Decoding Finance Bill 2012

Rajendra Nayak - Partner, International Tax Services, SR Batliboi & Co.
Unintended consequences of amending Sec 9!

Tax policy has in the recent years been a key lever, globally, to revive, resuscitate and re-set economies on a much-needed growth trajectory. In the Indian context, this couldn’t have been more relevant, in the wake of a slowdown in the economy in the past year, which was mainly due to an uncertain global economic environment and domestic challenges on certain macroeconomic factors. However, the road-map for providing for a better fiscal consolidation, as seen in some of the 2012 budget proposals, has been done at the cost of cataclysmically unsettling established tax positions, and which could (in)advertently vex the investment climate for multinationals.
“clarifying” the meaning of “through”
Perhaps bitter over the Vodafone defeat[1], and aware that the provisions for taxation of offshore indirect transfers of an underlying Indian asset in India as present in the Direct Taxes Code would not get promulgated soon, the Government has proposed to introduce and tax such transactions in the current Indian Tax Law (ITL), albeit retrospectively (i.e., from April 1962). However, in doing so, the Government has probably widened the scope of not just indirect transfer of a capital asset situated in India, but also of other source rule taxation of income, deemed to accrue or arise in India.
In this context, the source rule in the ITL under section 9(1)(i), provides certain streams of income, which are deemed to accrue or arise India. It is a legal fiction created to tax income, which may or may not arise in India and would not have been taxable but for the deeming provisions created under this section. The section provides source-based taxation of all income accruing or arising, whether directly or indirectly, through: (i) or from any business connection in India; (ii) or from any property in India; (iv) or from any asset or source of income in India; (v) the transfer of a capital asset situate in India. The Finance Bill 2012, has now “clarified” that in the source rule, the expression “through”, shall mean to include “by means of” or “in consequence of” or “by direct reason of”.
While the intent, as evident from the memorandum explaining the provision, is to only capture offshore indirect share deals which have substantial Indian underlying assets, there could be some unintended tax consequences. It may be noted that in the Vodafone ruling, the Supreme Court had held that the source rule provisions under the ITL needs to be strictly construed and in the absence of a “look through” provision, an indirect transfer would not be taxable in India. Now however, juxtaposing the proposed meaning of “through” with other limbs in the source rule (above), it would seem that the expanded meaning qualifies all the other streams of income, and may have far reaching consequences beyond the fact pattern in Vodafone-like cases. These cases may result more particularly in the context of a nonresident having any “property” or “asset or source of income” in India, rather than through a “business connection” as the same is restricted in the section itself to only operations carried out in India.
To illustrate, a nonresident provides a guarantee for a loan taken by another nonresident from a bank. As a guarantor, the nonresident, who has no business or profession in India, may provide a Indian shares as a collateral to the bank. The issue that may arise now is whether the guarantee fee that the non-resident guarantor earns arises directly or indirectly “through” or from an asset or property situated in India.
As a measure of clarification, explanation 5 provides that share or interest in a company or entity registered or incorporated outside India shall be deemed to be situated in India if the share or interest derives, directly or indirectly, its value substantially from the assets located in India. Once the asset is deemed to be in India, income from such asset is also deemed to accrue or arise in India. This could imply that any dividends distributed by the foreign company whose shares are deemed to be situated in India could also be regarded as accruing or arising India.

