Month: October

Having discussed the above, in this third and final part of this series, we shall discuss some special provisions under GloBE Rules dealing with business reorganizations, joint ventures, and PEs. Towards the end, we shall also discuss administrative and compliance aspects, which shall soon become a new way of life for MNE Groups covered by GloBE Rules.

NEGATIVE ADJUSTED COVERED TAX DUE TO SUPER/WEIGHTED DEDUCTIONS

Ordinarily, a jurisdiction that has zero GloBE income or GloBE loss may not trigger any GloBE TUT liability. This is because the ETR cannot be computed as the denominator is zero or a negative amount. Still, it is possible that the tax loss is higher than the book loss (or GloBE loss) – if local tax rules allow a weighted deduction of specific expenses (to incentivize specific activities, such as R&D) in computing taxable income.

Assume that, in year 1, there is a book loss of 1,000, and tax loss of 1,500, the difference of 500 being on account of weighted deduction. Assume that, in year 2, there is a book profit of 1,500, and a tax loss of  year 1 is fully offset, resulting in zero local tax liability in year 2. Assume that such jurisdiction’s local tax rate is 15 per cent.

In books, DTA of 225 is recognized for tax loss in year 1 (i.e. 1,500 x 15 per cent), which is reversed in year 2. ETR of year 2 is calculated as 225 / 1,500. Since ETR (after reckoning reversal of DTA) is 15 per cent, there is no GloBE TUT liability in year 2. Thus, there is no requirement under GloBE Rules to exclude reversal of DTA attributable to tax loss arising on account of weighted deduction, while determining ETR of year 2.

To ensure that the TUT is collected in year 1 itself, when a tax incentive of weighted deduction is claimed, despite year 1 having zero GloBE income or GloBE loss, a special provision¹ requires payment of GloBE TUT liability. Such a liability is not based on ETR formula. According to such provision, where adjusted covered tax (after reckoning generation of DTA) is less than [GloBE loss x 15 per cent], the difference straightaway becomes TUT liability. In the example on hand, in year 1, adjusted covered tax (after reckoning generation of DTA) is negative 225, and GloBE loss x 15 per cent is negative 150 (negative 1,000 x 15 per cent). The difference between negative 225 and negative 150 is 75, which straightaway becomes TUT liability in year 1.

1    Article 4.1.5

In Indian Income-tax Act (ITA), weighted deductions [along the lines of s.35(2AB) of ITA] have been phased out. ITA has a weighted deduction only in the form of s.80JJAA, which is allowed only against positive gross total income – such an incentive cannot be availed in a case of tax loss. But, if a CE in India generates DTA on account of business reorganization (as illustrated in the ensuing paras), such a DTA can result in TUT liability under the above provision, despite the jurisdiction having zero GloBE income or GloBE loss in the year of generation of such DTA.

BUSINESS REORGANIZATIONS TAKING PLACE AFTER GLOBE RULES ARE EFFECTIVE²

•    Consideration for transfer is, in whole or in significant part, discharged by way of equity interests.

•    The transferor’s gain is not subject to tax (under the domestic tax laws).

•    The transferee is required (under the domestic tax laws) to compute taxable income using transferee’s tax basis of the assets (i.e. no cost step-up).

If all the above three conditions are met – in GloBE calculations, for transferor, gain recognized in P&L account is excluded from the GloBE income – and therefore, is exempt from TUT liability. For transferee, carrying values of assets taken over, for the purpose of GloBE calculations, are pegged to those of transferor (i.e. no cost step-up in computation of GloBE income).

2 Readers may note that, this article only discusses GloBE Rules applicable to transfers of assets and liabilities, as per articles 6.3.1 to 6.3.32. There are separate rules for corporate transformations (such as conversion of company into another business vehicle such as LLP) or migration from one jurisdiction to another jurisdiction, which are not discussed in this article.

Example 1: Business transfer by a holding company to a wholly-owned subsidiary

For local tax purposes, the holding company claims capital gains tax exemption u/s 47(iv) of ITA on 10,000; and the cost in the hands of WOS is pegged to 1,000 on account of Explanation 6 to s.43(1) of ITA.

3 As per our understanding, and subject to confirmation of accounting experts, it is only for common control business transfer that IFRS/Ind-AS mandates the transferee to recognise at book value of transferor. This mandate may not apply to an asset transfer, which, the transferor and transferee may record at the transaction value.

In the case of WOS, the cost of capital asset as per books is 11,000. However, for the computation of a taxable income as per ITA, such cost is pegged to 1,000 on account of Explanation 6 to s.43(1) of ITA. Consequently, WOS is expected to have higher capital gains tax liability upon the sale of a such capital asset. Therefore, a question is whether WOS can recognize the provision for DTL of 2,500 (namely book to tax difference of 10,000 x 25 per cent applicable tax rate) in the year of acquisition of such capital asset? Under Ind-AS, WOS may not be able to recognize such a provision for DTL due to the “initial recognition exception” in para 15 of Ind-AS 12.

As a result, TUT liability is likely to arise in the case on hand – because, in the year of transfer of a capital asset, a gain of 10,000 recognized in P&L account of the holding company remains included in GloBE income as aforesaid (to recollect, GloBE income is computed at a jurisdictional level, by clubbing book results of the holding company and WOS). Still, there are no corresponding taxes payable on such a gain (either in the form of provision for DTL or provision for current tax because of exemption u/s 47(iv) of ITA).

In the future, assuming there is a violation of conditions of s.47(iv) of ITA and the holding company pays capital gains tax u/s 47A in the year of transfer to WOS, there is no clarity on the GloBE’s impact on the holding company and WOS. As GloBE Rules presently stand, such capital gains tax discharged by the holding company can be reckoned in adjusted covered tax (namely, numerator of ETR) only in a future year when such tax is provided for in the books of the holding company. Hence, there may be no ability to claim a refund of TUT liability already discharged in the year of transfer to WOS.

Example 2: Common control demerger

Assume that FCo (the ultimate parent entity of an MNE Group), has two wholly owned subsidiaries in India; namely DCo and RCo. DCo has two business undertakings, namely U1 and U2. U2 is demerged in favour of RCo under a tax-neutral demerger as per s.2(19AA) of ITA, where RCo issues equity shares to FCo as a consideration for such demerger. As DCo and RCo are considered entities under common control, in the ‘fit for consolidation’ accounts prepared as per IFRS/Ind-AS, both DCo and RCo would record the business transfer at book value. There is no gain recorded in the P&L account of DCo. Accordingly, the question of levying TUT liability as a consequence of tax-neutral demerger may not arise in the present  case.

Without prejudice to the above, even assuming DCo were to prepare ‘fit for consolidation’ accounts based on some other accounting standards other than IFRS/Ind-AS and recognize gain in P&L account w.r.t. tax neutral demerger, due to satisfaction of all three conditions specified aforesaid, such a gain may qualify for exclusion in computing GloBE income of DCo. To recollect, three conditions are as under:

•    Consideration for transfer is, in whole or in significant part, discharged by way of equity interests [namely; RCo issues equity shares to overseas parent of DCo].

•    The transferor’s gain is not subject to tax [namely; DCo’s gain, if any, is exempt from capital gains tax u/s. 47(vib) of ITA].

•    The transferee is required compute taxable income using transferee’s tax basis in the assets [namely; cost base in hands of RCo is pegged to that of DCo, as per Explanation 7A to s.43(1) of ITA and Explanation 2A to s.43(6) of ITA].

Example 3: Non common control demerger

Assume that, FCo1 (ultimate parent entity of an MNE Group), has a subsidiary in India, namely, DCo. DCo has two business undertakings; namely U1 and U2. FCo2 (ultimate parent entity of another unrelated MNE Group), also has a subsidiary in India, namely, RCo. U2 (having book value of 1,000) is demerged by DCo in favour of RCo, pursuant to a tax neutral demerger as per s.2(19AA) of ITA. RCo issues equity shares (having fair value of 11,000) to FCo1 as consideration for such demerger.

DCo and RCo are considered to be entities not under common control. In ‘fit for consolidation ‘accounts’ of DCo, in terms of Appendix A of Ind-AS 10, DCo recognizes a dividend payable of 11,000 (by taking into account fair value of shares to be issued by RCo to FCo1) by debit to reserves or retained earnings. Such dividend payable of 11,000 is settled by transfer of business having book value of 1,000 and difference of 10,000 is credited to P&L account of DCo. D Co does not pay any capital gains tax [as per s.47(vib) of ITA] and DCo also does not pay any minimum alternate tax [as per s.115JB(2A)(d) of ITA] in respect of such gain credited to P&L account.

Where all the three conditions are met, gain of 10,000 credited to P&L account can be excluded from GloBE income of DCo. In the present case:

•    Consideration for transfer is, in whole or in significant part, discharged by way of equity interests [namely; RCo issues equity shares to FCo1, the overseas parent of DCo].

•    The transferor’s gain is not subject to tax [namely; DCo’s gain, if any, is exempt from capital gains tax
u/s 47(vib) of ITA as also from MAT tax u/s 115JB(2A)(d)].

•    The transferee is required to compute taxable income using the transferee’s tax basis in the assets, [namely; the cost base in the hands of RCo is pegged to that of DCo, as per Explanation 7A to s.43(1) of ITA and Explanation 2A to s.43(6) of ITA].

However, assuming RCo were to claim cost step-up in respect of assets received upon demerger while computing taxable income as per ITA [by relying on Supreme Court’s decision in case of Smiffs Securities (2012) (348 ITR 302)], the third condition is not satisfied. In such a case, a gain of 10,000, credited to the P&L account of D Co, cannot be excluded from the GloBE income of DCo and may be subject to TUT liability.

Example 4: Tax exempt transfer by LLP to company u/s 47(xiii) of ITA

•    FCo to incorporate ICo.

•    LLP to transfer business as slump sale to ICo for agreed monetary consideration of 11,000 i.e. fair value, to be discharged in the form of allotment of equity shares by ICo to FCo.

•    ICo is to allot equity shares to FCo at a premium, such that the aggregate issue price is 11,000.

LLP and partners comply with all conditions of s.47(xiii) of ITA, and thus qualify for exemption u/s 47(xiii) of ITA. ICo allocates 1,000 to tangible assets and 10,000 to identifiable intangible assets (being brand). For the present case study, one may proceed on the assumption that purchase price allocation is on a fair and reasonable basis and that ICo is entitled to claim depreciation u/s 32 on intangible assets of 10,000 over 4 years basis SLM (assumed for simplicity). In terms of s.49(1)(iii)(e) of ITA, ICo cannot claim any cost step-up while computing capital gains on transfer of brand.

In the ‘‘fit for consolidation’ accounts, in terms of IFRS/Ind-AS, accounting principles applicable to a common control business combination are applied. Accordingly, both LLP and ICo recognize business transfer at book value of the transferor. The following is the accounting treatment adopted in P&L account forming part of ‘fit for consolidation’ accounts:

•    LLP recognizes profits of 10,000 in partner’s capital a/c (or other equity a/c), and not in P&L a/c.

•    ICo recognizes LLP’s assets in books based on carrying values of transferor, at 1,000 – as this is a common control business combination. As ICo does not recognize brand in books, ICo does not provide any amortization of such brand in books, year on year.

•    Considering that tax base of assets is higher by 10,000 and having regard to applicable tax rate of 25 per cent, ICo recognizes DTA of 2,500.

•    Over next 4 years, DTA as recognized will be reversed by debit to P&L a/c as and when amortization for local tax purposes is claimed by ICo. In the facts of the case, such unwinding will be at 625 per annum (namely, yearly depreciation of 2,500 x 25 per cent tax rate) over next four years.

