Glimpses Of Supreme Court Ruilings

14. Yum! Restaurants (Marketing) Private Limited vs. Commissioner of Income Tax, Delhi

Date of order: 24^th April, 2020

Doctrine of mutuality – Applicability of – The receipt of money from an outside entity without affording it the right to have a share in the surplus does not only subjugate the first test of common identity, but also contravenes the other two conditions for the existence of mutuality, i.e., impossibility of profits and obedience to the mandate – There is a fine line of distinction between absence of obligation and presence of overriding discretion – An arrangement wherein one member is subjected to the absolute discretion of another, in such a manner that the entire liability may fall upon one whereas benefits are reaped by all, is antithetical to the mutual character in the eyes of law – The raison d’être behind the refund of surplus to the contributors or mandatory utilisation of the same in the subsequent assessment year is to reduce their burden of contribution in the next year proportionate to the surplus remaining from the previous year – Non-fulfilment of this condition is antithetical to the test of mutuality

The appellant company Yum! Restaurants (Marketing) Private Limited (‘YRMPL’ or ‘assessee company’ or ‘assessee’) was incorporated by Yum! Restaurants (India) Pvt. Ltd. (‘YRIPL’), formerly known as Tricon Restaurants India Pvt. Ltd., as its fully-owned subsidiary for undertaking the activities relating to advertising, marketing and promotion (‘AMP activities’) for and on behalf of YRIPL and its franchisees after having obtained approval from the Secretariat for Industrial Assistance (‘SIA’) for the purpose of economisation of the cost of advertising and promotion of the franchisees as per their needs. The approval was granted subject to certain conditions as regards the functioning of the assessee whereby it was obligated to operate on a non-profit basis on the principles of mutuality.

In furtherance of the approval, the assessee entered into a tripartite operating agreement (the ‘tripartite agreement’) with YRIPL and its franchisees, wherein the assessee company received fixed contributions to the extent of 5% of gross sales for the proper conduct of the AMP activities for the mutual benefit of the parent company and the franchisees.

For the assessment year 2001-02, the assessee filed its return stating the income to be Nil under the pretext of the mutual character of the company. The same was not accepted by the A.O. who observed that the assessee company along with the franchisees was to contribute a fixed percentage of its revenue to YRMPL. However, as per the tripartite agreement submitted by YRMPL, YRIPL had the sole absolute discretion to pay to YRMPL any amount as it may deem appropriate and that YRIPL had no obligation to pay any amount if it chooses not to do so. YRIPL was under no legal obligation to pay any amount of contribution as per its own version reflected from the tripartite agreement. The A.O. determined the total income at Rs. 44,44,002, being the excess of income over expenditure for A.Y. 2001-02.

The imposition of liability by the A.O. was upheld by the CIT(A) on the ground of taint of commerciality in the activities undertaken by the assessee company.

The liability was further confirmed by the Tribunal, wherein the essential ingredients of the doctrine of mutuality were found to be missing. The Tribunal inter alia found that apart from others, contributions were also received from M/s Pepsi Foods Ltd. and YRIPL. Pepsi Foods Ltd. was neither a franchisee nor a beneficiary. Similarly, some contribution was also received from YRIPL who was not under any obligation to pay. Thus, the essential requirement, that the contributors to the common fund are either to participate in the surplus or they are beneficiaries of the contribution, was missing. Through the common AMP activities no benefit accrued to Pepsi Foods Ltd. or YRIPL. Accordingly, the principles of mutuality could not be applied.

The consistent line of opinion recorded by the aforementioned three forums was further approved in appeal by the High Court.

According to the Supreme Court, the following questions of law arose in the present case:

(i) Whether the assessee company would qualify as a mutual concern in the eyes of law, thereby exempting subject transactions from tax liability?

(ii) Whether the excess of income over expenditure in the hands of the assessee company is not taxable?

The assessee had contended before the Supreme Court that the sole objective of the assessee company was to carry on the earmarked activities on a no-profit basis and to operate strictly for the benefit of the contributors to the mutual concern. It was further contended that the assessee company levied no charge on the franchisees for carrying out the operations. While assailing the observations made in the impugned judgment, holding that Pepsi Foods Ltd. and YRIPL were not beneficiaries of the concern, the assessee company had urged that YRIPL was the parent company of the assessee and earned a fixed percentage from the franchisees by way of royalty. Therefore, it benefited directly from enhanced sales as increased sales would translate into increased royalties. A similar argument had been advanced as regards Pepsi Foods Ltd. It was stated that under a marketing agreement the franchisees were bound to serve Pepsi drinks at their outlets and, thus, an increase in the sales at KFC and Pizza Hut outlets as a result of AMP activities would lead to a corresponding increase in the sales of Pepsi. It was pointed out that Pepsi was also advertised by the franchisees in their advertising and promotional material, along with Pizza Hut and KFC.

