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India-Korea (Rep.)

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Treaty between India and Korea (Rep.) – Indian decision on taxability of offshore portion of composite contract

The Supreme Court of India delivered a ruling dated 18 May 2007 in the case of Commissioner of Income Tax v. Hyundai Heavy Industries Co. Ltd. (291 ITR 482) on whether a South Korean company was liable to tax in India on the offshore portion of a composite contract executed in South Korea, and also when does a permanent establishment (PE) come into existence in India in such contracts.

(a) Facts. The Taxpayer (i.e. Hyundai Heavy Industries Co. Ltd.; henceforth "Hyundai") was a foreign company based in South Korea. In March 1985, the Taxpayer entered into an agreement with the Oil and Natural Gas Company of India Ltd (ONGC) for designing, fabrication, hook-up and commissioning of certain platform/facility in Bombay High. The contract was in two parts, i.e. (i) fabrication of the platform in South Korea and (ii) installation and commissioning of the platform in India.

Hyundai filed its tax return in India showing "Nil" taxable income on the basis that it did not have a PE in India and therefore not liable to tax in India. It contended that since the duration of its activities in India (i.e. the installation and commissioning of the platform) was for less than 9 months (from November 1986 to April 1987), it did not have a PE in India. Accordingly, its "business profits" were not taxable in India under Art. 7 of the India-Korea (Rep.) tax treaty (the Tax Treaty).

Hyundai also contended that the contract was divisible into two parts, i.e. (i) fabrication of the platform in South Korea and (ii) installation and commissioning of the platform in India, and the income arising from the fabrication of the platform in South Korea was not taxable in India.

The Indian tax authorities rejected Hyundai's contentions and held that the income arising from the fabrication of the platform in South Korea was liable to tax in India. The tax authorities held that the duration of the entire project consisting of installation and commissioning lasted for more than 9 months and hence was a PE in India under Art. 5(3) of the Tax Treaty (Note. It is unclear, from the ruling, if there was a factual proof available on record to establish whether the period in India was more or less than 9 months). Hyundai's office in Bombay constituted its PE and, therefore, profits attributable to the PE were liable to tax in India under Art. 7 of the Tax Treaty.

The tax authorities rejected Hyundai's accounts on the basis that it had failed to produce the accounting details pertaining to the activities carried out by its PE in India, and that Hyundai had refused to produce the books of accounts maintained by it in South Korea. The tax authorities went on to hold that income from designing, fabrication, procurement of material etc. was partly attributable to the PE in India on the ground that such activities had a nexus with the ultimate activity of installation and commissioning of the platform, and thus, income to that extent from the South Korean activities were also taxable in India. The tax authorities took the view that the contract was not divisible as it was in respect of the turnkey project for a lump-sum price.

Accordingly, the tax authorities estimated Hyundai's net profit at 20% of the gross receipt (Note. This is based on the best judgement of the tax authorities although the exact basis of which has not been dealt with in the ruling. There is no legal basis for applying the rate of 20%, though a rate of 10% has been stipulated in Sec. 44BB of the Indian Income Tax Act 1961 (ITA) for such business; as applied by the Supreme Court in its ruling. It is possible that the tax authorities might have based the rate of 20% on the financials of the Taxpayer, applying certain accounting ratios). Consequently, the tax authorities taxed the entire revenue relating to the Indian operations and estimated the net profit of the Taxpayer at 20% of the gross receipt and 2% of the contract revenue in respect of the South Korean operations.

On appeal, the Commissioner of Income Tax (Appeals) held that profits attributable to the installation and commissioning work were attributable to the PE in India and therefore, 10% of receipts relating to work performed in India were taxable in India in accordance with Sec. 44BB of the ITA and the Central Board of Direct Taxation (CBDT) Instruction No. 1767 of July 1987. The Commissioner of Income Tax (Appeals) also held that 1% of the receipts pertaining to operations carried out in South Korea would also be taxable in India.

On further appeal to Income Tax Appellate Tribunal (ITAT), it was held that the taxable income in India would be 3% of the receipts pertaining to work performed in India (and not 10%). The ITAT held that installation PE came into existence post-completion of work in South Korea and hence, only income pertaining to work performed in India was taxable in India. The tax authorities' appeal against the order of the ITAT was rejected by the High Court, and the matter reached the Supreme Court.

(b) Issue. The key issues before the Supreme Court were:

-   whether the non-resident (i.e. Hyundai) was liable to tax in India on the offshore portion of a composite contract executed outside India;
-   when does a PE come into existence in India in such contracts; and
-   what are the profits reasonably attributable to Hyundai's PE in India.

(c) Decision. The Supreme Court ruled that Hyundai was not liable to tax in India in respect of income from its operations in South Korea and that the contract was a divisible contract which could not be viewed as one indivisible contract.

