Royalties and Fees for Technical Services in International Trade
M. M. Chishty and Sumangala A. Chakalabbi Students, University College of Law, Dharwad
Everything you ever wanted to know about Royalties and Fees for Technical Services you will find in this article which was rightly awarded the ‘Best Research Paper of 4th Nani Palkhivala Research Paper Competition for the year 2008′
In a globalised world, the transfer and sharing of intellectual property rights is crucial to the survival of modern industries and service sector in a highly competitive world. The present era is one in which capital is denoted by less of tangible assets like money and raw materials and more of intellectual property rights. In this context, it would only be in the self-interest of developing countries like India to create an atmosphere which is conducive to and promotes transfer of intellectual property and technology by foreigners.1 The taxation in India of such transfer is one aspect of creating that atmosphere. An ideal tax system would be one which keeps abreast of technological developments having effect on it, all the while keeping a delicate balance between providing maximum financial means to the Government and avoiding bleeding taxes on assessees. At this juncture, the pertinent questions would be has our tax system been mature enough to categorise and classify incomes arising by way of intellectual property and technology in accordance with time honoured principles of taxation or has it been befuddled by the intangible nature of the subject; and whether there is an effort by our taxation system to soften the rigours of taxation of cross-border journey of intellectual property.
The tax authorities are interested in classifying as much incomes as possible as royalties, because a fixed tax is imposed on royalties and fees for technical services; and assessees are interested in avoiding such classification since that which is not classified as royalty or fees for technical services is business income, which is taxed at a very low or nil rate.
2. TAXATION OF ROYALTIES AND FEES FOR TECHNICAL SERVICES
Royalties and fees for technical services arise from commercialisation of intellectual property rights. The tax authorities are interested in classifying as much incomes as possible as royalties, because a fixed tax is imposed on royalties and fees for technical services; and assessees are interested in avoiding such classification since that which is not classified as royalty or fees for technical services is business income, which is taxed at a very low or nil rate. This divergence of interests is the cause of much litigation.
2.1 General Considerations
2.1.1 Policy of Presumptive Taxation
The Income Tax Act provides that a nonresident having sources of income situated in India is taxed on presumptive basis on most of the incomes arising in India. The deeming provisions are ss. 44D and 115A of the Income Tax Act. These provisions read together provide for a special method for computing income by way of royalty or fees for technical services in the case of foreign companies. The rate of tax is fixed at a flat 10 percent2 of the gross receipts for royalty or technical services, in total disregard of any expenditures incurred by the non-resident referred to in §§ 28 to 44C of the Income Tax Act. Thus, 10 percent of the gross receipts to the foreign entity are to be withheld with disregard to the actual income accruing to the non-resident. This policy of presumptive taxation is grounded on reasons of practical convenience like absence of books of account, supporting evidences etc.3 provided they maintain a permanent establishment in India and comply with the requirements of §§ 44A and 288 of the IT Act.
2.1.2 Tax Withholding on Royalties and Technical Services
As regards transfer of payment to a nonresident in consideration of royalty or technical services received, § 195 of the IT Act provides that any person responsible for paying to a non-resident any sum chargeable under the Act shall at the time of credit of such income deduct income-tax thereon at the rates in force. Income by way of royalty or technical services is chargeable under the IT Act. Thus, the primary obligation of paying the tax on royalties or technical services is not on the nonresident himself but on the person who is making such payments to him. Failure to comply with this provision may result in disallowance of the expenditure, interest on the taxes and penal action.
2.1.3 Composite Agreements and Withholding Tax
Very often one comes across agreements in connection with royalties and fees for technical services wherein a resident agrees to pay contractual consideration to a non-resident. The consideration consists of two parts, one part is for royalties or technical services on which the resident is obliged to withhold tax, and the other part is claimed to be non-taxable in the hands of the nonresident recipient on grounds of being mere reimbursement of expenditure incurred by the nonresident, hence not liable to taxation. The pertinent questions that arise in such a factual matrix are whether such integrated payments can be subjected to different tax treatment, and whether withholding is to be on the net profit comprised in gross sums or on the gross sums themselves. We will attempt to find out the answers below.