In GloBE calculations of LLP, no adverse implications are likely to arise, because, as aforesaid, LLP does not record any gain on business transfer in P&L account.

In GloBE calculations of ICo, unless the three conditions aforesaid are cumulatively satisfied, DTA recognized by ICo in the year of business acquisition is likely to reduce adjusted covered tax (numerator of ETR). To recollect, generation of DTA reduces adjusted covered tax (and consequently, reduces ETR), and can result in potential TUT liability. A negative ETR also attracts TUT liability⁴.

In the present facts, the third condition of non-grant of cost step-up (namely; the transferee is required to compute taxable income using transferee’s tax basis in the assets) is not fulfilled. As a result, in GloBE calculations of ICo, DTA generated of 2,500 at 25 per cent tax rate will be recast to 1,500 at 15 per cent tax rate. There could be potential TUT liability on this account, unless the same is shielded by other high-taxed incomes in India.

4  For e.g., assuming ETR is -10 per cent, TUT percentage is 25 per cent [calculated as 15 per cent – (10 per cent) = 25 per cent].

Assume that FCo (ultimate parent entity of an MNE Group) has two wholly owned subsidiaries in India, ICo1 and ICo2. ICo1 transfers business having a book value of 1,000 to ICo2, at fair price of 11,000. The business transfer is not tax neutral (i.e. it is taxable in India). However, in the present case, ICo1 does not pay any capital gains tax on the business transfer because ICo1 sets off capital loss incurred on account of the sale of shares of an associate. Thus, specific to this transaction, ICo1’s tax liability as per ITA is nil.

In ‘fit for consolidation’ accounts, as this is a common control business combination, ICo1 does not recognize any gain on business transfer, and ICo2 records business acquisition at a book value of 1,000. Absent recognition of a gain in the P&L account, there is no TUT liability concerning ICo1. Also, as discussed in the previous part of this article, the capital loss on account of sale of shares of an associate is ignored in computing GloBE income of ICo1. In other words, while such capital loss has gone to reduce capital gains tax liability as per ITA, such a capital loss does not enter the calculation of GloBE income (namely, the denominator of ETR).

As the business transfer is not tax-neutral, ICo2 is eligible for a cost step-up in computing taxable income as per ITA. In ‘fit for ‘consolidation’ accounts, ICo2 recognizes DTA to reflect tax benefit on account of higher depreciation u/s 32 of ITA on the stepped-up cost. In the present case, DTA recognized by ICo2 in the year of business acquisition is 2,500 (book to tax difference of 10,000 x 25 per cent tax rate). For GloBE calculations of ICo2, such generation of DTA will be recast to 1,500 at 15 per cent tax rate. As the generation of DTA reduces adjusted covered tax, there could be a potential TUT liability on this account, unless the same is shielded by other high-taxed incomes in India.

ANTI-AVOIDANCE PROVISIONS FOR INTRA-GROUP ASSET TRANSFERS AFTER 30th NOVEMBER, 2021 BUT BEFORE APPLICABILITY OF GLoBE RULES

5    30th November, 2021 is when GloBE Rules were expected to be published – though they actually got published on 20th December, 2021. Article 9.1.3 is a specific anti avoidance provision to control restructuring which may happen after 30th November 2021 but before applicability of GloBE Rules, with a view to dilute future GloBE TUT liability – while such restructuring by itself may not attract any immediate GloBE TUT liability because such restructuring happens when GloBE Rules are not yet effective.

IPCo2 amortizes the cost of such a brand in ‘fit for consolidation’ accounts as also in computation of taxable income at 2,000 per annum over 5 years. The taxable income of IPCo2 for local tax purposes (after deduction of brand amortization) is 3,000, and the local tax liability of IPCo2 at 15 per cent tax rate is 450.

In the absence of article 9.1.3, GloBE income of IPCo2 would have been computed at 3,000, after considering deduction on account of brand amortisation. ETR of IPCo2 would have been 15 per cent (i.e. 450 / 3,000) – and there would have been no GloBE TUT liability in respect of IPCo2.  

Article 9.1.3 provides that, in the present case, the GloBE income of IPCo2 should be based on the carrying value of IPCo1. As a result, the carrying value of the brand is zero in computing the GloBE income of IPCo2. Thus, GloBE income of IPCo2 is 5,000, after disallowing brand amortization of 2,000 per annum. The ETR of IPCo2 is 9 per cent (i.e. 450 / 5,000), which attracts GloBE TUT liability of 6 per cent on GloBE income of 5,000. Article 9.1.3, therefore, seeks to control the cost step-up by shifting the assets from low tax jurisdiction to high tax jurisdiction after 30th November, 2021 but before the applicability of GloBE Rules.⁷

7    Assuming such a brand transfer happens after GloBE Rules apply, in year of brand transfer, IPCo1 is likely to trigger immediate GloBE TUT liability at 15 per cent on gain of 10,000. In subsequent years, brand amortisation can be deducted in computing GloBE income of IPCo2.

Article 9.1.3 is agnostic to what may have been the capital gains tax liability of the transferor in its jurisdiction in respect of the intra-group transfer. To illustrate, assuming that the aforesaid transaction of the brand transfer happened between two wholly owned subsidiaries of FCo in India, the transferor WOS may have discharged capital gains tax liability as per ITA on the transfer of self-generated brand at ~20 per cent. A literal application of article 9.1.3 may prevent transferee WOS from deducting brand amortization in computing GloBE income – which may result in GloBE TUT liability because brand amortization is deducted in computing taxable income as per ITA. Representations are made to the OECD to restrict the applicability of Article 9.1.3 to intra-group transfer that is tax exempt in the hands of the transferor, or where the transferor is in low tax jurisdiction. UK HMRC has also acknowledged significant uncertainty on this provision and has stated that this issue is to be raised as part of the GloBE implementation framework.

SPECIAL RULES FOR JOINT VENTURES UNDER GLoBE RULES⁸

As discussed in the previous article, in computing the GloBE income of the co-venturer, gain/loss as per equity method of the joint venture (as also gain/loss on disposal of shares of the joint venture) is excluded. However, where all the following conditions are satisfied, there are special provisions in GloBE Rules that require the co-venturer to bear TUT liability in respect of his proportionate interest in a joint venture:  

•    JV is an entity accounted for under the equity method in CFS of UPE; and

•    UPE of the co-venturer group directly or indirectly holds >= 50 per cent (i.e. at least 50 per cent) ownership interest
 in such JV; and

•    JV Group (namely, JV and subsidiaries of such JV) is not subject to GloBE Rules.

Where all the above conditions are satisfied, the co-venturer group is required to compute jurisdictional ETR and TUT of the JV Group by treating such JV Group as a separate MNE Group. In other words, assuming the co-venturer group has a WOS in the same jurisdiction as JV, the profit/loss and adjusted covered tax of such WOS cannot be blended with JV while determining jurisdictional ETR and TUT of JV Group.

8    Article 6.4
9    The term ‘ownership interest’ is separately defined under GloBE Rules.

The JV Co is merely a holding company which operates through three subsidiaries abroad having operations in zero tax jurisdiction, namely JV Sub 1 to JV Sub 3. JV Sub 1 has profit of 10,000. JV Sub 2 has loss of 15,000. JV Sub 3 has profit of 20,000.

JV Co itself prepares CFS to consolidate the results of these subsidiaries, and consolidated revenue as per such CFS is < € 750 million.

In this case, all three conditions specified above are satisfied qua both MNE Groups A and B. Hence, special provisions in GloBE Rules for JV are applicable qua both MNE Groups A and B. As per these special provisions, the jurisdictional ETR/TUT for JV Co Group is calculated separately, as if the JV Co Group is a separate MNE Group – de-hors any subsidiaries that MNE Groups A and B may have in the jurisdiction of JV Sub 1 to JV Sub 3. For example, assuming MNE Group A has a WOS in the same jurisdiction as JV Sub 1 to JV Sub 3, and such WOS incurs a loss of 15,000 – while the aggregate profit of JV Sub 1 to JV Sub 3 is 15,000 – loss of such WOS cannot be blended while determining ETR/TUT of JV Group as the JV Group is deemed as a separate MNE Group.

As per these special provisions, the ultimate parent entity of each co-venturer group that satisfies the three conditions specified above, is subject to TUT liability to the extent of his proportionate ownership interest in JV Co Group. In the present case, jurisdictional ETR of the JV Co Group is zero and its jurisdictional TUT is 15,000 x 15 per cent = 2,250. The MNE Group A is subject to TUT liability of 1,125 and likewise, the MNE Group B is also subject to TUT liability of 1,125. As per top-down approach, if the jurisdiction of the ultimate parent entity of the co-venturer group has not implemented GloBE Rules, such TUT liability can be recovered from the intermediate parent of such co-venturer group which directly or indirectly holds joint ownership interest in JV Co.

Contrastingly, assuming MNE Groups A and B each held 50 per cent ownership interest directly in JV Sub 1 to JV Sub 3 (without any holding company such as JV Co in between), ETR and TUT liability would have been calculated separately in respect of each of JV Sub 1 to JV Sub 3 – because each of JV Sub 1 to JV Sub 3 would be considered as a separate MNE Group. In this case, for JV Sub 3, MNE Group A would have been subject to TUT liability of 1,500 (namely, jurisdictional profit of 20,000 x 15 per cent x 50 per cent) and for JV Sub 1, MNE Group A would have been subject to TUT liability of 750 (namely; 10,000 x 15 per cent x 50 per cent).

Contrastingly, where MNE Groups A and B each held only 49 per cent ownership interest in JV Co – the remaining 2 per cent held by a third party – the second condition (of holding at least 50 per cent ownership interest) is not satisfied qua both MNE Groups A and B. Hence, special provisions in GloBE Rules for JV are not applicable for both MNE Groups A and B. Hence, neither MNE Group A nor MNE Group B needs to pay TUT liability in respect of JV Co Group.

Contrastingly, where consolidated revenue as per JV cCo’s CFS itself is > € 750 million and the jurisdiction of JV Co has adopted GloBE Rules – the third condition is not satisfied. Hence, special provisions in GloBE Rules for JV are not applicable for both M NE Groups A and B. In this case, the JV Co Group itself becomes an in-scope MNE Group – and the JV Co pays TUT in respect of each of JV Sub 1 to JV Sub 3 as per income inclusion rule. As TUT is recovered from JV Co itself, co-venturer groups are exempt from such TUT.

SPECIAL RULES FOR PEs UNDER GLoBE RULES

In fact, HO with only one or more PEs can also constitute an MNE Group within scope of GloBE Rules even if there are no other subsidiaries (subject however to satisfaction of revenue threshold being >= € 750 million)¹¹. For example, a large pharmaceutical MNE having only domestic manufacturing and R&D operations deriving revenue mainly from exports can constitute an MNE Group even in absence of overseas subsidiaries, if there are branch offices in overseas location/s which satisfy any of the four limbs of PE stated below.

