resident, being a person engaged in the business of running a news agency or of publishing newspapers, magazines or journals, no income shall be deemed to accrue or arise in India to him through or from activities which are confined to the collection of news and views in India for transmission out of India;

(d) in the case of a non-resident, being -

(1) an individual who is not a citizen of India; or

(2) a firm which does not have any partner who is a citizen of India or who is resident in India; or

(3) a company which does not have any shareholder who is a citizen of India or who is resident in India,

no income shall be deemed to accrue or arise in India to such individual, firm or company through or from operations which are confined to the shooting of any cinematograph in India;]

11

A perusal of the provisions extracted above shows that all income accruing or arising whether directly or indirectly through or from any business connection in India or from any property in India or through any assets or source of income in India or through transfer of capital assets situate in India, shall be deemed to accrue or arise in India. The mandate contained in the Explanation is that for the purpose of aforementioned clause where the business of which all the operations are not carried out in India, the income of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India. Here, for the deeming provisions to apply we need to examine whether any income accrues or arises to the applicant (whether directly or indirectly) through or from any ‘business connection’ in India.

10. The important aspect we have to consider here is whether the applicant has “business connection” in India.

The expression “business connection” was not defined for the purpose of the aforementioned provision, before March 31, 2003. By Finance Act, 2003 two Explanations were inserted after the then existing Explanation which is numbered as Explanation 1 of sub-section (1) of section 9 w.e.f. 1.4.2004. Explanation 2 which is relevant for our purpose defines the expression thus:

12

“Explanation 2 – For the removal of doubts, it is hereby declared that “business connection” shall include any business activity carried out through a person who, acting on behalf of the non-resident, -

(a) has and habitually exercises in India, an authority to conclude contracts on behalf of the non-resident, unless his activities are limited to the purchase of goods or merchandise for the non-resident; or

(b) has no such authority, but habitually maintains in India a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the non-resident; or

(c) habitually secures orders in India, mainly or wholly for the non-resident or that non-resident and other non-residents controlling, controlled by, or subject to the same common control, as that non-resident:”

The said Explanation contains an inclusive definition; it brings in the business activities specified in clauses (a) to (c), referred to above, within the fold of the expression “business connection” which has to be understood in its ordinary meaning. On the facts of this case it cannot be concluded that any of the business activities in the aforementioned clauses (a) and (c) are carried out in India by Mr. Naresh Goel for the applicant. The newly added Explanation 2 defining the expression “business connection” is of no consequence here. The fact that the said Explanation is inserted after Mr. Naresh Goel entered into contracts with GOAP in June 2002, and that it is declaratory may not therefore be relevant for the present discussion.

13

We may note here that the expression has been interpreted by the courts in various decisions. It will be useful to refer to the following :

11. In CIT, Punjab, v. R.D. Aggarwal & Co (56 ITR 20), the import of the expression is brought out in the following observation of the Supreme Court:

“The expression “business connection” postulates a real and intimate relation between the trading activity carried on outside the taxable territories and the trading activities within the territories, the relation between the two contributing to the earning of income by the non-resident in his trading activity”.

The Supreme Court, speaking through Hon’ble Mr. Justice Shah (as he then was) for the purpose of Section 42 of the Income-tax Act, 1922 laid down, “business connection” contemplated by section 42 involves a relation between a business carried on by a non-resident which yields profits and gains and some activity in the taxable territories which contributes directly or indirectly to the earning of those profits or gains. It predicates an element of continuity between the business of non-resident and the activity in the taxable territories, a stray or isolated

14

transaction not being normally regarded as a business connection.”

The requirement of continuity of transactions to form ‘business connection’ between a non-resident and a resident was laid down by the Supreme Court as long back in 1952 in Anglo-French Textile Company Limited (23 ITR 101). Hon’ble Mr. Justice Mahajan (as he then was) speaking for the Court, observed, “an isolated transaction between a non-resident and a resident in British India without any course of dealings such as might fairly be described as a business connection does not attract the application of section 42, but when there is a continuity of business relationship between the person in British India who helps to make the profits and the person outside British India who receives or realizes the profits, such relationship does constitute a business connection”.

12. In the light of above discussion, the essential features of “business connection” may be summed up as follows:-

(a) a real and intimate relation must exist between the trading activities by a non-resident carried on outside India and the activities within India:

15

(b) the relation contributes directly or indirectly to the earning of income by the non-resident in his business;

( c) a course of dealing or continuity of relationship and not a mere isolated or stray nexus between the business of the non-resident outside India and the activity in India, would furnish a strong indication of ‘business connection’ in India.

From the facts of the case it is evident that all the steps in formulating the proposal, filing the tender forms and signing etc. were taken in USA. They were, however, submitted through Mr. Naresh Goel Country Manager in India and the contract was also signed by him under the authority of the applicant for and on its behalf.

13. The Commissioner described Mr. Naresh Goel, as an employee of the applicant who is getting a salary of $ 3000 per month and the following perks:

Driver $ 125

Local conveyance $ 125

Travelling expenses $ 1000

Communication costs $ 120

Local expenses $ 100

In the agreement entered into between the applicant and Mr. Naresh Goel, he is described as Country Manager. It is specifically provided therein that he is an

16

independent consultant and not an employee of the company but from material placed before us and in the absence of any record to show that he is an agent of independent status, we cannot but conclude that he is at least a paid agent of the applicant for the purpose of collecting market information, notice inviting tenders by various institutions and Government departments relating to Sutron’s products and services, supply such information to the company, submit bid proposal to the respective customers prepared by the company and execute contracts for the enterprise and perform other tasks as authorized by the applicant.

Thus, it is seen that all these features are present in this case. It has, therefore, to be concluded that the applicant has business connection in India.

14. It will be apposite to notice at this stage that notwithstanding the provisions of section 5(2) and section 9(1)(i), having regard to the mandate contained in section 90(2) of the Act the provisions of the agreement entered into by the Central Government under section 90(1) of the Act will have overriding effect. It is a common ground here that such an agreement was entered into between the Government of Republic of India and the Government of USA which is referred

17

to herein as DTTA. No authority is needed for this proposition. [However, see 263 ITR 706 in the case of Union of India & Another v. Azadi Bachao Andolan & Another].

Article 7 (1) of DTAA which deals with business profits and in so far as it is evident, reads thus:

Article 7:Business profits

“1. The profits of an enterprise of a Contracting States shall be taxable only in that State unless the enterprises carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to (a) that permanent establishment; (b) sales in the other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment; or (c) other business activities carried on in the other State of the same or similar kind as those effected through that permanent establishment.

2. x x x x

3. x x x x

4. x x x x x

5. x x x x x

6. x x x x x

7. For the purposes of the Convention, the term “business profits” means income derived from any trade or business including income from the furnishing of services other than included services as defined in article 12 (royalties and fees for included services) and including income from the rental of tangible personal property other than property described in paragraph 3(b) of article 12 (royalties and fees for included services).”

18

Para 1 of Article 7 to the extent relevant for our purpose lays down that the profit of an enterprise of a contracting State shall be taxable only in that State unless the enterprise carries on business in the other contract State through permanent establishment situated therein. If the enterprise carries on business as aforesaid the profit of the enterprise may be taxed in the other State but only so much of them as is attributable to the permanent establishment. It means that the profits of the applicant shall be taxable only in USA unless the applicant carries on business in India through a permanent establishment situated therein. In such a case, the profits of the applicant may be taxed in India only to the extent they are attributable to the permanent establishment.

In para 7 of Article 7 “business profits” is defined to mean income derived from any trade or business including income from the furnishing of services other than included services as defined in Article 12 (Royalty and fees for included services) and including income from tangible personal properties other than property described in para 3 (b) of Article 12.

From the above, it is explicit that the business profits of the applicant, which means income, derived from sale and installation of equipment and machinery as well as from

19

furnishing of services will be taxable in India if they are through permanent establishment in India.

15. Article 5 of the said DTAA defines permanent establishment thus:

Article 5: Permanent establishment

1. For the purposes of this Convention, the term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on.

2. The term “permanent establishment” includes especially:

(a) a place of management;

(b) branch;

(c) an office;

(d) to (i) x x x x x x x x x x

3. Notwithstanding the preceding provisions of this article, the term “permanent establishment” shall be deemed not to include any one or more of the following:

(a) the use of facilities solely for the purpose of storage, display, or occasional delivery of goods or merchandise belonging to the enterprise;

(b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or occasional delivery;

(c) the maintenance of a stock or goods or merchandise belonging to the enterprise solely for the purpose of providing by the another enterprises;

(d) the maintenance of a fixed place of business solely for the purpose purchasing goods or merchandise, or a connecting information, for the enterprise;

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(e) the maintenance of a fixed place of business solely for the purpose of advertising, for the supply of information, for scientific research or for other activities which have a preparatory or auxiliary character, for the enterprise.

4. Notwithstanding the provisions of paragraphs 1 and 2, where a person-other than an agent of an independent status to whom paragraph 5 applies- is acting in a Contracting State on behalf of a an enterprise of the other Contracting State, that enterprise shall be deemed to have a permanent establishment in the first-mentioned state, if

(a) he has and habitually exercises in the first-mentioned State an authority to conclude contracts on behalf of the enterprise, unless the activities are limited to those mentioned in the paragraph 3 which, if exercised through a fixed place of business, would not make that fixed place of business a permanent establishment under the provisions of that paragraph;

(b) he has no such authority but habitually maintains in the first-mentioned State a stock of goods or merchandise from which he regularly delivered goods or merchandise on behalf of the enterprise, and some additional activities conducted in that State on behalf of the enterprise have contributed to the sale of goods merchandise; or

(c) he habitually secures orders in the first-mentioned State, wholly or almost wholly for 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, provided that such persons re acting in the ordinary course of their business. However, when the activities of such an agent are devoted wholly or almost wholly on behalf of that enterprise and the transactions between the agent and the enterprise are not made under arm’s-

21

length conditions, he shall not be considered an agent of independent status within the meaning of this paragraph.

6. The fact that a company which is a resident of a Contracting State controls or is controlled by a company which is a resident of the other Contracting State, or which carries on business in that other State (whether through a permanent establishment or otherwise), shall not of itself constitute either company a permanent establishment of the other.

A combined reading of paras 1 to 3 of Article 5 brings out the meaning of the expression ‘permanent establishment’. Whereas para 1 defines the expression to mean a fixed place of business through which a business of an enterprise is wholly or partly carried on, para 2 includes seven places specified in sub clauses (a) to (k) and furnishing of services specified in sub clause (l) within the scope of the expression and para 3 excludes the facilities noted in clause (a), maintenance of stock mentioned in clauses (b) and (c) and maintenance of fixed places for the purposes indicated in clauses (d) and (e) from the scope of the expression. Para 4, which commences with nonobstante clause, says that notwithstanding the definition of the expression outlined in para 1 and 2, a person acting in contracting state on behalf of enterprise shall be deemed to have a permanent establishment in the first mentioned state, if any one of the three clauses – (a) (b) (c) thereof – applies. Clause (a) deals with a person who has and habitually 22

exercises authority to conclude contract on behalf of the enterprise in the first mentioned state unless (i) the activities are limited to those mentioned in para 3 (excluded activities) and (ii) if they are exercised through a fixed place of business would not make that fixed place of business, a permanent establishment under the provisions of that para. Clause (b) deals with a person who act without authority, therefore, is not relevant for our purpose. Clause (c) says that the person habitually secure orders in the first mentioned state wholly or almost wholly for the enterprise. Para 5 contains an exclusionary clause and says that an enterprise of a contracting State shall not be deemed to have permanent establishment in the other contracting State merely because it carries on business in the other State through a broker, general commission agent or any other agent of an independent status provided that such persons are acting in the ordinary course of business. Nonetheless when the activities of such and agent are devoted wholly or almost wholly on behalf of that enterprise and the transactions between the agent and the enterprise are not made under arm-length condition, he shall not be considered as an agent of an independent status within the meaning of those paragraphs. This para would not apply as from the fact stated above, it is not possible to hold that Mr. 23

Naresh Goel is an agent of an independent status. The address of Mr. Naresh Goel is a fixed place from which the business of the applicant is partly carried on. It is immaterial if the same is his residential address. It may also be termed as a place of management or an office. None of the clauses in paras 3 and 4 or the stipulation in para 5 would apply. In the result, it has to be held that the applicant has a permanent establishment in India.

