Case Law Details
Interest earned on Income-tax refund from tax department cannot be considered as arising from indebtedness that is effectively connected with Permanent Establishment and is therefore taxable at 15 percent as per Article XI of India-Australia tax treaty.
ACIT Vs. Clough Engineering Ltd (ITAT Delhi – Special Bench)- Under Article 11(4) of the DTAA, interest from indebtedness “effectively connected” with a PE of the recipient is taxable under Article 7 and not under Article 11. Though the interest was connected with the PE in the sense that it has arisen on account of TDS from the receipts of the PE, it was not “effectively connected” with the PE either on the basis of asset-test or activity-test. The payment of tax was the responsibility of the foreign company and the fact that it was discharged by way of TDS did not establish effective connection of the indebtedness with the PE. In order to be “effectively connected”, it is not necessary that the interest income has to be necessarily business income in nature. Even interest assessable under “other sources” can qualify.
IN THE INCOME TAX APPELLATE TRIBUNAL
SPECIAL BENCH ‘B’ DELHI
BEFORE SHRI R.V. EASWAR : HON’BLE PRESIDENT,
SHRI R.P. TOLANI : HONORABLE JUDICIAL MEMBER &
SHRI K.G. BANSAL: HONORABLE ACCOUNTANT MEMBER
Assistant Commissioner of Income Tax
Vs.
M/s Clough Engineering Ltd.,
I.T.A No. 4771(Del)/2007 Assessment year: 2003-04)
M/s Clough Engineering Ltd.,
Vs.
Assistant Commissioner of Income Tax
(I.T.A No. 4986(Del)/2007 Assessment year: 2003-04)
ORDER
PER K.G. BANSAL : AM
One of the grounds in the appeal of the assessee is that- “on the facts and in the circumstances of the case and in law, the Commissioner of Income-tax (Appeals) [hereinafter referred to as ‘CIT(A)’] has erred in treating the interest income as business income directly connected with Permanent Establishment and taxing the same. CIT(A) has thereby erred in ignoring the provisions of Tax Treaty between India and Australia.”
1.1 These appeals were heard by the division bench of the Delhi Tribunal on 21.01.2010. It was concluded that apparently there is a conflict in the decisions taken by the Tribunal in the case of Assistant CIT Vs. Pride Foramer France SAS, (2008) 116 TTJ (Del) 369, and B.J. Services Co. Middle East Ltd. Vs. CIT, 2009-TIOL-387-ITAT-DEL, on this issue. Therefore, a recommendation was made to the President, Income-tax Appellate Tribunal, for constituting a Special Bench to consider and decide the following ground:-
“Whether the CIT(A) erred in treating the interest income as business income as against 15% as provided in para 6 of Article 12 of DTAA between India and the UK.”
Accepting the recommendation, the President constituted a Special Bench on 03.12.2010 to decide the aforesaid question.
1.2 In the course of hearing, it was found that the ground required some verbal change to project the real controversy. Accordingly, after consulting the rival parties, the following question has been drawn up in place of the question referred to the Special Bench by the President:-
“Whether, on the facts and in the circumstances of the case, interest on income-tax refund and fixed deposits with the bank is liable to tax with reference to Article 7 read with paragraph no. 4 of Article 11 or paragraph no. 2 of Article 11 of Indo-Australia Double Taxation Avoidance Agreement?”
2. The facts of the case, as mentioned in the assessment order, are that the assessee-company is incorporated under the laws of Australia. The return was filed on 28.11.2003 declaring total income of Rs. 1,49,15,800/-. The assessee claimed refund of Rs. 2,64,71,450/-. The return was processed u/s 143(1) of the Income-tax Act, 1961 (the Act), on 19.2.2004 and an amount of Rs. 2,37,14,680/- was refunded to the assessee. Thereafter, a notice u/s 143(2) dated 13.4.2004 was served on the assessee with a view to frame regular assessment.
2.1 The assessee has declared contract receipts from ONGC Ltd., Cairn Energy India Pvt. Ltd. and Niko Resources Ltd. The contracts are composite and turn-key in nature. The major scope of work is in respect of designing, engineering, procuring, fabricating, installing, laying pipe lines, testing, pre-commissioning of off-shore platforms etc. The income declared by the assessee-company inter-alia includes interest on income tax refund. It has been submitted that this interest income is taxable at the rate of 15% on gross basis in view of the provision contained in paragraph no. 2 of Article XI of the Indo-Australian Double Taxation Avoidance Agreement (the DTAA). However, the AO has come to the conclusion that the interest income is taxable under Article VII read with paragraph no. 4 of Article XI as the interest has been paid on the refund of tax deducted at source, made from the business receipts and, thus, it is directly connected with the business receipt.
