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Direct Tax

Merely because the activities carried out by Liaison Office (LO) are important for the completion of the contract, will it take away the auxiliary and preparatory nature of the activity?

UAE Exchange Centre vs Union of India & Anr [Supreme Court of India (SC) – Civil Appellate Jurisdiction – Civil Appeal No. 9775 of 2011]

Background

UAE Exchange Centre LLC is a UAE based limited company engaged in offering, among others, remittance services from UAE to India. The taxpayer obtained the approval u/s 29(1)(a) of Foreign Exchange Regulation Act, 1973 (FERA), and established a LO at Cochin, Chennai, New Delhi, Mumbai and Jalandhar. The taxpayer asserted that the remittance services are offered to NRI’s in UAE. After collecting the funds and one time fees from the NRI remitter, the taxpayer remits the funds to India in two ways:

  1. by telegraphic transfer through bank channels; or
  2. by sending the cheques through its LO to the beneficiaries in India, as designated by the NRI.

As some doubts with regards to whether any part of the income accrues/deemed to accrue in India were entertained, the assessee applied for obtaining an advance ruling with the Authority for Advance ruling (AAR).

The AAR ruled in affirmative. In its opinion, the commission which the applicant receives for remitting the amount covers not only the business activities carried on in UAE but also the activity of remittance of the amount to the beneficiary in India by cheques/ drafts through courier which is being attended to by the liaison offices. Further, there is also a continuity between the business of the applicant in the UAE and the activities carried on by the liaison offices. Therefore, it follows that income shall be deemed to accrue/arise to the applicant in UAE from ‘business connection’ in India.

Further, while analyzing the provisions of DTAA, the AAR was of the opinion that since the activity of the LO is a significant part of the main work of UAE establishment, it cannot be considered as auxiliary and preparatory in nature. Thus, the exclusion in Article 5 of India UAE DTAA shall not apply, and the LO would constitute a Permanent Establishment (PE) of the UAE Entity in India. Aggrieved by the same, the taxpayer had filed an appeal before the High Court, which ruled the appeal in favor of the taxpayer. The revenue had filed an appeal against the said order in Supreme Court (SC).

Held

The SC dismissed the appeal of the revenue by upholding the conclusions reached by the HC. In the opinion of the HC, “to say that a particular activity was necessary for the completion of the contract is, in a sense saying the obvious as every other activity which an enterprise undertakes in earning profits is with the ultimate view of giving effect to the obligations undertaken by an enterprise vis-a-vis its customer. If looked at from that point of view, then, no activity could be construed as preparatory or of an ‘auxiliary’ character.”

The SC also went a step ahead to hold that, the activities carried out by the LO do not fall under the definition of business activity as the LO does not undertake any activity of trading, commercial or industrial. It was observed that the assessee was not carrying out any business activity in India as such, but was only dispensing with the remittances by downloading information from the main server of the respondent in UAE and printing cheques or drafts drawn on the banks in India as per the instructions given by the NRI remitters in UAE.

However, even if the stated activity(activities) of the liaison office of the respondent in India is regarded as business activity, as noted earlier, the same being ‘of preparatory or auxiliary character’; by virtue of Article 5(3)(e) of the DTAA would fall out of the scope of PE, and thus, no income shall be chargeable to tax in India.

Our Comments

There are a plethora of decisions crystalizing the interpretation of the terms ‘preparatory and auxiliary.’

The SC in this decision has appreciated the fact that an activity considered as important for any contract can still retain preparatory and auxiliary nature.

Whether payment made by an Indian company to its group entity based in Switzerland towards recharge of social security, insurance, and relocation expenses of expatriate personnel, liable to tax in India as Fees for Technical Service?

The information contained herein is source-based.

Background

The applicant, an Indian company, was in the process of setting up a manufacturing plant in India. It has entered into an inter-company agreement with its group company based in Switzerland for the supply of experienced personnel.

The arrangement was such that no part of the salary of the expatriate employees would be paid outside India except for disbursing social security contribution, insurance, and relocation expenses by the Swiss company to expatriate employees in their home country. The assessee was to recharge these expenses on a cost to cost basis. The applicant deducted TDS u/s. 192 for entire salary payment to expatriate employees, including the amount towards reimbursements towards social security, insurance, and relocation expenses.