Para 6 is not relevant for the present discussion.

16. It is worth noticing that payment of consideration by the GOAP has been split in US dollars and in Indian currency under Packages 2 & 3 as is evident from Annexure I to the application as follows:

S.No.

Particulars

Amount

Package-3

Amount

Package-2

1.

Supply of foreign equipment

US $ 820584

US $ 327960

2.

Providing local material and services including, internal insurance, custom clearance, inland transportation, civil and mechanical works, installation, commissioning, acceptance and warranty for two years.

Rs.19246424/-

Rs.3147030/-

3.

Annual maintenance for a period of four years

US $ 15756

And

Rs.4375280/-

US $ 11250

And

Rs.1530000/-

24

In regard to the supply of foreign equipment under both the Packages even though the contracts were entered into in India, the delivery of the goods was in USA as goods were delivered to the carrier – Air India which was appointed as carrier of goods for and on behalf of the purchaser, GOAP. It has already been noted above that the consideration was paid in US dollars through the bankers of the applicant, Allfirst Bank, Baltimore, USA through Union Bank of California on shipment of the goods by the supplier, and the 10% had already been paid within 30 days of the signing of the contract against bank guarantee furnished by the applicant. 20% of the contract price is required to be paid between 30% of the installation upon issue of acceptance certificate by the purchaser.

17. It is also evident from Annexure I that consideration for providing local material and services including internal insurance, custom clearance, inland transportation, civil and mechanical works, installation and commissioning, acceptance and warranty for 2 years, the amount is payable in Indian rupees both under Package 2 as well as Package 3. The amount payable by GOAP for annual maintenance for a period of 4 years is both in US dollars and Indian rupee ( Package 3 – US $ 820584 i.e. Rs.19246424/- and Package 2 – US $ 327960 i.e. Rs.3147030 ). It is important to note here for items 2 and 3 noted in the above statement, as per 25

the contract form (P.I and P.II), the applicant entered into a Memorandum of Understanding with Arraycom on 19.12.2001 (Annexure P.12) which inter alia recites as under:

“ SUTRON will supply the Gauging Equipment – including the DCPs, INSAT Satellite transmitters, Sensors and associated ancillary equipment that will be shipped from the USA. The equipment and sensors will meet the tender specifications. SUTRON will complete the Factory acceptance Tests and will provide training to the customer and for Arraycom including the complete installation of 3 to 6 Remote Sations. SUTRON will provide warranty for the period of 2 years and the repairs of all equipment for a period of 4 additional years under the AMC as per terms of our proposal.

Arraycom will supply all local integration materials including maintenance free batteries, station mounting towers, masts, lightning rods, grounding rods, conduit for bubbler systems, provide all civil works, fencing gates, etc. Arraycom will also provide installation of SUTRON products and financial acceptance testing of the equipment; 2 years warranty service and AMC services for a total of 4 years.”

18. The applicant is not correct in saying that the applicant company and Arraycom, in fact, gave joint bid for 2 independent activities; the applicant bid for supply of equipment etc. while Arraycom bid for providing local services; both of them have calculated their bid price separately and are to receive the same in consideration of their respective activities. Sutron gets paid in US dollars and Arraycom get paid in Indian rupees. It is equally incorrect to say that profit earned by each of the two concerns, are to be derived by their respective activities and the earning of the

26

profits by one is totally independent of the other both for supply of foreign equipments as well as for providing local material and services. Indeed, the applicant alone gave bid for supplying goods, for warranty of 2 years and annual maintenance for 4 years for Package 2 and Package 3. The bid was accepted. The letter of Secretary, Planning of GOAP dated 10th October, 2002 corroborates: (i) agreements for supply of equipment under Packages 2 & 3 were concluded by the GOAP with M/s. Sutron Corporation, USA, duly approved by the World Bank, in the name of Sutron Corporation only, (ii) the applicant was requested to open an account in case it did not already have, to receive the Indian currency payment whenever due, and (iii) the payment will be made in the currency quoted in the contract price and question of paying the balance payments in US dollars in lieu of Indian rupees does not arise.

From the above discussion it follows that the applicant alone is entitled to receive and has received payments both for sale and supply of equipments as well as for providing services indicated above. It is by internal arrangement between the applicant and Arraycom with regard to division of work and sharing of price, that it will receive part of consideration. So far as the applicant is concerned, the income/profits under the aforementioned contracts with the GOAP for sale of equipment, installation and service

27

agreement, shall be deemed to accrue/arise in India and only so much of them will be taxed in India under Article 7(1) of DTTA, as is attributable to the permanent establishment.

19. For the aforementioned reasons, we rule on question No.1, that on the facts and in the circumstances of the case income could be deemed to accrue or arise under the said Act to the non-resident applicant company in India;

on question No.2, the applicant company has ‘permanent establishment’ in India as defined in Double Taxation Avoidance Agreement with the United States of America.

Pronounced by this Authority at its office on this 1st day of June, 2004.

Sd/-

(JUSTICE S.S.M. QUADRI)

CHAIRMAN

Sd/-

(K.D. SINGH)

MEMBER

Sd/-

(K.D. GUPTA)

MEMBER

=======================================================================================================

Withdrawal of Circular No. 23, dated 23-7-1969, Circular No. 163, dated 29-5-1975 and Circular No. 786, dated 7-2-2000 - The Central Board of Direct Taxes had issued Circular No. 23 (hereinafter called "the Circular") on 23rd July, 1969 (Annex 1) regarding taxability of income accruing or arising through, or from, business connection in India to a non-resident, under section 9 of the Income-tax Act, 1961.

2. It is noticed that interpretation of the Circular by some of the taxpayers to claim relief is not in accordance with the provisions of section 9 of the Income-tax Act, 1961 or the intention behind the issuance of the Circular.

3. Accordingly, the Central Board of Direct Taxes withdraws Circular No. 23, dated 23rd July, 1969 (Annex 1) with immediate effect.

4. Even when the Circular was in force, the Income-tax Department has argued in appeals, references and petitions that—

  (i)  the Circular does not actually apply to a particular case, or

 (ii)  that the Circular cannot be interpreted to allow relief to the taxpayer which is not in accordance with the provisions of section 9 of the Income-tax Act or with the intention behind the issue of the Circular.

It is clarified that the withdrawal of the Circular will in no way prejudice the aforesaid arguments which the Income-tax Department has taken, or may take, in any appeal, reference or petition.

5. The Central Board of Direct Taxes also withdraws Circular Nos. 163, dated 29th May, 1975 (Annex 2) and 786, dated 7th February, 2000 (Annex 3) which provided clarification in respect of certain provisions of Circular No. 23, dated 23rd July, 1969—Circular No. 7/2009, dated 22-10-2009.

ANNEX 1

CIRCULAR NO. 23, DATED 23-7-1969

Scope and ambit of ‘business connection’ in the case of a non-resident - The following are illustrative instances of a non-resident having business connection in India:

     -  Maintaining a branch office in India for the purchase or sale of goods or transacting other business.

     -  Appointing an agent in India for the systematic and regular purchase of raw materials or other commodities, or for sale of the non-resident’s goods, or for other business purposes.

     -  Erecting a factory in India, where the raw produce purchased locally is worked into a form suitable for export abroad.

     -  Forming a local subsidiary company to sell the products of the non-resident parent company.

     -  Having financial association between a resident and a non-resident company.

Clarifications regarding applicability of provisions of section 9 in certain specified situations :

   1.  NON-RESIDENT EXPORTERS SELLING GOODS FROM ABROAD TO INDIAN IMPORTER - No liability will arise on accrual basis to the non-resident on the profits made by him where the transactions of sale between the two parties are on a principal-to-principal basis.

        If the non-resident makes over the shipping documents to a bank in his own country which discounts the documents and sends them for collection to the bankers in India, who present the sight or usance draft to the resident importer and deliver the documents to him against payment or acceptance by the latter, the non-resident will not be liable to tax on the profit arising out of the sales on receipt basis.

   2.  NON-RESIDENT COMPANY SELLING GOODS FROM ABROAD TO ITS INDIAN SUBSIDIARY - In such a case, if the transactions are actually on a principal-to-principal basis and are at arm’s length and the subsidiary company functions and carries on business on its own, instead of functioning as an agent of the parent company, the mere fact that the Indian company is a subsidiary of the non-resident company will not be considered a valid ground for invoking section 9 for assessing the non-resident.

        Where a non-resident parent company sells goods to its Indian subsidiary, the income from the transaction will not be deemed to accrue or arise in India under section 9, provided that (a) the contracts to sell are made outside India, (b) the sales are made on a principal-to-principal basis and at arm’s length, and (c) the subsidiary does not act as an agent of the parent company.

   3.  SALE OF PLANT AND MACHINERY TO AN INDIAN IMPORTER ON INSTALMENT BASIS - Where the transaction of sale and purchase is on a principal-to-principal basis and the exporter and the importer have no other business connection, the fact that the exporter allows the importer to pay for the plant and machinery instalments will not, by itself, render the exporter liable to tax on the ground that the income is deemed to arise to him in India.

   4.  FOREIGN AGENTS OF INDIAN EXPORTERS - Where a foreign agent of Indian exporter operates in his own country and his commission is usually remitted directly to him and is, therefore, not received by him or on his behalf in India. Such an agent is not liable to income-tax in India on the commission.

   5.  NON-RESIDENT PERSON PURCHASING GOODS IN INDIA - A non-resident will not be liable to tax in India on any income attributable to operations confined to purchase of goods in India for export, even though the non-resident has an office or an agency in India for this purpose.

   6.  SALES BY A NON-RESIDENT TO INDIAN CUSTOMERS EITHER DIRECTLY OR THROUGH AGENTS - (a) Where non-resident allows an Indian customer facilities of extended credit for payment, there would be no assessment merely for this reason provided that (i) the contracts to sell were made outside India; and (ii) the sales were made on a principal-to-principal basis.

        (b) Where a non-resident has an agent in India and makes sales directly to Indian customers, section 9 of the Act will not be invoked, even if the resident pays his agent an overriding commission on all sales to India, provided that (i) the agent neither performs nor undertakes to perform any service directly or indirectly in respect of these direct sales; (ii) the contracts to sell are made outside India; and (iii) the sales are made on a principal-to-principal basis.

        (c) 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.

        (d) Where a non-resident principal’s business activities in India are not wholly channelled through his agent in India, the assessment in India will be on the sum total of the amount of profit attributable to his agent’s activities in India and the amount of profit attributable to his own activities in India, less the expenses incurred in making the sales.

   7.  EXTENT OF THE PROFIT ASSESSABLE UNDER SECTION 9 - If a non-resident has a business connection in India, it is only that portion of the profit which can reasonably be attributed to the operations of the business carried out in India, which is liable to income-tax —Circular : No. 23 [F. No. 7A/38/69-IT (A-II)], dated 23-7-1969.

