Compensation including interest not taxable in absence of PE

Court; Mumbai Income Tax Appellate Tribunal

Citation: M/s. Gold crest Exports Vs. ITO [2010-TII-124-1TAT-MUM-INTL]

Brief :Mumbai Income-tax Appellate Tribunal (the Tribunal) in the case of M/s. Gold crest Exports Vs. ITO [2010-TII-124-1TAT-MUM-INTL] held that compensation payable for breach of contract to a foreign company would not be taxable in the hands of the foreign company in the absence of a permanent establishment (“PE”) of the foreign company in India. The Tribunal further held that interest included in compensation merges with and partakes the character of compensation itself, and hence, would not be taxable under the tax treaty between India and UK (tax treaty). Therefore, deduction claimed by the assessee for compensation including interest cannot be disallowed on account of non-withholding of taxes therefrom.

Facts

• The assessee was engaged in the business of export and import and was also trading in different commodities.
• The assessee had entered into a contract with a foreign company through a broker for supply of commodities. It repudiated the contract on the grounds that the contract was signed only by the broker and not by the buyer.
• The foreign company claimed compensation from the assessee through arbitration proceedings. The arbitrator passed the award against the assessee, requiring the assessee to pay compensation including interest.
• The Assessing Officer (“AO”) disallowed the compensation paid to the foreign company on the ground that the assessee had not withheld taxes in terms of provisions of section 195(1) of the Income-tax Act, 1961 (“the Act”).
• The Commissioner of Income-tax (“CIT(A)”) upheld the AO’s order.

Issue- Whether compensation including interest paid under an arbitral award to a foreign company not having a PE in India would be allowable as a deduction even where tax is not withheld under section 195(1) of the Act.

Assessee’s contentions:-The assessee contended that:

• Compensation paid by the assessee was in compliance with its trading contract, in the nature of business profit
• The interest element in the compensation had lost its original character and assumed the character of a judgement debt as was held in the case of Islamic Investment Co. v. U0I [2004] 265 ITR 254 (Bom).
• Hence, in terms of the provisions of Article 7 of the tax treaty, the compensation paid would not be taxable under the tax treaty
• The foreign company had no PE in India.
• The obligation to deduct tax under section 195(1) of the Act arises only when income of the non-resident payee is subject to tax in India.

Revenue’s contentions- The revenue contended that:

• Compensation is taxable in India under section 9(1)(i) of the Act since it is income deemed to accrue or arise in India.
• The benefit of Article 7 of the tax treaty cannot be allowed as the assessee had not demonstrated that compensation income would be business income in the hands of the foreign company.
• The assessee had not withheld tax under section 195 (1) of the Act on the compensation paid in its books of account.

Tribunal Ruling-The Tribunal held that:

• The compensation had arisen out of a trading contract entered into by the assessee and the foreign company. Therefore, the compensation was business profit covered under Article 7 of the tax treaty.
• The contract was only for the supply of goods from India and it was not the case with the AO or the CIT(A) that the broker was the dependent agent of the foreign entity. Therefore, the foreign company had no PE in India in terms of the provisions of Article 5(5) of the tax treaty.
• In the case of Islamic Investment Co. (above), it was held that interest awarded in an arbitration award loses its original character and assumes the character of a judgement debt. Therefore, interest partakes the character of compensation itself.
• Relying on the decisions cited by the assessee (Please see Note 1 Below), the assessee was not liable to withhold tax under section 195(1) of the Act on any sum not taxable in India.
• Accordingly, deduction for compensation including interest would be allowable to the assessee.

Conclusion :-The Tribunal had applied the decision of the Islamic Investment Co. (above) to hold that the interest payable in view of a decree or arbitration award loses its original character and assumes the character of a judgement debt. Any such compensation under an award in connection with a business contract in the nature of business income would not be taxable in India in case the recipient does not have a PE in India. The Tribunal reiterated that withholding tax under section 195(1) of the Act would not be necessary in the absence of any income chargeable to tax in India in the hands of the payee.

Note- 1

• Mahindra & Mahindra v. DCIT (SB) [2009] 313 ITR 263 (AT)(Mum)
• Royal Airways Ltd. v. DDIT[2005] 98 ITD 259 (Del)
• Van Oord ACZ India (Pvt.) Ltd. v. CIT [2010] 36 DTR 425(Del)

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