Table of Contents
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1. Taxing Powers and Source of Income
The general understanding of power to tax income arising in a particular country would be that the country of source would have the right to tax the same. A nation is sovereign in respect of its territory and hence a transaction which takes place within its territory, involving use of the nation’s resources – be it place, purchasing power, consumption by the government, etc – should ideally be within the jurisdiction of the State.
In cross-border transactions there would be one or more actors who are not residents (from a tax perspective) or citizens of a State and hence the home State of residence or citizenship would also assert its right to tax the income arising to such person (individual, corporate entity, etc). In a scenario where both (or many nations) assert their right to tax the income, the person would be subject to double taxation. In order to alleviate this burden on the person, nations resolve to determine their taxing rights through bilateral instruments or the Double Taxation Avoidance Agreements (DTAAs).
An important aspect of taxation of non-resident by the source State is the link between the income earned/arising therefrom and the activity undertaken or source located in the State. Let us say, a payment is made to a non-resident through a bank in India. The payment may be in respect of goods purchased by the person in London. It would be argued that only the source of payment is in India and India cannot have any right to tax the payment. In another scenario, a subsidiary may sell goods in India which are manufactured using technology supplied by a non-resident. Two incomes may arise from this transaction – payment of royalty to the non-resident for the technology and income from sale of such products. The non-resident may further be entitled to a running royalty on the goods sold. However, would it be correct to say that the non-resident is liable to tax in India for sale of the goods also?
In CIT v. R. D. Aggarwal & Company1 the Supreme Court placed emphasis on real and intimate connection between the business carried on and the activity in the taxable territory. Thus, where the agent only assisted in inviting offers which the non-resident was not obliged to accept, there was no business connection.
“A business connection in S. 42 involves a relation between a business carried on by a non-resident which yields profits or 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 the non-resident and the activity in the taxable territories a stray or isolated transaction is normally not to be regarded as a business connection. Business connection may take several forms it may include carrying on a part of the main business or activity incidental to the main business of the non-resident through an agent or it may merely be a relation between the business of the non-resident and the activity in the taxable territories, which facilitates or assists the carrying on of that business.”
The professional relationship of a non-resident solicitor, with an Indian firm will also be a business connection. In Barendra Prosad Ray v. ITO2, the Court held that there was a connection between the Indian firm and the British solicitor which was real and intimate and not just a casual one and the fees earned by the solicitor was only through this connection, and he could not have done so without associating himself with the firm. Thus, the income earned by the solicitor was subject to tax in India, and payable by the firm as agents of the solicitor. It was opined that the context in which the expression “business connection” is used in section 9(1) clearly shows that there is no warrant for giving a restricted meaning to it by excluding “professional connections” from its scope.
Sale of capital assets located outside India and which had no connection with business operations in India would not be taxable in India due to absence of business connection. In CIT v. Quantas Airways Ltd.3 it was held that though capital gains was part of deemed income since the Parliament specifically included income
(a) through or from any property in India,
(b) through or from any asset or source of income from India and
(c) through or from sale of capital asset situate in India, sale of capital assets situated outside India would not be covered.
1.1 Source of income
The oft quoted description of source is
“Source means not a legal concept but something which a practical man would regard as a real source of income; the ascertaining of the actual source is a practical hard matter of fact.”
This is a passage from Ingram’s work on Income-tax, quoted by Mr Justice de Villiers and approved by Privy Council in Rhodesia Metals Ltd. (Liquidator) v. Commissioner of Taxes4.
In Anglo-French Textile Co. Ltd v. CIT5, the Supreme Court held that where profits were received wholly in India in respect of sales made partly in India and partly in British India, the same would be taxable in India and it cannot be said that the income arose outside India. In the instant case all the contracts in respect of the sales in British India were entered into in British India and deliveries were made and payments were received in British India even in respect of sales outside British India though agents.
The High Court of Delhi in CIT v. Havells India Ltd.6, examined the contention of the assessee that testing fees paid to an agency outside India to obtain a certification which was the requirement of the local laws so that the goods could be exported to that country was not taxable in India. The assessee argued that the source of income, namely the exports was outside India and hence, technical fee paid for earning of income outside India was not taxable in India and therefore no tax was required to be deducted at source. The assessee relied on CIT v. Anglo French Textiles Ltd.7, wherein the revenue authorities unsuccessfully argued that import entitlements earned by the assessee who exported goods from Pondicherry prior to its merger with India was taxable when it was encashed after such merger. The High Court held that the person making the payment from outside India is not the source and it is the export activity linked with the business carried on in India which is the source.