ANNEX 2

CIRCULAR NO. 163, DATED 29-5-1975

Agency engaged in activity of purchase of goods for export - The mere existence of an agency established by a non-resident in India will not be sufficient to make the non-resident liable to tax, if the sole function of the agency is to purchase goods for export—Circular : No. 163 [F. No. 488/23/73-FTD], dated 29-5-1975.

ANNEX 3

CIRCULAR NO. 786, DATED 7-2-2000

Clarification regarding taxability of export commission payable to non-resident agents rendering services abroad - 1. In their Audit Report for 1997-98 [D.P. No. 79(I.T.)] the Comptroller & Auditor General (C&AG) raised an objection that the Assessing Officer in computing the profits and gains of business or profession, in a case in Mumbai charge, had wrongly allowed a deduction in respect of a payment to a non-resident where tax had not been deducted at source. The nature of the payment in this case was export commission and charges payable for services rendered outside India. In the view of C&AG the expenditure should have been disallowed in accordance with the provisions of section 40(a)( i) of the I.T. Act, 1961. It has come to the notice of the Board that a similar view, on the same set of facts has been taken by some Assessing Officers in other charges.

2. The deduction of tax at source under section 195 would arise if the payment of commission to the non-resident agent is chargeable to tax in India. In this regard attention to CBDT Circular No. 23 dated 23rd July, 1969 is drawn where the taxability of ‘Foreign Agents of Indian Exporters’ was considered alongwith certain other specific situations. It had been clarified then that where the non-resident agent operates outside the country, no part of his income arises in India. Further, since the payment is usually remitted directly abroad it cannot be held to have been received by or on behalf of the agent in India. Such payments were therefore held to be not taxable in India. The relevant sections, namely section 5(2) and section 9 of the Income-tax Act, 1961 not having undergone any change in this regard, the clarification in Circular No. 23 still prevails. No tax is therefore deductible under section 195 and consequently, the expenditure on export commission and other related charges payable to a non-resident for services rendered outside India becomes allowable expenditure. On being apprised of this position, the Comptroller and Auditor General have agreed to drop the objection referred to above - Circular : No. 786, dated 7-2-2000.

Foreign company engaged in re-insurance with Indian companies - Regarding taxability of a foreign company on its profits of re-insurance with companies in India no uniform principle could be laid down which will be applicable in all cases. The ITOs will have to examine each case in the light of its facts and decide, where tax liability is attracted and what portion of the income from the re-insurance should be assessed— Circular : No. 35(XXXIII-7) of 1956 [F. No. 51(5)-IT 54], dated 3-9-1956.

Pensions received in India from abroad - Pensions received in India from abroad by pensioners residing in this country, for past services rendered in the foreign countries, will be income accruing to the pensioners abroad, and will not, therefore, be liable to tax in India on the basis of accrual. These pensions will also not be liable to tax in India on receipt basis, if they are drawn and received abroad in the first instance, and thereafter remitted or brought to India.

While the pension earned and received abroad will not be chargeable to tax in India if the residential status of the pensioner is either ‘non-resident’ or ‘resident but not ordinarily resident’, it will be so chargeable if the residential status is ‘resident and ordinarily resident’—Circular : No. 4 [F. No. 73A/2/69-IT (A-II)], dated 20-2-1969.

Shares allotted to non-residents in consideration for machinery and plant - Where shares in Indian companies are allotted to non-residents in consideration for machinery and plant, the income embedded in the payments would be received in India as the shares in the Indian companies are located in India and would accordingly attract liability to income-tax as income received in India—Circular : No. 382 [F. No. 484/12/78-FTD], dated 4-5-1984.

Taxation of Business Process Outsourcing Units in India - 1. A non-resident entity may outsource certain services to a resident Indian entity. If there is no business connection between the two, the resident entity may not be a Permanent Establishment of the non-resident entity, and the resident entity would have to be assessed to income-tax as a separate entity. In such a case, the non-resident entity will not be liable under the Act.

2. However, it is possible that the non-resident entity may have a business connection with the resident Indian entity. In such a case, the resident Indian entity could be treated as the Permanent Establishment of the non-resident entity. The tax treatment of the Permanent Establishment in such a case is under consideration in this circular.

3. During the last decade or so, India has seen a steady growth of outsourcing of business processes by non-residents or foreign companies to IT-enabled entities in India. Such entities are either branches or associated enterprises of the foreign enterprise or an independent Indian enterprise. Their activities range from mere procurement of orders for sale of goods or provision of services and answering sales related queries to the provision of services itself like software maintenance service, debt collection service, software development service, credit card/mobile telephone related service, etc. The non-resident entity or the foreign company will be liable to tax in India only if the IT-enabled BPO unit in India constitutes its Permanent Establishment. The extent to which the profits of the non-resident enterprise is to be attributed to the activities of such Permanent Establishment in India has been under consideration of the Board.

4. A non-resident or a foreign company is treated as having a Permanent Establishment in India under Article 5 of the Double Taxation Avoidance Agreements entered into by India with different countries if the said non-resident or foreign company carries on business in India through a branch, sales office, etc., or through an agent (other than an independent agent) who habitually exercises an authority to conclude contracts or regularly delivers goods or merchandise or habitually secures orders on behalf of the non-resident principal. In such a case, the profits of the non-resident or foreign company attributable to the business activities carried out in India by the Permanent Establishment becomes taxable in India under Article 7 of the Double Taxation Avoidance Agreement.

5. Paragraph 1 of Article 7 of the Double Taxation Avoidance Agreement provides that if a foreign enterprise carries on business in another country through a Permanent Establishment situated therein, the profits of the enterprise may be taxed in the other country but only so much of them as is attributable to the Permanent Establishment. Paragraph 2 of the same Article provides that subject to the provisions of Paragraph 3, there shall in each contracting State be attributed to that Permanent Establishment the profits 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. Paragraph 3 of the Article provides that in determining the profits of a Permanent Establishment there shall be allowed as deductions expenses which are incurred for the purposes of the Permanent Establishment including executive and general administrative expenses so incurred, whether in the State in which the Permanent Establishment is situated or elsewhere. What are the expenses that are deductible would have to be determined in accordance with the accepted principles of accountancy and the provisions of the Income-tax Act, 1961.

6. Paragraph 2 contains the central directive on which the allocation of profits to a Permanent Establishment is intended to be based. The paragraph incorporates the view that the profits to be attributed to a Permanent Establishment are those which that Permanent Establishment would have made if instead of dealing with its Head Office, it had been dealing with an entirely separate enterprise under conditions and at prices prevailing in the ordinary market. This corresponds to the "arm’s length principle". Paragraph 3 only provides a rule applicable for the determination of the profits of the Permanent Establishment, while paragraph 2 requires that the profits so determined correspond to the profit that a separate and independent enterprise would have made. Hence, in determining the profits attributable to an IT-enabled BPO unit constituting a Permanent Establishment, it will be necessary to determine the price of the services rendered by the Permanent Establishment to the Head Office or by the Head Office to the Permanent Establishment on the basis of "arm’s length principle".

7. "Arm’s length price" would have the same meaning as in the definition in section 92F(ii) of the Income-tax Act. The arm’s length price would have to be determined in accordance with the provisions of sections 92 to 92F of the Act.

8. The CBDT Circular No. 1/2004, dated 2-1-2004 is hereby withdrawn with immediate effect - Circular : No. 5/2004, dated 28-9-2004.

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 the business income becomes chargeable to tax if it is attributable to a permanent establishment of a foreign enterprise in India. Though different agreements have defined permanent establishment is slightly manner, generally it postulates existence of substantial element of a permanent nature of a foreign enterprise in another country which can be attributed to a fixed place of business in that country and it can be of such nature that it would amount to virtual projection of a foreign enterprise of a country into the soil of another country. The term ‘place of business’ covers any premises, facility or installation used for carrying on the business of the enterprise whether or not they are used exclusively for the purpose. The concept of fixity contemplates a degree of permanency to the place of business not in the sense that it perpetuates but in the sense that it endures. If the setting up of the place of business is permanent establishment unless it is maintained for such period that it cannot be considered a temporary one. The other essential ingredient of the ‘permanent establishment’ is that the business is carried on through such place of business wholly or partly. The definition of the expression ‘permanent establishment’ in all the treaties contains illustration of what may be taken to mean a permanent place of business such as a place of management, a branch, an office, a factory, a workshop, a warehouse, etc. The DTA agreements also contain exception to the general definition so as to exclude the following fro the concept of permanent establishment:

• The use of facilities solely for the purpose of storage or display of goods or merchandise belonging to the enterprise.

• The maintenance of a stock of goods or merchandize belonging to the enterprise solely for the purpose of storage or display.

• The maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandize or collecting information for the enterprise.

• The maintenance of the fixed place of business solely for the purpose of carrying on, for enterprise, any other activity of a preparatory or auxiliary character.

The definition or permanent establishment, inter alia, also means a person who represents permanent establishment and who in himself represents a fixed place of business. The person may be an individual or juridical entity. However, for a foreign company the subsidiary does not constitute a permanent establishment, as both are legal entities.

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New dimension to the definition of 'royalty'

The Hon’ble Delhi High Court has recently delivered a historical judgement in case of CIT v. D.C.M. Ltd. 336 ITR 599 in respect of meaning of the term “royalty”. An Indian company which is engaged in manufacturing of sugar entered into an agreement with a UK company for transfer of comprehensive technical information and know-how. The Indian company agreed to pay the specified amount towards supply of documents relating to technology.

The agreement between the parties envisages transfer of “comprehensive technical know-how and also supply of equipment” by UK company to the Indian company in order to enable the later to adopt the special process owned by the UK company.

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The Indian company contended that the payment was not in the nature of royalty; the remittance in the hands of UK company constituted industrial or commercial profits. Such profits could be taxed only if UK company was shown to have a permanent establishment in India.

It was commonly agreed by both the parties that UK company did not have any permanent establishment in India. Therefore, in terms of Agreement for Avoidance of Double Taxation between India and UK (DTAA) the remittance to be made to UK company could be taxed in India if the nature of remittance was “royalty” because while business profits of a foreign company can be taxed in India if the foreign company has a permanent establishment in India, but royalty received by a foreign company can be taxed in India even if foreign company does not have any permanent establishment in India.

Therefore, the issue to be considered by the High Court was whether the remittance to UK company constituted “royalty” or the same was “business profits”.

The Tribunal after analysing the agreement between the parties had come to the conclusion that the remittance concerned would be “royalty” if section 9(1)(vi) of the Income Tax Act is considered. But the definition of the term “royalty” is narrower in DTAA. The said payment will not be covered within the definition of royalty if the provisions of DTAA are considered. Therefore, in the absence of permanent establishment in India the remittance is not taxable in India.

It may be pointed out that the fundamental difference between the DTAA and Income Tax Act on this issue is while under the DTAA an amount is considered as “royalty” if it is received as a consideration for the use of, or the right to use intellectual properties. On the other hand, in the Income Tax Act payment will be royalty if made for “transfer of all” or “any rights” in intellectual properties. In other words, while under DTAA, an amount for the use of an intellectual property is royalty, under Income Tax Act payment for “transfer of all or any rights” will amount to royalty.

In the instant case the payment by the Indian company was held not to be the payment for “use” of or “right to use” any intellectual property. The payment infact was for “transfer” of the rights relating to the intellectual property. Therefore, the Hon’ble Delhi High Court held that the remittance made to UK company would not fall in the definition of “royalty” under DTAA.