What is a PE?¹²

For GloBE purposes, the term PE is defined broadly to have 4 legs (paragraphs) as below:

•    Para (a) – Treaty PE: Covers cases where a place of business is situated in the source jurisdiction, which is treated as a PE, following the applicable tax treaty (which has come into effect) between the HO-source jurisdiction and source jurisdiction taxes the income “attributable” to such PE in accordance with a provision “similar” to the business profits article of OECD Model Convention (MC) 2017 – irrespective of whether such applicable treaty between HO-source jurisdiction replicates the language or outcomes of Article 7 of OECD MC 2017. Treaty PE will typically include a Fixed PE and other forms of deemed PEs (like Service PE, Agency PE, Construction PE) which form a part of the HO-Source Jurisdiction tax treaty. However, cases where a place of business is not treated as a PE as per treaty due to a specific exception, such as the preparatory or auxiliary exception, may not be covered by Para (a). Similarly, the HO jurisdiction engaged in the operation of an aircraft in international traffic sets up a place of business in the source jurisdiction for such purpose, profits that are not taxed in the source jurisdiction due to specific exemption. This may not be covered by Para (a).

10    Article 1.3.1 and 1.3.2
11    Article 1.2.1 and 1.2.3
12    Article 10.1

•    Para (c) – Hypothetical PE: Covers cases where there is no tax treaty between the HO-source jurisdiction, and where the source jurisdiction does not have a corporate tax system, where a place of business in the source jurisdiction  would be treated as a PE under the OECD MC – and such PE would have been taxed under Article 7 dealing with business profits of such OECD MC¹³. Illustratively, this may be relevant for an HO in India which has a branch/presence/project in the Cayman Islands which passes the threshold of PE presence as per Article 5 of OECD MC 2017, which would have been taxed as per Article 7 of OECD MC 2017, but the Cayman Islands does not have a corporate tax system, and India does not have a treaty with Cayman Islands.

13    Interestingly, for this purpose, while the Model Rules define the OECD MC as referring to the 2017 update, the Commentary goes on to state that the “last version… of the year in which the analysis is made” to determine presence of PE

Importantly, as contradistinguished from other types of PEs covered by Paras (a) to (c) above, a PE covered by Para (d) is considered stateless of the GloBE Rules, meaning that the income of the PE would be subject to the GloBE Rules on a standalone basis without the benefit of jurisdictional blending with profits/ losses of other constituent entities located either in HO or in source jurisdiction.

Generally, a PE is located in the jurisdiction where it is treated as a PE, and is subject to tax¹⁴ [except in case of Stateless PE at Para (d) of the definition above].

Determination of ETR of PE

Considering that the concept of PE is found in the taxation laws rather than in accounting (as is also acknowledged by the Commentary), accounts may typically not treat the profits of a PE any differently than the profits of HO jurisdiction, leading to questions on the determination of ETR especially in cases where any separate financial accounts of PE do not exist. Accordingly, GloBE Rules have special provisions for the same as below:

•  Determination of GloBE income of PE¹⁵

For types of PEs covered by paras (a) to (c) above, the starting point for determining GloBE income of PE is income or loss of PE as per separate financial accounts on a standalone basis prepared by the PE (either prepared or required to be prepared specifically for computing GloBE income) based on accounting standards used in CFS of UPE.

14    Article 10.3.3
15    Article 3.4 of the Model Rules

For a stateless PE, GloBE income is the income exempted as per domestic tax laws of the HO jurisdiction, attributable to operations conducted overseas (namely; outside the HO jurisdiction). The expenses, which can be deducted against such income are those which are not deducted as per domestic tax laws of the HO jurisdiction. However,  nevertheless, they are attributable to operations conducted overseas.

 • Determination of Adjusted Covered Taxes of PE¹⁷

Tax paid on the income attributable to the PE as enumerated above (even if paid by the HO in the HO jurisdiction), is also allocated to the PE and considered for the determination of ETR of the location of the PE namely; the source jurisdiction¹⁸ [except in Para (d) PE namely; Stateless PE which does not qualify for jurisdictional blending]. In this regard, the determination of taxes paid in the HO jurisdiction related to the PE may be a complex exercise and is acknowledged by the Commentary as needing further work.

• Miscellaneous

The parameters of employees and tangible assets located in PE jurisdiction are not taken into account while computing the allocation keys for UTPR liability¹⁹ and substance-based income exclusion²⁰ of HO jurisdiction.

16    In the context of jurisdictions like India which may permit HO to set-off losses of a PE, special rules are provided in Article 3.4.5 for allocation of income of the PE in future years. On a similar note, tax adjustments for determination of ETR in such case are also given at Article 4.3.4.
17    Article 4.3
18    Understandably, cross-border allocation is not a feature of Stateless PE as defined in Para (d) of the definition, as such PE in fact is identified based on exemption provided by the HO jurisdiction.
19    Refer Definition of Number of Employees and Tangible Assets at Article 10.1.
20    Refer Article 5.3.6

Facts: To illustrate, assume FCo of Germany, part of an in-scope MNE Group for GloBE Rules, has a project office (PO) in India providing services in connection with extractive activities in the crude oil sector.

Gross receipts of FCo from operations in India is 1,000. In India, FCo offers income to tax on presumptive basis u/s 44BB which deems profit from such operations to be 10 per cent of the gross income i.e. 100. Accordingly, corporate tax paid by FCo in India at 40 per cent²¹ is 40.

FCo has not availed the opportunity u/s 44BB(3) to offer a lower amount of income to tax in India. Accordingly, the FCo does not maintain any books of accounts in India. While FCo is required to maintain financial statements in Germany in accordance with German Accounting Standards, such financial statements do not require separate identification of revenue and expenditure attributable to the PE.

21    Approximate tax rates have been taken for ease of computation.

Analysis: Para (a) of PE definition requires the following conditions to be satisfied for existence of PE thereunder:

•   Existence of place of business/deemed place of business.

•   Treatment as PE in accordance with relevant treaty (namely India-Germany) in force.

•   Source jurisdiction (namely India) to tax income “attributable” to PE in accordance with provisions “similar” to Article 7 of OECD MC 2017.

In this regard, there presently exist ambiguities whether presumptive taxation provisions in India as per s.44BB satisfies the last condition of taxation similar to Article 7 of OECD MC 2017. To recollect, taxation should be as per provision “similar” to and not “same as” Article 7 of OECD MC 2017. As per commentary, “similar” does not require the source jurisdiction “to replicate the language or outcomes” of Article 7 of OECD MC 2017, and can cover treaties based on OECD MC 2010 and UN MC 2017²². Whether s.44BB merely provides an alternative mechanism for taxation of income “attributable” to PE which is “similar” to Article 7 of OECD MC 2017 resulting in satisfaction of Para (a) of the PE definition, or, does s.44BB go beyond that (and does not satisfy condition of being “similar” to Article 7 of OECD MC 2017), can be a matter of debate.

22    Refer para 102, pg. 210 of commentary.

Alternatively, where conditions of Para (a) of PE definition are not met since taxation as per s.44BB is not considered to be “similar” to Article 7 of OECD MC 2017, Para (d) of PE definition namely; Stateless PE will trigger. In such case of Stateless PE, GloBE income will be amount exempted as per domestic tax laws of Germany i.e. 500. In such case, ETR is 8 per cent (40/500). This may attract TUT liability at 7 per cent. Again, for the purposes of Stateless PE, parameters of taxation as per domestic tax laws of source jurisdiction (India) are irrelevant.

DE MINIMIS EXCLUSION FOR THE JURISDICTION²³

To evaluate if this exclusion is applicable, MNE would need to compute GloBE revenue and GloBE income for the jurisdiction. The reference point is therefore income/revenue as adjusted for GloBE purposes. To minimize volatility, the exclusion is linked to average, determined by adopting simple average for current and preceding two fiscal years. In the computation of average:

•    Fiscal years that are not GloBE years (i.e. when GloBE Rules did not apply to the MNE – either because they are before applicability of GloBE Rules to in-scope MNE or because € 750 million threshold is not crossed) are excluded.

•    Fiscal years in which MNE had no presence in the jurisdiction (due to absence of CEs or such CEs were dormant) are also excluded.

To illustrate, for a newly formed MNE (to whom GloBE Rules did not apply in the past), a 3-year average may not be needed and GloBE revenue/income for evaluating the above exclusion is based on the current year alone. For year 2, the above exclusion is based on 2-year average i.e. current year as also preceding year.

23    Article 5.5

Every MNE Group is required to file a GloBE Information Return (GIR). While GIR needs to be filed only once internationally²⁴, such GIR requires myriad data points, some of which are not otherwise captured for local tax or financial reporting purposes. Some of the data which is required to be filed in GIR are:

•    Data available from financial accounts: Revenue, deferred tax, profits, dividend and capital gains on investments, etc.

•    Data available from income tax filings: Income tax accrued, PE status of branches, WHT and dividend tax, ALP in respect of intra-group transactions, business reorganizations, income tax accrued in respect of incomes excluded from GloBE income, etc.

•    Other data specifically collected for GloBE Rules: whether provision for DTL has reversed within 5 years, recast DTA/DTL to 15 per cent tax rate, maintain track of DTA for tax loss recognized and reversed under GloBE Rules, maintain track of various elections and choices under the GloBE Rules, standalone financial results of PE, determine ownership interest in the constituent entity for  computing TUT liability, etc.

24    The jurisdiction where such GIR is filed needs to automatically share this information with all other jurisdictions where MNE Group operates [Article 8.1].

While, at a conceptual level, this compliance burden is sought to be alleviated through the application of objective safe harbours, the actual design of such safe havens may be presently unclear and awaits clarity. The need to balance the request for simplicity by MNE Groups with the desire of tax authorities to ensure at least 15 per cent tax in each jurisdiction without leakage is a tightrope that OECD/BEPS IF needs to balance.

The Commentary gives many indications to evince that OECD/BEPS IF shall continually handhold implementation by developing a GloBE Implementation Framework and an Agreed Administrative Guidance, to guide jurisdictions for coherent and consistent implementation of GloBE Rules.

In this backdrop, as per ‘OECD’s economic analysis, GloBE Rules are estimated to generate $150 billion of additional tax revenues per year. One may wonder if this revenue is commensurate with the enhanced compliance costs and significant efforts that implementation of GloBE Rules may entail.

THE ROAD AHEAD

These concerns are evident from stalling of legislative developments within the US and EU. To address these concerns, the EU was the first to shift the timeline for implementation by a year – which is now also being replicated across jurisdictions like UK and Hong Kong.

Nonetheless, various jurisdictions (illustratively, Mauritius, Switzerland and Korea) are well ahead of the curve to legislate the GloBE Rules, and a plethora of other jurisdictions (such as Germany, France, Netherlands, Singapore, Indonesia, Malaysia) have indicated their intention to adopt GloBE Rules.

However, despite the growing acceptability of the GloBE Rules, Indian tax authorities, despite India being a signatory to the agreement of BEPS, that  released in July and October 2021, has not released any official statement stating India’s position on GloBE Rules. Rather, the focus of the Indian Government seems to be on the implementation of Pillar 1 and subject-to-tax rules (STTR). To an impartial observer, it may seem that India is on a wait-and-watch mode. Perhaps implementation may happen only after further guidance and clarifications are made available from OECD/BEPS IF.

[The authors are thankful to CA Geeta D. Jani and CS Aastha Jain (LLB) for their guidance and support.]

Owing to rising disputes, while the CBDT brought the specific amendment to clarify this aspect with retrospective effect in Finance Act 2012, it is important first to understand the history and logic behind this controversial issue:

BACKGROUND OF THE ISSUE

The definition of ‘international transaction’ u/s 92B of the Income-tax Act, 1961 (“the Act”) was amended to widen its scope. Clause (c) was added to the sub-section (2) of section 92B, with retrospective effect from 1st April, 2002 as mentioned below:

“(c) capital financing, including any type of long-term or short-term borrowing, lending or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business.”