2.2 The matter was agitated before the CIT(Appeals)-I, Dehradun. In the operative portion of his order in paragraph no. 5.2, it has been mentioned that it is an admitted fact that the assessee-company is carrying on business through the Permanent Establishment (the PE) in India. The interest income is not covered by the provision contained in section 44BB of the Act. Therefore, it has been held that the AO was right in taxing the interest income as business income.
3. Before us, the ld. counsel for the assessee has submitted that the total income of Rs. 1,49,15,800/- returned by the assessee inter-alia includes interest of Rs. 6 1,04,944/- received from the Income-tax department and Rs. 13,899/- received from the bank. No dispute has been raised regarding taxability of bank interest under Article VII read with paragraph no. 4 of Article XI of the DTAA. This leaves us with the taxation of interest of Rs. 61,04,944/- received from the Income-tax department.
4. The ld. counsel briefly summarized the history of the case. It is submitted that normally interest is taxed @ 15% on gross basis under Article XI of the DTAA. However, if an assessee has the PE in India and the indebtedness from which interest arises is effectively connected with the PE, then Article VII comes into operation and the interest income is taxable on a net basis at the rate applicable to a foreign company. The AO is of the view that the indebtedness is effectively connected with the PE as tax has been deducted at source from the business receipts. The ld. CIT(Appeals) has agreed with this view. The division bench of the Tribunal, which heard the case initially, is of the view that there is a conflict in decision in the matter in the case of B.J. Services Co. Middle East Ltd. and Pride Foramer France SAS (supra) and, therefore, the question has been referred to the President for constituting a Special Bench. The President has constituted such a bench. After consultation the question has been modified to project the real controversy and the modified question is acceptable to the assessee.
5. He referred to the provision contained in section 90(2) of the Income-tax Act to the effect that where the Central Government has entered into an agreement with the Government of another country outside India or specified territory outside India, as the case may be, 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. In view of this provision, he proceeded at the outset to examine the taxability of interest under the Act.
5.1 In this connection, it is submitted that interest is normally taxable under the head “Income from other sources”, unless the source of the interest is the business of the assessee. He relied on the decision in the case of Traco Cable Co. Ltd. Vs. CIT, Ernakulam, (1968) 72 ITR 503. The assessee- company claimed that the deposit of the share capital made by the company in the bank was a business carried on by it, as empowered by a clause in its memorandum of association and, therefore, the interest income was the business income. However, the Hon’ble Court mentioned that the clause in the memorandum merely authorizes the company to invest and deal with the funds not immediately required, in such a manner as may be determined from time to time. Therefore, it may be open to the assessee-company to carry on the business of investing and dealing with the funds upon securities or otherwise. However, the question in this case is as to whether the assessee company had carried out such a business as a matter of fact. When examined in this light, it is found that it has not commenced business and, therefore, amounts not immediately required in the business have been invested for earning interest income. The receipt of interest is incidental to the deposits. The finding of the Tribunal is that the deposit of the share capital has not been made with the bank in the course of business. Therefore, it has been held that the interest amount is taxable under the residuary head. Further, reliance has been placed on the decision of ‘A’ bench of Bangalore Tribunal in the case of Atria Power Corporation Ltd. Vs. Deputy CIT, (2011) 128 ITD 322, dealing with interest earned on income-tax refunds. It has been held that the same is taxable under the residuary head and not as a part of profits and gains of the power-generation business. This decision referred to the observations of the Hon’ble Supreme Court in the case of Smt. Padmawati Jaikrishna Vs. Additional CIT, (1987) 166 ITR 176, to the effect that the court is inclined to agree with the High Court that so far as meeting the liability of income-tax and wealth-tax is concerned, it is 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 earning income. Reliance has also been placed on the decision of Hon’ble Bombay High Court in the case of CIT Vs. Samir Diamond Exports Ltd., (2000) 245 ITR 548, in which it is mentioned that there is merit in the contention advanced on behalf of the assessee. Firstly, both the Commissioner of Income-tax(Appeals) as well as the Tribunal have followed the judgment dated January 8, 1993, in the case of Royal Cushions Vs. CIT (unreported). Secondly, both the above authorities have found that both the items, namely, interest on refunds and interest on loans fall under a different head of income, viz., “Income from other sources”. Reliance has also been placed on the decision in the case of Collis Line Pvt. Ltd. Vs. ITO, ‘A’ Ward, Company Circle, Ernakulam, (1981) 135 ITR 390 (Ker.). It is mentioned that the assessee is not a banking company. It had not deposited the money by way of money¬lending as a business. That is not its object. The interest arose from amounts deposited in bank otherwise than by way of business. The amount was deposited because money was lying idle and it was safer and wiser to put it in the bank. The interest thereby earned was incidental to main purpose of the deposit, which was safe keeping and not earning profits. Such income is rightly found to be the income from other sources. Reliance has also been placed in the case of Madhya Pradesh State Industries Corporation Ltd. Vs. CIT, (1968) 69 ITR 824. It has been mentioned that the ld. counsel appearing for the assessee did not press the argument that the interest received by the assessee from the bank is receipt of income from money-lending activity. He, however, contended that share monies were monies relating to the business of the assessee and any interest thereupon would be the business income as the assessee was authorized by its memorandum of association to invest in and deal with the money of the company in any securities, investments etc. It is further mentioned that for determining whether an act was done in the course of carrying on the business, it is not sufficient to look at the memorandum of association only but to find out whether the act done was in pursuance of the objects enumerated in the memorandum. Therefore, it is necessary to see whether the objects have been pursued. On the facts, it cannot be urged that the bare fact that the assessee deposited money in the bank is by itself sufficient to show that the deposits were made with a view to carry on the business. Accordingly, it has been held that the interest received by the assessee is chargeable u/s 56 as income from other sources.
