SUMMARY OF CASE LAW
The services rendered and the work undertaken by the applicant-Australia n company in terms of the Agreement for Basic Engineering and Procurement services fall within the scope of `royalties’ as defined in Article XII(3) of the DTAA between India and Australia and the receipts are taxable in India by virtue of Article XII(2); under the Income-tax Act too, they are so taxable; the exclusion clause under Article XII (4) of the DTAA is not attracted in view of the absence of the effective connection between PE and the services, and therefore, the royalty income is liable to be taxed under Article XII(2) of the DTAA read with section 9(1)(vi) and other charging provisions of the Act.
12.1. The case of the applicant set up in the application is that the “activities of basic engineering services were primarily carried out at Perth, Australia with a few trips to India for site visits and meetings”. It is also stated that “procurement functions and assistance in detailed engineering were essentially performed in India”. Then, a Chart is given showing duration of stay of employees during 2001 to 2002 and 2002 to 2003. In the course of arguments, it has been stated that as per the first agreement, more than 80 per cent of the services were carried out at Perth. The services relating to detailed engineering are part of Phase-II as noted earlier. Though the applicant stated in its written submissions filed on 11.2.2008 that some part of the assistance and supervision of the detailed engineering was provided by the applicant, it is not in conformity with the case of the applicant that Phase-II of BE & P agreement was not at all carried out. In fact, Mr. R. Brook Smith, Manager of the applicant in his affidavit clarified that no work was carried out in respect of Phase-II of the two agreements, viz. BE & P – Project Management Services. It may be recalled that in the second phase of carrying out the detailed engineering services only, the applicant’s personnel were required to supervise the work of local engineering contractor vide Art. IV of the Agreement. Now, coming to Phase-1 which consists of two types of services viz. basic engineering and procurement of long lead items, the averment of the applicant that procurement services were essentially performed from India is quite contrary to the terms of the Agreement. In Art. VII which refers to “price and price basis”, the break-up of lump sum price in respect of Jamnagar to Bhopal and Goa to Hyderabad pipelines is given. In para A.1 and B.1 of Art. VII it is specifically stated : “lump sum fixed price for Phase 1 – basic engineering and procurement services of long lead items from Perth.” Even in the written submissions dated 11.2.2008, the applicant clarified at page 2 that “the contractor was to provide basic engineering and procurement services from Perth, Australia and detailed engineering and procurement services from Mumbai.” Further, para 3 of Appendix I which says that provision shall be made for seven Reliance project team members to be stationed at Contractor’s head-office during phase I work reinforces the fact that phase I of the work was to be carried out from the head-office in Perth. It is not known on what basis the applicant has stated that services relating to procurement of long lead items were essentially performed in India. Assuming that something different from what had been stated in the agreement had factually taken place, the same should have been clarified. No material whatsoever has been placed before us to substantiate that the services relating to procurement which is an integral part of the BE & P Agreement were performed in India substantially or partly. Though the summary of invoices under which the amounts were received from time to time was given in a book filed at the last hearing, we do not find any details of the items of work covered by those invoices or the place of performing the related services. There is not a single document which goes to prove that procurement services relating to Phase-I were done in India. It is, therefore, not possible to conclude that PE at Mumbai had any role to pay in regard to the services covered by the first Agreement i.e. either basic engineering or procurement. There is another aspect which we would like to advert to in this context. Art. V of the Agreement sets out the “overall Schedule and Milestones.” In regard to the Jamnagar to Bhopal Pipelines, it is stipulated : “Phase-1: Basic Engineering and ordering of long lead items shall be completed as per agreed sub-milestones before 20th October, 2001” (The schedule date of completion of Phase II work i.e. detail engineering etc. was 20th May, 2002). But, as seen from the Chart appended to the application, the first visit of two employees who stayed on for 75 days was only in October, 2001. In the succeeding month, 4 employees came and worked in India for a duration of 8 days. The Project Manager Mr. Mark Vaughan came to India only in April, 2002 and stayed for 236 days. Thus, by the date the applicant’s employees started carrying out the work at the fixed place in Mumbai, their schedule for completion of first phase – both basic engineering and procurement was completed. This is also a pointer to the fact that PE did not have any role worth-mentioning in carrying out the services under Phase I of the first agreement. Basic Engineering & Procurement services constituting Phase I of the Agreement were evidently carried out from Perth without reference to any permanent establishment in India.