As regards the doctrine of mutuality, it was urged by the assessee company that the doctrine merely requires an identity between the contributors and beneficiaries and it does not contemplate that each member should contribute to the common fund or that the benefits must be derived by the beneficiaries in the same manner or to the same extent. Reliance had been placed by the appellant upon reported decisions to draw a parallel between the functioning of the assessee company and clubs to support the presence of mutuality.

The Revenue / respondent had countered the submissions made by the assessee company by submitting that the moment a non-member joins the common pool of funds created for the benefit of the contributors, the taint of commerciality begins and mutuality ceases to exist in the eyes of law. It had been submitted that the assessee company operated in contravention of the SIA approval as contributions were received from Pepsi, despite it not being a member of the brand fund. It was urged that once the basic purpose of benefiting the actual contributors was lost, mutuality stands wiped out.

The Supreme Court held that it was undisputed that Pepsi Foods Ltd. was a contributor to the common pool of funds. However, it did not enjoy any right of participation in the surplus or any right to receive back the surplus which was a mandatory ingredient to sustain the principle of mutuality.

The assessee company was realising money both from the members as well as non-members in the course of the same activity carried on by it. The Supreme Court noted that in Royal Western India Turf Club Ltd., AIR 1954 SC 85 it has categorically held such operations to be antithetical to mutuality. Besides, the dictum in Bankipur Club (1997) 5 SCC 394 was apposite.

According to the Supreme Court, the contention of the assessee company that Pepsi Foods Ltd., in fact, did benefit from the mutual operations by virtue of its exclusive contracts with the franchisees was tenuous, as the very basis of mutuality was missing. Even if any remote or indirect benefit is being reaped by Pepsi Foods Ltd., the same could not be said to be in lieu of it being a member of the purported mutual concern and, therefore, could not be used to fill the missing links in the chain of mutuality. The surplus of a mutual operation was meant to be utilised by the members of the mutual concern as members enjoy a proximate connection with the mutual operation. Non-members, including Pepsi Foods Ltd., stood on a different footing and had no proximate connection with the affairs of the mutual concern. The exclusive contract between the franchisees and Pepsi Foods Ltd. stood on an independent footing and YRIPL as well as the assessee company were not responsible for implementation of the contract. As a result, the first limb of the three-pronged test stood severed.

The Supreme Court held that the receipt of money from an outside entity without affording it the right to have a share in the surplus did not only subjugate the first test of common identity, but also contravened the other two conditions for the existence of mutuality, i.e., impossibility of profits and obedience to the mandate. The mandate of the assessee company was laid down in the SIA approval wherein the twin conditions of mutuality and non-profiteering were envisioned as the sine qua non for the functioning of the assessee company. The contributions made by Pepsi Foods Ltd. tainted the operations of the assessee company with commerciality and concomitantly contravened the prerequisites of mutuality and non-profiteering.

The Court further held that YRIPL and the franchisees stand on two substantially different footings. For, the franchisees are obligated to contribute a fixed percentage for the conduct of AMP activities, whereas YRIPL is under no such obligation in utter violation of the terms of the SIA approval. Moreover, even upon request for the grant of funds by the assessee company, YRIPL is not bound to accede to the request and enjoys a ‘sole and absolute’ discretion to decide against such request. An arrangement wherein one member is subjected to the absolute discretion of another, in such a manner that the entire liability may fall upon one whereas benefits are reaped by all, is the antithesis to the mutual character in the eyes of law.

According to the Supreme Court, the contention advanced by the appellant that it is not mandatory for every member of the mutual concern to contribute to the common pool failed to advance the case of the appellant. The Court held that there is a fine line of distinction between absence of obligation and presence of overriding discretion. In the present case, YRIPL enjoyed the latter to the detriment of the franchisees of the purported undertaking, both in matters of contribution and of management. In a mutual concern, it is no doubt true that an obligation to pay may or may not be there, but in the same breath it is equally true that an overriding discretion of one member over others cannot be sustained in order to preserve the real essence of mutuality wherein members contribute for the mutual benefit of all and not of one at the cost of others.