5.2 Our attention has also been drawn towards the provision contained in section 2(28A) where the term “interest” has been defined to mean interest payable in any manner in respect of any monies borrowed or debt incurred (including a deposit, claim or other similar right or obligation) and includes any service fee or other charge in respect of monies borrowed or debt incurred or in respect of any credit facility, which has not been utilized. Therefore, it is contended that interest received from Income-tax Department falls within the definition.
5.3 The case of the assessee on the basis of the aforesaid jurisprudence is that the tax deducted at source is the source on which interest has been received. The tax has been deducted by operation of law and, therefore, the indebtedness cannot be said to arise in the course of carrying on the business. Accordingly, under the Act the assessee is liable to be taxed on the amount under the residuary head and not under the business head. In view thereof, the indebtedness cannot be said to be effectively connected with the business carried on by the PE. The domestic law is equally applicable to the assessee and, therefore, it cannot be said that the indebtedness is connected with the PE of the assessee. Further, the assessee is entitled to the beneficial provision of or interpretation under the domestic law in view of the provision contained in section 90(2) of the Act.
6. Coming to the DTAA, the ld. counsel explained the contents of Article XI dealing with taxation of “interest”. We will paraphrase the relevant paragraphs of the article, which have been referred to by the ld. counsel, taking into account the facts of our case. Paragraph no. 1 provides that the interest arising in India to which the assessee is beneficially entitled may be taxed in Australia. Paragraph no.2 provides that such interest may also be taxed in India, according to the laws of India, but the tax so charged shall not exceed 15% of the gross amount of the interest. Paragraph no. 3 defines the term “interest” to include within its ambit interest from Government securities or from bonds or debentures and interest from any other form of indebtedness as well as all other income assimilated to income from money lent by the law, relating to tax in India. The case of the ld. counsel is that provisions contained in these paragraphs are applicable to the facts of the case. However, he also drew our attention towards paragraph no. 4 which provides exceptions to the contents of paragraphs nos. (1) and (2). It is provided that these paragraphs shall not apply if the assessee carries on business in India, in which the interest arises, through a PE situated in India, and the indebtedness in respect of which the interest is paid is effectively connected with such PE. In such a case, the provisions of Article VII shall apply. It is submitted that the AO has invoked the provision contained in paragraph no. 4 and held that the indebtedness from which the interest arises is effectively connected with the PE. The case of the ld. counsel is that the payment of tax is the responsibility of the foreign company and not that of the PE. Therefore, the PE is not the creditor of the income-tax department. Accordingly, the indebtedness is not effectively connected with the PE.
6.1 In this connection, reliance has been placed on the decision of “L” Bench of Mumbai Tribunal in the case of M/s Hapag Lloyd Container Linie GmbH for assessment year 2004-05 in ITA No. 6214/Mum./2007 dated 27.12.2010, a copy of which has been placed in the paper book (2/3) on pages 59 to 74. The question before the Tribunal was-whether, the CIT(Appeals) erred in holding that interest of Rs. 12,44,428/- granted on income-tax refund is covered by Article 11 of the DTAA and, therefore, taxable in India? The question was raised in a situation where the case was covered under Article 8 of the Tax-Treaty between India and Germany. It has been mentioned that interest on funds which are connected with operation of ships or aircraft in international traffic is covered within the ambit of paragraph (3) for assuming the character of profit from operation of ships or aircraft in international traffic. It does not and cannot refer to any interest other than that. Interest on income-tax refund does not have relation with operation of ships or aircraft in the international traffic and, therefore, it cannot be brought within the purview of article 8. A reference was made to the ruling of Authority for Advance Rulings in ABC, (1999) 236 ITR 637, being a U.K company, in which it has been held that the interest amount in dispute has not arisen out of any business operation in India. It is the statutory interest granted on delayed refund under the provisions of the Act. There cannot be any dispute that the interest has been paid on delayed refund. Refund due and payable to the assessee is the debt owed and payable. The debt-claim is not connected in any way with any activity of the PE or base in India. The right to get interest arises because of delay in making refund of the excessive collection of tax. This is clearly a case falling under paragraph no. 2 of Article 12 of the U.K. DTAA. In the decision, it has been mentioned in paragraph no. 11 that the Authority is reminded of the maxim “generalia specialibus non derogant”, according to which a special provision overrides the general provision. Therefore, the mandate of an article dealing with a distinct item of income has overriding effect over that of general article. Adverting to the facts of the case, it has been noted that although Article VII covers “business profits” but since Article VIII specifically deals with shipping or air transport in international traffic, it is only Article VIII which shall apply in relation to taxability of profits from operation of ships or aircraft in international traffic. When the contents of Article VIII(3) are examined in conjunction with the contents of Article XI, it emerges that interest income of every kind as referred to in Article XI arising in India and paid to a resident of Germany shall be subject to tax in India and the mandate of Article VIII shall not apply unless it is specifically covered under Article VIII(3). This exception extends only to interest income on funds which are connected with operation of ships in international traffic. Naturally, interest on income-tax refund cannot have any relation with operation of ships or aircraft in international traffic and hence cannot be brought within the purview of Article VIII.
