Compensation including interest on cancellation of contract not taxable in absence of PE

Recently, the Mumbai bench of the Income Tax Appellate Tribunal (the Tribunal) in the case of Gold crest Exports Vs. ITO (ITA No. 442/Mum/2009) held that the compensation payable due to the cancellation of contract was arising out of the trading contract and therefore, such income in the hands of payee (UK entity) was in the nature of business profit under Article 7 of the India-UK tax treaty (the tax treaty). However, in the absence of Permanent Establishment (PE) of UK entity in India the compensation awarded was not taxable in India. Further, it was held that interest on such compensation partake the character of the compensation.

Accordingly, the Tribunal held that the taxpayer was not liable to withhold tax on such compensation under Section 195 of the Income-tax Act, 1961 (the Act) and there was no justification for disallowing amount of the compensation claimed by the taxpayer under Section 40(a) of the Act.

Facts of the case

• The taxpayer entered into a contract for supply of Indian Natural Whitish Sesame Seeds with a UK entity through a broker. Subsequently, the taxpayer repudiated the contract on the ground that the seller did not obtain the export contract duly signed by the buyer and contract was merely signed by the broker. The foreign buyer invoking arbitration clause claimed the compensation from the taxpayer through the arbitration proceedings. The Arbitrator passed the award determining the claim of the foreign buyer against the taxpayer of US $ 81,225, payable with interest @ 5 percent per annum.

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