1.2 Income accruing or arising in India and deeming fiction in Section 9 of Income Tax Act
The answer to the issue of establishing the link between income and country of source can be found in Section 9 of the Income-tax Act, 1961 (‘the IT Act’) which enshrines the concept of business connection and deems certain income to accrue or arise in India. India will seek to tax those incomes which have a link with India either through a place, a person or by means of significant economic presence. Section 9 provides that certain incomes are deemed to accrue or arise in India. As per Section 4 of the IT Act, income tax shall be charged on income of the previous year. Section 5 contains the scope of total income and provides that it shall comprise of income received, or deemed to be received in India, income arising or accruing in India or deemed to accrue or arise in India and income accruing or arising to a person (resident) outside India. A resident is thus taxed on global income while a non-resident can be taxed only in respect of income received deemed to be received or income accruing or arising or deemed to accrue or arise in India.
An exposition of the words “accrue and arise” was given by the Supreme Court in CIT v. Ahmedbhai Umarbhai & Co.8
“Whether the words ‘derive’ and ‘Produce’ are or are not synonymous with the words ‘accrue’ or arise it can be said without hesitation that the words ‘accrue’ or ‘arise’ though not defined in the Act are certainly synonymous and are used in the sense of ‘bringing, in as a natural result’. Strictly speaking, the word ‘accrue’ is not synonymous with ‘arise’, the former connoting idea of growth or accumulation and the latter of the growth or accumulation with a tangible shape so as to be receivable. There is a distinction in the dictionary meaning of these words, but throughout the Act they seem to denote the same idea or ideas very similar and the difference only lies in this that one is more appropriate when applied to a particular case. In the case of a composite business, i.e., in the case of a person who is carrying on a number of businesses, it is always difficult to decide as to the place of the accrual of profits and their apportionment inter se. For instance, where a person carries on manufacture, sale, export and import, it is not possible to say that the place where the profits accrue to him is the place of sale. The profits received relate firstly to his business as a manufacturer, secondly to his trading operations, and thirdly to his business of import and export.”
The word ‘accrue’ was interpreted by the Supreme Court in E.D. Sassoon & Company Ltd v. CIT9 wherein the issue was whether the commission which was ascertained at the end of accounting period had in fact accrued on the date of transfer of the agency during the year and hence no income was taxable in the hands of the transferor. The assessee argued that the very source of income – the managing agency had been transferred and on date of transfer no income accrued to them for the broken period. The Supreme Court held that as per the terms of the Managing Agency Agreement, the commission became due after the net profits were ascertained and no income accrued to the assessee for the broken period for which services had been rendered during the year.
“It is clear therefore that income may accrue to an assessee without the actual receipt of the same. If the assessee acquires a right to receive the income, the income can be said to have accrued to him though it may be received later on its being ascertained. The basic conception is that he must have acquired a right to receive the income. There must be a debt owed to him by somebody. There must be as is otherwise expressed debitum in presenti, solvendum in futuro;”
A combined reading of Section 4 and Section 5 of the IT Act reveals that India asserts it right to tax a non-resident in case of the following:
(a) Income which is received or is deemed to be received in India in such year by or on behalf of such person or
(b) accrues or arises or is deemed to accrue or arise to him in India during such year.
Thus, if receipt, arising or accrual is in India or is deemed to be in India, the income would be taxable. The concept of actual receipt, arising or accrual is relatively easy to understand since it can be traced to a source or event. For instance, salary received in a bank account in India, sale of immovable property situated in India, professional fee for services rendered in India, interest earned on money lent in India and so on. Accrual, understood as right to the income can also be traced similarly. For instance, consultancy services rendered in a year wherein payment is received three months after rendering of service. The income becomes due to the service provider before its actual receipt. If earning of the income is linked to India, accrual would also be taxable. However, where the link is not readily identifiable, the deeming provisions have to be taken into account. Section 9 provides the various incomes which are deemed to accrue or arise in India. Thus, interest paid on a loan except where it relates to a business outside India would be taxable.
1.3 Specific exclusions in Section 9
Certain incomes like shooting of cinematograph film or running of magazine by non-resident are specifically excluded from the scope of deemed income. Thus, in respect of business transactions the concept of business connection is important. Income arising through or from any property situated in India or source situated in India is also included in the scope of Section 9. The link with income which relates to a specific asset or place like immovable property or investment in shares of an Indian company is easy to establish and understand. However, in the context of business transactions which may spread over multiple jurisdictions, it is relatively difficult to establish or disprove the connection.
