Clough Engineering Ltd. v. ACIT ITA No. 4771 & 4986 (Del.)/(2007) (SB) Article 5, 7, 11 of India-Australia DTAA A.Y.: 2003-04. Dated: 6-5-2011

• Interest earned by foreign company on tax refund is not effectively connected with PE in India based on ‘asset-test’ or ‘activity-test’. The ‘indebtedness’ in respect of which interest arose is not ‘effectively connected’ with PE as ‘payment of tax’ is primarily the liability of a foreign company and not PE.
• The Interest on income tax refund is taxable in terms of Article 11(2) on gross basis (@ 15%) in the hands of foreign company and not on net basis (full rate) under Article 7 r.w. Article 11(4).

Facts:

• The taxpayer, an Australian company, had a PE in India. PE was carrying out designing, engineering, procuring, fabricating, installing, laying pipelines, testing and pre-commissioning of off-shore platforms on contractual basis.
• The taxpayer received tax refund along with interest in respect of excess TDS which was deducted from contract receipts of the PE. The taxpayer claimed that such interest income was taxable at the rate of 15% on gross basis as per Article 11(2) of the DTAA.
• The Tax Authority held that the interest income was received on refund of the tax deducted at source made from business receipts and was directly connected with the business receipts of PE in India and hence the same was chargeable as profits of the PE under Article 7 r.w. Article 11(4) of the DTAA.
• The CIT(A) accepted the contentions of the Tax Authority. The matter was carried to the Tribunal and in view of conflicting decisions rendered by different Benches of the Tribunal3, a Special Bench was constituted to address the matter.

Ruling:
The ITAT rejected the contentions of the Tax Authority and held as under:

• For determining taxation of interest under DTAA, what is relevant to determine is whether or not the indebtedness is effectively connected with the PE.
• If debt is effectively connected with the PE as contemplated by Article 11(4), income would become taxable under Article 7 as business profits.
• The fact that interest income is not business income is not determinative of whether income is assessable under Article 7. For taxation under Article 7, effective connection with the PE is relevant.
• Interest income does not have to be necessarily business income in nature for establishing the effective connection with the PE, since it would render provision contained in Article 11(4) of DTAA redundant.
• In the present case, income is connected with the PE in the sense that it has arisen on account of TDS from the receipts of the PE. However, payment of tax is the responsibility of FCO. Tax liability is determined after computation of income. Tax is not expenditure but appropriation of profit. Thus, though the debt is connected with receipts of the PE, it cannot be regarded as effectively connected with such receipts as primary responsibility is that of FCO and such liability crystallise on the last day of the previous year. In fact, FCO is entitled to pay taxes from any sources.
• Merely because taxes are collected at source, it will not create effective connection of the indebtedness with the PE, as tax is only the appropriation of profit.
• In the circumstances such interest is not effectively connected with the PE. Hence, it is liable to tax in terms of Article 11 (on gross basis) and not in terms of Article 7 (on net basis).