It is important to note that while the Memorandum contained reference as regards to the purpose of inclusion of various items in the definition, there was no specific mention of ‘capital financing’ and the purpose or implication of its inclusion within the definition of ‘international transaction’.

As per the Guidance note on Report under Section 92E of the Act issued by the Institute of Chartered Accountants of India (‘ICAI’):

“Advance payments received or made and debts arising during the course of business shall need to be carefully considered and reported by the accountant however ensuring that there is no duplication or overlap with reporting of the principal transactions to which such advances or debts relate to, unless the accountant identifies factors which cause such advances or debts as separate transactions.”

In view of the above, the issue to be considered is whether the trade advances/trade receivables / similar deferred payments should be treated as:

• Arising in the ordinary course of the business of the taxpayer and hence would not constitute a separate ‘international transaction’ (the impact of the interest loss on account of the credit period would get offset by the higher profits earned on account of the increase in sales or pricing as a result of extending such credit terms to the customers);

OR

• Separate lending or borrowing transactions liable to interest.

BENCHMARKING OF THE TRANSACTION

On the basis the guidance provided by ICAI, one of the most important exercises is to delineate outstanding receivables arising in the ordinary course of business from the receivables for which the realization is intentionally delayed to fund the overseas associated enterprises (‘AE’). The following steps may be followed for the same:

Step 1 – Identify receivables in the ordinary course of business. Since the principal transaction would already be benchmarked, separate benchmarking of such outstanding receivables may lead to duplication. Hence, an exercise needs to be conducted to separate the overdue receivables as per the contractual agreement with the overseas AE.

Step 2 – Post conducting of such an exercise, an analysis may also be conducted qua industry practice, on the basis of the information available in the public domain to identify the general credit period prevalent in such industry (e.g., textile and real estate enjoy higher credit period as compared to commodity and bullion) to determine the overdue receivables in comparison to the comparable companies.

Step 3 – The receivables overdue qua contract and qua industry need to be reported and benchmarked appropriately. To benchmark these overdue receivables, it is crucial to determine the reason for such a delay in realization. In case of genuine reasons beyond the control of the taxpayers, appropriate documentation should be maintained to prove such a bona fide reason. Certain common practical challenges faced by businesses recently are listed below (illustrative):

a)    Supply chain disruptions in view of COVID may cause a shortage of containers for transit of goods impacting the sale of goods sold on Free on Board (‘FOB’) basis.

b)    In cases where semi-finished goods are sold to the AE which further sells the goods to ultimate customers, due to a shortage of containers for shipment, the AE is unable to ship the goods and hence delays the sale and realization on an overall basis.

c)    Due to the ongoing geo-political reasons and point a) mentioned above, the transit time of shipments has significantly increased.

d)    Liquidity crunch or bankruptcy of AE may have led to write-off in the books of the taxpayer.

e)    Delay in realization of the amount from the ultimate customer may lead to delayed payment by the AE to the taxpayer.

f)    In certain cases, the taxpayer, at the time of finalization of books determines the true-up required to be recovered from AE as per the contractual agreement. Since the determination of true-up is done at the time of finalization of books, the payment of the same is realized after a long time as compared to the original timeline by which the taxpayer was supposed to realize such an amount.

g)    In some countries, any payment to an overseas party may lead to withholding tax implications requiring the payer to approach the tax authorities for seeking exemption on withholding tax on payment for non-taxable transactions to the taxpayer. Such approval from the tax department may take time and hence, result in the delay of realization.

h)    In certain cases, the taxpayer undertakes the transaction of purchase and sale with the same AE. In WNS Global Services Pvt Ltd – ITA No.1451/Mum/2012, the Mumbai ITAT held that the credit period provided by the AE vis-à-vis credit period provided by the taxpayer for such transactions respectively may require to be analyzed in aggregation, since analyzing the sales transaction in singularity may portray a distorted picture of delayed realization of proceeds to the taxpayer.

Step 4 – Post determining the reason for delayed realization, the next step is to benchmark the overdue receivables. The points mentioned below are important in this context:

a)    For calculating the credit period, the weighted average collection period could be computed (by assigning weights to the value of invoices) rather than computing simple average of collection period. This approach can be useful to put more weights to the high-value transactions. Further, in cases wherein the payment has been received in advance, such negative credit period invoices may also be considered to reduce the overall credit period.

b)    If the reason for a delayed realization is due to genuine business rationale beyond the control of the taxpayer as well as the AE, detailed documentation at an appropriate time is the key to benchmarking the transaction and creating a defense against potential adjustment. For instance:

– In case of long transit time for shipment of goods, a formal dialogue for renegotiating the credit period offered to the AE and the resulting amendment in the contract, along with documentation of detailed justification of such modification, can portray the genuineness of variation in credit period.

–  In case of a liquidity crunch or bankruptcy of an AE, formal documentation of various attempts made for the recovery and statutory documents supporting such a condition may create a substantial backup for benchmarking.

– In cases where the determination of a true-up at the time of finalization of books resulted in the delayed realization of receivables, one of the possible solutions can be that the AE provides an ad-hoc advance payment during the end of the financial year on the basis of the history of such true-up payments in earlier years. While the accurate amount gets determined at the time of finalization of books, such advance payment by the AE can create an important backup for the taxpayer to prove that there was a bona fide intention of the taxpayer for realizing the amount in time and only the differential amount can be settled at a later point of time.

– If the AE has funds but is unable to pay the taxpayer on time due to regulatory reasons, such an amount may be earmarked and deposited in the bank, and the interest earned on it may also be passed on to the taxpayer as and when the principal amount is paid to the taxpayer. Such an arrangement can justify that the taxpayer has not suffered any loss due to the delayed receipt of the amount.

Further, it may be separately noted that as per the FEMA regulations, the period of realization for exports is nine months from the date of export.

However, the RBI had extended the period of realization of export proceeds from the existing nine months to fifteen months from the date of export due to the COVID pandemic for exports made between 1st April, 2020 to 31st July, 2020. Such an extension of timeline for realization of proceeds by RBI can also be taken as a base to substantiate the delay in realization of proceeds during such period on an overall basis due to industry-wide and worldwide issues.

However, it is to be noted that the above timeline is the maximum period within which the export proceeds are required to be realized.

The above reasons, supported with the detailed backup documentation can also help the taxpayers avoid substantiate penal consequences, if any, as the same may prove the bona fide intent of the taxpayer to the tax administrators.

c)    If the taxpayer is unable to prove the genuine business reason for delayed receipt, the taxpayer may be required to receive an arm’s length interest income for the overdue period.

The above steps can be followed to comprehensively analyze the outstanding receivables and decide the need for separate disclosure and benchmarking.

CALCULATION OF THE ARM’S LENGTH INTEREST INCOME

A)    If the receivable is denominated in the foreign currency and upon realization of the same, the currency gain or loss due to the fluctuation in the exchange rate will be borne by the Indian taxpayer, then the appropriate reference rate for determining the arm’s length interest charge would be LIBOR (London Interbank Offered Rate) / SOFR (Secured Overnight Financing Rate) / SONIA (Sterling Overnight Interbank Average Rate), etc.

B)    If the receivable is denominated in the Indian currency, then the appropriate base rate would be the Indian bank reference rate such as PLR, base rate, etc.

Reference rates prescribed by the Indian tax and other regulatory authorities with respect to minimum interest income to be charged on loans and advances provided to AE for specific cases:

a)    As per safe harbour rule 10T of Income-tax Rules, 1962 (‘IT Rules’):

i.    If the intra-group loan is advanced in Indian Currency – the interest rate is to be charged on the one-year marginal cost of funds lending rate of State Bank of India plus prescribed basis points as per the credit rating of AE.

ii.    If the intra-group loan is advanced in Foreign Currency – the interest rate is to be charged on the six-month LIBOR of the relevant foreign currency plus prescribed basis points as per the credit rating of AE.

b)    As per rule 10CB of IT Rules, in case a transfer pricing adjustment is made, and such adjustment money is not repatriated back to India by the taxpayer within the prescribed period, the same gets recharacterized as advance provided to AE (secondary adjustment) and interest on the same is required to be levied at the rate of:

i.    In case the respective international transaction is denominated in Indian Currency – at one-year marginal cost of fund lending rate of State Bank of India as on 1st April of the relevant previous year plus 325 basis points.

ii.    In case the respective international transaction is denominated in Foreign Currency – at six-month LIBOR as on 30th September of the relevant previous year plus 300 basis points.

c)    As per Foreign Exchange Management (Overseas Investment) Regulations, 2022, loans advanced by an Indian entity should be backed by a loan agreement with an arm’s length interest rate charged on the same.

d)    In terms of Regulation 15 of Notification No. FEMA 23 (R)/2015-RB dated 12th January, 2016, where an exporter receives advance payment (with or without interest), from a buyer outside India, the exporter shall be under an obligation to ensure that the shipment of goods is made within one year from the date of receipt of advance payment; the rate of interest, if any, payable on the advance payment should not exceed LIBOR plus 100 basis points.

The above-prescribed interest rate may be considered as a guide. However, the exact computation of arm’s length interest rate will depend upon the facts and circumstances of each case.

Further, in case an interest is charged to the AE, then such interest amount needs to be repatriated to India by the AE.

OTHER METHODS OF BENCHMARKING SUPPORTED BY JUDICIAL PRECEDENTS

a) Working Capital Adjustment

1 IT(TP) No. 346/Bang/2015
2 IT(TP)A No.474/Bang/2015

One of the main features of such working capital adjustment is that it takes into account both debtors and creditors. In view of the same, in case any taxpayer is providing a high credit period in sales, but at the same time is also enjoying high credit period on purchase, such mutual credit period is taken into consideration and, hence it does not portray a distorted picture of only delayed realization of receivables to the taxpayer.

There are many judicial precedents that support the above method of benchmarking (e.g., Kusum Health Care Pvt. Ltd.³ and Visual Graphics Computing Services (India) Pvt Ltd⁴), and are also recommended by the Organization for Economic Co-operation and Development (‘OECD’) for benchmarking of debtors and creditors. In view of the same, it may be recommended to conduct this exercise on a regular basis to avoid any potential litigation.

b) Comparison of credit period to AE vis-à-vis unrelated entity

c) Taxpayer is a debt-free company

3 ITA 765 of 2016, Delhi High Court
4 T.C.A.No.414 of 2018, Madras High Court
5 D.B. Income Tax Appeal No. 56 / 2017, Rajasthan High Court
6 ITA No.1614/Del./2018, Delhi ITAT
7 ITA No.1451/Mum/2012, Mumbai ITAT
8 ITA 379/2016, Delhi High Court

It is further provided that the excess money available with the AE due to the primary adjustment if not repatriated to the taxpayer into India within the prescribed time limit, then the primary adjustment will be deemed as an advance extended to the overseas AE and interest on such advance shall be computed in the manner as prescribed.

In view of the above provisions, receivables arising out of secondary adjustment need to be accounted for in the books along with the interest income as prescribed by CBDT. As mentioned above, since the interest rate has been prescribed by the CBDT, the same provides an indication of the interest rate which may be adopted by the tax authorities for benchmarking of overdue trade receivables as well.

DISCLOSURE REQUIREMENTS

i) Receivables – Disclosure
As mentioned above, outstanding receivables need to be bifurcated in the following categories:

a)    Receivables arising out of the ordinary course of business which do not necessitate that the transaction gets recharacterized as advance provided to AEs.

b)    Receivables in nature of debts which warrant the taxpayer to charge interest on such overdue receivables.