6.2 Our attention has been drawn towards the OECD commentary on the model convention. It is mentioned therein that certain states consider that dividends, interest and royalties arising from sources in their territory and payable to individuals or persons who are residents of other States fall outside the scope of the arrangement made to prevent them from being taxed in both the States. Paragraph no. 4 is not based on such a conception which is sometimes referred to as “the force of attraction of the permanent establishment”. It does not stipulate that interest arising to a resident of a Contracting State from a source situated in the other State, must by a kind of legal presumption or fiction, be related to a permanent establishment which that resident may have in the latter State, so that the said State would not be obliged to limit its taxation in such a case. The paragraph merely provides that in the State of source the interest is taxable as a part of profits of the PE, if it is paid in respect of debt-claims forming part of the assets of the PE or otherwise effectively connected with that PE. In that case, paragraph no. 4 relieves the State of source of the interest from any limitation under the Article. It is further mentioned that a debt-claim in respect of which interest is paid will be effectively connected with the PE and will form part of its business assets, if the economic ownership of the debt-claim is allocated to the PE. In this very connection, our attention has been drawn to the extract of OECD commentary furnished by Shri D.P. Mittal in his book, which is the same in content as mentioned above. It has also been submitted that the words “effectively connected with” have not been defined either in the DTAA or the Act. However, our attention has been drawn towards the USA analysis, in which it is mentioned that in general, U.S. treaties expressly exclude from the scope of interest article interest that is attributable to or effectively connected with either the PE in the source Contracting State through which the obligor carries on business, or a fixed base from which the obligor performs independent personal services. Such interest is considered taxable under the Business Profits or Independent Personal Services articles. This standard is substantially stricter than that in Article 11(4) of the U.N. Model treaty, under which interest that is effectively connected with business activities carried on in the source State that are of the same or a similar kind as those effected through a permanent establishment are taxable as business profits. The term “attributable to”, which is used in the U.S. Model Treaties and “effectively connected” with, which is used in OECD Model Treaties, generally are not defined in U.S. income-tax treaties. Therefore, their meaning generally must be determined in accordance with the law of the Contracting State imposing the tax. Nothing suggests that the two terms are intended to have different meanings under the treaties. It is also mentioned that if a non-U.S person is considered engaged in U.S. trade or business, the enquiry becomes whether the interest is effectively connected with the trade or business. In the case of U.S-source interest other than in the case of banking, financing or similar business, is effectively connected with a U.S. trade or business if the obligations on which the interest is paid or used in, or held for use in, the conduct of U.S. trade or business, which is the asset-use test; or the activities of the U.S. trade or business is a material factor in realization of the interest, which is the business-activities test. Thus, it is argued by the ld. counsel that for determining whether the indebtedness is effectively connected with the PE one of the two tests need to be satisfied. However, if all interest incomes are brought to taxation under Article VII, it will create anomaly in the sense that paragraph nos. (1) and (2) will be left with no content. Further, under Article VII only that profit is taxed as business profit which is attributable to the PE. In order to support this contention, a reference has been made to paragraph no. 60 of the decision in the case of Sumitomo Corporation Vs. Dy. CIT, (2007) 114 ITD 61, in which it is mentioned that the term “effectively connected” used in Article XII(5) of the DTAA is not to be construed as the opposite of “legally connected”, but in the sense of something “really connected”. This connection has to be seen not in form but in real substance. The income-producing activity should be closely connected in terms of relationship besides being connected economically also with the PE. Reliance is also placed on the ruling of Authority for Advance Rulings in the case of Worley Parsons Services (P) Ltd., (2009) 312 ITR 273, a ruling in the case of an Australian company. It is inter-alia mentioned that the effective connection should be between the royalty generating services and the permanent establishment. The expression “services” is significant and should be given due weight. It is not enough that there is a PE of the non-resident in the source country carrying out some activities in connection with the project or the work. The PE may be effectively connected with the project and the contract from a broader prospective but the connection contemplated by paragraph no. 4 of Article XII is in respect of services that fall within the purview of royalty. The PE or the fixed base set up in