The Hon’ble High Court observed that “the transfer of technology is quite often, as in the present case, brought about by executing agreements which give rights far greater than a mere right to use albeit on a non exclusive basis”. In order to fall within the definition of royalty, the “right conferred should be of usage; anything more than that takes it out of ambit of the definition of the royalty as provided in DTAA”.

As the UK company did not have a permanent establishment in India, the remittances made by the Indian company to UK which constituted “business profit” could also not be taxed in India.

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A Permanent Establishment of a Mauritian company in India cannot be considered as a ‘domestic company’ and accordingly, it will have to pay a higher rate of tax prescribed under the Act.

Mumbai bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of JCIT v. State Bank of Mauritius Ltd. (2009-TIOL-712-ITAT-MUM) has held that the foreign company having Permanent Establishment (PE) in India cannot be taxed at the rate applicable to domestic company in view of insertion of Explanation 1 to section 90 of the Income-tax Act, 1961 (the Act) by Finance Act 2001 with retrospective effect from 1 April 1962. Accordingly, it will have to pay tax at the rate prescribed in the Finance Act (i.e. at higher rate) even if a taxpayer is covered by the provisions of the India-Mauritius tax treaty (the tax treaty).

Facts of the case

The taxpayer was a company incorporated in Mauritius and it had a Permanent Establishment (PE) in India. The taxpayer, as per article 24 of the tax treaty i.e. ‘non-discriminatory’ clause, claimed its status as equivalent to a ‘domestic company’ as defined under section 2(22A) of the Act and contended that higher rate of tax (50 percent) prescribed for non-resident companies and also surcharge will not be applicable in its case. However, the AO contended that non-resident company has to pay taxes at the rate provided in the Finance Act. Accordingly, the AO held that the taxpayer was liable to pay tax at higher rate. Commissioner of Income-tax (Appeals) observed that there was no limitation to non­discriminatory provision of the tax treaty and once it prevailed in a conflict situation, lower rate of 40 percent will apply and not the higher rate of 50 percent.

Taxpayer’s contentions

After referring article 24 ‘Non Discrimination’ of the tax treaty the taxpayer claimed that its status was equivalent to ‘domestic company’ as defined in section 2(22A) of the Act and therefore, it was liable to pay tax at the rate of 40 percent and not at the rate of 50 percent. Further, surcharge applicable to other ‘non-resident’ companies will not apply in its case.

Tax department’s contentions

The tax department relied on the decision of the Authority for Advance Rulings in the case of Societe Generate wherein it was held that a non-domestic company has to pay taxes at the given rate in the Finance Act. Accordingly, the taxpayer was liable to pay tax at the rate of 50 percent.

Tribunal’s ruling

• • The Tribunal observed that earlier there were certain decisions in favour of the taxpayer wherein it was held that since the provisions regarding levy of higher taxation of the Act was less favourable to the foreign companies which is against the provision of the tax treaty, provisions of the tax treaty would override to the normal provisions of the Act and hence foreign companies would be chargeable at the rates prescribed for domestic companies. However, Finance Act 2001 inserted an explanation 1 to section 90 of the Act with retrospective effect from 1 April 19622 to end this controversy.

Note:-  The explanation states that the charge of tax in respect of a foreign company at a rate higher that the rate at which a domestic company is chargeable, shall not be regarded as less favourable charge or levy of tax in respect of such foreign company.

• • The Tribunal further observed that a similar view was taken by the Mumbai Tribunal in the case of Chohung Bank v. DDIT [2006] 102 ITD 45 (Mum) where the Mumbai Tribunal held that the higher rate of tax charged was not affected by the non-discrimination clause incorporated in the tax treaty since the domestic and foreign banking companies did not function under similar circumstances.

  • The Tribunal held that tax rates prescribed in the Finance Act has to be applied even if a taxpayer foreign company is covered by the provisions of the tax treaty. Accordingly, the taxpayer was liable to pay tax at the higher rate of tax.

  • Further, the Tribunal on the issue of disallowance of expenditure under section 37(2) of the Act observed that as per article 7 of the tax treaty expenditure is to be allowed on the basis whether the same is incurred for the purposes of business of the PE and no restriction provided in the Act can be imposed. Accordingly, the Tribunal held that since the expenditure incurred by the taxpayer was in relation to the PE in India and therefore, as per article 7 of the tax treaty disallowance cannot be made as per the restrictions provided under the Act.

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Rolls Royce Singapore Pvt Ltd vs. ADIT (Delhi High Court) --

It is critical to examine if the agent has carried out work wholly or almost wholly for the other enterprise, to determine if he is an independent agent under the India- Singapore Double Taxation Avoidance Agreement (DTAA). The attribution of profit to the Permanent Establishment (PE) needs to be done on the basis of a Transfer Pricing Analysis.

Attribution of profit to a fixed place PE is based on the functional and factual analysis. Hence, if the assessee does not bring out such analysis in detail, he would be burdened with the approximate view of the appellate authorities.

Rolls Royce Singapore Pvt Ltd vs. ADIT (Delhi High Court) -

It is critical to examine if the agent has carried out work wholly or almost wholly for the other enterprise, to determine if he is an independent agent under the India- Singapore Double Taxation Avoidance Agreement (DTAA). The attribution of profit to the Permanent Establishment (PE) needs to be done on the basis of a Transfer Pricing Analysis.

Attribution of profit to a fixed place PE is based on the functional and factual analysis. Hence, if the assessee does not bring out such analysis in detail, he would be burdened with the approximate view of the appellate authorities.

REPORTABLE

                    IN THE HIGH COURT OF DELHI AT NEW DELHI

ITA1278/2010,ITA1280/2010

ITA1281/2010,ITA1282/2010

ITA1284/2010,ITA249/2011

ITA250/2011,ITA251/2011

ITA252/2011,ITA253/2011

ITA254/2011,ITA255/2011

ITA256/2011,ITA257/2011

ITA258/2011,ITA259/2011

ITA260/2011

Judgment Reserved On: 19.7.2011

Judgment Delivered On: 30.8.2011

1.     ITA1278/2010

Rolls Royce Singapore Pvt. Ltd.Vs. Assistant Director of Income Tax

2. ITA1280/2010

Rolls Royce Singapore Pvt. Ltd.Vs. Assistant Director Of Income Tax  

3. ITA1281/2010

Rolls Royce Singapore Pvt. Ltd. Vs.  Assistant Director Of Income Tax

4.   ITA1282/2010

Rolls Royce Singapore Pvt. Ltd. Vs. Assistant Director Of Income Tax

5.  ITA1284/2010

Rolls Royce Singapore Pvt. Ltd.Vs. Assistant Director Of Income Tax

6. ITA249/2011

Assistant Director Of Income Tax Vs. Rolls Royce Singapore Pvt. Ltd.

7. ITA250/2011

Assistant Director Of Income Tax Vs. Rolls Royce Singapore Pvt. Ltd. 

8. ITA251/2011

Assistant Director Of Income Tax Vs.  Rolls Royce Singapore Pvt. Ltd. \=

9. ITA252/2011

Assistant Director Of Income Tax Vs. Rolls Royce Singapore Pvt. Ltd.    

10. ITA253/2011

Assistant Director Of Income TaxVs. Rolls Royce Singapore Pvt. Ltd.   .

11. ITA254/2011

Assistant Director Of Income Tax Vs. Rolls Royce Singapore Pvt. Ltd.  .

12. ITA255/2011

Assistant Director Of Income Tax Vs. Rolls Royce Singapore Pvt. Ltd. 

13. ITA256/2011

Assistant Director Of Income Tax Vs.  Rolls Royce Singapore Pvt. Ltd.

14. ITA257/2011

Assistant Director Of Income Tax Vs.  Rolls Royce Singapore Pvt. Ltd.

15. ITA258/2011

Assistant Director Of Income Tax    Vs.  Rolls Royce Singapore Pvt. Ltd.

16. ITA259/2011

Assistant Director Of Income Tax   Vs. Rolls Royce Singapore Pvt. Ltd.

17. ITA260/2011

Assistant Director Of Income Tax  Vs. Rolls Royce Singapore Pvt. Ltd.

A.K. SIKRI, J.

1. These 17 appeals arise out of the common order dated 19th March, 2010 passed by the Income-Tax appellate Tribunal (hereinafter referred to as the ITAT), 5 appeals are filed by the assessee and 12 appeals are filed by the Revenue. Particulars of the five appeals of the assessee are as under:-

These appeals pertain to the assessment year 2000-01 to 2004-05.

2. Before coming to the respective grievances of the Assessee and the Revenue, we would like to trace the genesis of the dispute and the nature of impugned order passed by the Tribunal as narration thereof would make it easier to understand the grounds on which the impugned orders are challenged by both the parties.

3. The assessee viz Rolls Royce Singapore Ltd. (hereinafter referred to as the „Singapore Company‟) is a company incorporated under the laws of Singapore. The principal activities of the Singapore Company are sale of spares parts for oil field equipment and engines and turbine compressor systems and electronic retrofit projects and services rendered in connection with repair and overhauling of such equipment. The Singapore Company is a non-resident for the tax under the provisions of Income-Tax Act, 1961.

4. The Singapore Company rendered repair and maintenance services and supply spares to customer in India in the Oil and Gas industry. The major clients of the Singapore Company in India include public sector undertakings like ONGC, Gail etc. The largest customer of the Singapore Company in India is ONGC. As per the standard practice adopted by ONGC, before making remittance to foreign suppliers/service provides, ONGC used to obtain a certificate from the tax authorities at Dehradun to apply the appropriate withholding rate and thereafter obtained a „No Objection Certificate‟, on the basis of which remittance is made outside India. This practice continued for some time.

5. The assessee filed its return of income for the assessment years 2001-02, 2002-03 and 2003-04 on 31st December, 2003 voluntarily with the Assistant Director of Income Tax, Circle 2 (1), International Taxation, New Delhi. Likewise, for the assessment year 2004-05, the Singapore Company filed return on 14th September, 2004.

6. For all these years in the voluntary Income Tax Return filed by the Singapore Company, it had disclosed Fees for Technical Services (hereinafter referred to as the FTS) income. The returns were processed by issuing notice under Section 143 (2) of the Income-Tax Act (hereinafter referred to as „the Act‟) and ultimately different assessment orders were passed making various additions. Summary of the returns filed and income assessed by the Assessing Officer for these years is as under:

7. As is clear from the above, the Singapore Company filed voluntary return for the first time starting from assessment year 2001-02. According to the Assessing officer, return for the previous years namely assessment years, 1998-99,1999-2000, 2000-01 should also have been filed. Notices under Section 148 of the Act for all these three years were accordingly issued pursuant to which the Singapore Company filed its return declaring „Nil‟ income for assessment year 1998-99 and 1999-2000. In respect of assessment year 2000-01, return was filed declaring an income of Rs. 280,00,213/-, the Assessing Officer had assessed the income for these years. However, the contention of the Singapore Company was that since it had acquired the energy business from M/s Cameroon Energies Private Limited only in the financial year 1999-2000 (corresponding to assessment year 2000-01), no income was earned by it in the assessment year 1998-99 and 1999-2000. Though, the Assessing Officer did not accept this plea and made the assessment, the CIT (A) granted the relief agreeing with the contention of the Singapore Company and his order has been affirmed by the ITAT as well. Insofar as assessment year 2000-01 is concerned, against the declared income of Rs.         28,00,120/-, the Assessing Officer made addition of Rs. 5,135,140/- towards business income and accepting the FTS income as declared by the Singapore Company.