The Court observed that the settled legal position is that in order to qualify as a mutual concern, the contributors to the common fund either acquire a right to participate in the surplus or an entitlement to get back the remaining proportion of their respective contributions. Contrary to the above stated legal position, as per clause 8.4 the franchisees did not enjoy any ‘entitlement’ or ‘right’ on the surplus remaining after the operations were carried out for a given assessment year. As per the aforesaid clause the assessee company may refund the surplus subject to the approval of its Board of Directors. It implied that the franchisees / contributors could not claim a refund of their remaining amount as a matter of right. According to the Supreme Court, the raison d’être behind the refund of surplus to the contributors or mandatory utilisation of the same in the subsequent assessment year is to reduce their burden of contribution in the next year proportionate to the surplus remaining from the previous year. Thus, the fulfilment of this condition is essential. In the present case, even if any surplus is remaining in a given assessment year, it would not reduce the liability of the franchisees in the following year as their liability to the extent of 5% was fixed and non-negotiable, irrespective of whether any funds were surplus in the previous year. The only entity that could derive any benefit from the surplus funds was YRIPL, i.e., the parent company. This was antithetical to the test of mutuality.

It was observed that the dispensation predicated in the tripartite agreement may result in a situation where YRIPL would not contribute even a single paisa to the common pool and yet be able to derive profits in the form of royalties out of the purported mutual operations, created from the fixed 5% contribution made by the franchisees. This would be nothing short of derivation of gains / profits out of inputs supplied by others. According to the Supreme Court, the doctrine of mutuality, in principle, entails that there should not be any profit-earning motive, either directly or indirectly. One of the tests of mutuality requires that the purported mutual operations must be marked by an impossibility of profits and this crucial test was also not fulfilled in the present case.

The Supreme Court further observed that the exemption granted to a mutual concern is premised on the assumption that the concern is being run for the mutual benefit of the contributors and the contributions made by the members ought to be directed accordingly. Contrary to this fundamental tenet, the tripartite agreement relieves the assessee company from any specific obligation of spending the amounts received by way of contributions for the benefit of the contributors. It explicates that the assessee company does not hold such amount under any implied trust for the franchisees.

According to the Supreme Court, the assessee company had acted in contravention of the terms of approval.

The appellant had urged before the Supreme Court that no fixed percentage of contribution could be imputed upon YRIPL as it did not operate any restaurant directly and, thus, the actual volume of sales could not be determined. According to the Court this argument was not tenable as YRIPL received a fixed percentage of royalty from the franchisees on the sales. If the franchisees could be obligated with a fixed percentage of contribution, 5% in the present case, there was no reason as to why the same obligation ought not to apply to YRIPL.

The Court further noted that the text of the tripartite agreement pointed towards the true intent of the formation of the assessee company as a step-down subsidiary. It was established to manage the retail restaurant business, the advertising, media and promotion at the regional and national level of KFC, Pizza Hut and other brands currently owned or to be acquired in future. In its true form, it was not contemplated as a non-business concern because operations integral to the functioning of a business were entrusted to it.

The Supreme Court held that the doctrine of mutuality bestows a special status to qualify for exemption from tax liability. The appellant having failed to fulfil the stipulations and to prove the existence of mutuality, the question of extending exemption from tax liability to the appellant, that, too at the cost of the public exchequer, did not arise.

The assessee company had relied upon reported decisions before the Supreme Court to establish a parallel between the operations carried out by it and clubs. According to the Supreme Court, all the members of the club not only have a common identity in the concern but also stand on an equal footing in terms of their rights and liabilities towards the club or the mutual undertaking. Such clubs are a means of social intercourse and are not formed for the facilitation of any commercial activity. On the contrary, the purported mutual concern in the present case undertook a commercial venture wherein contributions were accepted both from the members as well as from non-members. Moreover, one member was vested with a myriad set of powers to control the functioning and interests of other members (franchisees), even to their detriment. Such assimilation could not be termed as a case of ordinary social intercourse devoid of commerciality.

The Supreme Court was of the view that once it had conclusively determined that the assessee company had not operated as a mutual concern, there was no question of extending exemption from tax liability.

To support an alternative claim for exemption, the assessee company took a plea in the written submissions that it was acting under a trust for the contributors and was under an overriding obligation to spend the amounts received for advertising, marketing and promotional activities. It urged that once the incoming amount is earmarked for an obligation, it does not become ‘income’ in the hands of the assessee as no occasion for the application of such income arises.

The Supreme Court left the question of diversion by overriding title open as the same was neither framed nor agitated in the appeal memo before the High Court or before it (except a brief mention in the written submissions), coupled with the fact that neither the Tribunal nor the High Court had dealt with that plea and that the rectification application raising that ground was pending before the Tribunal.