the source country should be engaged in the performance of royalty generating services, irrespective of what other activities it performs. At least, it should facilitate the performance of such services. The terminology “effective connection” denotes a real and intimate connection. Coming to the facts of the case, it is mentioned that it has to be ascertained whether the PE set up in India in connection with pipelines project work is effectively connected with the services performed by the applicant under the two agreements. On a deep consideration, the AAR are of the view that the applicant has not been able to make out the effective connection in the sense in which it has been explained earlier. It has further been mentioned that in order to see whether the payments in the nature of royalties received by the applicant are taxable in India, the particular agreement under which the royalties have been received should be considered on stand-alone basis. A lump sum consideration with a break up of phase-I and phase-II, is stipulated under the agreement and the scope of works/services as well as rights and obligations in the agreements are clearly separate and distinct, though related to one project. It is also mentioned that the effective connection contemplated by Article XII(4) must be between the services giving rise to royalty and the PE. That there is overall connection of such services to the project and the fact that such services are essential for the execution of the project is a different aspect. The case of the ld. counsel is that the same logic shall apply mutatis mutandis while interpreting paragraph no. 4 of Article XI.
7. In reply, the ld. DR submitted that although the interest has not arisen out of the business transactions, but it is also a fact that tax was deducted from the monies receivable in the course of the business of the PE and, therefore, there is a direct nexus of the indebtedness with the assets of the business.
7.1 Coming to the analogy taken from the domestic law, it is submitted that if the assessee opts to be taxed under the DTAA, the classification of income is not required to be done under the five heads. In fact, no head of income has been prescribed under the treaty. Therefore, it cannot be said that the provisions contained in paragraph no. 2 of Article XI are analogous to the provisions contained in the Act regarding computation of income under the residuary head. Elaborating further, it is submitted that if such an analogy is to be adopted, it should be carried to its logical conclusion. Under the domestic law, the rate of tax is the same for business head and the residuary head of income. However, if the interest is to be assessed under Article XI (2), it will get taxed on a gross basis at the rate of 15%. If it is to be taxed under Article VII read with Article XI(4), the normal rate of tax will be applicable on the net income. Thus, the analogy breaks down when we look to the rate of taxation. The analogy also breaks down for the simple reason that Article XXII of the DTAA is in the nature of a residuary article, dealing with incomes not covered under any other provisions. If at all any analogy can be drawn from the Act, it could be only between Article XXII of the DTAA and the residuary head of income in the Act.
7.2 Coming to the treaty, it is elaborated that the expression used is to the effect that indebtedness is effectively connected with the PE and not that the interest income is effectively connected with the PE. As mentioned earlier, the debt arose because of tax deduction at source from the business receipts of the PE. Therefore, if the FAR analysis is carried out, the asset will have to be allocated to the PE. Accordingly, it can be very well said that economic ownership of the debt lies with the PE. Thus, asset-test is satisfied in this case. Further, since the tax was deducted from the business receipts of the assessee, even the activity-test stands satisfied because it was in the course of the business transactions of the assessee that the debt arose. Accordingly, it is argued that both the tests are satisfied.
7.3 It is submitted that the taxation of interest-receipt does not depend upon the reason on account of which the income arose. It may be due to delay on the part of the revenue to grant refund but nonetheless the income remains the income and there is satisfaction of asset-test as well as activity-test. Elaborating further, it is submitted that the DTAA is not based on U.S model but it is based on OECD model. The U.S. model is altogether different. Therefore, U.S. technical explanation cannot be relied upon for interpreting the provisions of the DTAA. Coming to the OECD commentary, it is submitted that it is mentioned that if the interest is paid in respect of debt-claim forming part of the assets of the PE or otherwise effectively connected with the PE, paragraph no. 4 relieves the source State from the limitation imposed under paragraph nos. (1) and (2) of Article XI. The commentary contemplates economic ownership of the debt-claim. As mentioned earlier, if FAR analysis is made, the deduction from monies receivable as tax would fall under the economic ownership of the PE. Therefore, the commentary supports the case of the revenue. Accordingly, it is urged that the case of lower authorities regarding taxation under Article VII read with Article XI(4) may be upheld on the ground of economic ownership of the asset held by the PE.