Explanation 2 to the section declares that business connection will include activities carried out through a person. Section 2(13) of the IT Act defines business in a wide manner to include any activity, trade, manufacture or concern in the nature of trade, commerce, etc. There is no threshold or attribute defined for ‘connection’ For instance, the provisions of Section 92(A) lay down the test of control, participation in management or capital or deems dependence for technology or raw material to conclude that two persons are related or ‘associated enterprises’.
Section 9 does not prescribe any such threshold. Certain conditions are prescribed in the case of an agent as mentioned earlier in Explanation 2 and Explanation 2A on Significant Economic Presence (SEP) inserted by Finance Act, 2018 with effect from 1-4-2019 lays down that a threshold may be prescribed. By Finance Act, 2020 the provisions regarding SEP have been omitted and will be reintroduced for AY 2022-23. A new Explanation 3A has been inserted w.e.f.1-4-2021 in terms of which income attributable to the operations carried out in India, as referred to in Explanation 1, shall include income from—
(i) such advertisement which targets a customer who resides in India or a customer who accesses the advertisement through internet protocol address located in India;
(ii) sale of data collected from a person who resides in India or from a person who uses internet protocol address located in India; and
(iii) sale of goods or services using data collected from a person who resides in India or from a person who uses internet protocol address located in India;
By Notification No. 42/2021, dated 3-5-2021, new Rule 11UD was inserted and the threshold limits for determining SEP were prescribed as follows:
- INR 2 crores in case of transaction in respect of any goods, services or property carried out by a non-resident with any person in India including provision of download of data or software in India. The limit will apply for payment or aggregate of payments in respect of such transaction(s).
- Three lakh users have been prescribed for systematic and continuous soliciting of business activities or engaging in interaction with users.
Thus activity, person and source of income are important to decide whether a business connection is constituted. In the absence of any threshold or objective parameters questions like whether the activity contributes significantly to the business of the non-resident, duration of the activity will not make material difference so long as a link can be established with a source in India.
Dividend, interest, royalty and fee for technical services (FTS) are specifically included in Section 9 of the IT Act.
Given the expansive coverage of Section 9, it is important to understand how the scope of taxation has been defined/agreed to by the countries in the relevant DTAAs. The DTAAs between countries largely follow the OECD Model Tax Convention (OECD MTC) or the UN Model Double Taxation Convention (UN MTC). The US has a separate model. In all models what is relevant is the determination of the taxing right based on whether the non-resident or rather his income has a link in the source State. However, the DTAAs incorporate various conditions in order to provide the criteria to determine such link. In a DTAA contracting States may also cede a part of their taxing rights.
2. Concept of Permanent Establishment
Article 5 of the OECD Model Tax Convention as also of UN MTC is relevant for this discussion. DTAAs generally incorporate specific Articles setting out the jurisdiction of the signatory to tax particular incomes like dividend, interest etc. As regards business income, the host country where certain activities of the enterprise may be carried out would get the right to tax only if there is exists a permanent establishment of the foreign enterprise in the host country. The concept of ‘permanent establishment’ or PE as defined/agreed to between the signatory nations in the DTAA will determine which State and when it will have the right to tax. Broadly, a simple understanding of PE is the place [in the host country] through which the business of an enterprise is carried on. Thus, a PE has to have some degree of permanence so that solitary or few isolated transactions are excluded and the business of the foreign enterprise must have a real link to such place in the host state. As per the OECD commentary on Article 7, the concept of PE reflects the international consensus that until an enterprise of one State has a permanent establishment in another State, it should not properly be regarded as participating in the economic life of that other State to such an extent that the other State should have taxing rights on its profits. The concept of PE was further expanded from ‘place’ to include ‘person’ [Article 5(6)] and now nations are deliberating on incorporating the concept of ‘virtual’ link to bring digital transactions within the ambit of DTAAs.
As discussed later, the test of permanence envisages a certain period of activity or presence. Year 2020 witnessed the spread of COVID-19 pandemic and hence forced presence of personnel in various countries and the necessity to carry out the activities – business activity, management, advisory etc., from countries where they were not resident nor intended to stay for a long time. Of course, this extraordinary situation was not contemplated in the legislation and treaties. The test of PE or business connection may thus be fine-tuned accordingly if nations reach a consensus.
The definition of ‘business connection’ in the domestic law and PE in the DTAAs have many parallels and the criteria of person (agent) being a business connection or PE or significant economic presence as introduced by Finance Act, 2017 are notable.