12.2. It is true that some preparatory work involving on-the-spot studies would have been done by the applicant’s employees at the initial stages. For instance, item no.2 of phase-I mentions `pipeline route studies’. So also for preparing the documents under item 3 as a prelude to statutory approval process such as environmental clearance etc., site inspections may be necessary. But, this process of on-the-spot observations and collection of data would have been done much before the PE became functional in India. As already noted, the visits of applicant’s personnel to India and their stay at Mumbai commenced only in October, 2001 by which date the services under the Ist Phase of Agreement were to be completed. It is not the case of the applicant that the PE came into existence even before Oct., 2001. On the other hand, the specific averment in the application shows that there were `few trips to India for site visits and meetings’ in connection with the basic engineering services. In the absence of any details, the few short visits of the employees deputed by the applicant for going ahead with the work under the Agreement cannot be construed to give rise to a permanent establishment at the initial stage itself. Presumably, faced with this difficulty, the learned counsel for the applicant repeatedly stressed that the two agreements entered into in connection with the project and executed partly have to be seen as one as they are integrally connected. In other words, the applicant would like to say that the effective connection to the PE stands established by reference to the services rendered under any one of the Agreements. It is also the case of the applicant that although the bulk of services under the first agreement (BE & P) were carried out in Australia, even those services have close connection with the PE for the reason that the work done in Australia was based on the inputs gathered in India for a project to be undertaken in India and the end-product of the technical/scientifi c services was delivered and utilized in India. None of these arguments, in our view, are legally tenable. 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 were received should be considered on stand alone basis. A lump sum consideration with a break up of Phase I and II was stipulated under the agreement and the scope of work/services as well as the rights and obligations in the agreements are clearly separate and distinct, though related to one project. The inter-relation of the various agreements to the project as a whole cannot be denied. But that is not to say that the permanent establishment must be deemed to have effective connection with all the services – wherever and whenever rendered. It would be appropriate to apply the test of effective connection between the PE and the royalty related services with reference to each Agreement which is clearly separable from the other. Viewed from this angle, it cannot be said that the services giving rise to the royalties in connection with first agreement get effectively connected with the PE merely for the reason that some services under a different agreement were provided through the media of PE at a later stage. It would have been a different matter, if as averred in the application, the procurement services relating to phase-I were mostly or substantially performed in India. The reason is that procurement services are part of the very same agreement and even the consideration was not split up by reference to basic engineering services and procurement services. But, the applicant could not substantiate its statement that the procurement services were “essentially performed in India”. Coming to the second aspect of the argument, the contention of the applicant is equally untenable. Performing and providing services from Australia under the BE & P Agreement cannot, without anything more, give rise to effective connection with the PE in India. We reiterate that the effective connection contemplated by Art. 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. Such overall connection unrelated to the role of the permanent establishment cannot be brought within the ambit of the exclusion clause contained in Art.XII(4). The words “effectively connected with the PE” are not words of redundance and should be given their due meaning, as discussed earlier. A real and perceptible connection should exist to fulfill the said criterion.
12.3. In order to decide the question whether effective connection exists between the services performed under the BE&P Agreement and the PE, basic facts relating to the functions exercised by the staff stationed at the PE, the work turned out by them in relation to the services under the agreement and the billing if any done by PE for the items of work done by it should have been placed on record. As the things stand, we have only bald and vague averments of the applicant.
13. While on the point of applicability of the exclusion clause (Article XII.4 of the DTAA), it is necessary to refer to certain observations of the Supreme Court of India in Ishikawajima- Harima Heavy Industries vs DIT. On a reading of the judgment as a whole, we find that the issues were considered from the point of view of Article 12.5 of the Indo-Japan DTAA, the scope of deemed income provision in S.9(1)(vii) and the territorial nexus principle. Their Lordships came to the conclusion that the offshore services in the nature of technical services having been rendered completely outside India with the PE having no role to play in respect thereof, the consideration received on account of such offshore services cannot be subjected to Indian income-tax either under Article XII of DTAA or under section 9(1)(vii) of the Act.