7.4 It is further submitted that cases dealing with “Royalties” under Article XII are not applicable under Article XI.
8. In the rejoinder, the ld. counsel clarified that there is no question of opting for taxation under the DTAA. Section 90(2) of the Act provides in express-terms that if any provision of the Act is more beneficial to the assessee, the same shall be given effect to. It was further clarified that provisions of Article XII are analogous to provisions of Article XI and, therefore, it will not be correct to argue that the cases dealing with royalty or fees for technical services are not applicable. The ratio of these cases shall be applicable mutantis mutandis to the provisions contained in Article XI. It is also clarified that the treaty does not contain heads of income. The scheme is that prescription has been made in respect of certain incomes and what is not covered under the prescription is to be considered under Article XXII. Since there is no effective connection between the PE and the debt-claim, the provisions contained in Article XI (4) cannot be invoked.
9. We have considered the facts of the case and submissions made before us. The facts are that the assessee received interest on income-tax refund amounting to Rs. 61,04,944/- from the income-tax department. It also received a sum of Rs. 13,899/- as interest from the bank on the fixed deposits placed with it. No dispute has been raised by the ld. counsel in respect of the bank interest. Therefore, the only question left now is-whether, the sum of Rs. 61,04,944/- is taxable on gross basis @ 15% or on net basis at the rate applicable to a foreign company?
10. We may deal with the question from the stand point of section 90(2) of the Act. The provision reads as under:-
“(2) Where the Central Government has entered into an agreement with the Government of any country outside India or specified territory outside India, as the case may be, 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.”
10.1 The gist of the provision is that in a case where the provisions of the DTAA apply to an assessee, the provisions of this Act shall apply to the extent they are more beneficial to that assessee. According to us, it will become necessary to have proper appreciation of the words “more beneficial”. Although this point has not been elaborated upon by any of the contending parties, it is clear to us that application of the provision can be made after ascertaining- (i) tax payable by the assessee under the DTAA, and (ii) tax payable by the assessee under the Act. If tax payable under the Act is lesser than the tax payable under the treaty, it can be concluded that the provisions of the Act are more beneficial to the assessee. However, if the tax payable by the assessee under the treaty is lesser than the tax payable under the Act, he shall have the benefit of the DTAA. If we compute the income of the assessee under the head “other sources”, the net income by way of interest received from the income-tax department shall amount to Rs. 61,04,944/-. This amount will be taxed at the rate applicable to a foreign company, which is more than 15%. Therefore, on making the assessment of tax under the treaty and the under the Act, it will be found that tax payable under the Act is more than the tax payable under the treaty. Accordingly, the aforesaid provision will come to the aid of the assessee to come to an automatic conclusion, without exercise of any option, that it should get the benefit under the DTAA. No other consideration is material for this purpose as ultimately what is to be seen is whether the provisions of the Act are more beneficial to the assessee or not. Accordingly, it is held that the assessee is entitled to the benefit under the treaty.
11. Coming to the treaty, the facts are that the tax was deducted at source from the business receipts of the PE. Therefore, indebtedness is connected with the PE. However, the treaty uses the words “effectively connected with the PE ”. The question was referred to the Special Bench for the reason that there is an apparent conflict of views in the case of Pride Foramer France SAS and B.J. Services Co. Middle East Ltd. (supra). The admitted position in the case of B.J. Services Co. Middle East Ltd. is that no dispute existed on the facts that-(a) the assessee is a non-resident having a PE in India; (b) the assessee is carrying on the business in India through the PE; and (c) the interest is effectively connected with such PE in India. Thus, there was no dispute in this case regarding existence of “effective connection”. The Tribunal mentioned that in ordinary circumstances paragraph no. 2 would have been made applicable. However, in terms of paragraph no. 6 of Article XII, the provisions of paragraph no. 2 shall not be applicable if the beneficial owner of the interest carries on business in India, in which interest arises through a PE situated in India and the debt-claim in respect of which interest is paid is effectively connected with such PE in India. As the factual position regarding “effective connection” was not under dispute, it was but natural for the Tribunal to come to the conclusion that Article XII (6) shall be applicable read with Article VII. However, in this case, the factual position regarding “effective connection” is under dispute. In the case of Pride Foramer France SAS, the assessee had received interest on income-tax refund. It was pleaded that no conscious effort was made through the PE to earn the interest except for pursuing the matters before the authorities. It was further pleaded that as the interest was sui generis, it could not be considered within the purview of Article XII(5). The Tribunal mentioned that Article XII of the DTAA with UK and France are in pari-materia. There is no dispute that the interest was paid on account of delay by the revenue in grant of income-tax refund. Reference was made to an earlier decision of the Tribunal in the case of the assessee in which it was held that the expenses incurred cannot be set off against interest on income-tax refund because such interest cannot be termed as business income. Therefore, it could not be said to be attributable to the business activities or derived from such activities. It was merely a fallout of profits earned and appropriation of profits. Taking a cue from this decision, it has been held that the interest income could not be brought to tax under Article XII(5) read with Article VII. Another argument was advanced to fortify this decision, namely, that the assessee is not in the business of obtaining income-tax refund and earning interest thereon. It is merely the fallout of appropriation of profit and when excess amount is paid to the revenue than what is due under the Act, the assessee gets the fund and when there is a delay in granting refund, the assessee gets the interest. Therefore, the case of the assessee was accepted by mentioning that it was not business income but income from other sources. We find that the assessee had disputed the existence of effective connection between the PE and the interest. However, the Tribunal allowed the appeal by drawing analogy from various heads of income. We are of the view that such analogy is not appropriate. The reason is that if aforesaid decision is accepted, only that interest which is in the nature of business income will go out of the purview of paragraph no. 4 of Article XI of the DTAA. This is not the intent of the paragraph. Therefore, we will have to examine as to whether the test of effective connection is satisfied in this case or not. And this brings us to the provisions of the DTAA and jurisprudence thereon.