8. With this, we revert back to the assessment years 2000-01 to 2004- 05 which are the subject matter of appeals filed by the Singapore Company. It can be seen from the returns filed by the Company that during this period, the Singapore Company has been offering its service fee income on cash basis as “Fees for Technical Services” under Section 9 (1) (vii) read with Section 115A of the Act, Section 43 (2) and Section 145 of the Act. According to the Company, the income from supplies is not taxable in India on the ground that it does not have any Permanent Establishment in India. This plea was not accepted by the Assessing Officer who held that the Singapore Company had Permanent Establishment (PE) in India and for this purpose income from supplies made by the company is taxed in India as business income. The Assessing Officer while making additions on this account in respect of these assessment years had returned the following findings:

(i)  The appellant has a business connection/PE in India.

(ii) The supplies and services are intricately and inextricably linked with each other.

(iii) The AO taxed business profits from supplies by attributing 100% of the profit (and 75% of the profits in AY 2004-05) to the Business connection/PE by applying profit earned by M/s Rolls Royce Plc, an entity incorporated in the UK. However, he accepted the position taken by the appellant that service fees shall be subject to tax at the rate of 20% plus surcharge and cess even though he alleged that services and supplies are inter-related and they are effectively connected with the business connection/PE.

It would also been seen that the Assessing Officer did not accept the income from FTS as declared by the assessee and made additions thereto. The reason, according to the Assessing Officer, was that the Singapore Company was liable to pay tax from its income from services and supplies on accrual basis.

9. The Singapore Company filed separate appeals for these years which were disposed of by the CIT (A) vide consolidated orders dated 19th April, 2008. Vide this order, the CIT (A) granted partial relief to the Singapore Company in the following manner:-

a) profits should be attributed to PE in India, for the assessment years 2000-01 and 2001-02, at 10% of net profit, and for 2002-03, 2003-04 and 2004-05 at 25%.

b) No income is chargeable to tax in the hands of the company during the assessment years 1998-99 and 1999-2000 since it did not earn any income during these periods.

Against the above consolidated order of the Ld. CIT (A), the appellant filed the appeals before the Tribunal. The revenue has also filed appeals against the Ld. CIT (A)‟s order in reducing the rate of profit attributable to PE in India in A.Y. 2000-1 to 2004-05.

10. In the appeals filed by the assessee before the Tribunal, the first issue before the Tribunal was as to whether FTS was taxable on accrual basis or on cash basis. The Singapore Company had offered the income „receipt or cash basis‟ on the ground that this was the method of accounting followed by it. The Assessing Officer had not accepted the same in respect of assessment year 1998-99 and 1999-2000 holding that the method of accounting of Singapore Company should have been mercantile basis as per the Income Tax Law and the income of the company was accordingly re-casted. Insofar as assessment year 2002- 03 and 2004-05 are concerned, the Singapore Company had declared the receipts from Indian companies as FTS and subject it to tax under Section 115 A of the Act. Again, the Assessing Officer held that the Singapore Company was supposed to maintain the accounts on accrual or mercantile basis. This view of the Assessing Officer was affirmed by the CIT (A) and the ITAT has also upheld the same in the impugned order. We may add at this stage itself that this issue does not arise in the present appeals as the decision of the ITAT in this aspect has been accepted by the Singapore Company.

11. The second issue taken up by the ITAT pertained to the validity of Assessing officer‟s action in initiating the proceedings under Section 147 of the Act in respect of assessment year 1998-99 to 2001-02. We have already pointed out above that in respect of these three years, the assessee /Singapore Company had not filed any return and the returns were filed after the notices under Section 148 of the Act were issued. The CIT (A) held that reopening of the assessment by invoking the provisions of Section 147 of the Act was valid which is upheld by the ITAT also. Again, this is not the subject matter of the present appeals.

12. The bone of contention in the appeals filed by the Singapore Company are the findings returned by the ITAT on the questions as to whether the Singapore Company had no business connection or Permanent Establishment in India insofar as its business activity of supplying the goods or spare parts to Indian customers is concerned. As already indicated in brief above, the Assessing Officer had held that the assessee is having PE in India and, therefore, the income earned by it from supplying the goods or spare parts to Indian customers was taxable in India. This view has been upheld by the CIT (A) as well as the ITAT. We may now proceed to give some details for forming such a view.

13.  As pointed out above, though in the income tax return filed by the Singapore Company it had shown income from maintenance services as Fee for Technical Services (FTS) and paid tax @ 20% thereupon as per the provisions of the Income Tax Act, it had not declared any income for supply of equipments made to the Indian clients on the ground that it had no PE in India and, therefore, its business income from supply of spare parts is not chargeable to tax in India.

14. The AO, on the other hand, was of the view that it was the responsibility of the assessee company flowing from the supply of original equipment supplied by the other companies belonging to Rolls Royce Group, to supply spare parts to the Indian clients, whom the equipments were supplied by the other companies of Rolls Royce Group. In other words, the AO had taken a view that since the assessee company was discharging the contractual obligation of the supplier of the original equipment, providing maintenance services as well as making supply of spares by the assessee company was incidental to the supply of original equipment made by the other company of Rolls Royce Group. The AO had also taken a view that such services and spares cannot be procured by the India customer from any independent party, and it was only the assessee, who could provide such services to the Indian clients. The AO, therefore, had taken a view that the assessee company has business connection and source of income in India in terms of Section 9 (1 (i) of the Act. The A.O. has also taken a view that the assessee company has permanent establishment in India as well. The AO, therefore, held that by reason of existence of business connection and source of income and permanent establishment in India, the assessee is liable to pay tax in respect of income earned on supply of spares as business profit. It was further observed by the AO that assessee has an executive agent in India in the form of ANR, whose only source of income in India is from the assessee, and M/s ANR was responsible to the assessee and was not doing any activities other than what were directed by the assessee. The AO, therefore, had taken a view that the assessee has a business connection or PE in India in the form of ANR.

15. The AO further stated that the income of the assessee from maintenance services accrues or arise in India by deploying engineers and personnel for undertaking maintenance of the equipment at the sites of the Indian clients located in India, and the maintenance activities cannot be isolated from the supply of spares. He further observed that supply of spares and services or maintenance of the equipments are inextricably linked to each other as the service engineers would certainly required spares parts to be replaced or overhauled.

16. The AO further stated that the assessee company has placed one Mr. Venketaramana as Exclusive Regional Sales Manager in India and, thus, income of the assessee from supply of spares accrue or arise in India from the activities of its Sales manager as well.

17. The CIT (A) agreed with the A.O‟s view. In the light of various points raised by the A.O. the CIT (A) held that the assessee company has a PE in India on following counts:-

(i)             That the assessee has a source of income in India;

(ii)           That the assessee has established a complete set up of facility for providing services to the customers, during the whole year; and those services and facilities were provided in respect of the original equipment supplied by    some other who are related/associated concern of the assessee for a period of more than 30 days.

(iii)          That office of the ANR was used for receiving and soliciting orders;

(iv)         M/s ANR is a dependent agent permanent establishment of assessee.

18. In other words, the CIT (A) took a view that the Singapore company has a permanent establishment in India within the meaning of Article 5 (1), 5(2) (f), 5 (2) (i), 5 (5), 5(6) and 5(8) of the DTAA.

19. In the appeals filed by the Singapore Company against the aforesaid findings of the CIT (A), it was submitted that ANR Associates private Ltd. (ANR) was an independent entity and was not related to the Singapore Company at all; ANR had various other clients from where it was earning the revenue and the appellant was the sole customer; ANR did not have the power to negotiate and conclude the contracts on behalf of the Singapore Company and the transactions between the ANR and the Singapore Company were on principal to principal basis. Therefore, ANR could not be treated as an independent agent, or Permanent Establishment of the Singapore Company. In any case, even if ANR presumed to be the PE of the Singapore Company, fee of US $ 40,000/- per annum paid by the Singapore Company to ANR       was Arms Length Price (ALP). The said fee was already taxed at the hands of the ANR and, therefore, having regard to the provisions of the Double Taxation Avoidance Agreement (DTAA), there was no question of taxing any income at the hands of the Singapore Company in respect of supplies made by it to Indian customers.

20. We would like to point out at this stage that on multiple grounds, the Assessing Officer and the CIT (A) had held that the Singapore Company had PE in India. Many of these grounds have not been accepted by the Tribunal. It has given detailed reasons for knocking out the various basis adopted by the Assessing Officer for forming the opinion that the assessee had PE in India. For example, the ITAT has not accepted that merely because the Singapore Company is a part of a Group Company of Rolls Royce which has world vide operation, because of other operations of the Group Companies, the Singapore Company shall be deemed to have PE in India. According to ITAT the Singapore Company, like each company belonging to Rolls Royce Group is a separate entity and a separate tax assessee. Likewise, merely because some income has accrued to the Singapore Company in India from deployment of Engineers and personnel in undertaking  the maintenance  and service of equipments at the sites of Indian clients located in India is not ground to hold that it has PE in India. In the absence of any material showing and indicating that the contract for providing service and supplying spare parts are inter-connected and related. Similarly, findings of the Assessing Officer that Singapore Company shall be deemed to have Permanent Establishment in India to carry on the business through PE as it has been providing service facility in India for a period of 183 days in a fiscal year to ONGC and GAIL in connection with their activity of exploration, exploitation or extraction of material oil in India has been upset and turned down by the Tribunal holding that no material has been brought on record to prove and establish the same.

21. In fact, the only reason given by the Assessing Officer, accepted by the CIT (A) and affirmed by the ITAT for holding that the Singapore Company has PE in India is premised on the relationship between the Singapore Company with ANR, which makes the ANR as the PE of Singapore Company within the meaning of Article 5 (1) and 5 (2) of DTAA between India and the Singapore, is that the said ANR is a dependent agent of the Singapore Company within the meaning of Article 5 (8) read with Article 8 and 9 of DTAA.

22. We would like to point out here that the Assessing Officer as well as the CIT (A) had inter alia, held that the activities of ANR are much more than those provided for in the contract entered into between the Singapore Company and ANR. The Assessing Officer had recorded in its order that the Singapore Company had paid the commission of 5% of the contract value to ANR over and above, the US$ 40,000/- per annum payable under the written contract made with ANR. This finding has not been accepted by the ITAT. It concluded that the Singapore Company paid commission @ 5% of sales value to ANR before the written agreement was entered into on and from 1.1.2002. From the date of agreement, instead of paying commission @ 5% of the total invoice value, a lump-sum commission of US$ 40,000/- was paid to ANR. There was no evidence to hold that in addition to this US$ 40,000/- the Singapore Company was paying commission @ 5% on sale as well and claim of the Revenue that activities of ANR are much more than what is provided for in the agreement has also held to be wrong and was rejected.

23. After holding so, the Tribunal proceeded to discuss the question as to whether in the light of nature of activities carried out by the ANR as per the agreement, the Singapore Company can be said to have a PE in India in the form of ANR. The Tribunal after extracting the terms of the  agreement as to the nature of the services to be provided by ANR to the Singapore Company and terms relating to “Limitation and Restrictions”, “Representations and warranties of ANR”, “Confidentiality” etc. in the light of provisions of DTAA held that relationship between the Singapore Company and ANR was not on principal to principal basis. Instead, the ANR acted as a dependent agent of Singapore Company and its activities were controlled by the Singapore Company. The ANR was, therefore, could not be regarded as an agent of an independent status within the meaning of Article 5 (9) of DTAA. For arriving at this conclusion, the Tribunal has, inter alia, recorded the following findings:-

(1) Activity of ANR Associates during the period from 1.1.2002 was more or less similar what has been stipulated in the written agreement dated 1.1.2002, except the amount and basis of payment of commission/ remuneration to ANR.