13.1. Now we will see what exactly has been said in the decision from the standpoint of Article 12.5 of Indo-Japan Treaty (corresponding to Article XII.4 of the Indo-Australian Treaty). At page 441 of ITR, it was observed thus: “Since the appellant carries on business in India through a permanent establishment, they clearly fall out of the applicability (sic) of Article 12(5) of the DTAA and into the ambit of Article 7.” Then, it was observed that PE had no role to play in the transaction that was sought to be taxed. Thereafter, while laying down the propositions (vide page 447 of ITR), it was said that “the terms “effectively connected” and “attributable to” are to be construed differently even if the offshore services and the permanent establishment were connected.” As far as this observation is concerned, what follows from the words of their Lordships is that the existence of effective connection with the PE does not automatically result in attribution of income to that PE because under Art.7.1, the profits that can be taxed are only those attributable to the PE, that is to say, the operations/activiti es of the PE. In fact, para 6 of the Memorandum of Understanding (Protocol) reached between India and Japan specifically states that the term `directly or indirectly’ attributable to that PE shall be referable to profits arising from transactions in which the PE has been involved and such profits are attributable to the PE to the extent appropriate to the part played by the PE in those transactions. The Supreme Court has specifically referred to para 6 of the Protocol in construing the expression `attributable’ . The observation of their Lordships though contained in one sentence would imply that there may be situations in which the services etc. have an effective connection with the PE, still attribution in terms of Art. 7.1 may not be possible. Such an attribution could only be in accordance with what has been laid down in the Protocol to the DTAA. In this context, it is important to note that there is no categorical finding or observation of the Supreme Court anywhere in that case that the offshore services were effectively connected to the PE in India. On the other hand, the learned Judges guardedly added a rider while formulating propositions 2 and 6 to the following effect: “assuming the offshore elements form an integral part of the contract” and more importantly – “even if the offshore services and the permanent establishment were connected.” We are of the humble opinion that the discussion proceeded on the basis that by reason of the exclusion clause contained in Article 12.5 of Indo-Japan Treaty, the clause dealing with business income i.e., Art.7 would apply and by applying the said Article, only that portion of the income arising from the operations of PE can be taxed in India. No specific finding was recorded by their Lordships on the point of `effective connection’, but the learned judges discussed the issue on the assumption that the exclusion clause applies and as a sequel to that Article 7 would come into play. Moreover, from what is stated at p.441, the Supreme Court cannot be said to have laid down a proposition that the mere existence of PE is enough to trigger the exclusion clause in Art.12.5 so as to make room to Art.7. Art.12.5 (corresponding to Art.XII.4 of India-Australia Treaty) categorically lays down the requirement of effective connection with the PE; otherwise, the exclusion provision would not come into play. In fairness to the applicant’s counsel, we must say that the counsel did not choose to lay stress on the wording – “since the appellant carries on business through PE” occurring in the quoted sentence at p.441. He agreed that “effective connection” is an essential ingredient that has to be satisfied. In the case of services etc. falling under royalty or FTS, Art.VII gets attracted only if their effective connection with the PE is established.
13.2. There is one more aspect which will have some relevance in understanding the observations referred to supra. In the DTAA between India and Japan, the terminology of Art.12 is somewhat different. The phraseology used in Art.12.5 is “the right, property or contract in which the royalties or fees for technical services are paid is effectively connected with the PE”. In such a case, Art.7 will apply. Instead of the word `services’ occurring in the Treaty with which we are concerned, the expression `contract’ is used therein. In view of this language of Art.12 (5), a view can be taken that the contract as a whole was effectively connected with the PE though the particular services (offshore services) were not so connected. Apparently, for this reason, their Lordships have proceeded on the premise that the offshore services forming part of the contract though rendered outside India were effectively connected to the PE, though the PE had no role in playing the actual rendering of such services.
13.3. Another proposition laid down by the Supreme Court in Ishikawajima case which needs to be explained is proposition No. 8. The legal position is stated thus:
“Article 7 of the DTAA is applicable in this case and it limits the tax on business profits to that arising from the operations of the permanent establishment. In this case, the entire services have been rendered outside India, and have nothing to do with the permanent establishment and can thus, not be attributable to the permanent establishment and therefore not taxable in India.”