11.1 Before proceedings with the determination of the issue, the provisions of Article XI of the DTAA are reproduced below:-
“Article XI-Interest-1. Interest arising in one of the Contracting States, being interest to which a resident of the other Contracting State is beneficially entitled, may be taxed in that other State.
2. Such interest may also be taxed in the Contracting State in which it arises, and according to the law of that State, but the tax so charged shall not exceed 15 per cent of the gross amount of the interest.
3. The term “interest” in this Article includes interest from Government securities or from bonds or debentures, whether or not secured by mortgage and whether or not carrying a right to participate in profits, and interest from any other form of indebtedness as well as all other income assimilated to income from money lent by the law, relating to tax, of the Contracting State in which the income arises, but does not include interest referred to in paragraph (1) of Article 8.
4. The provisions of paragraphs (1) and (2) shall not apply if the person beneficiary entitled to the interest, being a resident of one of the Contracting States, carries on business in the other Contracting State, in which the interest arises, through a permanent establishment situated therein, or performs in that other State independent personal services from a fixed base situated therein, and the indebtedness in respect of which the interest is paid is effectively connected with such permanent establishment or fixed base. In such a case, the provisions of Article 7 or Article 14, as the case may be, shall apply.
5. Interest shall be deemed to arise in a Contracting State when the payer is that State itself or a political sub¬division or local authority of that State or a person who is a resident of that State for the purposes of its tax. Where, however, the person paying the interest, whether the person is a resident of one of the Contracting State or not, has in one of the Contracting States or outside both Contracting States a permanent Establishment or fixed base in connection with which the indebtedness on which the interest is paid was incurred, and such interest is borne by such permanent establishment or fixed base, then such interest shall be deemed to arise in the State in which the permanent establishment or fixed base is situated.
6. Where, owing to a special relationship between the payer and the person beneficially entitled to the interest, or between both of them and some other person, the amount of the interest paid, having regarding to the indebtedness for which it is paid, exceeds the amount which might have been expected to have been agreed upon by the payer and the person so entitled in the absence of such relationship, the provisions of this Article shall apply only to the last-mentioned amount. In that case, the excess part of the amount of the interest paid shall remain taxable according to the law, relating to tax, of each Contracting State, but subject to the other provisions of this Agreement.”
11.2 In the case of Traco Cable Co. Ltd. (supra), the decision under the Act is that for an income to be business income, the actual activities and not the clauses of memorandum of association have to be looked into. In the case of Ataria Power Corporation Ltd., it has been held that the interest earned on income-tax refund is assessable under the residuary head and it does not form part of profits and gains of power-generation business. In the case of Samir Diamond Exports Ltd. (supra), it has been held that interest on refund and loans are taxable under the residuary head and, therefore, do not form part of the profits of the business computed for the purpose of the deduction u/s 80HHC. In the case of Collis Line Pvt. Ltd., it has been held that the main purpose of deposit was to keep idle money safe by depositing into the bank, therefore, the earning of interest was incidental to the main purpose of keeping the money safe. Such income is taxable under the residuary head. In the case of Madhya Pradesh State Industries Corporation Ltd., the decision is that the interest earned on share money is chargeable to tax under the residuary head. The case of the ld. counsel, on the basis of the aforesaid jurisprudence, is that interest received by the assessee on income-tax refund is not the business income. Similar consideration will be applicable while interpreting paragraph no. (4) of Article XI in respect of the words “effectively connected with such permanent establishment”. On the other hand, the case of the ld. DR is that paragraph no. (4) overrides paragraph nos. (1) and (2) of this article. The assessee has a PE in India. The indebtedness arose as tax was deducted from the business receipts of the PE and, therefore, on asset-test the indebtedness is effectively connected with the PE. Similar provision exists in the U.K. and France DTAAs. It is further argued that the provision contained in paragraph no. (4) read with Article VII cannot be equated with the provisions contained in Chapter IVD regarding “profits and gains of business or profession”. If that is done, the paragraph no. 4 will become redundant. The real test is not whether the interest is business income or not, but whether the indebtedness is effectively connected with the PE. Therefore, the jurisprudence under the Income-tax Act, which nowhere contains similar words, cannot be taken recourse to for interpreting the provision. Having considered these matters, we agree with the ld. DR that since the words “effectively connected with such permanent establishment” do not find a place in the Act anywhere, therefore, the decided cases thereunder cannot form the basis for understanding the real import of the expression. Article VII deals with taxation of business profits and also provides for mechanism to compute the profits of the business. Paragraph no. 4 relieves the source State from the rigors of paragraphs nos. (1) and (2) in case the interest is found to be effectively connected with the PE, even if it is not in the nature of business income of the assessee but is effectively connected with the PE. If interest is the business income as a matter of fact, such income falls automatically within the ambit of Article VII without even taking recourse of paragraph no. 4. Therefore, this paragraph contemplates a different condition upon whose satisfaction interest becomes taxable under Article VII. It is an accepted canon of interpretation that no part of the statute should be rendered null and void by interpretation. Therefore, some meaning has to be placed on the contents of this paragraph. Accordingly, we proceed with the other cases relied upon by the rival parties.