From the perspective of disclosure in Form 3CEB, in case of category a) mentioned above, if after carrying out the necessary exercise, as also suggested by ICAI Guidance Note, the receivables are in the ordinary course of business and not characterizable as advances, then reporting of such receivables separately may prove to be duplication of reporting the transactions by way of the principal transaction as well as trade receivables. However, on a conservative basis, such receivables
and payables may be reported in the notes section of Form 3CEB to avoid unnecessary litigation for non-disclosure.

However, in case of category b) mentioned above, it is important to disclose the transaction separately in Form 3CEB in Clause 14, and also to charge interest in line with Para 3 above in order to avoid litigation at a later stage.

Similar disclosures would also be required for receivables arising out of secondary adjustment along with disclosure of the interest income earned from it.

Further, since such overdue receivables are deemed as advance, the same should not trigger compliances under ODI (‘Overseas Direct Investment’) regulations applicable to loan transactions.

ii) Payables – Disclosure
Generally, outstanding payables are not a cause of concern for the Indian taxpayer, but it is important to analyze the same from the perspective of overseas AE.

From the Indian taxpayer’s perspective, if the credit period availed is in excess qua contract and qua industry, one possible interpretation can be that the Indian taxpayer is using such funds at the behest of the overseas AE. However, since it is beneficial from the Indian taxpayer’s perspective, any transfer pricing adjustment made by the Income-tax authorities on such a transaction would have an effect of reducing the income chargeable to tax or increasing the loss, as the case may be. Such adjustment is prohibited vide Section 92(3) of the Act since it leads to base erosion of tax from India.

Further, the outstanding payable of the Indian taxpayer would be outstanding receivable from an overseas AE perspective. It could result in adverse consequences for overseas AE, as the law mandates each taxpayer to demonstrate the arm’s length nature of its international transaction. Further, there are conflicting judgments on the applicability of the base erosion principle while dealing with disputes relating to overseas AE.

Hence, the exercise and steps mentioned for outstanding receivables above should also be followed for outstanding payables to the extent applicable. It would be advisable to make appropriate disclosures of identified overdue payables in Form 3CEB of the Foreign Company and undertake appropriate benchmarking of the same and maintenance of documentation.

CONCLUSION
One may need to review voluminous data to assess the rationale for delays, if any, and consequent interest costs. In case the impact of interest cost resulting from the delay is not significant, then there may be a temptation to ignore charging interest in the inter-company transaction to minimize administrative hassles. However, at this juncture, it is important to weigh the penal consequence of 2 per cent of the transaction value which gets triggered due to the non-disclosure of overdue transactions in the year-end compliances.

In the inter-company contracts, the clauses related to invoicing (i.e., budgeted cost or actual cost) invoice frequency, credit term, penal interest clause etc. should be carefully drafted. Further, aforesaid clauses should be regularly reviewed to ensure the conduct of the parties is in line with contractual arrangements. It is observed that MNCs sometimes mention a percentage of penal interest to be charged in case of delay in payments. However, in actual practice, such an interest is waived or not charged. It is critical that any such waiver is backed with appropriate justification and documentation. Further, in cases wherein parties don’t have the intention to charge penal interest for delays, then such clauses should be carefully drafted as the same can go against the taxpayer.

In the assessment proceedings, the tax officers have been specifically seeking details of the settlement of receivable and payable transactions throughout the year and scrutinizing ageing analysis of year-end debts closely. Thus, it is imperative that the taxpayer compiles the said information proactively and maintains adequate justification to defend stray situations of delays, if any, in settling inter-company debts.

As discussed above, the FEMA regulations permit nine months from the date of export to realize the proceeds from the overseas entity. However, the tax officers often consider a narrow credit period of 45 days to 90 days. It will be helpful if some guidance is provided by the government to field officers to consider the credit period in line with FEMA regulations.

Further, the taxpayer must be vigilant to ensure that the receivables and payables are settled in the normal credit period. In case of delays in settlement, the taxpayer should gather evidence to demonstrate his bona fide behaviour and situations beyond his control. Further, the documents should also clearly demonstrate there was no intention to fund the operation of overseas AE through an excess credit period.

Provisions of PE are typically included under Article 5 of a tax treaty. While Article 5(1) to Article 5(3) provides for what constitutes a PE, Article 5(4) provides for a list of activities that do not constitute a PE, even if such activities are undertaken from a fixed place of business in the Source Country (generally known as ‘preparatory and auxiliary exemption’). At the same time, the OECD Commentary (2017) enlists a number of business activities which are treated as exceptions to the general definition of the term PE and which when carried on through fixed places of business, are not sufficient to constitute a PE.

In the above context, a question arises: Does ‘business connection’ include preparatory / auxiliary exemption? The term business connection is not defined under the Income-tax Act, 1961 (the Act) and is interpreted by placing reliance on judicial precedents (key reference provided by the Apex Court in the case of R.D. Aggarwal). Thus, ‘business connection’ draws meaning from the definitions pronounced by judicial precedents, and it may include carrying on a part of the main business, or merely a relation between the business of the foreign company and the activity in India which assists in carrying on the business of the foreign company. Thus, although not explicit, the term business connection includes preparatory and auxiliary activities (POA) when read with ‘contributes directly or indirectly to the earnings of the non-resident from its business’1.

This article aims at providing the effect of MLI (Article 13) on Article 5(4) where activities that do not constitute PE as per Article 5(4) will constitute a PE under MLI Article 13 if certain conditions are satisfied. Thus, Article 13 is a game-changer. In simple words, where in substance cohesive business activities of a foreign enterprise are broken down or fragmented to fit the definition of the exempted activities of erstwhile Article 5(4), they may no longer be able to escape PE status and therefore taxation. This will impact many multinational companies and hence is pertinent to note.

The Table below classifies the negative list of Article 5(4):

* Highlighted part is amended under BEPS AP 7

As can be observed from the above, initially, OECD was of the view that the enlisted negative activities from Article 5(4)(a) to Article 5(4)(d) of the OECD Model Convention, 2014 would apply automatically to exclude the constitution of a PE, more so considering the erstwhile business models. For example, a non-resident company maintains warehouse facilities solely for the purpose of storage of its goods in the Source State. The delivery of goods would be undertaken through an independent third party in the logistic business. Under the erstwhile PE provisions, the foreign company is not required to substantiate that this activity is auxiliary in nature as the application of Article 5(4)(a) of the OECD Model Convention is automatic. Only Article 5(4)(e) and Article 5(4)(f) subject the specified activities to be of a ‘preparatory and auxiliary character’. In the above example, if a non-resident company maintains a warehouse for storage of finished goods [Article 5(4)(a)] and maintains an office for procurement activities, Article 5(4)(d) and Article 5(4)(f) would apply and the ‘overall activity of the fixed place of business resulting from this combination’ should be of a preparatory or auxiliary character to be exempted from constitution of a PE. In reality, the multinational enterprises (MNEs) have benefited from the automatic application of the enlisted negative activities by ensuring that their fixed place of business solely carries on the enlisted negative activity [Article 5(4)(a) to Article 5(4)(d)].

The Executive Summary of the BEPS Action Report No. 7 (at point 10) states that ‘depending on the circumstances, activities previously considered to be merely preparatory or auxiliary in nature may nowadays correspond to core business activities. In order to ensure that profits derived from core activities performed in a country can be taxed in that country, Article 5(4) is modified to ensure that each of the exceptions included therein is restricted to activities that are otherwise of a “preparatory or auxiliary” character… BEPS concerns related to Article 5(4) also arise from what is typically referred to as the “fragmentation of activities”. Given the ease with which multinational enterprises (MNEs) may alter their structures to obtain tax advantages, it is important to clarify that it is not possible to avoid PE status by fragmenting a cohesive operating business into several small operations in order to argue that each part is merely engaged in preparatory or auxiliary activities that benefit from the exceptions of Article 5(4). The anti-fragmentation rule proposed in [this report] will address these BEPS concerns.’

In order to understand the above in detail, let us consider the following examples:

– The above example includes a company operating an online shop in Country A and selling goods to customers in Country B through a website.
– For delivery and storage of goods, the company maintains a warehouse in Country B.
– Erstwhile Article 5(4) included an exception wherein maintenance of a fixed place in India solely for the purpose of storage and delivery would not constitute a PE. This was based on the principle that such activities are considered as preparatory and auxiliary in the entire scheme of business operations.
– However, with the advancement of internet, the manner in which businesses are operated has evolved. Given this, since most of the business operations of the company are undertaken online, maintenance of a warehouse in Country B for storage and delivery may no longer be considered as preparatory and auxiliary in nature but the core activity. This therefore makes the exceptions provided under Article 5(4) redundant.
– BEPS AP 7 / MLI Article 13 seek to address the above challenges and amend the PE provisions to be in line with the advanced business model.

Anti-fragmentation: Splitting for creating preparatory and auxiliary activities
Earlier, the determination of PE and the enlisted negative activities was considered vis-à-vis the said enterprise which carried on such activities, and not that of the group companies assessed in totality. The aggregation of ‘places of business’ carried on by other members of the group companies was specifically denied by the OECD Commentary (2014). So, the MNEs fragmented their business operations into various activities among different places and different related enterprises, with a view to fall within the negative list and avoid the existence of a PE in the Source State. For example, large multinationals can fragment their operations into smaller businesses (such as entity A storing goods, entity B delivering goods and entity C providing sales support activities), thereby arguing that each business part is just preparatory and auxiliary in nature.

MLI Article 13 provides for amendment in the PE provisions to avoid such situations by aggregating the activities provided by group companies in the Source State to determine whether or not a PE is constituted. The following examples can help in understanding fragmentation of activities by foreign companies:

Example 1:

Thus, in the above example F Co. has fragmented its business activities in Country B by incorporating two separate entities undertaking (i) warehouse and storage functions, and (ii) support services.

Example 2:

And in the above example, R Co. has fragmented its business activities in Country B by incorporating various entities undertaking (a) procurement functions, (b) bonded warehouse, (c) distribution centre, (d) processing department, etc. This sets a clear example of fragmentation of activities which, if considered individually, will qualify for the preparatory and auxiliary exemption.

MLI ARTICLE 13

The member State may choose to apply paragraph 2 of Article 13 (Option A) or paragraph 3 of Article 13 (Option B) or not to apply any option. Under Option A, the specific activities mentioned in the tax treaties will not constitute a PE, insofar as the activities of the PE are preparatory and auxiliary in nature. In other words, the activities of a PE, even if aligned with sub-paragraphs (a) to (f) of Article 5(4), will only be exempt from being a PE if the overall conduct of the activities is preparatory and auxiliary in nature. A majority of the member States have agreed to this view.

Further, under Option B, paragraph 78 of the OECD Commentary (2017) provides that ‘some Member States consider that some of the activities referred to in Article 5(4) are intrinsically preparatory and auxiliary and, in order to provide greater certainty for both tax administrations and taxpayers, take the view that these activities should not be subject to the condition that they be of a preparatory or auxiliary character, and that concern about inappropriate use of the specific activity exemptions can be addressed through anti-fragmentation rules’. This option allows the member States to continue to use the existing language; however, at the same time they have agreed that an enterprise cannot fragment a cohesive business operation into smaller business operations in order to call it preparatory and auxiliary.