The Supreme Court in Ishikawajma-Harima Heavy Industries Ltd. v. DIT10 opined that business connection and permanent establishment are different concepts:
“69. It is, therefore, in our opinion, the concepts profits of business connection and permanent establishment should not be mixed up. Whereas business connection is relevant for the purpose of application of section 9; the concept of permanent establishment is relevant for assessing the income of a non-resident under the DTAA. There, however, may be a case where there can be over-lapping of income; but we are not concerned with such a situation. The entire transaction having been completed on the high seas, the profits on sale did not arise in India, as has been contended by the appellant. Thus, having been excluded from the scope of taxation under the Act, the application of the Double Taxation Treaty would not arise.”
2.1 Charge of tax
To determine tax liability, two factors are important – subject matter of taxation and who will discharge the liability if it arises. As per Section 4 of Income-tax Act, 1961, income tax will be charged on total income of a person. Section 4 says income tax will be charged in respect of the total income of the previous year of every person. Ideally, the charge of tax would be ‘on’ the income of a person. V.S. Sundaram in his seminal work on The Law of Income Tax in India, a commentary on Indian Income Tax Act, 1922, published by Butterworth & Co. (India) Ltd], notes that ‘in respect of’ really means ‘on’ and refers to Kennard Davis v. Commissioner of Inland Revenue11. Thus, the charge will be on the entire income which is chargeable to tax in terms of the IT Act.
The subject matter of taxation is ‘income’. In simple terms, income is understood as an earning, an addition or receipt as opposed to an inheritance, a windfall gain, a compensation for accident, damages claimed in tort and so on. Income can have many a colour, contours and connotations. As a subject matter of taxation it is indeed difficult to define. An interesting exposition in the context of dividend is found in Eisner v. Macombar12 that income is not mere growth or increment in value in a capital investment, it is essentially a gain or profit in itself of exchangeable value, proceeding from capital, severed from it and received by the taxpayer for his separate use, benefit and disposal.
Entry 82 in the Union List in Schedule VII of the Constitution of India reads as ‘Taxes on income other than agricultural income’. The power to tax agricultural income is with States. ‘Agricultural income’ extends to income from agricultural operations and letting of land for agricultural purposes. Income from sale/transfer of agricultural land is, however, exigible to income tax. Income which includes agricultural and non-agricultural components is taxed by a separate scheme of taxation under the IT Act.
The Income-tax Act, 1961 extends to the whole of India. As per Section 2(25A) of the IT Act, India includes the landmass, territorial waters, seabed, subsoil, continental shelf, exclusive economic zone (EEZ) and other such maritime zones. This territorial extent or ambit of taxation is quite easy to comprehend and understand in defined political sphere. However, income by nature arises from various sources and the situs of such source is difficult to determine in intangible aspects for instance business activity carried out in two different countries, rendered wholly from or in another country and so on. The source of the income and situs of the recipient form equally good or competing bases for taxation by a particular country.
Illustration: If A Ltd renders consultancy services from France to B Ltd in India, the activity of rendering service is undertaken outside India but the payment is from India and service would be used in India. Logical arguments can be made by both India and France to tax the fee for consultancy services.
2.2 Legislation with extra-territorial effect
An important aspect which arises for consideration is whether India can legislate in respect of matters not falling within its territorial limits and those which have a link (substantial or minimal) with events or matters which may be within its jurisdiction. Can India require/enforce persons not within its taxing jurisdiction to comply with its law?
In GVK Industries Ltd v. ITO13 the Supreme Court of India held that India can legislate in respect of matters which have a link with the territory of India. Interpreting Article 245 of the Constitution wherein Article 245(2) lays down that a law made by the Parliament shall not be deemed to be invalid on account of the fact that it has extra-territorial operation, the Supreme Court referred to Article 245(1) which states that Parliament may make laws ‘for’ the whole or any part of the territory of India. However, India cannot legislate for a foreign territory. Thus, the powers of taxation so far as they relate to or have a link with India can be exercised even if they involve foreign operation or may have effect outside India.
An instance of such a provision with extra-territorial effect can be seen in Section 195. Explanation 2 to Section 195(1) states that the obligation to deduct tax on payment of any sum chargeable to tax in India would extend to all persons resident or non-resident whether or not the person has a link to India through a place of residence or business or the presence. A similar obligation has been cast on supplier of service located outside India when service is provided to non-taxable online recipient in respect of Online Information and Database Access or Retrieval Service (OIDAR) under IGST Act and this is discussed in the chapter on IGST.
The charge of income tax is on the total income. Broadly, India seeks to tax any income the source of which can be traced to India. The scope of total income in case of a resident extends to his global income – income from any source so long as it is received by him or accrues or arises (or deemed to be so) within or outside India. A non-resident is liable to pay tax on all income sourced from India as also incomes deemed to be received, accruing or arising in India.