On the strength of the above passage it is possible to contend that in the instant case also, Article VII of the DTAA should be applied. As discussed earlier, Article VII comes into the picture only when the exclusion clause in XII.4 comes into play. To attract XII(4) there must be effective connection between the services giving rise to royalty income and the PE in India. In the case of Ishikawajima, it was not found as a matter of fact that the offshore services were effectively connected with the PE. On the other hand, the observation in the above extracted passage and elsewhere would show that the non-resident’ s PE in India had nothing to do with the offshore services. Then, why their Lordships have expressly stated that “article 7 is applicable in this case”? It seems to us that this proposition should be read along with the preceding two propositions No. 7 & 6. In proposition No.7 the application of section 9(1)(vii)(c) was ruled out by interpreting that provision in a particular manner. That means, the income cannot be treated as FTS under the Act. It would then be business income having regard to the well established rule that if a matter is governed by the DTAA as well as statutory provision, whichever is more beneficial to the assessee, could be invoked, Art. 7 of DTAA could be invoked by the non-resident assessee as it turned out to be beneficial to him. Secondly, as discussed earlier, effective connection was assumed by their Lordships in paragraph 6 without expressing any opinion whether in fact such connection was there. At the cost of repetition, the words “even if the offshore services and the PE were connected” occurring in proposition No.6 are important. On such assumption, their Lordships proceeded to set out the legal consequence i.e. Article 7 being triggered by virtue of the operation of exclusion clause in Art.12 (5). In the present case, having regard to our categorical finding that the BE & P Services were not connected with the PE, Articles XII.2 and 3 govern the case of the applicant, there is no scope to invoke Art. VII through the route of Art. XII.4.
13.4. We, therefore, find nothing in the Ishikawajima Judgment that supports the applicant on the point of applicability of exclusion clause in Art. XII (4).
15. As regards Art. XII(4), another issue debated was whether in the event of holding that the services constituting `royalty’ are effectively connected to the PE in India, the entire receipts shall be taxed only in accordance with Art. VII to the complete exclusion of Article XII(2). The contention of the Revenue is that the receipts resulting from the services effectively connected to the PE shall be taxed in the manner provided by Article VII and the remaining receipts arising from the services unconnected to the PE would still be taxable under Article XII(2) of DTAA read with section 9(1)(vi) of the I.T. Act. Referring to the phraseology of Article XII (4), it is contended that the exclusion provision in Article XII(4) shall be strictly confined to that part of the income arising from the services connected with the PE. Otherwise, it is pointed out by the Revenue’s representative that an anomalous situation could arise. A non-resident performing the entirety of services from abroad in respect of a project to be carried out in India, will have to pay tax on the entire of `royalty’ income by reason of the fact that it has not set up a PE in India whereas a non-resident rendering few services through the media of a small PE set up in India will be able to avoid the payment of tax on “royalty” income except in respect of those few services rendered through the PE.
17.3. On an analysis of Section 9(1), we find that under the first clause, all l income accruing or arising, whether directly or indirectly through or from any business connection in India or property in India or any asset or source of income in India or through the transfer of a capital asset situate in India shall be deemed to accrue or arise in India. The Explanation thereto engrafts a limitation on the rule laid down in clause (i). Explanation (a) lays down that in the case of a business of which all the operations are not carried out in India, the deemed income under the clause shall be confined only to such part of the income as is reasonably attributable to the operations carried out in India. Then follow the specific clauses deeming certain specific heads of income as accruing or arising in India in certain circumstances and subject to certain limitations. Those specific items are salaries, dividend, interest, royalty and fees for technical services. We have already extracted clause (vi) of Section 9(1) which relates to income by way of royalty and which is relevant for our purpose. Sub-clause (vii) of Section 9(1) dealt with by the Supreme Court in Ishikawajima relates to fees for technical services. It reads thus:
(vii) income by way of fees for technical services payable by –
(a) the Government; or
(b) a person who is a resident, except where the fees are payable in respect of services utilized in a business or profession carried on by such person outside India or for the purposes of making or earning any income from any source outside India; or
(c) a person who is a non-resident, where the fees are payable in respect of services utilised in a business or profession carried on by such person in India or for the purposes of making or earning any income from any source in India.
It may be noticed that these three sub-clauses of clause (vii) are identical to the three sub-clauses of clause (vi).