15. Basir Ahmed Sisodiya vs. The Income Tax Officer Date of order: 24^th April, 2020

Cash credits – The appellant / assessee, despite being given sufficient opportunity, failed to prove the correctness and genuineness of his claim in respect of purchase of marble from unregistered dealers to the extent of Rs. 2,26,000 and resultantly, the said transactions were assumed as bogus entries (standing to the credit of named dealers who were non-existent creditors of the assessee) – The appellant / assessee, however, in penalty proceedings had offered explanation and caused to produce affidavits and record statements of the unregistered dealers concerned and establish their credentials and that explanation having been accepted by the CIT(A) who concluded that the materials on record would clearly suggest that the unregistered dealers concerned had sold marble slabs on credit to the appellant / assessee, as claimed – That being the indisputable position, the Supreme Court deleted the addition of amount of Rs. 2,26,000

The appellant / assessee was served with a notice u/s 143(2) of the Income-tax Act, 1961 (the ‘1961 Act’) by the A.O. for the A.Y. 1998-99, pursuant to which an assessment order was passed on 30^th November, 2000. The A.O., while relying on the balance sheet and the books of accounts, inter alia took note of the credits amounting to Rs. 2,26,000. He treated that amount as ‘cash credits’ u/s 68 of the 1961 Act and added the same in the declared income of the assessee (the ‘second addition’). According to the A.O., the credits of Rs. 2,26,000 shown in the names of 15 persons were not correct and any correct proof / evidence had not been produced by the assessee with respect to the income of the creditors and source of income. He also made other additions to the returned income.

Aggrieved, the assessee preferred an appeal before the Commissioner of Income Tax (Appeals), Jodhpur. The appeal was partly allowed vide order dated 9^th January, 2003. However, as regards the trading account and credits in question, the CIT(A) upheld the assessment order.

The assessee then preferred a further appeal to the ITAT. Having noted the issues and objections raised by the Department and the assessee, the ITAT partly allowed the appeal vide order dated 4^th November, 2004. However, the order relating to the second addition regarding the credits of Rs. 2,26,000 came to be upheld.

The assessee then filed an appeal before the High Court u/s 260A of the 1961 Act. The appeal was admitted on 27^th April, 2006 on the following substantial question of law:

‘Whether claim to purchase of goods by the assessee could be dealt with u/s 68 of the Income-tax Act as a cash credit, by placing burden upon the assessee to explain that the purchase price does not represent his income from the disclosed sources?’

The High Court dismissed the appeal vide impugned judgment and order dated 21^st August, 2008 as being devoid of merits. The High Court opined that the amount shown to be standing to the credit of the persons which had been added to the income of the assessee, was clearly a bogus entry in the sense that it was only purportedly shown to be the amount standing to the credit of the fifteen persons, purportedly on account of the assessee having purchased goods on credit from them, while since no goods were purchased, the amount did represent income of the assessee from undisclosed sources which the assessee had only brought on record (books of accounts), by showing to be the amount belonging to the purported sellers and as the liability of the assessee. That being the position, the contention about impermissibility of making addition under this head, in view of addition of Rs. 10,000 having been made in trading account, rejecting the books of accounts for the purpose of assessing the gross profit, could not be accepted. The gross profit shown in the books had not been accepted on the ground that the assessee had not maintained day-to-day stock registers, nor had he produced or maintained other necessary vouchers, but then, if those books of accounts did disclose certain other assets which were wrongly shown to be liabilities, and for acquisition of which the assessee did not show the source, it could not be said that the A.O. was not entitled to use the books of accounts for this purpose.

The assessee in the civil appeal before the Supreme Court reiterated the argument that the A.O., having made the addition u/s 144 of the 1961 Act being ‘best judgment assessment’, had invoked powers under sub-section (3) of section 145. For, assessment u/s 144 is done only if the books are rejected. In that case, the same books could not be relied upon to impose subsequent additions as had been done in this case u/s 68.

The assessee filed an I.A. No. 57442/2011 before the Supreme Court for permission to bring on record subsequent events. By this application, the assessee placed on record an order passed by the CIT(A) dated 13^th January, 2011 which considered the challenge to the order passed by the Income-Tax Officer (ITO) u/s 271(1)(c) dated 17^th November, 2006 qua the assessee for the self-same assessment year 1998-99. The ITO had passed the said order as a consequence of the conclusion reached in the assessment order which had by then become final up to the stage of ITAT vide order dated 27^th April, 2006 – to the effect that the stated purchases by the assessee from unregistered dealers were bogus entries effected by him. As a result, penalty proceedings u/s 271 were initiated by the ITO. That order was set aside by the appellate authority [CIT(A)] in the appeal preferred by the assessee, vide order dated 13^th January, 2011 with a finding that the assessee had not made any concealment of income or furnished inaccurate particulars of income for the assessment year concerned. As a consequence of this decision of the appellate authority, even the criminal proceedings initiated against the assessee were dropped / terminated and the assessee stood acquitted of the charges u/s 276(C)(D)(1)(2) of the 1961 Act vide judgment and order dated 6^th June, 2011 passed by the Court of Additional Chief City Magistrate (Economic Offence), Jodhpur City in proceedings No. 262/2005.