Section 9 of the IT Act dealing with income deemed to accrue or arise in India is important from the perspective of non-residents. The expression ‘business connection’ traces its origin to pre-Independence British India and has been subject to myriad interpretations. According to Kanga and Palkhivala in “The Law and Practice of Income Tax” (7th edition; published in 1976), “the categories of business connection are incapable of exhaustive enumeration”
Section 9 may be understood in 2 parts
(a) income arising through or from any business connection or property or asset or source of income in India and
(b) specific inclusions like royalty, fee for technical services (FTS), salary, interest and dividend.
The meaning and scope of these incomes in domestic law and the DTAA have been discussed in the subsequent chapter.
2.3 Business connection and permanent establishment
Let us now try to understand business connection and its interplay with the concept of ‘permanent establishment’ since wherever there is a DTAA between India and another country, the terms of the DTAA will prevail to the extent they are more favourable to the non-resident (tax resident of the other State). Section 90(2) of the IT Act provides for this relief. To this extent, it can be said that India cedes some of its taxing right under the DTAA and in effect restricts the applicability of charge of income tax. Wherein the income of a non-resident with whose country India does not have a DTAA, is to be assessed, relief is available to the extent of tax paid outside India on income which accrues or arises outside India.
The concept of business connection is wider than that of PE and includes property situate in India, deemed accrual and so on. Typically, the DTAAs would have a separate Article to tax income from immovable property situated in a State, royalty etc. The concept of PE is relevant for business income.
2.4 Place where business is carried out and source of payer establishes business connection
Source State would include the place where commercial need arose. Referring to the decision of the Supreme Court in GVK Industries v. ITO [2015] 371 ITR 453 (SC) wherein the Authority for Advance Rulings in Sea Bird Exploration FZ LLC, In re13a held that where the vessels for undertaking seismic survey were operating in Bombay High and payer was an Indian company, sufficient nexus was established with the territory of India and income arose to the non-resident in India and was taxable. The argument of the applicant that contracts were signed outside India as a Bare Boat Charter and vessels were delivered outside India to offset taxability was not accepted. The fact that the applicant was in Bombay High was stated to establish source in India.
The observation of the ITAT in Birla Corporation Ltd. v. Asstt. CIT14 following Asstt. CIT v. Epcos AG15 provides a perspective on the interplay between taxation under the domestic law and DTAA. The ITAT, Jabalpur quoted:
“…the question of dealing with the tax treaty provisions becomes relevant only when the first bridge is crossed i.e. when taxability under the domestic law is established. On a conceptual frame, however, this approach may not have many noticeable merits other than our comfort levels. In our considered view, in a cross-border tax situation (i.e. in a situation in which economic activities leading to earning an income are carried out in more than one jurisdiction, or in which the source of income and residence of the person earning such an income are in two different tax jurisdictions), first thing to be ascertained is the rights of the taxing jurisdictions over taxability – full or partial – of that income. As the Special Bench of this Tribunal, in the case of Motorola Inc. v. Dy. CIT16 (supra) appropriately observes, a tax treaty certainly does not constitute an exemption system. Strictly speaking, a tax treaty may not even constitute alternative taxation regime, for the elemental reason that no tax treaty or DTAA, whatever one calls it, can ever impose taxes. A view is thus indeed possible that there cannot be an alternate taxation regime which does not impose taxes. Yet, a tax treaty can be said to be an alternate taxation regime in the sense that it allocates taxing rights of the competing tax jurisdictions. As far as the related tax jurisdictions are concerned, a tax treaty, first and foremost, allocates the rights of taxation of the tax jurisdictions over a tax object.”
- 1965 SCR (1) 660
- [1981] 6 Taxman 19/129 ITR 295 (SC)
- [2002] 122 Taxman 935 (Delhi)
- [1941] 9 I.T.R. (Suppl.) 45, 52 (P.C.)
- 1953 SCR 454
- [2012] 21 taxmann.com 476/208 Taxman 114 (Delhi)
- [1993] 199 ITR 785
- 1950 SCR 335
- 1955 SCR 599
- [2007] 158 Taxman 259 (SC)
- 8 Tax Cases 341, (1923) 1 K.B.370
- (1920) 252 U.S. Reports 189 [Sundaram]
- [2015] 54 taxmann.com 347/231 Taxman 18 (SC)
13a. [2021] 124 taxmann.com 56 (AAR – New Delhi)
- [2015] 53 taxmann.com 1/153 ITD 679 (Jabalpur – Trib.)
- [2009] 28 SOT 412 (Pune-Trib.)
- [2005] 147 Taxman 39 (Mag.)/95 ITD 269 (Delhi) (SB)
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