(i) Scheme of taxability of non-residents. The Court observed that under Sec. 4 of the ITA, it is the taxable income of every "person" which is taxable. Sec. 5(2) of the ITA lays down that in the case of non-residents, their taxable income in India is confined to income which accrues or arises in India or is deemed to accrue or arise in India, and income which is received or is deemed to be received by such foreign company in India. Therefore, under the ITA, the taxable unit is the foreign company and not its branch or PE in India.

A non-resident Taxpayer may have several streams of income accruing or arising to it in India or outside India but so far as the taxability under Sec. 5(2) of the ITA is concerned, it is restricted to income which accrues or arises, or is deemed to accrue or arise in India.

Therefore, income which accrues or arises to a foreign company in India can be only such portion of income as is attributable to its business carried out in India. This business could be carried out through its branch(es) or through some other form of its presence in India such as an office, project site, factory, sales outlet, etc., i.e. a PE. Therefore, under the ITA, while the taxable subject is the foreign company, it is taxable only in respect of the income which accrues or arises in India.

The Court held that the ITA does not provide for the taxation of a PE of a foreign company, other than a presumptive basis taxation for certain types of income like under Secs. 44BB, 44BBA, 44BBB, etc. (Note. Secs. 44BB, 44BBA, 44BBB, etc. legislate the presumptive tax provisions for computing business profits in connection with the business of exploration etc. of mineral oils, operation of aircrafts, civil construction etc. in certain turnkey power projects).

In the absence of specific provisions under the ITA to compute profits accruing in India to foreign entities, the profits attributable to a PE in India of a foreign company are required to be computed using normal accounting principles and having regard to general provisions of the ITA. Therefore, ascertainment of a foreign company's taxable business profits in India involves an artificial division between profits earned in India and profits earned outside India.

(ii) Taxability of Indian operations/PE. The Supreme Court further observed that the law is concerned with the profits earned in India and, therefore, a method is to be evolved to ascertain the profits arising in India and that can be done by treating the Indian PE as a separate profit centre vis-à-vis the foreign company (i.e. the parent South Korean entity; Hyundai). Such demarcation is necessary to earmark the tax jurisdiction over the operations of a company. Unless the PE is treated as a separate profit centre, it is not possible to ascertain the profits of the PE which, in turn, constitutes profits arising to the foreign entity/company in India. The computation of profits of the PE in the taxable jurisdiction decides the quantum of income on which the source country can levy the tax. It is necessary that the profits of the PE are computed as independent units.

The Court also observed that of the profits earned by Hyundai on supplies of fabricated platforms cannot be attributed to its PE in India as the installation PE came into existence only after the transaction was materialized. The installation PE came into existence only on conclusion of the transaction giving rise to the supplies of the fabricated platforms, i.e. only after the fabricated platform was delivered in South Korea to the agents of ONGC. Therefore, the profits on such supplies of fabricated platforms cannot be said to be attributable to the PE.

The Court observed that under Art. 7 (1) of the Tax Treaty, the profits to be taxed in the source country (i.e. India) are not the real profits but hypothetical profits which the PE would have earned if it was wholly independent of its enterprise (i.e. Hyundai). Therefore assuming that the supplies were necessary for the purposes of installation activity and even if the supplies were an integral part, no part of profits on such supplies can be attributed to the independent PE unless it is established by the tax authorities that the supplies were not at an arm's length price.

The Court observed that the attraction rule implies that when a foreign company sets up a PE in another country, it brings itself within the fiscal jurisdiction of that country to such a degree that such source country can tax all profits that the such company derives from that country – whether through PE or not. It is the act of setting up a PE which triggers the taxability of transactions in the source state. Therefore, unless the PE is set up, the question of taxability does not arise – whether the transactions are direct, or through the PE.

In the case of a turnkey project, the PE is set up at the installation stage while the sale of equipment is finalized before the installation stage. The setting up of PE, in such a case, is an event subsequent to the conclusion of the contract of sale. It is as a result of the sale of equipment that the installation PE comes into existence. However, the Court remarked that this is not an absolute rule. In this case, there was no allegation made by the tax authorities that the PE came into existence even before the sale took place outside India.

Accordingly, the Court concluded that the profits accrued to Hyundai for work carried out outside India were not taxable in India.

(iii) Quantum of taxable income in India. On the issue of quantum of income that should be attributed to India, pertaining to the installation and commissioning work in India, the Supreme Court held that 10% of the gross receipts relating to such services should be taxable in India.

The Court noted that the accounts submitted by Hyundai were rejected by the tax authorities. Hyundai had not challenged the rejection of the accounts and had contended that its income (relating to Indian operations) should be taxed on a presumptive basis at 10% applying Sec. 44BB of the ITA or under CBDT Instruction No 1767 dated July 1987, where if the sale takes place outside India, only 10% of the gross receipts in respect of installation/commissioning activities taking place in India, is to be brought to tax in India.

Having regard to the stand taken by Hyundai in its tax assessment, the Court ruled that 10% of the receipts were taxable in India in respect of work performed in India.

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