The Supreme Court noted that during the course of appellate proceedings, the appellant filed an application under Rule 46A vide letter dated 16^th October, 2008 and the same was sent to the ITO, Ward-1, Makrana vide this office letter dated 28^th January, 2009 and 1^st December, 2010 to submit remand report after examination of additional evidences. Along with the application under Rules 46A, the appellant filed affidavits from 13 creditors, the Sales Tax Order for the Financial Year 1997-98 showing purchases from unregistered dealers to the tune of Rs. 2,28,900, cash vouchers duly signed on revenue stamp for receipt of payment by the unregistered dealers and copy of ration card / Voter ID Card to show the identity of the unregistered dealers. The A.O. recorded statements of 12 unregistered dealers out of 13. In the report dated 22^nd December, 2010, he mentioned that statements of the above 12 persons were recorded on 15^th / 16^th December, 2010 and in respect of identify the unregistered dealers filed photo copies of their voter identity cards and all of them had admitted that they had sold marble on credit basis to Basir Ahmed Sisodiya, the appellant, during F.Y. 1997-98 and received payments after two or three years. However, he observed that none of them had produced any evidence in support of their statement since all were petty, unregistered dealers of marble and doing small business and therefore no books of accounts were maintained. Some of them had stated that they were maintaining small dairies at the relevant period of time but they could not preserve the old dairies. Some of them had stated that they had put their signature on the vouchers on the date of the transactions.

The Supreme Court further noted that the CIT(A) had observed that in respect of the addition of Rs. 2,26,000 there had been no denial of purchase of marble slabs worth Rs. 4,78,900 and sale of goods worth Rs. 3,57,463 and disclosure of closing stock of Rs. 2,92,490 in the trading account for the year ended on 31^st March, 1998. Without purchases of marble, there could not have been sale and disclosure of closing stock in the trading account which suggested that the appellant must have purchased marble slabs from unregistered dealers. The CIT(A) had found that the explanation given by the appellant in respect of purchases from unregistered dealers and their genuineness were substantiated by filing of affidavits and producing these before the A.O. in the course of remand report, and the A.O. did not find anything objectionable in respect of the identity of the unregistered dealers and claims made for the sale of marble slabs to the appellant in the F.Y. relevant to A.Y. 1998-99.

The Supreme Court observed that considering the findings and conclusions recorded by the A.O. and which were commended to the appellate authority as well as the High Court, it must follow that the assessee despite being given sufficient opportunity, failed to prove the correctness and genuineness of his claim in respect of purchase of marble from unregistered dealers to the extent of Rs. 2,26,000. As a result, the said transactions were assumed as bogus entries (standing to the credit of named dealers who were non-existent creditors of the assessee).

According to the Supreme Court, the assessee, however, in penalty proceedings had offered explanation and caused to produce affidavits and record statements of the unregistered dealers concerned and establish their credentials and that explanation having been accepted by the CIT(A) who concluded that the materials on record would clearly suggest that the unregistered dealers concerned had sold marble slabs on credit to the assessee, as claimed.

The Supreme Court was therefore of the view that the factual basis on which the A.O. formed his opinion in the assessment order dated 30^th November, 2000 (for A.Y. 1998-99) in regard to the addition of Rs. 2,26,000, stood dispelled by the affidavits and statements of the unregistered dealers concerned in penalty proceedings. That evidence fully supported the claim of the assessee. The appellate authority vide order dated 13^th January, 2011, had not only accepted the explanation offered but also recorded a clear finding of fact that there was no concealment of income or furnishing of any inaccurate particulars of income by the appellant / assessee for the A.Y. 1998-99. That now being the indisputable position, it must necessarily follow that the addition of the amount of Rs. 2,26,000 could not be justified, much less maintained.

The Supreme Court, therefore, allowed the appeal.