The assessee approached the Authority for Advance Ruling (AAR) for determining the taxability of this cost recharge.

Held

Referring to the intercompany agreement, AAR observed that –

  • The assessee was exercising full operational control, and the employee is required to abide by the policy regulations and guidelines of the applicant company;
  • The assessee had the power to terminate the employment, and the employee is forbidden to supply his capacity to work to someone else during the period of employment;
  • There was no lien on the employment of the seconded employees;
  • The assessee was solely responsible for all payment to expatriate personnel and that no salary payments are made by the applicant outside India;
  • The employees offered their entire salary, including the social security/ insurance/relocation expenses receipts to tax in India.

Considering the above, the AAR was of the opinion that the reimbursement towards social security, insurance, and relocation expenses should not be considered as FTS.

Our Comments

The debate over taxability of cost recharge of the salary of deputed employees has been going on for decades.

However, unlike other situations, in the current scenario, where only the contribution part of the salary was reimbursed, considering the facts of the case, the AAR has ruled favorable, which is a welcome decision.

Transfer Pricing

Benefit test vs prescribed rules for benchmarking technical fees

UPS Express Private Ltd1

Ruling

The taxpayer had entered into a technology license agreement with its Associated Enterprise (AE) for availing exclusive rights to use technical information for which the taxpayer was required to pay a technical know-how fee at 2% of gross export revenue. The taxpayer had benchmarked the said transaction using the Transactional Net Margin Method (TNMM) as the Most Appropriate Method (MAM). Before the Transfer Pricing Officer (TPO), the taxpayer had not furnished any document to establish receipt of socalled technology, training, etc. during the year. The TPO also observed that the said technology is available for the world for more than 15–20 years, and nothing new was provided to the AE during the year. Accordingly, the TPO concluded that the taxpayer failed to prove its benefit test, and therefore, ALP is determined as Nil. The Dispute Resolution Panel (DRP) upheld the order of the TPO by also placing reliance on the order for AY 2013-14.

Income Tax Appellate Tribunal (ITAT) noted that the TPO's application of benefit test is not as per the rules prescribed under Rule 10B and 10AB or a method as per section 92C.

The ITAT concluded that even as the transaction was never benchmarked in the earlier years and in light of the fact that the TPO has not applied appropriate principles as prescribed, the matter was remitted for fresh benchmarking.

Our Comments

Benchmarking of an international transaction should follow the principles prescribed in relevant sections and rules. Also, ad-hoc methods (such as benefit test) cannot be applied as a blanket method to consider ALP of technical fees as Nil.

Characterization of 'distribution fee' whether it is in the nature of royalty or not; and selection of comparables for the distribution fee

Sony Pictures Networks India Pvt. Ltd. [Successor of MSM Discovery (P.) Ltd.] - ITA No.971/Mum/2016

Ruling

The taxpayer was engaged in the business of channel distribution and had paid 'license fee' to AE's for the distribution of content. It had adopted the TNMM as MAM, however stating that information regarding the companies carrying on the same function was not available in the public domain. Accordingly, it adopted companies engaged as software distributors/selling intangible products as comparable.

The TPO held that the distribution fee paid by the taxpayer was in the nature of royalty, and accordingly, it should be benchmarked using the Royaltystat database, thereby suggesting an upward TP adjustment.

The DRP upheld TPO's view as the taxpayer itself had used the word' license fee' to describe the distribution fee paid to its AE. While upholding the TPO's approach, the DRP also carried out alternative benchmarking by applying internal TNMM comparing AE and Non-AE Segment and made an upward adjustment.

The ITAT observed that the taxpayer only acts as an intermediary between the broadcaster and the ultimate customer who views the channel. It neither holds any right in the content that is broadcasted over the channel nor any right to make any changes in the content to be broadcasted on the channel. Accordingly, it concluded that the distribution fee was not in the nature of royalty u/s 9(1)(vi). Hence, the royalty search undertaken by TPO was not appropriate. Accordingly, even the royalty benchmarking was void. ITAT also relied on the decision of jurisdictional High Court in the case of SET India Pvt Ltd, wherein it held that'the distribution fee paid was not in the nature of royalty.'