17.5. On a reading of the above passage, two things are not clear: First, why reference has been made to sub-clause (c) of Section 9(1)(vii) instead of sub-clause (b) which is couched in a different language and deals with a different situation? The relevant portion in sub-clause (b) that covered the case of the appellant – Ishikawajima is the “income by way of fees for technical services payable by a person who is a resident.” In sub-clause (b), there is no mention at all of the services being utilized, much less rendered, in India. Secondly, why their Lordships stated that sub-clause (c) of Section 9(1)(vii) specifically* requires two conditions to be met, namely, that “the services which are the source of income that is to be taxed has to be rendered as well as utilized in India” in order to be taxable in India? The expression `rendered’, perhaps used in the sense of `performed’ is not to be found even in the inapplicable clause (c). Though it is difficult to find an answer, we cannot ignore the dicta in the above passage. We have to respect the observations of the Supreme Court and the spirit behind it, without invoking the doctrine of per incuriam as far as possible.. The overall impression we get, especially after reading some of the subsequent paragraphs, is that their Lordships wanted to interpret Section 9(1)(vii) in harmony with territorial nexus principle. Hence, the requirement of rendering the services in India was read into the said provision, though specifically that requirement is not to be found in that clause. A reference to certain other passages would perhaps throw better light in understanding the implications of the dicta laid down in Ishikawajima case. At page 443, it was observed: “Section 9 spells out the extent to which the income of non-resident would be liable to tax in India. Section 9 has (sic) a direct territorial nexus”. The following passages at pages 444-445 which have bearing on the interpretation of the opening part of Section 9(1)(vii) [which is in parimateria with Section 9(1)(vi)] are also relevant.
“92. Section 9(1)(vii) of the Act whereupon reliance has been placed by the learned Additional Solicitor General, must be read with section 5 thereof, which takes within its purview the territorial nexus on the basis whereof tax is required to be levied, namely, (a) resident; and (b) receipt or accrual of income.”
“94. What is relevant is receipt or accrual of income, as would be evident from a plain reading of section 5(2) of the Act. The legal fiction created although in a given case may be held to be of wide import, but it is trite that the terms of a contract are required to be construed having regard to the international covenants and conventions. In case of this nature, interpretation with reference to the nexus to tax territories will also assume significance. Territorial nexus for the purpose of determining the tax liability is an internationally accepted principle. An endeavour should, thus, be made to construe the taxability of a non-resident in respect of income derived by it. Having regard to the internationally accepted principle and DTAA, it may not be possible to give an extended meaning to the words “income deemed to accrue or arise in India” as expressed in section 9 of the Act. Section 9 incorporates various heads of income on which tax is sought to be levied by the Republic of India. Whatever is payable by a resident to a non-resident by way of fees for technical services, thus, would not always come within the purview of section 9(1)(vii) of the Act. It must have sufficient territorial nexus with India so as to furnish a basis for imposition of tax.” (emphasis supplied)
23. In view of the foregoing discussion, the answers to the questions formulated by the applicant (vide para 3 supra) are as follows:
Q.nos. (a) & (b): The services rendered and the work undertaken by the applicant in terms of the Agreement for Basic Engineering and Procurement services fall within the scope of “royalties” as defined in Art. XII(3) of the DTAA between India and Australia and the receipts are taxable in India by virtue of Art. XII(2). Under the Act too, they are so taxable. Though the applicant had a PE in India set up in October, 2001 or thereafter, there is no proof to the effect that the services contemplated by the said Agreement were in anyway connected with the PE. The effective connection between the PE and the royalty generating services under the BE & P Agreement is not established.
Q.nos. (c) & (d): The exclusion clause under Art. XII(4) of the DTAA is not attracted in view of the absence of effective connection between PE and the services, and therefore, the royalty income is liable to be taxed under Art. XII(2) of the DTAA read with section 9(1)(vi) and other charging provisions of the Act. The question of attribution of only a part of the income to the PE does not arise as Art. VII which envisages such principle does not apply. The entire receipts under the BE & P Agreement are liable to be taxed as royalty income on gross basis and at the rate of 15 per cent However, the receipts from the P.M. Services agreement, shall be treated as business income and be taxable only to the extent they are attributable to the operations of PE in India. The permissible deductions and rate of tax concerning business income will be applicable.