(2) The purpose of entering into agreement or understanding that ANR was the replacement of Singapore Company to have certain in-country support services in relation to the promotion and supporting its project in India. ANR was chosen since it has the infrastructure in India to provide such services.

(3) ANR was to provide services in relation to promoting and supporting the sale of „projects‟ in India. The expression „products‟ has been deleted in the Schedule A to the agreement which has two sections. Section-I is with regard to new unit products used by oil and gas industries and Section-2 is with regard to the customers service products under oil and gas industry.

(4) Clause 8.2 of the Agreement imposed certain limitations and restrictions upon ANR with stipulation that it shall Act exclusively for the  assessee in relation to the promotion of its product and shall not directly or indirectly assist any other person, the firm or company competing with the assessee or shall not advice or represent  or be concerned with or interested in the business of any such person, firm or any company in India.

24. Thus, ANR was prohibited from promoting identical products of any such person, firm or company competing with the firm of assessee. These unusual restrictions imposed upon the ANR would suggest that ANR never intended to work as an independent agent in its ordinary course of business. Reading the agreement as a whole would suggest that ANR was a Singapore Company exclusively in respect of nature of products mention in Schedule A of the agreement. Thus, this would suggest that ANR was not acting in the independent status and in the ordinary course of their business while rendering to the assessee in-country support services of the nature described in condition 3 of the agreement in relation to promote and supporting the sale of products in India.

25. As per Clause 5 of the agreement, ANR was supposed to take instructions and advice from, and make the services available to the Singapore Company through Mr. Sudhir Mayor for the products identified in Section 1 of Schedule-A and Mr. Dave Klug for products identified in Section-2 of Schedule A or other nominees. Agreement also provided that Mr. Robert Turner will only liaison on behalf of the Singapore Company.

26. Thus, the ANR‟s activities was subject to close supervision of the Singapore Company as it was to report to take instructions and advice from and make the services available to Singapore Company through Mr. Sudhir, Mr. Dave and Mr.Robert Turner. Consequently, ANR has to perform its services under the exclusive control and detail instructions of the Singapore Company which goes to suggest lack of legal independents on the part of ANR.

27. According to the ITAT, the ANR was the sole agent of the Singapore Company and it was “almost wholly” earning from Singapore Company. Likewise, the Singapore Company was the client of ANR. This conclusion was drawn from the circumstances that though it was stated that the ANR was providing services to other companies and was earning commission from them, the extent of service rendered by ANR and the amount of commission had not been disclosed. Only a certificate was given by ANR by rendering services and earnings commission from other companies which were not sufficient to prove and establish that ANR was not getting “almost wholly” on behalf of the Singapore Company. The effect and difficulties about the services rendered and commission earned from other companies was within the knowledge of the ANR but the Singapore Company has chosen not to collect this information and given to the authorities, therefore, adverse inference was to be necessarily drawn when Singapore Company has failed to furnish any such documents as requested by the Assessing Officer.

28. Even the commission of US$ 40,000 per annum paid by the Singapore Company to ANR was not at arm‟s length payable to the agent had not termed with reference to the value of foreign products sold in the relevant year. Prior to 1.1.2002, commission was being paid @ 5% of invoice value, which had now been changed to lump-sum amount of US$ 40,000/- payable annually. This sort fixation of remuneration is usually not done between two independent parties in any uncontrolled transaction. The remuneration payable, therefore, seems to be in the nature of transaction controlled by the Singapore Company and cannot be considered to be made on arm‟s length. More so, when Singapore Company had not furnished any instance of transaction entered into between the two independent parties in uncontrolled manner in support of its contention that remuneration of lump-sum amount of US$ 40,000/- was determined at arm‟s length.

29. On the basis of the aforesaid findings the ITAT has summarised the activities of ANR in connection with the Singapore Company as under:

“(i) That ANR is maintaining premises in India to carry out its obligation as an agent of the assessee company.

(ii)           ANR exclusively or almost wholly carries out the business on behalf of the assessee at their premises in India.

(iii)          The activities of ANHR includes promotion of products of the assessee, maintaining relationship with customers and potential customers of the assessee with regard to their equipments need.

(iv)         Making liaison with operators of equipments, which has been sold to oil and gas industry.

(v)           Making customers aware of suitable products sold by the assessee company.

(vi)         Arrangements of sales presentation and demonstration for assessee‟s customers.

(vii)        Assisting assessee in creating technical and commercial environment about its products required in oil and gas industry in India.

(viii)   Providing logistic services to the assessee.

All these activities    have been provided by ANR to the assessee in India from its fixed place of business maintained in India. This makes it clear that ANR or its offices are used by the assessee company for soliciting order by performing the activities or services mentioned in para 3 and 4 of the agreement. It also makes it clear that ANR is acting almost exclusively for assessee in relation to promotion of assessee‟s products in India.

Therefore, in the light of the aforesaid factors discussed and pointed out by us, that is, (i) that ANR was not acting in its ordinary course of business while acting for the assessee to provide services as per agreement dated 01.01.2002, and (ii) an extensive control was being exercised by the assessee upon, ANR who was bound to take instructions and advice from the assessee or its representative and (iii) that assessee has been rendering services almost wholly for the assessee, and (iv) and the transaction between them is not at Arm‟s length,         we hold that ANR is not an independent agent within the meaning of para (9) of the Article 5   of DTAA between India and Singapore.”

30. On this basis, the ITAT concluded that Singapore Company had Permanent Establishment in India within the meaning of Article 5 (1) of DTAA through its dependent agent ANR. The Tribunal has also held that even in terms of Article 5 (8), Article 5 (9) of the DTAA, ANR would be deemed to be the “Permanent Establishment” in India. This position is discussed in para 98 of the impugned order which reads as under:

“In the instant case, it is an admitted position that clause (a) and (b) of para (8) of Article 5 does not apply inasmuch as there is no material or evidence brought on record to show and establish that the ANR habitually exercised an authority to conclude contracts on behalf of the assessee company in India or ANR habitually maintained in India a stock of goods or merchandise from which it regularly delivers goods or merchandise on behalf of the assessee company. However, having regard to the fact that ANR has been rendering services to negotiate and secured orders in India since long it can be said that ANR associates habitually secured orders in            India wholly or almost wholly for the assessee company. This would be established from the very fact that prior to 01.01.2002, the assessee used to get commission at the rate of 5% of invoice value and that commission was deducted by ONGC from invoice value payable to assessee company and then paid to ANR. In other words, a role played by ANR in securing orders from ONGC on a consideration of % of invoice value was even recognized by the assessee‟s customer, namely, ONGC. The payment of 5% of commission of sale value is substantial amount having regard to the over all net profit of about 12 to 14% earned by the assessee from supply of spares. The agent ANR had a relation or connection with ONGC with regard to contract of supply of spares by assessee company is well established from the fact that even the commission payable to ANR was directly deducted by ONGC from sale value and then paid to ANR. Further, the very fact that remuneration for the services by ANR to assessee company in any year has been fixed at an fixed fee of US$ 40000 from 01.01.2002 also suggest that ANR was dependent agent as he agree to remuneration at a fix amount of US$ 40000 as against earlier arrangement of payment of specific percentage of sale value of items or products sold by assessee company to Indian clients. The nature of overall services rendered by ANR to assessee company as described in clause 3, 4, and 5 read with clause 8,9 and 10 relating to limitations and restrictions, representations             and warrantees of ANR and confidentiality would show that ANR was instrumental in securing orders           in India for the assessee company and was acting at the instructions of assessee company. Therefore, ANR shall be deemed to be agency PE in India within the meaning of para (8) and (9) of Article 5 of the Treaty.”

31. After giving the aforesaid findings, the Tribunal proceeded to determine the income that would be chargeable to tax in the hands of Singapore Company in India from the business activity of the sale of spare parts in view of Article 7 of the DTAA which provides that “so much of the profit as is attributable to PE in India can be taxed in India”. As lump-sum commission of US$ 40,000 was not treated at arm‟s length, the Tribunal went into the issue of percentage of the income and arrived at a conclusion that the amount of profit attributable to PE at 10%, as determined by CIT (A) would be proper as against the Assessing Officer‟s view that it should be 25%. As a result, the order of the CIT (A) on this aspect has been sustained and appeals filed by the Revenue for increase of the profits from 10% to 25% have been dismissed.

32. In the appeals filed by the Singapore Company, the appellant has confined its and challenge to the findings of the ITAT that ANR is a Permanent Establishment of Singapore Company in India as per Article 5 (9) of the DTAA between India and Singapore.

33.In the alternative, it is also argued that order of the Tribunal is also

questioned where it is held that the lump-sum commission of US$ 40,000 per annum is not at arm‟s length and fixing 10% of the profits on sales of the spare parts made in India by the Singapore Company is to be carried out by ANR in India and chargeable to tax in India. 34.

34. These appeals were admitted on as many as seven substantial questions of law reproduced below:-

“a. Whether in the facts and circumstances of the case, the ITAT grossly erred in holding that the appellant has a business connection in India?

b. Whether in the facts and circumstances of the case, the ITAT grossly erred in holding that the Appellant has a Permanent Establishment in India as per Article 5 of the DTAA between India and Singapore?

c. Whether in the facts and circumstances of the case, the ITAT grossly erred in holding that the appellant partly carried on a business in India through the premises of ANR under Article 5 (1) of the DTAA between India and Singapore?

d. Whether in the facts and circumstances of the case, the ITAT grossly erred in holding that the appellant should be regarded as having a permanent establishment by way of premises used as a sales outlet or for soliciting and receiving orders in India under Article 5 (2) (i) of the DTAA between India and Singapore?

e. Whether in the facts and circumstances of the case, the ITAT grossly erred in holding that ANR should be regarded as a Dependent Agent Permanent Establishment of the Appellant under the Article 5 (8) of the DTAA between India and Singapore on the premise that ANR habitually secures orders wholly and mainly on behalf of the appellant?

f. Whether in the facts and circumstances of the case, the ITAT grossly erred in concluding that ANR has not been compensated at arm‟s length price, without adequate basis to arrive at such a conclusion?

g. Whether in the facts and circumstances of the case, the ITAT grossly erred in holding that 10 percent of the profits on sales of spare parts made in India by the Appellant should be attributable to the activities carried out by ANR in India and should be chargeable to tax in India under the Act?.”

35. However, focus of learned counsel for the appellant remained on the aforesaid two aspects viz question of law at „e‟ and „f‟.Infact, Mr. Ganesh, learned Senior Counsel appearing for the appellant submitted that the issue of arm‟s length price be decided first because of the reason that if it is held that the payment of aforesaid commission to the ANR was at arm‟s length, the issue as to whether the Singapore Company acted through ANR as its PE in India or not would be rendered academic. He thus, opened his arguments on the alternate issue of ALP and in fact entire emphasis of Mr. Ganesh was to convince this Court that the commission payable was at ALP.

36. In view of the aforesaid approach of the learned counsel for the appellant limiting scope of its challenge to the ITAT order, we proceed on the basis that the assessee has business connection in India through ANR. It is also an admitted fact that ANR is an agent of the assessee India. In these circumstances, we answer questions of law no. „a‟ to „d‟ in favour of the Revenue and against the assessee.

37. In this backdrop, the only two issues that need to be decided are:-

(i)         Status of ANR – Whether dependent agent within the meaning of Article 5 (8) of DTAA.

(ii)        The payment of US$ 40,000 per annum made by the assessee to the ANR can be treated as ALP.

