The Hindu Business Line : `Economic nexus'-based taxation

By reiterating the importance of establishing "economic nexus" for bringing income to tax in India, great significance gets attached to the concept, especially in times when states are unsure of the extent of their jurisdiction to tax cross-border services.

In a challenging economy, making every rupee count is part of the corporate DNA. At most companies, strategic tax planning plays an important role in achieving that goal. One area that is drawing increasing attention is the issue of "economic nexus". The legal concept of `nexus' determines whether a business has enough of a presence in a country to become subject to its taxes. It refers to the extent of physical presence in a country that triggers a company's tax liability in that country. The concept of economic nexus holds that tax nexus exists whenever a business has derived revenue or income from a customer in a country, even if the business has no property, employees or other significant physical presence in that territory.

Globally, taxing corporates on the basis of the concept of economic nexus is gaining significance. In a latest case involving economic nexus, the Supreme Courts of West Virginia and New Jersey upheld the concept of taxing on that basis despite lack of physical presence in the state.

Hyundai Case

In line with the above globally accepted concept of taxing based on economic nexus, the Supreme Court of India also recently held in the Hyundai Heavy Industries Co Ltd case that income from offshore design and fabrication activities would not be taxable in India merely because such activities are rendered in relation to a turnkey project located in India. Though there was a permanent establishment (PE) in India in the form of a project office, income was held to be taxable only to the extent it was attributable to the activities carried on by the PE in India.

The taxpayer, Hyundai Heavy Industries Co. Ltd (HHI), is a resident of Korea, primarily engaged in turnkey projects in the heavy industries sector. HHI had entered into an agreement with ONGC for designing, fabrication, hook-up and commissioning of South Basin Field in the Bombay High. The contract was in two parts, one for designing and fabrication of platform and other for installation and commissioning of the platform in the South Basin Field. HHI undertook the installation activities in India over six months.

`No Tax'

HHI contented that the income from installation activities in India was in the nature of business income. As per Article 7 of the Tax Treaty, business income would be subject to tax in India only if HHI had a PE in India in terms of Article 5(3) of the Tax Treaty. Article 5(3) of the Tax Treaty provides that any construction assembly or installation project or supervisory activities which last for more than nine months would constitute a PE. As the installation activities carried by HHI in India were for less than nine months, HHI contented that they did not expose a PE in India and accordingly filed a `Nil' return of income in India stating that no income from installation activities in India was taxable in India.

The assessing officer (AO) rejected this contentions on the ground that the taxpayer had a PE in India as the project lasted for more than nine months and in any event the project office in India would constitute a PE under Article 5(2)(c) of the Tax Treaty. Accordingly, the claim of the tax assessee (HHI) for exemption under Article 7 of the Tax Treaty was not maintainable and, therefore, the profits attributable to the PE were liable to be taxed in India. On the question of quantum of profits taxable in India, the AO held that the contract was not divisible in terms of off- and on-shore activities but was a turnkey project at a lumpsum price.

The AO held that income from designing, fabrication, procurement of material, etc., which were undertaken outside India, was partly attributable to the PE of the assessee in India having nexus with the ultimate activity of installation and commissioning of platform and, therefore, the income to that extent from the Korean operations was also taxable in India. The AO rejected the accounts maintained in India and resorted to a best judgment assessment and estimated 20 per cent of the gross receipts of the Indian operations as the net profits under the turnkey contract and 2 per cent of the contract revenue in respect of the Korean operations.

On further appeal, the CIT(A) upheld the order of the AO holding the contract to be a composite one and that the offshore activities undertaken in Korea had nexus with the activity carried on-shore in India and, therefore, it cannot be said that no part of the income from the Korean operations was at all attributable to the PE in Bombay High. The CIT(A) directed the AO to compute profits at the rate of 10 per cent of the receipts relatable to the Indian operations in terms of Section 44BB of the Income-Tax Act, 1961 read with Instruction No.1767 dated July 1, 1987 and 1 per cent of the receipts in respect of the Korean operations.

