Taxation of Royalties and FTS as Business Profits (Interplay of Sections 44BB, 44D and 44DA)

fiogf49gjkf0d

1.0 Background

Income in the nature of Royalties and Fees for Technical Services (FTS) in the hands of nonresidents are generally taxed on gross basis as per Article 12 of the applicable Treaty or u/s.115A read with section 9(1)(vi) and (vii) of the Income-tax Act, 1961 (the ‘Act’). Essentially both kinds of income are subset of Business Income. Therefore, ideally they should be taxed on a net basis. However, even under tax treaties these incomes are taxed on gross basis in the State of Source, albeit at a concessional rate. Prior to the enactment of section 44DA on Statue, section 44D was in operation (Applicable to agreements entered into by non-residents up to 31st March 2003) which specifically disallowed deduction of any expenditure in computing Foreign Company’s Income by way of Royalties and FTS. Thus, it resulted in taxation of royalties/FTS on gross basis even in a case where there existed a Permanent Establishment in India. However, the silver lining was applicability of section 44BB which covered payments in connection with supplying of Plant and Machinery on hire which is used or to be used for prospecting for, extraction or production of mineral oils including natural gas. Section 44BB provides for presumptive basis of taxation whereby 10% of the gross amount is deemed to be taxable profits.

2.0 Royalty and FTS

— Sections 9(1)(vi) and (vii) of the Act In this Article, we shall discuss the provisions of Royalty and FTS in the context of sections 44BB, 44D and 44DA only. We shall not go into the other aspects or controversies in respect of Royalty and FTS.

2.1 Royalty

Clause (iva) of the Explanation 2 of the section 9(1)(vi) provides that “the use or right to use any industrial, commercial or scientific equipment but not including the amounts referred to in section 44BB” would constitute royalty. This exception is significant in that it substantially reduces tax liability in the hands of the recipient of royalty income. Section 115A provides that royalties referred to in section 9(1)(vi) are taxed at the rate of 10% on gross basis (other than royalty referred to in section 44DA), whereas if the income is taxed u/s.44BB, then the incidence of tax would be @ 4% on gross basis (excluding applicable Surcharge and Education Cess).

2.2 Fees for Technical services (FTS)

Explanation 2 of section 9(1)(vii) excludes consideration for any construction, assembly, mining or like project undertaken by the recipient from the purview of FTS. The CBDT has issued an Instruction No. 1862, dated October 22, 1990 based on the opinion of the then Attorney General of India Shri Soli J. Sorabjee in the context of interpretation and coverage of section 9(1)(vii) in respect of contract between ONGC and M/s. Scan Drilling Co. Ltd. Accordingly “the expressions ‘mining project’ or ‘like project’ occurring in Explanation 2 to section 9(1)(vii) of the Income-tax Act would cover rendering of services like imparting of training and carrying out drilling operations for exploration or exploitation of oil and natural gas . . . .” Based on the above CBDT Instruction in ONGC v. ACIT, (2007) 12 SOT 584 (Delhi) it was held that imparting training for carrying out of drilling for exploration of oil and natural gas was held to be covered by the exception referred to in Expl. 2 to section 9(1)(vii) and can be taxed on presumptive basis u/s.44BB of the Act. Supervisory services In Income-tax Officer v. SMS Schloemann Siemag Aktiengesellshaft Dusseldorf, (57 ITD 254) it was held that mere ‘supervisory services’ undertaken by the assessee would not amount to undertaking of the construction or assembly of the plant for exclusion from FTS under Expl. 2 to section 9(1)(vii) of the Act.

3.0 Section 44D of the Act

Section 44D of the Act dealt with computation of royalty or FTS received by a foreign company from Government or an Indian concern in pursuance of an agreement entered into before 1st April 2003. Up to 31st March 1976 it provided for a flat deduction of 20% from the gross amount of royalty or FTS. From 1st April 1976 to 31st March 2003 it did not provide for deduction of any expenditure. In other words royalty or FTS (not covered 44BB) earned by a foreign company during this period was taxed on gross basis @ 30/20% (plus applicable Surcharge and Education Cess). Thus, the incidence of taxation was quite high even though the foreign company would have a permanent establishment in India.

4.0 Section 44DA of the Act

Section 44DA was introduced vide the Finance Act, 2003 to replace section 44D of the Act. It also covers income by way of royalty and FTS. The distinguishing features of both the sections are as follows:

Abbreviations :
(i) NR = Non-resident * Plus applicable Surcharge and Education Cess
(ii) FTS = Fees For Technical Services
(iii) PE = Permanent Establishment as defined Clause (iiia) of section 92F

5.0 Interplay of sections

44BB, 44D and 44DA Royalty and FTS are essentially covered by section 9 r.w.s. 115A as well as sections 44BB and 44D and 44DA. The impact of taxation in each of the case differs depending upon the applicability of provisions and existence or otherwise of a PE. The overall implications under various provisions of the Act can be summarised as follows: If Royalty & FTS as per

•  section 115A tax section 9(1)(vi)/(vii) @10% on gross basis and No PE If No Royalty and ? If income is covered No PE by section 44BB — Presumptive Profit @10% of gross receipts. Effective rate of tax 4% [With an option to tax on net basis u/s.44BB(3)] If Royalty & FTS as per
• Section 44DA on net section 9(1)(vi)/(vii) basis @ 40% and PE (Rates are quoted without Surcharge and Education Cess) In Geofizyka Torun Sp. zo. o. (2010) 320 ITR 0268 — the AAR explained the relationship between section 44BB and 44DA as under: “If the business is of the specific nature envisaged under 44BB, the computation provision therein would prevail over the computation provision in section 44DA.”