38. On this, questions of law „e‟ and „f‟ are formulated. If answer to any of these questions is in favour of the assessee, then no further discussion is needed.     However, if these questions are decided against the assessee then the last question would be as to whether 10% of the profits of sales on spare parts made in India held as exigible to tax by the ITAT is wrong. We may again point out here that the Assessing Officer had attributed 25% of profits on sales of spare parts to the activities carried out by the ANR as chargeable to tax which was reduced to 10% by the CIT (A). The Revenue has also filed appeals challenging this part of the order of the Tribunal as Revenue claims that order of the Assessing Officer fixing 25% profits on sales on spare parts was proper and valid. Therefore, while discussing the question of law no. „g‟,appeals of the Revenue shall also be taken into consideration.

Question of Law-„e‟

“Whether in the facts and circumstances of the case, the ITAT grossly erred in holding that ANR should be regarded as a Dependent Agent Permanent Establishment of the Appellant under the Article 5 (8) of the DTAA between India and Singapore on the premise that ANR habitually secures orders wholly and mainly on behalf of the appellant?

39. This question becomes relevant having regard to the provisions of Article 5 of the DTAA between India and Singapore, the relevant provisions of this Article is as under:-

ARTICLE 5 – Permanent Establishment

1. For the purpose of this Agreement, the term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on.

2. The term “permanent establishment” includes especially:-

(a)……

(b)……

(c)……

(d)……

(e)……

(f)…….

(g)……

(h)……

(i) A premises used as a sales outlet or for soliciting and receiving orders;

(j)…

3….

4….

5

6….

7

8.      Notwithstanding the provisions of paragraph

1 and 2 , where a person – other than an agent of an independent status to whom paragraph 9 applies – is acting in a Contracting State on behalf of an enterprise of the other Contracting State, that enterprise shall be deemed to have a permanent establishment in the first-mentioned State, if-

(a) he has and habitually exercises in that State an authority to conclude contracts on behalf of the enterprise, unless his activities are limited to the purchase of goods or merchandise for the enterprise;

(b)     he has no such authority but habitually maintains in the first-mentioned State a Stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the enterprise; or

(c)     he habitually secures orders in the first-mentioned State, wholly or almost wholly for the enterprise itself or for the enterprise and other enterprise controlling, controlled by, or subject to the same common control, as that enterprise,

9. 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, provided that such persons are acting in the ordinary course of their business. However, when the activities of such an agent are devoted wholly or almost wholly on behalf of that enterprise itself or on behalf of that enterprise and other enterprises controlling, controlled by, or subject to the same common control, as that enterprise, he will not be considered an agent of an independent status within the meaning of this paragraph.

40. The endeavour of the assessee is to demonstrate that ANR is an agent of an independent status and, therefore, paragraph-8 of this Article have no application. Additionally, it was also argued that ANR had not undertaken any of the activities specified in said paras 8 (a) to (c) of para 8 of Article 5 and for this reason also, this para have no application. It was further argued that the activities of ANR as an agent were not devoted wholly or almost wholly on behalf of the assessee and thus conditions stipulated in para 9 of Article 5 are not fulfilled and on this reckoning also ANR would not be considered as an agent of independent status within the meaning of said para.

41. We have already taken note of the reasons which are given by the Tribunal in support of its findings that provisions of para 8 & 9 of Article 5 stand attracted in the instant case.

42. His submission was that the Tribunal had given two reasons for drawing the conclusion which were totally immaterial having regarding to the provisions of Article 5 (9). In this behalf, he referred to the following discussion in the Tribunal‟s order containing these reasons:

(1) The Tribunal had held that ANR was prohibited from taking competitive products. In the agreement, certain limitation and restriction has also been imposed upon ANR vide condition 8.2 that ANR associates shall act exclusively for assessee in relation to the promotion of its product and shall not directly or indirectly assist any other person, the firm or company competing with assessee or shall not advice or represent or be concerned with or interested in the business of any such person, firm or company in India. In other words, in respect of the products mentioned in Section 1 and 2 of Schedule-A, ANR was restricted to assist directly or indirectly any other person, firm or company competing with the assessee or directly or indirectly advice or represent or be concerned with or interested in the business of any other person, firm or company in India competing with assessee. It is, thus, clear that ANR was prohibiting from promoting the identical products of any other person, firm, or company competing with assessee.                This unusual restriction imposed upon ANR would suggest that ANR never intended to act as an independent agent in the ordinary course of its business. Reading the agreement as a whole would suggest that ANR has been rendering services to assessee company exclusively in respect of the nature of the products mentioned in Schedule A of the agreement, and has been restrained or prohibited from assisting, advising or representing any other person, firm or company competing with the assessee in the same line of business. This short of restriction and limitation imposed upon ANR associates would suggest that ANR associates was not acting in the independent status and in the ordinary course of their business while rendering to the assessee in-country support services of the nature described in condition No.3 and 4 of the agreement in relation to promote and supporting the sale of products in India, details of products being described in Schedule-A of the agreement. Therefore, on this count, ANR cannot be regarded as an agent of an independent status within the meaning of para (9) of Article 5 of DTAA between India and the Singapore. Further, para (9) of Article 5 provides that when the activities of an agent of an independent status acting in the ordinary course of his business are devoted wholly or almost wholly on behalf of the enterprise itself or on behalf of that enterprise and other enterprises controlling, controlled, by, or subject same control, as that enterprise, he will not be considered an agent of an independent status within the meaning of para (9) of Article 5 of DTAA.

(2) The Tribunal also held that the assessee exercised extensive control over ANR as for various actions, the ANR was supposed to take instructions and advise from the representatives of the assessee. The discussion of the Tribunal in this behalf is reproduced as under:-

“It is pertinent to note that Clause-5 of the agreement dated 01.01.2002 between the assessee and ANR provides that ANR shall report to, take instructions and advice from, and make the services available to the assessee through Mr. Sudhir Mayor for the products identified in section 1 of Schedule A and Mr. Dave Klug for the products identified n section 2 of Schedule A, or their nominees. Mr. Robert Turner will handle liaison on all administrative aspects of this agreement on behalf of company. The assessee may change the person or persons nominated under this clause at any time by notice in writing to ANR. Further clause 8.2 of the said agreement provides that ANR shall act exclusively for the assessee in relation to the promotion of its products and shall not directly or indirectly assist any other person,firm or company competing with the assessee company or advice or represent or be concerned with or interested I the business of any such person, firm or company in India. This clause makes it clear that ANR is prohibited and restrained from handling identical products or goods for principal. As per the condition enumerated in clause -5 of the agreement, it is clear that his activities are subject to close supervision of the assessee company as in the said clause it has been provided that ANR shall report to, take instructions and advice from, and make the services available to the assessee through Mr. Sudhir Mayor for the products identified n section 1 of Schedule A and Mr. Dave Klug for the products identified in Section 2 of Schedule A, or their nominees, and Mr. Robert Truner will handle liaison on all administrative aspects of this agreement on behalf of company. The assessee may change the person or persons nominated under this clause at any time by notice in writing to ANR. This makes it clear that ANR has to perform his services under the extensive control and detailed instructions of the assessee company, which goes to suggest a lack of legal independence on the part of the ANR. Furthermore,     the stipulations  about  representations    and warranties of ANR and confidentiality, which has already    been reproduced  above,     also indicate an extensive control exercised by the assessee company over ANR while ANR was acting for the assessee.”

43.  Mr. Ganesh, learned Senior Counsel appearing for the assessee rebutted those reasons by arguing that ANR was already an existing company and was not created by the assessee. The said ANR had its own infrastructure and its own business etc. before it entered into the agreement with the assessee. He submitted that Article 5 (9) was self-working and highly evolved provision and only those conditions mentioned therein was to be seen. According to him, the Tribunal committed fundamental error of law by giving its own reasons which were irrelevant in the context of Article 5 (9).

44. We are not impressed by that part of the submission of Mr. Ganesh where he argues that the Tribunal has taken into consideration those aspects which are not relevant for the purposes of Article 5 (9). As is clear from the extracted portion of the Tribunal‟s order, that the focus of the Tribunal was entirely on Article 5 (9) and it was discussing as to whether the activities of ANR was devoted wholly or almost wholly on behalf of the assessee and further as to whether the assessee was exercising extensive control over the ANR. These very criteria are laid down in Article 5 (9) for the purposes of determining as to whether such an agent of independent status or not.

45. It would, however, be a different question as to whether the reasons given by the Tribunal are sufficient to hold that the criteria stipulated in Article 5 (9) treating ANR as dependent agent are satisfied. Coming to this aspect, the argument of Mr. Ganesh was that merely because ANR was prohibited from taking a competitive products would not mean that it was an agent of independent status. What was to be seen was that the „activities‟ of ANR are devoted wholly or almost wholly on behalf of the assessee. According to Mr. Ganesh, ANR had many other activities and was doing business for many other parties. Agency of the assessee held by ANR was only one of those many activities. This contention of the assessee is not accepted by the Tribunal as according to the Tribunal the assessee had not stated as to the extent of services rendered by ANR to other companies as well as the amount of commission earned by ANR from them. The particulars of other clients and commission earned by ANR from them was within the knowledge of ANR but the assessee did not chose to collect the same and provide it to the Assessing Officer. The Tribunal further observed that the assessee failed to furnish all such details on requisition by the Assessing Officer. It was disputed by the learned counsel for the assessee     that there was no such requisition made and the assessee was never asked to furnish such information. The fact remains that it was the contention of the assessee that the assessee was not the sole client of ANR and that activities of ANR were not devoted wholly or almost wholly on behalf of the assessee. The assessee produced a communication dated 18th January, 2007 addressed to it by ANR conforming that ANR had rendered services and had earned commission from companies other than the assessee during the final year 2003-04 and that the assessee was not the only source of income during the year. After this letter was produced, the Assessing Officer did not ask for further information. The learned counsel for the Revenue could not show anything to the contrary or dispute the fact that the Tribunal has gone on the wrong premise that the assessee failed to furnish all such details even after requisitioned by the Assessing Officer. It could not be denied that there was no such requisition made and the assessee was never asked to furnish any such information. On this wrong premise, the Tribunal has arrived at wrong conclusion.

46. We may record here that Mr. Ganesh produced the Income-Tax Returns of M/s ANR for certain relevant years which show that ANR had been rendering services to other companies as well from where it had been earning commission and the commission earned from the assessee was not the only source of income during the year. We do not want to comment more. The question whether ANR has income from other clients as well and the extent of such income is very relevant to decide as to whether the criteria stipulated in Article 5(9) is satisfied or not. Since the Assessing Officer did not look into the matter from this angle and the ITAT also disposed of the issue deciding against the assessee on wrong premise, we are of the opinion that for this limited issue matter needs to be remanded back to the Assessing Officer. The Assessing Officer shall decide the question of applicability of Article 5 (9) as to whether the ANR was providing services t companies other than the assessee as well and had substantial income from those other companies and whether the company stipulated in Article 5 (9) namely ANR was wholly or almost wholly working on behalf of the assessee will have to be determined afresh by the Assessing Officer.

47. The assessee is permitted to file the evidence in the form of Income Tax Return or otherwise on this issue. We may, however, make it clear that onus would be on the assessee to show that ANR had been rendering services and earning commission from other companies on the basis of which it cannot be said that the ANR devoted wholly or almost wholly on behalf of the assessee. These matters are thus remanded back to the Assessing Officer for fresh adjudication.

Question of Law – „f‟

Whether in the facts and circumstances of the case, the ITAT grossly erred in concluding that ANR has not been compensated at arm‟s length price, without adequate basis to arrive at such a conclusion?