With regards to the benchmarking approach, taking software distributors as comparable companies, ITAT upheld the approach considering the functional similarities, and also reliance was placed on prior years.

Our Comments

In the case of inter-company transactions, it is pertinent to peruse the covenants of the agreement to confirm the actual conduct of parties. In this instant case, whether the licensee has access to the right to use, i.e., modify, add, amend, etc. and use without restriction was apparent from the contractual obligations that helped to conclude the characterization.

If there are conditions attached to actual use which does not give the right to the taxpayer for actual use, the payment for such transaction may not be said to be royalty.

Further, taxpayers may be prudent before filing any compliance forms in relation to the nomenclature of the transaction.

Whether PSM or TNMM should be used to benchmark royalty payment

Toyota Kirloskar Auto Parts Pvt. Ltd. - ITA No.1915/Bang/2017 & ITA No.3377/Bang/2018

Ruling

The taxpayer was engaged in manufacturing auto components using AE's technology. The taxpayer paid a royalty to its AE and benchmarked the transaction using TNMM as MAM.

The TPO was of the view that the technology provided by AE included generic and proprietary technology; it had to be regarded as technology only for setting up of business. The economic life of such technology had eroded as the taxpayer was using the same technology for a period of more than 5 years. Thus, TPO felt that there was no necessity to pay a royalty of 5% on the sales, thereby rejecting TNMM and adopted Profit Split Method (PSM) as MAM. The TPO, while applying PSM, determined the ratio of profit split as 1:1 on the basis of a detailed FAR analysis of the taxpayer, and an adjustment was made.

DRP upheld the order of the TPO and stated that the earlier orders of Tribunal holding TNMM as MAM could not be applied in AY 2013-14 because the useful economic life of the technology does not exist in AY 2013-14.

ITAT rejected TPO/DRP's contention on taxpayer being a start-up and economic life of the technology as baseless and further states that "In any event, the passage of time cannot be the basis to discard TNMM."

ITAT went on to add, in order to apply PSM, there should be a contribution by each of the parties to a transaction for earning profits. The contribution of each of the parties is identified, and the profit is split between those parties. In the said case, the use of technology in the manufacturing and sale of the product contributed to the profit of the taxpayer. However, the AE had nothing to do with that, the ITAT stated that "There is, therefore, an absence of the first condition for the application of PSM as MAM."

Noting that the taxpayer only leverages on the use of technology from the AE and does not contribute any unique intangibles to the transaction, accordingly, the ITAT rejected the application of PSM.

Our Comments

PSM can be used only in a case involving the transfer of unique intangible or in multiple inter-related international transactions that cannot be valued separately.

Whether it is appropriate to club royalty payments made to two different AE providing benefits independent of each other

Vesuvius India Ltd.,- ITA No.1333/ Kol/2017, ITA No.1289/Kol/2017 & ITA No. 206 & 207/Kol/2018

The taxpayer is engaged in the business of manufacturing and trading of refractories. The taxpayer was granted a license to use the technical information to manufacture and service the product, for which the taxpayer was to make royalty payments as follows -

Rate % Sales Domestic Export
Refractory License 3% 5%
Systems License 2% 3%

The taxpayer had adopted the CUP method to justify the ALP.

The TPO opined that for benchmarking purposes, the rates for both the rights to use were to be clubbed, i.e., 5% and 8%, respectively. Further, the TPO relied on royalty payment data relating to certain companies extracted from 'Royaltystats.com' database and arrived at the average rate of royalty at 4.25% on net sales, thereby concluding that the royalty payments were excessive.

The CIT(A) did not agree with the TPO's approach, and hence, the Revenue was in appeal before the ITAT.

ITAT noted that:

  • the taxpayer had received substantial benefits by paying a royalty to its AEs, which outweighs the quantum of royalty payable;
  • the royalty rates were within the limits prescribed by the Government. vide its Press Note 2 (2003 Series) dated 24 June 2003 (5% on domestic sales and 8% on export sales);
  • the two royalty payments against should not be clubbed as each of the two agreements have separate identifiable deliverables and should be compared individually for benchmarking.