16. Union of India (UOI) and Ors. vs. U.A.E. Exchange Centre Date of order: 24^th April, 2020

India-UAE DTAA – Merely having a fixed place of business through which the business of the assessee is being wholly or partly carried on is not conclusive unless the assessee has a PE situated in India, so as to attract Article 7 dealing with business profits to become taxable in India, to the extent attributable to the PE of the assessee in India – As per Article 5, which deals with and defines the ‘Permanent Establishment (PE)’, a fixed place of business through which the business of an enterprise is wholly or partly carried on is to be regarded as a PE and would include the specified places referred to in Clause 2 of Article 5, but Article 5(3) of the DTAA which starts with a non obstante clause and also contains a deeming provision predicates that notwithstanding the preceding provisions of the Article concerned, which would mean clauses 1 and 2 of Article 5, it would still not be a PE if any of the clauses in Article 5(3) are applicable – No income as specified in section 2(24) of the 1961 Act was earned by the liaison office of the respondent in India because the liaison office was not a PE in terms of Article 5 of DTAA as it was only carrying on activity of a preparatory or auxiliary character

The respondent, a limited company incorporated in the United Arab Emirates (UAE) was engaged in offering, among other things, remittance services for transferring amounts from UAE to various places in India. It had applied for permission u/s 29(1)(a) of the Foreign Exchange Regulation Act, 1973 (‘the 1973 Act’), pursuant to which approval was granted by the Reserve Bank of India (the RBI) vide letter dated 24^th September, 1996.

The respondent set up its first liaison office in Cochin, Kerala in January, 1997 and thereafter in Chennai, New Delhi, Mumbai and Jalandhar. The activities carried on by the respondent from the said liaison offices were stated to be in conformity with the terms and conditions prescribed by the RBI in its letter dated 24^th September, 1996. The entire expenses of the liaison offices in India were met exclusively out of funds received from the UAE through normal banking channels. Its liaison offices undertook no activity of trading, commercial or industrial, as the case may be. The respondent had no immovable property in India otherwise than by way of lease for operating the liaison offices. No fee / commission was charged or received in India by any of the liaison offices for services rendered in India. It was claimed that no income accrued or arose or was deemed to have accrued or arisen, directly or indirectly, through or from any source in India from liaison offices within the meaning of section 5 or section 9 of the Income-tax Act, 1961 (the 1961 Act). According to the respondent, the remittance services were offered by it to non-resident Indians (NRIs) in the UAE. The contract pursuant to which the funds were handed over by the NRI to the respondent in the UAE was entered into between the respondent and the NRI remitter in the UAE. The funds were collected from the remitter by charging a one-time fee of Dirhams 15. After collecting the funds from the NRI remitter, the respondent made an electronic remittance of the funds on behalf of its customer in one of two ways:

(i)  By telegraphic transfer through bank channels; or

(ii) On the request of the NRI remitter, the respondent sent an instrument / cheque through its liaison offices to the beneficiaries designated by the NRI remitter.

In compliance with section 139 of the ITA, 1961, the respondent had been filing its returns of income from the A.Y. 1998-99 and until 2003-04, showing Nil income, as according to the respondent no income had accrued or was deemed to have accrued to it in India, both under the 1961 Act as well as the agreement entered into between the Government of the Republic of India and the Government of the UAE, which is known as the Double Taxation Avoidance Agreement (‘DTAA’). This agreement (DTAA) had been entered into between the two sovereign countries in exercise of powers u/s 90 of the 1961 Act for the purpose of avoidance of double taxation and prevention of fiscal evasion with respect to taxes and income on capital. The DTAA had been notified vide notification No. GSR No. 710(E) dated 18^th November, 1993. The returns were filed on a regular basis by the respondent and were accepted by the Department without any demur.

However, as some doubt was entertained, the respondent filed an application u/s 245Q(1) before the Authority for Advance Rulings (Income Tax), New Delhi, which was numbered as AAR No. 608/2003 and sought ruling of the Authority on the following question:

‘Whether any income is accrued / deemed to be accrued in India from the activities carried out by the Company in India?’

The Authority vide its ruling dated 26^th May, 2004 answered the question in the affirmative, saying, ‘Income shall be deemed to accrue in India from the activity carried out by the liaison offices of the applicant in India.’ In so holding, the Authority opined that in view of the deeming provision in sections 2(24), 4 and 5 read with section 9 of the 1961 Act, the respondent-assessee would be liable to pay tax under the 1961 Act as it had carried on business in India through a ‘permanent establishment’ (PE) situated in India and the profits of the enterprise needed to be taxed in India, but only that proportion that was attributable to the liaison offices in India (the PE).

The Authority held that the applicant had liaison offices in India which attended to the complaints of the clients in cases where remittances were sent directly to banks in India from the UAE. In addition, in cases where the applicant had to remit the amounts to the beneficiaries in India as per the directions of the NRIs, the liaison offices downloaded the information from the internet, printed cheques / drafts in the name of the beneficiaries in India and sent them through couriers to various places in India. Without the latter activity, the transaction of remittance of the amounts in terms of the contract with the NRIs would not be complete. The commission which the applicant received for remitting the amount covered not only the business activities carried on in the UAE but also the activity of remittance of the amount to the beneficiary in India by cheques / drafts through courier which was being attended to by the liaison offices.