Paragraphs 2 & 3 of MLI Article 13
Article 5(4) of the OECD Model Tax Convention (2017) is modified to provide for Option A or Option B. Both the options preserve the specific variant of listed activities under each Covered Tax Agreement (CTA). It does not replace the list of exempt activities in the current CTAs with the above BEPS AP 7-suggested Article 5(4). Hence, in order to accommodate the model version and the existing version, Article 13 of the MLI provides for the following:
• Option A – provides additional condition that the specific activity exemption would apply only if the listed activities are of preliminary or auxiliary nature (POA) (remains explicit);
• Option B – provides automatic exemption to listed activities, irrespective of the same being POA in nature (i.e., remains explicit);
• If member states decide to not choose any option: the provisions of Article 5(4) as existing under the CTAs will remain in force (i.e., remain implicit).

An alternative rule is designed for those countries that are of the opinion that the examples stated under Article 5(4)(a) to Article 5(4)(d) of the OECD Model (2014) should always be deemed as not creating a PE, without the need to further go into the deliberation of whether or not they meet the general preparatory and auxiliary nature standard.

Paragraph 4 of MLI Article 13
Article 13(4) of the MLI relates to the anti-fragmentation rule wherein, irrespective of the above options (i.e., Option A or Option B or none), the member States will have another option to implement the anti-fragmentation rule. The objective is to avoid fragmentation of activities between closely-related parties so as to fall within the scope of preparatory and auxiliary character, and thereby avoid constituting a PE in the Source State. It provides as under:

‘Para 4. A provision of a Covered Tax Agreement (as it may be modified by paragraph 2 or 3) that lists specific activities deemed not to constitute a permanent establishment shall not apply to a fixed place of business that is used or maintained by an enterprise if the same enterprise or a closely related enterprise carries on business activities at the same place or at another place in the same Contracting Jurisdiction and:
a) that place or other place constitutes a permanent establishment for the enterprise or the closely related enterprise under the provisions of a Covered Tax Agreement defining a permanent establishment; or
b) the overall activity resulting from the combination of the activities carried on by the two enterprises at the same place, or by the same enterprise or closely related enterprises at the two places, is not of a preparatory or auxiliary character,
provided that the business activities carried on by the two enterprises at the same place, or by the same enterprise or closely related enterprises at the two places, constitute complementary functions that are part of a cohesive business operation.’

Accordingly, clause 4.1 is inserted to Article 5(4) of the OECD Model Convention and its commentary is provided in paragraphs 79 to 81 of the OECD Commentary (2017). Under Article 13(4) of the MLI (above), the scope for specific activity exemption is not available where there is at least one of the places where these activities are exercised (and) must constitute a PE or, if that is not the case, the overall activity resulting from the combination of the relevant activities must go beyond what is merely preparatory or auxiliary. Until now, the PE status remained embedded per se to its place of business through which the business activities were carried on. But now, the different places of business in the Source State would be combined and if at least one of the places constitutes a PE, then all places of business would constitute a PE for the enterprise as well as for its closely related enterprises carrying on activities in the said Source State. Accordingly, the profits attributable to the PE would be subject to tax in India.

BEPS AP 7 had made application of the anti-fragmentation rule mandatory for those opting for Option B, but the MLI has changed its applicability from mandatory to optional for all three options (including Option B).
India has opted for option A, i.e., wherein PE exemption to listed activities under Article 5(4) shall be subject to activities being preparatory-auxiliary in nature, whereas for the anti-fragmentation rule India is silent, indicating that this rule will be applicable if there is no reservation from the other contracting State in the CTA. It must be noted that in paragraph 51 of the Positions on Article 5, India states that it does not agree with the interpretation given in paragraph 74 because it considers that even when the anti-fragmentation provision is not applicable, an enterprise cannot fragment a cohesive operating business into several smaller operations in order to argue that each is merely engaged in a preparatory or auxiliary activity.

Understanding ‘complementary functions’ and ‘cohesive business operations’
In order to determine the preparatory and auxiliary character, the activity carried on would be compared with the main and core business of the enterprise. Further, based on Article 14 of the MLI, the activity so carried on would be combined with other activities that constitute ‘complementary functions’ that are part of a cohesive business carried on by the same enterprise or closely related enterprises in the same state. Neither MLI nor the OECD Commentary defines the terms ‘complementary functions’ and ‘cohesive business’. However, both these terms cannot be interpreted independently but together as a ‘part of’ the whole. Further, it refers to complementary functions, rather than complementary products or complementary business, etc., indicating interconnected (or closely connected) functions, or intertwined, or interdependent functions, with respect to technology, or value-added functions, or the nature of their ultimate purpose or use.

Paragraph 7 of the OECD Report on ‘Additional Guidance on the Attribution of Profits to Permanent Establishments’, BEPS AP 7, dated March, 2018, provides that ‘the anti-fragmentation rule recommended in the Report on Action 7 (at paragraph 39) is contained in the new paragraph 4.1 of Article 5. It prevents paragraph 4 from providing an exception from PE status for activities that might be viewed in isolation as preparatory or auxiliary in nature but that constitute part of a larger set of business activities conducted in the source country by the enterprise (whether alone or with a closely related enterprise) if the combined activities constitute complementary functions that are part of a cohesive business operation’.

Attribution of profits to PE
Paragraph 8 of the OECD Report on ‘Additional Guidance on the Attribution of Profits to Permanent Establishments’, BEPS AP 7, dated March, 2018, provides that Article 5(4.1) is applicable in two types of cases. First, it applies where the non-resident enterprise or a closely related enterprise already has a PE in the source country, and the activities in question constitute complementary functions that are part of a cohesive business operation. A determination will need to be made as to whether the activities of the enterprises give rise to one or more PEs in the source country under Article 5(4.1). The profits attributed to the PEs and subject to source taxation are the profits derived from the combined activities constituting complementary functions that are part of a cohesive business operation. This is considering the profits each one of them would have derived, if they were a separate and independent enterprise performing its corresponding activities, taking into account, in particular, the potential effect on those profits of the level of integration of these activities. Examples of this type of fact pattern are contained in new paragraph 30.43 of the revised Commentary (at point 40-41 of the Report on AP 7).

Paragraph 9 of the OECD Report on ‘Additional Guidance on the Attribution of Profits to Permanent Establishments’, BEPS AP 7, dated March 2018, provides that the second type of case to which Article 5(4.1) applies is a case where there is no pre-existing PE but the combination of activities in the source country by the non-resident enterprise and closely related non-resident enterprises results in a cohesive business operation that is not merely preparatory or auxiliary in nature. In such a case, a determination will need to be made as to whether the activities of the enterprises give rise to one or more PEs in the source country under Article 5(4.1). The profits attributable to each PE so arising are those that would have been derived from the profits made by each activity of the cohesive business operation as carried on by the PE, if it were a separate and independent enterprise, performing the corresponding activities taking into account, in particular, the potential effect on those profits of the level of integration of these activities.

Understanding ‘preparatory and auxiliary character’
Paragraph 60 of the OECD Commentary (2017) provides that an activity that has a preparatory character is one that is carried on in contemplation of what constitutes an essential and significant part of the activity of the enterprise as a whole. It is usually carried on for a relatively short period, which, depending on the circumstance, could be carried on for a longer duration. Auxiliary activity supports the essential and significant part of the activity. In absolute terms, auxiliary activities would not require significant proportion of the assets or employees, when compared with the total assets or employees of the enterprise.

Further, Paragraph 61 of the OECD Commentary (2017) provides that the activity purported to be covered under the specified activity exemptions ought to be carried on for the enterprise itself. If the activity is undertaken on behalf of the other enterprises at the same fixed place of business, the said activity would not be exempt from the PE status in the garb of Article 5(4) of the applicable tax treaty. The OECD Commentary (2017) provides an example that if an enterprise that maintained an office for the advertising of its own products or services, which was also engaged in advertising on behalf of other enterprises at that location, would be regarded as a PE of the enterprise.

Understanding ‘closely related enterprises’
Article 15 of the MLI defines the term ‘Closely Related Enterprises’ (CRE). The concept of CRE is distinguished from the concept of ‘Associated Enterprises’ of Article 9 of the OECD Model Convention. It is important to note that the term ‘control’ is not defined therein. Further, the member States that have made reservations to Article 12-14 of the MLI can opt out of Article 15.

‘Article 15 – Definition of a Person Closely Related to an Enterprise
1. For the purposes of the provisions of a Covered Tax Agreement that are modified by paragraph 2 of Article 12 (Artificial Avoidance of Permanent Establishment Status through Commissionnaire Arrangements and Similar Strategies), paragraph 4 of Article 13 (Artificial Avoidance of Permanent Establishment Status through the Specific Activity Exemptions), or paragraph 1 of Article 14 (Splitting-up of Contracts), a person is closely related to an enterprise if, based on all the relevant facts and circumstances, one has control of the other or both are under the control of the same persons or enterprises. In any case, a person shall be considered to be closely related to an enterprise if one possesses directly or indirectly more than 50 per cent of the beneficial interest in the other (or, in the case of a company, more than 50 per cent of the aggregate vote and value of the company’s shares or of the beneficial equity interest in the company) or if another person possesses directly or indirectly more than 50 per cent of the beneficial interest (or, in the case of a company, more than 50 per cent of the aggregate vote and value of the company’s shares or of the beneficial equity interest in the company) in the person and the enterprise.
2. A party that has made the reservations described in paragraph 4 of Article 12 (Artificial Avoidance of Permanent Establishment Status through Commissionnaire Arrangements and Similar Strategies), sub-paragraph a) or c) of paragraph 6 of Article 13 (Artificial Avoidance of Permanent Establishment Status through the Specific Activity Exemptions), and sub-paragraph a) of paragraph 3 of Article 14 (Splitting-up of Contracts) may reserve the right for the entirety of this Article not to apply to the Covered Tax Agreements to which those reservations apply.’

India has adopted Article 15 of the MLI. However, India has reserved its right to not include the words ‘to which it is closely related’ in Article 5(6) of the OECD Model Convention (2017). For instance, India has not reserved the right to paragraph 4 of Article 13 of the MLI, which means that it has accepted to bring the anti-fragmentation rule to the existing tax treaties. Again, this can only be confirmed if the other contracting state doesn’t create reservation to paragraph 4 of Article 13.

Paragraph 5 to 8 of MLI Article 13
Paragraph 5 contains compatibility clauses which describe the relationship between Article 13(2) through (4) and provisions of CTA. Paragraph 6 contains reservation rights of the member States, indicating that the provisions addressing the concerns of BEPS AP 7 are not required in order to meet a minimum standard test. The member State may reserve the right for the entirety of Article 13 of MLI not to apply to its CTAs.

Paragraph 7 requires that parties that opted for Option A or Option B to notify the depository of the Option so selected. Paragraph 180 of the Explanatory Statement further confirms that ‘An Option would apply to a provision only where all Contracting Jurisdictions have chosen to apply the same Option and have made such a notification with respect to that provision’. For example, if a contracting State chooses Option A while the other chooses Option B, the asymmetrical decisions conclude in the non-application of the provision in its entirety. This is illustrated in paragraph 7 of Article 13, which states that ‘an Option shall apply with respect to a provision of a CTA only where all Contracting Jurisdictions have chosen to apply the same Option and have made such a notification’. Accordingly, India has selected and notified Option A. Unless the other contracting State selects Option A, the tax treaty will remain unchanged.

Paragraph 8 requires each party that has not opted out of applying Paragraph 4 (anti-fragmentation rule) or for the entirety of Article 13, to notify the depository of each of its CTAs that includes specific activity exemptions. Paragraph 181 of the Explanatory Statement further confirms that ‘Paragraph 4 will apply to a provision of a CTA only where all Contracting Jurisdictions have made such a notification with respect to that provision pursuant to either paragraph 7 or paragraph 8.’