ITAT also observed that AEs have their own R&D, and whenever the taxpayer receives a new product inquiry, the specifications are sent to refractory licensor who provide technical details to the taxpayer to enable it to manufacture the requisite product as per the group's standards. The aforesaid services are available as and when needed by the taxpayer. By providing the benefits on a continuous basis, independent of each other, each of the two agreements have separate identifiable deliverables. So, both must be compared individually for benchmarking.

Hence, ITAT concluded that royalty data of various companies obtained and used by TPO for applying the CUP method are different from products, terms and scope of royalty payments made by the appellant and accordingly, application of CUP method by the TPO for determining ALP is not as per the law. The appeal of the Revenue is dismissed.

Our Comments

In cases where taxpayers have royalties for multiple products, which are separately identifiable, an individual transaction based benchmarking is preferred. Further, documentation and governmental regulations are also key in providing support for the fact that the payments are reasonable.

1 ITA No. 7320/Mum/2018 – AY 2014-2015

Indirect Tax

Whether salary paid to directors of the company is liable to GST under the reverse charge mechanism (RCM)?

[Background: Services provided by an employee to his employer in the course of employment are covered in Schedule III to the CGST Act, i.e., they shall be treated neither as a supply of goods nor a supply of services. However, services supplied by a director of a company to the said company are chargeable to GST under RCM as per Notification No. 13/2017-Central Tax (Rate) dated 28 June 2017.]

Clay Craft India Pvt. Ltd. - Authority for Advance Ruling (AAR), Rajasthan [2020 (4) TMI 228]

Applicant’s contentions

  • Under the Companies Act, the definition of ‘director’ includes a ‘director’ in the employment of the company.
  • The applicant is paying GST under RCM on the commission being paid to the directors in lieu of their services.
  • The directors are treated as fulltime employees of the applicant company and are being paid salary accordingly.
  • The directors are also considered as employees for the purpose of policies, benefits, and provident fund laws applicable to the applicant.
  • Therefore, the remuneration paid to the director in the form of salary should be covered under Schedule III, and hence, not liable to GST.

The AAR held as follows:

    • The consideration in the form of salary and commission paid to the directors by the company is against the services provided by them to the company, and the company is a recipient of such service, and directors are the suppliers.
    • The directors are not the employees of the company.
    • The RCM notification has given a distinct identity to the services provided by a director, and hence the entire consideration paid to directors should be chargeable to GST under RCM.

Our Comments

It is the general industry view that the RCM notification intends to tax directorship services provided by non-executive/part-time directors whose remuneration is in the form of commission, sitting fees, etc. The view that salary paid to full-time directors is not liable to tax under RCM has also been upheld by the Tribunal under the erstwhile service tax law, where similar provisions exist. This view has also been upheld under a recent GST AAR, Karnataka ruling in the case of Anil Kumar Agrawal.

Given the contradictory nature of the rulings, and the significance of the issue which can virtually impact a large number of businesses, the government should come up with a clarificatory circular to avoid protracted GST litigations.

Which rate of exchange (import or export) should be applicable for valuation in the case where goods are supplied within India, but the billing is done in foreign currency?

Bharat Heavy Electrical Limited – AAR, Uttarakhand [2020 (4) TMI 66]

Facts

  • The applicant entered into an EPC contract, wherein the prices are in three currencies viz. INR, Euros and USD.
  • Certain supplies involved in the contract will be made by the applicant in foreign currencies.
  • Exchange rates by Customs are declared under two categories, viz. import and exports.
  • The applicant submits that normally the foreign currency pricing is adopted in the contract to cover the cost of imported content used in the project.

Based on the above facts, the AAR ruled as follows:

  • Under the GST law, the transaction value is the price actually paid or payable for the supply of goods and/or services.
  • Therefore, in the present case, the rate of exchange of imported goods shall be applicable in as much as the foreign currency price in the contract is to cover imported content of the material used for the intended purpose.

Our Comments

This was a peculiar scenario wherein prices for certain supplies to be made in India were agreed in foreign currencies. In view of a lack of clarity in the valuation provisions of the GST law to deal with such a scenario, the AAR relied on the underlying intention of the parties to determine the appropriate Customs rate.