Divisible Contract

On second appeal, the Income-Tax Appellate Tribunal held that the contract was divisible. The installation PE came into existence only after the work in Korea got completed and, therefore, only the income from Indian operations was attributable to the PE and thus taxable in India. The matter was carried in appeal to the High Court by the tax authorities but was summarily dismissed. The tax authorities therefore filed an appeal in the Supreme Court.

The Supreme Court observed that an artificial division between profits earned in India and profits earned outside India is necessary for the ascertainment of a foreign enterprise's taxable business profits in India. It was also held that, as per the Act, the taxable unit is the foreign company and not its branch or PE in India, and as per Sections 5(2) and 9 of the Act, such entity would be taxable only in respect of income that accrues or arises or is deemed to accrue or arise in India and which is attributable to the business carried on in India. The computation of profits in each PE jurisdiction decides the quantum of income on which the source country can levy the tax.

As the provisions of the Tax Treaty would override the provisions of the Act, it was observed that, in terms of Article 7 of the Tax Treaty, only so much of the profits as are attributable to the PE in India are taxable on the assumption that the PE is a separate and distinct entity. In a turnkey project, the PE is set up at the installation stage while the entire turnkey project, including the sale of equipment is finalised before the installation stage. Further it was observed that the there was neither any allegation by the tax authorities that the PE came into existence even before the sale took place outside India nor was it the tax authorities' contention that the price at which ONGC was billed for the supply of the fabricated platforms included any element of service rendered by the PE. It was, therefore, held by the apex court that the profits attributable to the Korean operations were not taxable in India in view of Article 7 of the Tax Treaty.

Hypothetical profits

In terms of Article 7(1) of the Tax Treaty, the profits to be taxed in the source country were not the real profits but the hypothetical profits that the PE would have earned if it was wholly independent of the foreign enterprise. Therefore, even if the tax authorities argued that the supplies were integral to the activity of the PE in India, no part of the profits could be attributed to the independent PE unless it is established that the supplies were not at arm's length. The tax authorities had not alleged that the price at which the billing was done directly to the Indian customer included any element for services rendered by the PE and were not at arm's length therefore, no profits attributable to the Korean operations could be taxable in India. Applying these principles to the case of HHI, it was held that the installation activities took place subsequent to a transaction, where fabricated platforms were delivered to agents of ONGC outside India. Thus, the PE came into existence subsequent to the transaction involving supply of fabricated platforms. The applicability of the "force of attraction" principle contained in the Tax Treaty was also discussed and held that as the fabrication activities took place before the PE came into existence, the profits from such activities could not be taxable in India.

Therefore, it was held that payments made towards fabricated platforms could not be attributable to the PE, and that such payments towards fabrication activities carried on in Korea would not be taxable in India in the absence of economic nexus of such payments with the PE in India.

Accordingly, the Supreme Court held that the CIT(A) was right in holding that 10 per cent of the gross receipts in respect of the activities of installation and commissioning performed in India were taxable.

Amended Provision

It is also relevant to note the Supreme Court decision in Ishikawajma Harima Heavy Industries Ltd vs DIT, wherein it was held that the concept of territorial nexus was fundamental in determining taxability of any income in India, and that income from offshore supply of equipment and services by the foreign company outside India would not be taxable in India merely because the equipment was supplied in relation to a turnkey project in India. However, recently, the Finance Act, 2007 amended the provisions of Section 9 of the Act to state that such income shall be taxable regardless of territorial nexus irrespective of whether the non-resident has a residence or place of business or business connection in India.

These decisions reaffirm the ambiguities surrounding taxation of foreign companies rendering cross-border services in carrying out turnkey projects in India where a part of the work has been carried on outside India. By reiterating the importance of establishing "economic nexus" for the purpose of bringing income to tax in India, the cases assume great significance in times when states are unsure of the extent of their jurisdiction to tax cross-border services.

(The authors are Bangalore-based chartered accountants)