The extract of Article 13(5) to Article 13(8) is provided below:

‘Para 5. a) Paragraph 2 or 3 shall apply in place of the relevant parts of provisions of a Covered Tax Agreement that list specific activities that are deemed not to constitute a permanent establishment even if the activity is carried on through a fixed place of business (or provisions of a Covered Tax Agreement that operate in a comparable manner).
b) Paragraph 4 shall apply to provisions of a Covered Tax Agreement (as they may be modified by paragraph 2 or 3) that list specific activities that are deemed not to constitute a permanent establishment even if the activity is carried on through a fixed place of business (or provisions of a Covered Tax Agreement that operate in a comparable manner).
Para 6. A Party may reserve the right: a) for the entirety of this Article not to apply to its Covered Tax Agreements; b) for paragraph 2 not to apply to its Covered Tax Agreements that explicitly state that a list of specific activities shall be deemed not to constitute a permanent establishment only if each of the activities is of a preparatory or auxiliary character; c) for paragraph 4 not to apply to its Covered Tax Agreements.
Para 7. Each party that chooses to apply an Option under paragraph 1 shall notify the Depository of its choice of Option. Such notification shall also include the list of its Covered Tax Agreements which contain a provision described in sub-paragraph a) of paragraph 5, as well as the article and paragraph number of each such provision. An Option shall apply with respect to a provision of a Covered Tax Agreement only where all Contracting Jurisdictions have chosen to apply the same Option and have made such a notification with respect to that provision.
Para 8. Each party that has not made a reservation described in sub-paragraph a) or c) of paragraph 6 and does not choose to apply an Option under paragraph 1 shall notify the Depository of whether each of its Covered Tax Agreements contains a provision described in sub-paragraph b) of paragraph 5, as well as the article and paragraph number of each such provision. Paragraph 4 shall apply with respect to a provision of a Covered Tax Agreement only where all Contracting Jurisdictions have made a notification with respect to that provision under this paragraph or paragraph 7.’

India context: Impact analysis of key India tax treaties:

CONCLUSION
The specific activity exemption provisions are important from the point of view of the relief they provide to non-resident entities who have only incidental activities in India. Hence, one needs to be careful while applying these provisions to a particular case. The amendment provided in Article 13 of the MLI is largely impacting industries such as e-commerce / EPC / consumer, wherein foreign companies have typically been taking exemptions from PE pursuant to the negative list / anti-fragmenting activities in India. However, on account of amendments made by Article 13, it is imperative for all foreign companies to revisit their existing PE positions.

Now, the Taxation Laws (Amendment) Act, 2021 [TLA, 2021] has nullified the retrospective nature of the original amendment. The ‘Statement of Objects and Reasons’ to The Taxation Laws (Amendment) Bill, 2021 candidly highlighted the ill-effects of the retrospective amendment.

BACKGROUND

It all started in the year 2007 in the landmark case of Vodafone International which entered the Indian telecom market by acquiring the telecom business of Hutchinson India. Vodafone International, a Dutch-based Vodafone entity, acquired indirect control in Hutchison Essar Limited (HEL), an Indian company, from a Cayman Islands-based company, viz., Hutchison Telecommunications International Limited (HTIL). It did this by acquiring a single share in CGP Investment (CGP), another Cayman Islands company, from HTIL in February, 2007. CGP held various Mauritian companies, which in turn held a majority stake in HEL.

In September, 2007 the Revenue authorities issued a show cause notice to Vodafone International for failure to withhold tax on the amount paid for acquiring the said stake as they believed that HTIL was liable for capital gains it earned from the transfer of the share of CGP, as CGP indirectly held a stake in HEL. Vodafone International was also sought to be treated as a ‘representative assessee’ u/s 163 and a capital gains tax demand of Rs. 12,000 crores was sought to be recovered from Vodafone International.

But Vodafone International claimed that the Indian Revenue authorities had no jurisdiction over the transaction as the transfer of shares had taken place outside India between two companies incorporated outside India and the subject of the transfer was shares, the situs of which was also outside India. The matter was litigated up to the Supreme Court which, in 2012, in the landmark judgment in Vodafone International Holdings B.V. vs. Union of India1, absolved Vodafone of the liability of payment of Rs. 12,000 crores as capital gains tax in the transaction between it and HTIL.

The Court held that the Indian Revenue authorities did not have jurisdiction to impose tax on an offshore transaction between two non-resident companies wherein controlling interest in a resident company was acquired by the non-resident company.

But the Indian Government believed that the verdict of the Supreme Court was inconsistent with the legislative intent as they believed that India, in its sovereign taxing powers, was empowered to tax such indirect transfers of assets located in India. Thus, an amendment was brought about by the Finance Act, 2012 with retrospective effect, to clarify that gains arising from the sale of shares of a foreign company are taxable in India if such a share, directly or indirectly, derives its value substantially from the assets located in India. Section 119 of the Finance Act, 2012 also provided for validation of demand, etc., under the Income-tax Act, 1961 for cases relating to indirect transfer of Indian assets.

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1          [2012]
341 ITR 1 (SC)

Pursuant to this amendment, an income tax demand has been raised in 17 cases which include the prominent cases of Vodafone and Cairn Energy. It is believed that the total estimated demand in these 17 cases totals up to an enormous sum of Rs. 1.10 lakh crores2.

In the ‘Statement of Objects and Reasons’ to The Taxation Laws (Amendment) Bill, 2021 it has been noted that in two out of these 17 cases, assessments are pending due to a stay granted by the High Court.

The ‘Statement of Objects and Reasons’ to The Taxation Laws (Amendment) Bill, 2021, observes that in four cases, arbitration under the Bilateral Investment Protection Treaty (BIT) with the United Kingdom and the Netherlands had been invoked against the demands. Of these four cases, in two, Vodafone and Cairn Energy, the result of arbitration has been against the Income-tax Department.

In the case of Vodafone, the Singapore seat of the Permanent Court of Arbitration of The Hague ruled that India’s imposition of a tax liability on Vodafone, as well as interest and penalties, breached an investment treaty agreement between India and the Netherlands3. The Arbitral Tribunal held that the imposition of the asserted liability notwithstanding, the Supreme Court judgment is in breach of the guarantee of fair and equitable treatment laid down in Article 4(1) of the BIT between India and the Netherlands. The Arbitral Tribunal directed India to reimburse the legal costs of approximately INR 850 million to Vodafone.

The said arbitral award was challenged by the Indian Government in Singapore because according to it taxation is not a part of the BIT and it falls under the sovereign power of India.

Similarly, in the case of Cairn Energy, a Scottish firm, the Permanent Court of Arbitration having its legal seat in the Netherlands, in December, 2020 awarded it $1.2 billion (over Rs. 8,800 crores) plus costs and interest which totalled $1.725 million (Rs. 12,600 crores) as of December, 20204. The Tribunal held that India had failed to comply with its obligations under the India-UK BIT. India appealed against the said award in a court in The Hague, Netherlands.

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2   https://www.business-standard.com/article/pti-stories/us-court-sets-timelines-for-cairn-india-legal-case-121082700964_1.html

3   https://wap.business-standard.com/article-amp/economy-policy/govt-to-amend-income-tax-act-to-nullify-retrospective-tax-demands-121080501146_1.html

4              https://wap.business-standard.com/article-amp/economy-policy/govt-to-amend-income-tax-act-to-nullify-retrospective-tax-demands-121080501146_1.html

In June, 2021, the Tribunal Judiciaire de Paris, a French court, allowed Cairn’s application to freeze 20 residential real estate assets owned by the Indian Government. The properties directed to be frozen are worth approximately $23 million, a fraction of the Arbitral Award5. Cairn also filed a lawsuit in the U.S. District Court for the Southern District of New York, seeking to make Air India liable for the Arbitral Award that was awarded to it. The lawsuit argued that the carrier as a state-owned company, being an alter-ego of the State, is legally indistinct from the State itself and was bound to discharge the duties of the State (India).

Thereafter, Cairn made a plea before the U.S. Court to make Air India deposit money under the apprehension that New Delhi may sell the airline by the time the decision seeking seizure of the national carrier’s aircraft is pronounced by the U.S. Court6. Despite the toughening stand taken both by Cairn and India before the U.S. Court, it has come to light that discussions are taking place between the officials of Cairn and the Income-tax Department whereby Cairn is hopeful of an amicable settlement in light of the recent amendment to the provisions of Explanation 5 to section 9(1)(i) vide TLA, 2021. The CEO of Cairn has also given a statement accepting the Government’s offer to settle the disputes and accept the refund of Rs. 7,900 crores and has also stated that the shareholders are in agreement with accepting the offer and moving on7.

And recently, on 13th September, 2021, Cairn and Air India jointly asked the New York Federal Court to stay further proceedings in Cairn’s lawsuit targeting Air India for enforcement of the $1.2 billion arbitral award awarded to Cairn by the Permanent Court of Arbitration at the Hague in light of the amendment vide TLA, 2021. Both the parties requested for stay of any further proceedings in the matter till 31st October, 2021 and requested for new dates in November, 2021 by stating that the stay of proceedings would give them additional time to evaluate the effects and the implications of the TLA, 20218.

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5   https://www.thehindubusinessline.com/business-laws/needed-framework-for-enforcement-of-investment-treaty-arbitration/article36302023.ece

6   https://www.livemint.com/companies/news/cairn-ups-ante-in-us-court-in-its-fight-against-india-on-tax-11630(news-item
dated 05.09.2021)

7   https://www.telegraphindia.com/business/cairn-energy-accepts-modi-governments-offer-to-refund-rs-7900-crore/cid/1829799
(news-item dated 07.09.2021)

TLA, 2021

The said Bill was introduced by the Ministry of Finance in the Lok Sabha on 5th August, 2021 and was passed by the Lok Sabha and the Rajya Sabha on 6th August, 2021 and 9th August, 2021, respectively. Thereafter, the TLA, 2021 received the assent of the President of India on 13th August, 2021.

As per the said Act, the following amendments have been made to Explanation 5 to section 9(1)(i) of the Income-tax Act, 1961:

A. Vide the newly-inserted 4th proviso to Explanation 5 to section 9(1)(i), it has been provided that nothing contained in Explanation 5 shall apply to:

i. an assessment or reassessment to be made under sections 143, 144, 147,153A or 153C; or
ii. an order to be passed enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assessee u/s 154; or
iii. an order to be passed deeming a person to be an assessee in default under sub-section (1) of section 201,

in respect of income accruing or arising through or from the transfer of an asset or a capital asset situate in India in consequence of the transfer of a share or interest in a company or entity registered or incorporated outside India made before the 28th day of May, 2012.

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8   https://economictimes.indiatimes.com/news/economy/policy/cairn-energy-air-india-seek-stay-on-new-york-court-proceedings/articleshow/86227073.cms
(news-item dated 15.09.2021)

9   https://timesofindia.indiatimes.com/business/india-business/1-4-billion-cairn-arbitration-award-finance-minister-says-its-her-duty-to-appeal/articleshow/81348282.cms

i. an assessment or reassessment has been made under sections 143, 144, 147,153A or 153C; or
ii. an order has been passed enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assessee u/s 154; or
iii. an order has been passed deeming a person to be an assessee in default under sub-section (1) of section 201; or
iv. an order has been passed imposing a penalty under Chapter XXI or u/s 221,

in respect of income accruing or arising through or from the transfer of an asset or a capital asset situate in India in consequence of the transfer of a share or interest in a company or entity registered or incorporated outside India made before the 28th day of May, 2012 and the person in whose case such assessment or reassessment or order has been passed or made, as the case may be, fulfils the specified conditions, then, such assessment or reassessment or order, to the extent it relates to the said income, shall be deemed never to have been passed or made, as the case may be.