There was, therefore, a real relation between the business carried on by the applicant for which it received commission in the UAE and the activities of the liaison offices (downloading of information, printing and preparation of cheques / drafts and sending the same to the beneficiaries in India), which contributed directly or indirectly to the earning of income by the applicant by way of commission. There was also continuity between the business of the applicant in the UAE and the activities carried on by the liaison offices in India. Therefore, it followed that income had deemed to have accrued / arisen to the applicant in the UAE from ‘business connection’ in India.

The Authority further held that insofar as the amount was remitted telegraphically by transferring directly from the UAE through bank channels to various places in India and in such remittances the liaison offices had no role to play except attending to the complaints, if any, in India regarding the remittances in cases of fraud etc., it could be said to be auxiliary in character. However, downloading the data, preparing cheques for remitting the amount and dispatching the same through courier by the liaison offices was an important part of the main work itself because without remitting the amount to the beneficiaries as desired by the NRIs, performance of the contract would not be complete. It was a significant part of the main work of the UAE establishment. It, therefore, followed that the liaison offices of the applicant in India for the purposes of this mode of remittance were a ‘permanent establishment’ within the meaning of the expression in the DTAA.

Following the impugned ruling of the Authority, dated 26^th May, 2004, the Department issued four notices of even date, i.e., 19^th July, 2004 u/s 148 of the 1961 Act addressed to the respondent and pertaining to A.Y.s 2000-01, 2001-02, 2002-03 and 2003-04, respectively. The respondent approached the Delhi High Court by way of Writ Petition No. 14869/2004, inter alia for quashing of the ruling of the Authority dated 26^th May, 2004, quashing of the stated notices and for a direction to the appellants not to tax the respondent in India because no income had accrued to it or was deemed to have accrued to it in India from the activities of its liaison offices in India.

The High Court was of the opinion that the Authority proceeded on a wrong premise by first examining the efficacy of section 5(2)(b) and section 9(1)(i) of the 1961 Act instead of applying the provisions in Articles 5 and 7 of the DTAA for ascertaining the respondent’s liability to tax. Further, the nature of activities carried on by the respondent-assessee in the liaison offices being only of a preparatory and auxiliary character, were clearly excluded by virtue of the deeming provision. The High Court distinguished the decisions relied upon by the Authority in Anglo-French Textile Co. Ltd., by agents, M/s. Best & Company Ltd., Madras vs. Commissioner of Income Tax, Madras AIR 1953 SC 105 and R.D. Aggarwal & Company (Supra). The ratio in these decisions, according to the High Court, was that the non-resident entity could be taxed only if there was a business connection between the business carried on by a non-resident which yields profits or gains and some activity in the taxable territory which contributes directly or indirectly to the earning of those profits or gains.

The High Court then concluded that the activity carried on by the liaison offices of the respondent in India did not in any manner contribute directly or indirectly to the earning of profits or gains by the respondent in the UAE and every aspect of the transaction was concluded in the UAE, whereas the activity performed by the liaison offices in India was only supportive of the transaction carried on in the UAE. The High Court also took note of Explanation 2 to section 9(1)(i) and observed that the same reinforces the fact that in order to have a business connection in respect of a business activity carried on by a non-resident through a person situated in India, it should involve more than what is supportive or subsidiary to the main function referred to in clauses (a) to (c). The High Court eventually quashed the impugned ruling of the Authority and also the notices issued by the Department u/s 148 of the 1961 Act, since the notices were based on the ruling which was being set aside. The High Court, however, gave liberty to the appellants to proceed against the respondent on any other ground as may be permissible in law.

Feeling aggrieved, the Department filed a Special Leave Petition before the Supreme Court.

According to the Supreme Court, the core issue that was required to be answered in the appeal was whether the stated activities of the respondent-assessee would qualify the expression ‘of preparatory or auxiliary character’?

The Supreme Court observed that having regard to the nature of the activities carried on by the respondent-assessee, as held by the Authority, it would appear that the respondent was engaged in ‘business’ and had ‘business connections’ for which, by virtue of the deeming provision and the sweep of sections 2(24), 4 and 5 read with section 9 of the 1961 Act, including the exposition in Anglo-French Textile Co. Ltd. (Supra) and R.D. Aggarwal & Company (Supra), it would be a case of income deemed to accrue or arise in India to the respondent. However, in the present case, the matter in issue would have to be answered on the basis of the stipulations in the DTAA notified in exercise of the powers conferred u/s 90 of the 1961 Act.

