Composite contract involving offshore supply of equipment and onshore supply and services should be looked at as an integrated one only when the allocation of profits between the offshore and onshore components is unreasonable and artificially split up. ? Overall position of the entire contract needs to be considered and if no profits are earned by the taxpayer on an overall basis, no income from composite contracts can be taxed in India.

Overall position of the entire contract needs to be considered and if no profits are earned by the taxpayer on an overall basis, no income from composite contracts can be taxed in India.

• Taxpayer, a Chinese company (FCO), had entered into various contracts with Indian entities for setting up of turnkey thermal power projects. Each of these contracts were divided into two parts — one for supply of equipment and materials of thermal power plant and second for erection and services of units of main plant along with some common facilities.
• FCO had a project office in India which constituted a permanent establishment (PE) of FCO in India.
• In terms of the contract, consideration receivable by FCO was separately provided in respect of offshore supply and onshore activities.
• FCO contented that consideration for offshore supply of equipment was not taxable in India under the Income-tax Act as well as the DTAA. As regards onshore activities, FCO incurred substantial losses which were reported and claimed in return of its income filed in India.
• The Tax Department treated the entire project as an integrated one and held that contract was manipulated and artificially split up in such a way that FCO’s onshore activities will always result in losses. Further, FCO’s PE had a role in the overall execution of the project and hence, income in India should be computed by attributing profits to the PE under the DTAA as well as transfer pricing provisions under the Income-tax Act.
•  The matter was referred to transfer pricing officer who attributed profits in India on both offshore and onshore components resulting in taxable income of FCO in India.

 ITAT Ruling:

•  Reference was made by the ITAT to the AAR ruling in the case of Alstom Transport SA1 where the AAR held that a composite contract for installation and commissioning cannot be split up into separate parts and the contract has to be read as a whole having regard to its object and the purpose it sought to be achieved. This was held by applying the ‘look at’ principle adopted by Supreme Court (SC) in the case of Vodafone2. The prior decisions of SC3 where a dissecting approach in respect of such contracts was adopted are overruled as the decision in the case of Vodafone will have greater precedence as the same is rendered by a Larger Bench of the SC.
• There may be legitimate issues regarding whether the ‘look at’ approach can be applied in all cases in which separate contracts are entered into for offshore supplies and onshore services. The ratio of the AAR ruling in the case of Alstom Transport can be made applicable in cases where values assigned to onshore services are prima facie unreasonable vis-a-vis values assigned to offshore supplies, which make no economic sense when viewed in isolation with offshore supplies contract. The ratio can be accepted where transactions are to be essentially looked at as a whole and not on a stand-alone basis, when the overall transaction is split in an unfair and unreasonable manner with a view to evade taxes.
• Presence of ‘cross-fall breach clause’ (ensuring that performance of entire project was treated as single-point responsibility and non-performance of any part would be treated as a breach of whole contract) indicates that the contract could be viewed as an integrated one. However, this fact by itself does not mean that consideration for onshore activities is understated to avoid taxes in India.
• In FCO’s case, losses were incurred not only in respect of onshore activities, but also on offshore supplies executed from China. If losses are incurred on the entire project, the mere fact that losses were incurred on onshore activities cannot be a sufficient reason to indicate that the arrangement was tax avoidant.
• Even if the contracts are taken together as an integrated whole and if there are no profits earned under the contracts, there can be no occasion to tax income from such contracts in India.
• The Tax Department needs to examine the matter in light of the fact that FCO has incurred losses on the entire project on an overall basis. The transfer pricing provisions under the Incometax Act would apply only if the basic position of FCO for claiming overall losses is rejected.