Abbreviations : (i) NR = Non-resident
(ii) P&M = Plant & Machinery
(iii) FTS = Fees For Technical Services
(Rates are quoted without Surcharge and Education Cess)

6.0 Taxability under DTAA

By and large all tax treaties which contain Articles on Royalty and FTS provide for their taxation in the State of Source (SS) on gross basis, albeit, at reduced rates. However, wherever the recipient has a PE in the ‘SS’, and such incomes are effectively connected with that PE, then they are taxed as ‘Business Profits’ [DDIT v. Pipeline Engineering GMBH, (2009) 318 ITR (A.T.) 0210]. Article 7 of DTAAs provides that profits attributable to a PE in ‘SS’ are taxed therein. Article 7 further provides for computation of profits where by deduction of expenses are allowed in accordance with the provisions of and subject to limitations of the taxation laws of SS. In some treaties specific deductions are mentioned, whereas in most treaties they are left to domestic tax laws.

Business Profits, thus taxable in India would be subject to provisions of section 28 to 44C of the Act. However, section 44D contained non-obstante clause which provided that “notwithstanding anything to the contrary contained in section 28 to 44C……” income derived by a foreign company in the nature of royalty and FTS to be taxed on gross basis. This resulted in severe difficulties as despite treaty provisions, Royalty and FTS even though attributable to a PE used to be taxed on gross basis. In DDIT v. Pipeline Engineering GMBH, [(2009) 318 ITR (A.T.) 0210] the Mumbai Tribunal held that “the combined reading of the treaty and the act leads to only one conclusion that no deduction is to be allowed against the receipts by way of royalties or fees for technical services in case of non-resident company, even if the business profits in respect of such income are to be computed under Article 7 of the DTAA”.

In order to avoid this anomaly, section 44DA was introduced w.e.f. 1st April 2004, which provided for net basis of taxation where royalty and FTS are effectively connected to a PE and incurred wholly and exclusively for the business carried on by that PE.

7.0 Judicial precedence

Majority of the decisions are in respect of characterisation of income between royalty as defined u/s.9(1)(vi) and business income covered by section 44BB of the Act.

7.1  Choice to opt for presumptive taxation

In DSD INDUSTRIEANLAGEN GmbH v. DDIT, (2009 TII 67 ITAT-Del.-Intl), the Tribunal held that the option to compute the income either on a presumptive basis or under normal provisions of the Act lies with the assessee and that he may exercise this option annually. “The Assessing Officer cannot force the system, which has been followed in the earlier year as per the option by the provision of law itself.”

7.2 Cases pertaining to section 44BB

7.2.1  Mobilisation expenses

In WesternGeco International Limited (2011) 338 ITR 0161 it was held that mobilisation and demobilisation revenues whether in respect of vessels moving into India or moving outside India are taxable in aggregate u/s.44BB on presumptive basis and that “there is no scope for splitting up the amount payable to the assessee.” The assessee however can opt for net basis of taxation u/s.44BB(3).

However, in case of R&B Falcon v. ACIT, (2007) 14 SOT 281 (Delhi) it was held that mobilisation revenue attributable to activities carried out in India are only liable to be included for the purposes of section 44BB.

7.2.2 In the undernoted cases the services of seismic data acquisition and processing were held to be covered under the provisions of section 44BB of the Act:

(i)    WesternGeco International Limited. (2011) 338 ITR 0161

(ii)    Geofizyka Torun SP. ZO.O. (2010) 320 ITR 0268

(iii)    Seabird Exploration FZ LLC (2010) 320 ITR 0286

7.2.3 Time charter

In the undernoted cases the income derived by provision of time charter of seismic vessel were held to be covered by section 44BB of the Act:

(i)    Wavefield Inesis ASA, (2010) 322 ITR 0645

(ii)    Bourbon Offshore Asia Pte. Ltd., (2011) 337 ITR 0122

7.2.4 General applicability of section 44BB

In the undernoted cases section 44BB was held to be applicable:

(i)    DIT v. Jindal Drilling and Industries Ltd., (2010) 320 ITR 0104 (Delhi)

(ii)    ONGC as agent of Foramer France (1999) 70 ITD 468 (Delhi)

(iii)    Paradigm Geophysical Pvt. Ltd. (2008 TIOL 362 ITAT-Del.)

(iv)    Dresser Mineral International Inc., 50 TTJ 273 (Del.)

(v)    Scan Drilling Co. (Delhi ITAT)

(vi)    Lloyd Helicopters International (2001) 249 ITR 162 (AAR)

7.2.5 Some Specific inclusions while considering Gross Receipts u/s.44BB:

(i)    Services tax : Technip Offshore Contracting bv (2009 TIOL 54 ITAT-Del.)

(ii)    Taxes paid on behalf of NR contractor: Compagnie General (48 ITD 424)

8.0 Conclusion

The cases discussed here are not exhaustive. It is neither possible nor intended to cover all case laws on the subject in one article. The object here is to analyse the impact and interplay of sections 9(1)(vi) and (vii), 44BB, 44D and 44DA and 115A and to assess the taxability of Royalty and FTS both on gross as well as net basis.

As India is aggressively exploring its oil and gas resources, more and more foreign companies are setting up their operations in India in the field of prospecting, exploring and production of oil and natural gas and therefore study of these sections of the Act will gain importance in coming days.