Keeping in view the finding recorded by the High Court, the Supreme Court proceeded on the basis that the respondent-assessee had a fixed place of business through which its business was being wholly or partly carried on. That, however, would not be conclusive until a further finding is recorded that the respondent had a PE situated in India so as to attract Article 7 dealing with business profits to become taxable in India, to the extent attributable to the PE of the respondent in India. For that, one has to revert back to Article 5 which deals with and defines the ‘Permanent Establishment (PE)’. A fixed place of business through which the business of an enterprise is wholly or partly carried on is regarded as a PE. The term ‘Permanent Establishment (PE)’ would include the specified places referred to in clause 2 of Article 5. According to the Supreme Court, it was not in dispute that the place from where the activities were carried on by the respondent in India was a liaison office and would, therefore, be covered by the term PE in Article 5(2). However, Article 5(3) of the DTAA opens with a non obstante clause and also contains a deeming provision. It predicates that notwithstanding the preceding provisions of the Article concerned, which would mean clauses 1 and 2 of Article 5, it would still not be a PE if any of the clauses in Article 5(3) are applicable. For that, the functional test regarding the activity in question would be essential. The High Court had opined that the respondent was carrying on stated activities in the fixed place of business in India of a preparatory or auxiliary character.

The Supreme Court, after noting the meaning of the expression ‘business’ in section 2(13) of the 1961 Act, discerning the meaning of the expressions ‘business connection’ and ‘business activity’ from section 9(1) of the 1961 Act and the dictionary meaning of the expressions ‘preparatory’ and ‘auxiliary’, concluded that since the stated activities of the liaison offices of the respondent in India were of preparatory or auxiliary character, the same would fall within the excepted category under Article 5(3)(e) of the DTAA. As a result, it could not be regarded as a PE within the sweep of Article 7 of the DTAA.

According to the Supreme Court, while answering the question as to whether the activity in question could be termed as other than that ‘of preparatory or auxiliary character’, it was to be noted that the RBI had given limited permission to the respondent u/s 29(1)(a) of the 1973 Act on 24^th September, 1996. From paragraph 2 of the stated permission it was evident that the RBI had agreed for establishing a liaison office of the respondent at Cochin, initially for a period of three years, to enable the respondent to (i) respond quickly and economically to inquiries from correspondent banks with regard to suspected fraudulent drafts; (ii) undertake reconciliation of bank accounts held in India; (iii) act as a communication centre receiving computer (via modem) advices of mail transfer T.T. stop payments messages, payment details, etc., originating from the respondent’s several branches in the UAE and transmitting to its Indian correspondent banks; (iv) printing Indian Rupee drafts with a facsimile signature from the Head Office and counter signature by the authorised signatory of the office at Cochin; and (v) following up with the Indian correspondent banks. These were the limited activities which the respondent had been permitted to carry on within India. This permission did not allow the respondent-assessee to enter into a contract with anyone in India but only to provide service of delivery of cheques / drafts drawn on the banks in India.

The permitted activities were required to be carried out by the respondent subject to conditions specified in Clause 3 of the permission, which included not to render any consultancy or any other service, directly or indirectly, with or without any consideration and further that the liaison office in India shall not borrow or lend any money from or to any person in India without prior permission of the RBI. The conditions made it amply clear that the office in India would not undertake any other activity of trading, commercial or industrial, nor shall it enter into any business contracts in its own name without prior permission of the RBI. The liaison office of the respondent in India could not even charge commission / fee or receive any remuneration or income in respect of the activities undertaken by it in India. From the onerous stipulations specified by the RBI, it could be safely concluded, as opined by the High Court, that the activities in question of the liaison office(s) of the respondent in India were circumscribed by the permission given by the RBI and were in the nature of preparatory or auxiliary character. That finding reached by the High Court was unexceptionable.

The Supreme Court concluded that the respondent was not carrying on any business activity in India as such, but only dispensing with the remittances by downloading information from the main server of the respondent in the UAE and printing cheques / drafts drawn on the banks in India as per the instructions given by the NRI remitters in the UAE. The transaction(s) had been completed with the remitters in the UAE, and no charges towards fee / commission could be collected by the liaison office in India in that regard. To put it differently, no income as specified in section 2(24) of the 1961 Act was earned by the liaison office in India and more so because the liaison office was not a PE in terms of Article 5 of the DTAA (as it was only carrying on activity of a preparatory or auxiliary character).

The concomitant was that no tax could be levied or collected from the liaison office of the respondent in India in respect of the primary business activities consummated by the respondent in the UAE. The activities carried on by the liaison office in India as permitted by the RBI clearly demonstrated that the respondent must steer away from engaging in any primary business activity and in establishing any business connection as such. It could carry on activities of preparatory or auxiliary nature only. In that case, the deeming provisions in sections 5 and 9 of the 1961 Act could have no bearing whatsoever.

The Supreme Court dismissed the appeal with no order as to costs.