48. The submission of the assessee in this behalf is that even if the ANR is to be treated as PE of the assessee company in India as per Article 7 (2), only that income is to be treated as business profits which is reasonably attributed to the Permanent Establishment namely the profits which Permanent Establishment might be accepted to make if it were a distinct and separate enterprise. It was argued that the remuneration of US$40,000 per annum paid by the assessee to ANR could be treated as the profit on reasonable basis. It was argued that the question of ALP could arise only there was a connection between the two. Even if the ANR was PE of the assessee as that had no bearing o the fixation of the price i.e. commission agreed to between the parties. Stress was laid down to the fact that there was no way the assessee could dictate the commission to be charged by ANR. ANR was negotiating at third party in the market place and, therefore, sum of US$ 40,000 agreed to between the parties which was payable by the assessee to ANRT was at arm‟s length and could be treated as reasonable. In support of his submission, he relied upon the judgment of the Supreme Court in the case of DIT (International Taxation) Vs. Morgan Stanley and Co. Inc. (2007) 292 ITR 416 (SC) and specifically referred to paras 29,31 and 32 of the said judgment which reads as under:

“29. As regards determination of    profits attributable to a PE in India (MSAS) is concerned on the basis of arm’s length principle we have quoted Article 7(2) of the DTAA. According to the AAR where there is an international transaction under which a non­resident compensates a PE at arm’s length price, no further profits would be attributable in India. In this connection, the AAR has relied upon Circular No. 23 of 1969 issued by CBDT as well as Circular No. 5 of 2004 also issued by CBDT. This is the key question which arises for determination in these civil appeals.

31. Article 7 of the U.N. Model Convention inter alia provides that only that portion of business profits is taxable in the source country which is attributable to the PE. It specifies how such business profits should be ascertained. Under the said Article, a PE is treated as if it is an independent enterprise (profit center)  dehors the head office and which deals with the head   office at arm’s length. Therefore, its profits are determined on the basis as if it is an independent enterprise. The profits of the PE are determined on the basis of what an independent enterprise       under      similar circumstances might be expected to derive on its own. Article 7(2) of the U.N.   Model Convention advocates the arm’s  length approach for attribution of profits to a PE.

32. The object behind enactment of transfer pricing regulations is to prevent shifting of profits outside India. Under Article 7(2) not all profits of MSCO would be taxable in India but only those which have economic nexus with PE in India. A foreign enterprise is liable to be taxed in India on so much of its business profit as is attributable to the PE in India. The quantum of taxable income is to be determined in accordance with the provisions of I.T. Act. All provisions of I.T. Act are applicable, including provisions relating to depreciation, investment losses, deductible expenses, carry-forward and set-off       losses etc. However, deviations are made by DTAA in cases of royalty, interest etc. Such deviations are also made under the I.T. Act (for example: Sections 44BB, 44BBA etc.). Under the impugned ruling delivered by the AAR, remuneration to MSAS was justified by a transfer pricing analysis and, therefore, no further income could be attributed to the PE (MSAS). In other words, the said ruling equates an arm’s length analysis (ALA) with attribution of profits. It holds that once a transfer pricing analysis is undertaken; there is no further need to attribute profits to a PE. The impugned ruling is correct in principle insofar as an associated enterprise, that also constitutes a PE, has been remunerated on an arm’s length basis taking into account all the  risk-taking functions of the enterprise. In such cases nothing further would be left to be attributed to the PE. 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 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 functional and factual analysis to be undertaken in each case. Lastly, it may be added that taxing corporate on the basis of the concept of Economic Nexus   is an important feature of Attributable  Profits (profits attributable to the PE).”

49. He also referred to the judgment of the Bombay High Court in Set Sattellite (Singapore) PTE Ltd. Vs. Deputy Director if Income-Tax, International Taxation and another (2008) 307 ITR 205 (Bom) wherein the Court held that when an agent in India was taxed on the fare value of activities in India, the same could not be taxed all over again in the hands of the assessee as being income attributable to deem permanent establishment. This very Treaty between Singapore and India was interpreted in the following manner:

“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 arms length payment. The principles contained in the matter of income from international transaction on an arms 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 C.I.T. which has been accepted it is clear that the Appellant herein has paid to its P.E. on arms length principle.”

50. There is no quarrel if it is a fair price paid by the assessee to ANR for the activities of the assessee in India through its PE namely ANR and the said price i.e. US$ 40,000 per annum has already been taxed in India at the hands of ANR, then no question of taxing the assessee again would arise. However, on the facts of this case, we are of the opinion that Mr. Sabharwal, learned counsel for the Revenue rightly argued that the judgment of Supreme Court in Morgan Stanley & Co. and Bombay High Court in Set Satellite (Singapore) PTE Ltd. Vs. Deputy Director of Income-Tax, International Taxation and another (supra) would not apply to the facts of this case. In Morgan Stanley, the Supreme Court accepted the payment as reasonable and fulfilling the ALP criteria only because the remuneration paid to the agent in India was justified by a Transfer Pricing Analysis. This Transfer Prices Analysis (TPA) is to be under take4n by invoking the provisions of Section 92 of the Act. Similar was the position in Set Satellite (supra) No such exercise is done in the instant case. The entire thrust of Mr. Ganesh was that ANR was a third party and had negotiating and could not be dictated by the assessee insofar as commission paid by the assessee to ANR is concerned.      This argument may look attractive when considered in isolation.                     However, the surrounding facts and circumstances under which                  the aforesaid commission came to be fixed would negative the submission of Mr. Ganesh. The agreement in question under which aforesaid commission of US$ 40,000 per annum was fixed, was dated 1st January, 2002 made effective from that date. Prior to this agreement executed between the parties in writing, the arrangement between the assessee and ANR profit for 5% commission of invoice value by the assessee to ANR on the sales. The Tribunal thus held that this sort fixation of remuneration is usually not done between two independent parties in any uncontrolled transaction. The remuneration payable, therefore, seems to be         in the nature of transaction controlled by the Singapore Company and cannot be considered to be made on arm‟s length. More so, when Singapore Company had not furnished any instance of transaction entered into between the two independent parties in uncontrolled manner in support of its contention that remuneration of lump-sum amount of US$ 40,000/- was determined at arm‟s length.

51. From the aforesaid it is clear that the assessee could dictate the terms of the payment by altering the same and reducing it to the US$ 40,000 per annum from 5% of invoice value when assessee found that on the basis of 5% total commission payable could be much higher. This clearly leads to the inference that the assessee was in a position to dictate the terms and in the absence of any Transfer Pricing Analysis by the Transfer Pricing Officer in the instant case, it cannot be said that such commission could fit the description of “reasonable profits” within the meaning of Article 7 (2) of DTAA.

52. FAR formally takes into consideration the Functions, Assets used and Risk involved. Thus to find out whether the agent is remunerative at arm‟s length, it is necessary to take into account all the risk taking function of the multi-national enterprise. If all the risk taking functions of the enterprise have not been taken into account, there would be a need to attribute profits to the PE for those functions/risks of the dependent agent that have not been considered. In the absence of such an exercise and any material on record on these aspects, we are of the opinion that the assessee has not been able to establish that the remuneration paid to ANR was equal to arm‟s length remuneration. We are of the opinion that the Assessing Officer in his order has rightly pointed out that the Supreme Court has referred to the “functions performed only the risk assumed by the enterprise” as distinguished from the functions performed and the risk assumed by the agent (who may constitute a dependent agent PE). The Assessing Officer has also quoted Rule 10B (2) of the Income-Tax Act which provides    that uncontrolled transaction shall       be judged with

reference to following:-

(a)….

(b)    the functions performed, taking into account assets employed or to be Employed and the risk assumed, by the respective parties to the transactions;

(c)    the contractual terms (whether or not such terms are formal or in writing) of the transaction which lay down explicitly or implicitly how the responsibility, risks are benefits are to be divided between the respective parties to the transactions:

(d)….

53. No such exercise is undertaken in the present case. Further, it also needs to be highlighted that no plausible or justifiable reason is coming forthwith for changing the commission from 5% of the invoice value to US$40,000 per annum.

54. We thus, are quite in agreement with the conclusion of the Tribunal on this aspect and answer this question in the negative i.e. in favour of the Revenue and against the assessee.

Question of Law ‟g‟

“Whether in the facts and circumstances of the case, the ITAT grossly erred in holding that 10 percent of the profits on sales of spare parts made in India by the Appellant should be attributable to the activities carried out by ANR in India and should be chargeable to tax in India under the Act?.”

55. Once we hold that commission of US$40,000 per annum does not represent the ALP, it is difficult to find fault in the order of the CIT (A) as well as ITAT fixing 10% of the invoice value for the purpose of taxation, inasmuch as the test is “profits accepted to make”. The CIT (A) has pointed out in this behalf that the performance of ANR is to render support service in relation to promotion of sale and the products of the assessee in India and it has no authority negotiate, accept any order or make or vary any contract or to make any warranty or representation in terms of paragraph 8.1 of the Agreement. Therefore, the risk assumed by the ANR is limited. Even otherwise, it has not come on record that ANR has performed or assumed responsibility for anything beyond what is written in the agreement. ANR is performing the functions of promoting the sale, soliciting orders and those proceed relatable to market activity within India has to be attributable to the part played by the PE. On this account, very significant aspect noted by the two authorities below is that details of business transactions obtained from ONGC under Section 131 of the Act, in the form of various documents supplied by ONGC revealed that supplies constitute the major part of the business. Therefore, the income with respect to the supplies was to be computed in terms of Article 7 of DTAA and not under Article 12. This was the reason that the CIT (A) reduced the percentage from 25% to 10%. For this purpose, the CIT (A) referred to the judgment of Bombay Tribunal in the case of Ingersoll Rand Company Vs. ITO 4 ITD 654 (Bom.) The ITAT while agreeing with the aforesaid view of CIT (A) additionally referred to the judgment of the Supreme Court in Annamali timber Trust Co. Vs. CIT 41 ITR 781 (SC) wherein it is held that there was justification only of apportionment of 10% of assessee‟s share of profit of the trading operations carried out in India when except entering into contract in taxable territory all other operations were carried out outside taxable territory. The CIT (A), however, held the view that attribution of income at the rate of 10% will not represent adequate attribution to all activities including services being performed in India by ANR. Thus, while restricting the attribution to 10% in respect of supplies, insofar as assessment year 2002-03,2003-04 and 2004-05 are concerned, the CIT (A) maintained the attribution of income @ 25% of the profits.

56.       We are agree with the following conclusion of the ITAT:-

“The order of the CIT (A) in applying the rate of 10% of the profit attributable to PE in India is, thus, upheld, which would be applied for all the assessment years under consideration. In other words, the CIT (A)‟s order in applying the rate of 25% of the profit being allocated to PE in India in assessment years 2002-03, 2003-04 and 2004- 05 has been reduced to 10% and the AO is, therefore, directed to compute the profit accordingly.”

57. The issue is accordingly answered and, therefore, on this point, while rejecting the plea of the assessee, we also reject the appeals of the Revenue for taxing 25% of the invoice value.

58. As a result, the appeals of the assessee are partly allowed to the extent indicated while answering Question No. „e‟ referring the matters back to the Assessing Officer for the limited purpose.

59. In the appeals preferred by the Revenue only the extent of income attributable to the PE is questioned. The case of the Revenue is that it should not have been restricted as done by the CIT (A) and modified by the ITAT. The submission is that the order of the Assessing Officer be maintained.

60. Since we have upheld the order of the ITAT in its entirety including on this aspect while discussing the appeals of the assessee, as a consequence, all the appeals of the Revenue on this aspect are also dismissed.

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