11.3 In the case of Pride Foramer France SAS (supra), it was held that interest on income-tax refund was sui generis and it was neither derived from nor attributable to the business activities of the assessee. It was also contended that the assessee is not in the business of obtaining income-tax refund and earning interest thereon. Therefore, it was held that the same is taxable under the residuary head of income under the Act. Consequently, it was concluded that the same cannot be related to the activity of the PE. We have already held that paragraph no. (4) brings within its ambit not merely the interest earned from the business but something more, i.e., interest on indebtedness which is effectively connected with the PE. Interpreting this expression on the basis of the heads of income would render this paragraph null and void. Therefore, without commenting on the merits of the decision, it can be said that this case does not lay down the law in entirety as it misses the point mentioned above. The case of B.J. Services Co. Middle East Ltd., (supra) does not help us in deciding this issue as in that case there was no dispute that-(i) the assessee is a non-resident having PE in India; (ii) the assessee is carrying on business in India a through a PE situated in India; and (iii) the interest is effectively connected with such PE in India. However, this decision does not proceed on the footing that only that interest which is part of the business profits can be brought within the ambit of paragraph no. (4). In the case of Worley Parsons Services Pte. Ltd. (supra), the ruling is that for bringing to tax the royalties received under Article VII read with Article XII, there must be effective connection between the earning of the income and the PE or the fixed base. This ruling also does not help us incoming to appropriate conclusion for the reason that royalty is, in general, the business income, although taxable at concessional rate in absence of PE or its effective connection with the PE or the fixed base. Such is also the position in the case in the case of Sumitomo Corporation (supra). In the case of Hapag & Loyd Container, interest on income-tax refund was excluded from Article 8 as it had no connection with the shipping business. Therefore, it was held to be taxable under Article 11. But this case also does not take us any further in regard to controversy before us.
11.4 Thus, we are again left with the fundamental question as to whether the debt-claim in this case can be said to be effectively connected with the PE. We have already held that the claim is connected with the PE in the sense that it has arisen on account of tax deduction at source from the receipts of the PE. However, it is also a fact that payment of tax is the responsibility of the foreign company. The same is determined after computation of its income and the tax forms not an expenditure for earning the income but an item of appropriation of profit. Therefore, even if the debt is connected with the receipts of the PE, it cannot be said to be effectively connected with such receipts because the responsibility to pay the tax lies on the shoulders of the assessee-company from the final profit ascertained as on the last date of the previous year and on closing the books of account. It is for the company to pay the tax from any source available with it. It so happened in this case that the tax got automatically deducted from the receipts of the PE by operation of law. Such collection of tax by force of law would not establish effective connection of the indebtedness with the PE as ultimately it is only the appropriation of profit of the assessee company. However, we may add that we do not venture to say that the interest income has to be necessarily business income in nature for establishing the effective connection with the PE because that would render provision contained in paragraph 4 of Article XI redundant. Thus, there may be cases where interest may be taxable under the Act under the residuary head and yet be effectively connected with the PE. The bank interest in this case is an example of effective connection between the PE and the income as the indebtedness is closely connected with the funds of the PE. However, the same cannot be said in respect of interest on income-tax refund. Such interest is not effectively connected with PE either on the basis of asset-test or activity-test. Accordingly, it is held that this part of interest is taxable under paragraph no. 2 of Article XI. Thus, the ground referred to the Special Bench is partly allowed. The Division Bench shall dispose off the appeal in conformity with this order.
The order was pronounced in the open court on 6th May, 2011.
Date of order: 6th May, 2011.