Royalty blues for taxpayers
The Government has also amended the source rule on taxation of royalty related transactions, provided under section 9(1)(vi) of the ITL. The royalty source rule provides that any income payable by way of royalty in respect of any right, property or information is deemed to accrue or arise in India. The term “royalty” has been defined to mean consideration received or receivable for transfer of all or any right in respect of certain rights, property or information. There have been a catena of judicial decisions, which have interpreted this definition in a manner which has raised doubts as to whether consideration for use of computer software is royalty or not; whether the right, property or information has to be used directly by the payer or is to be located in India or control or possession of it has to be with the payer. Similarly, doubts have been raised regarding the meaning of the term “process”.
The debate principally has focused on characterizing transactions as generating either “royalty” or “sales” income. The characterization of income as “royalty” or “sales” income can have obvious consequences, particularly in light of the fact that under the ITL as well as under many Double Taxation Avoidance Agreements (DTAAs), income characterized as “royalty” attracts withholding tax, whereas any income characterized as “sales” income or “business profits” would not be subject to tax in India in the absence of a permanent establishment (PE) or other taxable presence of the nonresident in India.
The Indian tax authority has generally taken a position that income arising from such transactions should be characterized as “royalty”, irrespective of the nature of rights acquired by the end-user or re-seller. The Taxpayer's position on the other hand generally has been that characterization as royalty or business profits, especially under an applicable DTAA, should be based on the nature and extent of rights granted to the end user. Depending upon the nature and extent of rights granted, a distinction needs to be made between a "copyright” transaction (generally giving rise to royalty) and "copyrighted article" transaction (generally giving rise to sales income). Further, supply of “shrink wrapped” computer program should be regarded as a "copyrighted article" transaction.
The overall tenor of judicial thinking on this issue, as evident in the Delhi High Court (HC) ruling in the case of Ericsson [246 CTR 422], has recognized the distinction between copyright right and copyrighted article. However, a different approach has been taken by the Karnataka HC in the case of Samsung Electronics [245 CTR 481], wherein it was held that payment for shrink-wrapped software is taxable as royalty. On the issue of whether payments for using segment capacity in a transponder for up-linking/ down-linking data is taxable under the ITL, the Delhi HC in the case of Asia Satellite [332 ITR 340], ruled that such payments do not constitute royalty under the ITL as the Taxpayer does not grant the customer a right to use the “process” of transmitting signals/data under the arrangement.
Appearing to clear and clarify  the conflict on various court decisions, as stated in the memorandum explaining the provisions, the Government proposes to amend retrospectively (i.e., June 1976) the definition of royalty in favor of the Tax Authority, to enlarge its scope whereby: 
  • The consideration for the transfer of all or any right would include right for use or right to use a computer software (including the granting of a license) to be taxable as royalty regardless of the medium through which the right is transferred;
  • ‘royalty’ would also include consideration paid for right, property or information, regardless of such right, property or information being: in the possession of the payer; used directly by the payer; located in India.
  • the expression ‘process’ includes transmission by satellite (including up-linking, amplification, conversion for down-linking of any signal), cable, optic fibre or by any other similar technology regardless of whether such process being secret or not

While the above amendments do not directly impact the interpretation of the term “royalty” under an applicable tax treaty, it is likely that the tax authority could now seek to argue that the clarification in domestic tax law is an expression of the intention that also existed when the tax treaty was negotiated and should be considered for interpreting the terms “right to use copyright”, “process” that are used in the in the royalty definition of the tax treaty; but not defined. The Government could also seek to notify the meaning of these terms for purpose the tax treaty.
What is perhaps significant in the section 9 source-rule proposals is its retroactive operation and whether they are constitutionally valid. This aspect, may be challenged legally as it may be argued that, the proposals not really “clarify”, but purport to make substantive amendments to the source-rule, and accordingly infringe on the rights of the taxpayers. The proposals, if passed, would have far reaching impact on past assessments and for the tax deductors, including representatives for non residents.
Rapid technological evolution in the space and communications industries has taken place over the last decade, which has resulted in changes in business practices and business models. The emerging convergence in communications, technology, media and outer space activities raises a number of tax issues such as our ability to apply our traditional principles of source and residence for taxing these activities, applying the conventional concept of fixed place of business or permanent establishment as a threshold for taxing cross-border activities, challenges in classifying income arising from these activities as royalty or technical service fees. It might be expected that many countries could react by protecting and expanding their own taxing jurisdiction over income arising from cyberspace, outerspace and ocean activity, creating double taxation issues. The proposed amendments in the Finance Bill, 2012 reflects India’s reaction to these technology developments.
As India moves towards a more open economy and emerges as a key stakeholder in global trade and commerce, cross-border transactions will continue to grow manifold. However, lack of a clear and certain tax environment, as reflected in the Government’s belligerence in pushing through vexatious tax proposals, is likely to exacerbate the ambiguity that currently prevails on these matters and exasperate interested investors. While the future may be fraught with uncertainty, careful and comprehensive tax and risk management would go a long way in avoiding possible pitfalls for multinationals.