C. Vide the newly-inserted 6th proviso to Explanation 5 to section 9(1)(i), it has been provided that where any amount becomes refundable to the person referred to in the 5th proviso as a consequence of him fulfilling the specified conditions, then, such amount shall be refunded to him, but no interest u/s 244A shall be paid on that amount.

Vide the Explanation inserted below the newly-inserted 6th proviso, the conditions to be satisfied for the purposes of the 5th and 6th provisos have been provided. To paraphrase, the following conditions have been provided:

• where the said person has filed any appeal before an appellate forum or a writ petition before the High Court or the Supreme Court against any order in respect of the said income, he shall either withdraw or submit an undertaking to withdraw such appeal or writ petition, in such form and manner as may be prescribed;
• where the said person has initiated any proceeding for arbitration, conciliation or mediation, or has given any notice thereof under any law for the time being in force or under any agreement entered into by India with any other country or territory outside India, whether for protection of investment or otherwise, he shall either withdraw or shall submit an undertaking to withdraw the claim, if any, in such proceedings or notice, in such form and manner as may be prescribed;
• the said person shall furnish an undertaking, in such form and manner as may be prescribed, waiving his right, whether direct or indirect, to seek or pursue any remedy or any claim in relation to the said income which may otherwise be available to him under any law for the time being in force, in equity, under any statute or under any agreement entered into by India with any country or territory outside India, whether for protection of investment or otherwise; and
• such other conditions as may be prescribed.

Necessary amendments have also been effected to section 119 of the Finance Act, 2012 which provided for validation of demand, etc., under the Income-tax Act, 1961 for cases relating to indirect transfer of Indian assets.

From the above amendments, one may clearly observe that a two-tier amendment has been made.

The first tier of amendment, consistent with the position of the Government not to levy or raise any new demands in light of the retrospective amendment vide the Finance Act, 2012, makes a necessary provision to that effect so as to provide that no tax demand shall be raised in future on the basis of retrospective amendment vide the Finance Act, 2012 for any offshore indirect transfer of Indian assets if the transaction is undertaken before 28th May, 2012 (i.e., the date on which the Finance Bill, 2012 received the assent of the President). It would be pertinent to note that in various instances, in the case of retrospective amendments, the law has expressly provided for provisions to ensure that past concluded assessments are not disturbed. In this regard, a useful reference may be made to the proviso to section 14A(1), section 92C(2B) and section 92CA(2C). Thus, the first tier of amendment made vide the newly-inserted 4th proviso is in line with the said provisions and provides protection in respect of transfers made prior to 28th May, 2012 from any fresh proceedings. It is rather wider than the said provisions, as it also provides protection from proceedings under sections 153A, 153C and 201(1).

As regards the second tier of amendment, it provides for nullification of assessments already made in respect of indirect transfer of Indian assets made before 28th May, 2012 (as validated by section 119 of the Finance Act, 2012) on fulfilment of certain conditions as specified.

Pursuant to such amendments, the CBDT has published the draft rules for implementing the amendments made by the TLA, 2021 on 28th August, 2021 inviting comments from all stakeholders latest by 4th September, 2021. Vide the said draft, CBDT has proposed to insert Rule 11UE along with Forms 1 to 4 which specify the conditions to be fulfilled and the process to be followed to give to the amendment made by the TLA, 2021.

The said rules provide for furnishing various undertakings including irrevocable withdrawal, discontinuance or an undertaking not to pursue any appeal / application / petition / proceedings. It is also required to forgo any awards received by it by virtue of any such related orders.

IMPACT OF TLA, 2021

It would be pertinent to note that by virtue of the amendment, the purchaser or payer who was liable to deduct tax at source by virtue of section 195 in respect of capital gains accruing to a non-resident assessee by virtue of indirect transfer under Explanations 5 to 7 to section 9(1)(i), can no longer be treated as an assessee-in-default u/s 201(1) if such purchaser or payer fulfils the conditions specified. However, it would be pertinent to note that the issue of treating a person as an assessee-in-default for non-deduction of tax at source in respect of past transactions in light of retrospective amendments, is no longer res integra in light of the decision in Engineering Analysis Centre of Excellence Private Limited vs. CIT [2021] 432 ITR 471 (SC)/[2021] 125 taxmann.com 42 (SC), wherein it has been held that a person mentioned in section 195 of the Income-tax Act cannot be expected to do the impossible, namely, to apply retrospective provision at a time when such provisions were not actually and factually in the statute. Thus, from the payers’ point of view, the amendment nullifying its liability as an assessee-in-default u/s 201(1) is not of much relevance in light of the judgment in Engineering Analysis (Supra). As a result of the same, even if the deductors / payers who have been held to be in default choose not to comply with the conditions mentioned in the Explanation to the newly-inserted 5th and 6th provisos, the litigation continuing in the normal course as provided in the Income-tax Act would result in favourable verdicts for them in light of the judgment in Engineering Analysis (Supra). A deductor / payer may therefore not choose the option of the 5th proviso which requires him to forgo interest on refund. He would rather stay in the normal stream where he has more than a reasonable chance of success and in such event he need not forgo interest.

In certain cases, assessment may have been made by the Department on the purchasers or payers u/s 161 read with sections 160 and 163 in their capacity as agents (representative assessees) of the non-residents in respect of the income accruing or arising in respect of indirect transfers under Explanations 5 to 7 to section 9(1)(i) [for instance, the case of Vodafone]. In such case, the assessments made on such agents would be nullified if the conditions specified therein are satisfied.

It may be noted that clause (iii) of the newly-inserted 5th proviso to Explanation 5 to section 9(1)(i) only deals with an order deeming a person to be an assessee in default u/s 201(1) and does not deal with the case of deductors / payers in whose case disallowance u/s 40(a)(i) is made. It may also be noted that nullification of an order u/s 201(1) does not automatically absolve a person of the disallowance u/s 40(a)(i). However, the same may not be of much significance, given that the payment made towards acquisition of shares of a foreign company is not ordinarily claimed as revenue expenditure in respect of which a disallowance u/s 40(a)(i) may be made.

It may be possible that in certain cases, in order to put an end to litigation, the said person as specified in the newly-inserted 5th proviso may have made an application under the Direct Tax Vivad se Vishwas Act, 2020 and duly paid the amount as specified in the Form No. 3 issued by the designated authority u/s 5(1) of the said Act. Section 7 of the said Act provides that any amount paid in pursuance of a declaration made u/s 4 shall not be refundable under any circumstances. It may be noted that as per the later part of the newly-inserted 5th proviso to Explanation 5 to section 9(1)(i), the assessment or reassessment or order, to the extent it relates to the income in respect of income accruing or arising through or from the transfer of an asset or a capital asset situate in India in consequence of the transfer of a share or interest in a company or entity registered or incorporated outside India made before the 28th day of May, 2012, shall be deemed never to have been passed or made. When the assessment or reassessment or order to the extent it relates to the said income is deemed never to have been passed or made, the question of the same being ‘disputed tax’ u/s 2(j) of the Direct Tax Vivad se Vishwas Act, 2020 does not arise as the very demand ceases to exist in the eyes of law. In such circumstances, it cannot lie in the mouth of the Revenue to refuse the grant of refund of the amount paid as specified in the Form No. 3 issued by the designated authority u/s 5(1) of the said Act. If a sum is paid outside the aforesaid Act, the bar of refund should not apply to such payment as held in Hemalatha Gargya vs. CIT [2003] 259 ITR 1 (SC).

The newly-inserted 6th proviso to Explanation 5 to section 9(1)(i) provides that where any amount becomes refundable to the person referred to in the 5th proviso as a consequence of him fulfilling the specified conditions, then such amount shall be refunded to him, but no interest u/s 244A shall be paid on that amount. The said proviso appears to be violative of Article 14 of the Constitution as it is discriminatory and arbitrary. It may be noted that though taxing statutes being fiscal legislations enjoy a greater presumption towards the constitutionality of the same, the same must nevertheless satisfy the tests of Article 14 of the Constitution in order to save them from the vice of unconstitutionality. The newly-inserted 6th proviso may be discriminatory on the following three fronts:

a) There appears to be a clear discrimination between persons referred to in the 4th and 5th provisos. It may be noted that as regards the persons referred to in the 4th proviso, no new assessment would be made in respect of indirect transfers which have taken place prior to 28th May, 2012. Thus, no prejudice would be caused to them. However, in respect of persons referred to in the 5th proviso, who have already been assessed and recoveries may have been made from them, such recoveries are refundable without interest u/s 244A. While persons covered in the 4th proviso would not have parted with any funds and hence are justifiably not entitled to any compensatory interest, the persons covered in the 5th proviso having parted with funds are justifiably entitled to compensatory interest. These two categories of persons are in unequal situations but are treated equally insofar as non-payment of compensatory interest is concerned. This causes discrimination.

b) There also appears to be discrimination between persons to whom a sum is refundable on account of any other provision of the IT Act and persons to whom a sum is refundable under the newly-inserted 5th and 6th provisos. In case of the former, interest u/s 244A being a normal incident of refund would automatically accrue as held by the Supreme Court in Union of India vs. Tata Chemicals Ltd. [2014] 363 ITR 658 (SC). However, as regards the persons referred to in the 5th proviso, they would not be entitled to any refund despite there being a wrongful retention of sums by the Revenue in light of a non-existent demand.

c) The third type of discrimination occurs between persons who have effected indirect transfers but action is time-barred at the time when the TLA, 2021 was enacted and the persons referred to in the newly-inserted 5th and 6th provisos. As per section 149(1)(b) (as amended vide the Finance Act, 2021), the maximum time limit available to issue notice u/s 148 is ten years from the end of the relevant assessment year. Without going into the applicability of the said clause, it may be noted that even if the Department were to reopen past concluded assessments or assess any person in connection with income accruing or arising as a result of indirect transfer, it could at the maximum have done so in respect of A.Y. 2011-12 and for A.Y. 2012-13 (in respect of transfers concluded prior to 28th May, 2012 due to bar under the newly-inserted 4th proviso). Thus, in respect of transfers which have taken place prior to A.Y. 2011-12, no action under sections 147 and 148 would lie. However, in respect of persons who fall under the 5th and 6th provisos (which would include the above cases under sections 147 and 148), no interest on refund would accrue u/s 244A, leaving them in a position worse off than those who have escaped any action due to non-availability of any recourse under the provisions of the IT Act to the Department.

Thus, the validity and constitutionality of the 6th proviso being discriminatory on the above three counts may be subjected to challenge as violative of Article 14 of the Constitution.

It may be noted that the Draft Rule 11UE(3)(b)(I), in addition to furnishing of undertaking by the declarant, also requires furnishing of declaration by any of the interested parties which, as per Part K and Part L of the Form 1, refers to all the holding companies in the entire chain of holding as defined under the Companies Act, 2013 of the declarant, and all persons whose interest may be directly or indirectly affected by the undertaking in Form 1. Though Explanation (iv) to the newly-inserted 5th and 6th provisos is wide enough to empower the Board to prescribe any other conditions, such power does not extend to imposing conditions on persons other than the declarant assessee. Thus, the draft Rule 11UE(3)(b)(I)(ii) requiring such undertaking from interested third parties, if enacted without any change, may be subjected to challenge on the basis of being contrary to the provisions of the Act.

CONCLUSION