At the outset, it should be mentioned that the integrity of the integrated payments itself is subject to challenge by the ‘disjunctive test’ laid down by the Supreme Court in Sultan Brothers v. CIT.4 By this test, the Assessing Officer can enquire whether the contract could still have stood if hypothetically the contract were to be split, and the reimbursement ignored—if it can, then the sums can be subject to different tax treatment, otherwise not.
The issue of whether sums representing integrated consideration can be subjected to different tax treatment came up in the case of Sedco Forex International Drilling Inc v. Deputy CIT.5 In this case, the assessee company had entered into a contract with ONGC for providing certain services with regard to oil exploration in Indian territorial waters, and the consideration paid for these services was mentioned in two parts—(a) contract amount and (b) mobilisation expenses incurred by the contractor in transporting the oil rig from Portugal to Mumbai. While tax liability on the first part was not denied, the same was denied on the second part on grounds of reimbursements. The tribunal held that on a reading of the contract that the obligation to incur expenses on mobilisation of the oil rig from Portugal to Mumbai was of the assessee and not of ONGC; hence by mentioning these amounts separately in the agreement and by describing one as reimbursement, the assessee’ obligation is not converted into the contractee’s obligation. Since by the ‘indivisibility doctrine’ the mobilisation expenses were an integral part of the gross consideration received by the assessee, tax was liable to be deducted on both parts of the sums received.
The next issue that arises is whether tax is to be withheld on the net profit comprised in gross sums or on the gross sums themselves. We have already discussed above that withholding tax on royalties and fees for technical services are taxed on a flat rate basis, in total disregard of the actual expenditure incurred by the non-resident.6 The application of this principle can be seen in the case of Associated Cement Co. Ltd v. CIT,7 wherein ACC had entered into a contract for loading packed cement bags into trucks, and was to pay a fixed sum of forty one paise per tonne of cement loaded. The contract further provided that in case the contractor was obliged to upwardly revise the wages of his employees as per the recommendations of the Wages Board, then ACC would have to increase the payment accordingly. The assessee withheld tax on the original contract amount, i.e. on 2 percent of 41 paise, but refused to withhold tax upon the hiked wage on the ground that additional payment was a reimbursement simpliciter. It was also an admitted position that there was no taxable surplus in the hands of the contractor on additional amounts paid because he was obliged to pass on the entire sum to his labour. But the court refused to buy this reason stating: Indeed, it is neither possible nor permissible for the payer to determine what part of the amount paid by him to the contractor constitutes the income of the latter. It is not also possible that the Parliament could have intended to cast such impossible burden upon the payer nor could it be attributed with the intention of enacting such an impractical and unworkable provision. In other words, qua the resident, the base figure to apply the tax withholding rate is the gross amount paid to the non-resident, and it is not for the resident to ascertain the taxable income comprised in such gross sums; that is the job of the Assessing Officer. In Sprint RPG India Ltd. v. Commr. of Customs,8 where the Supreme Court had to consider the issue whether customs duty on software imported on hard disk drives should be valued on the basis of at hard disk simpliciter at 25 percent or on the basis of computer software at 10 percent. Propounding the doctrine of ‘essential character’ of the goods, the Court noted that the total value of the hard disk drives was estimated at Rs. 60,000/- while the value of the software so imported was of Rs. 68 lacs, and therefore held that the essential character of the goods was software. But just because two items are complementary and supplementary to each other does not mean that they cannot be individually valued always. As the Court succinctly put the matter in another case:9 Secondly, that a computer and its software are distinct and separate is clear, both as a matter of commercial parlance as also upon the material on record. A computer may not be capable of effective functioning unless loaded with software such as discs, floppies and CD ROMs. But that is not to say that these are a part of the computer or to hold that, if they are sold along with the computer, their value must form part of the assessable value of the computer for the purposes of excise duty. To give, an example, a cassette-recorder will not function unless a cassette is inserted in it; but the two are well-known and recognized to be different and distinct articles. The value of the cassette, if sold along with the cassette-recorder, cannot be included in the assessable value of the cassette-recorder. Just so, the value of software, if sold along with the computer, cannot be included in the assessable value of the computer for the purposes of excise duty.
It is submitted that this amendment cannot have the effect of nullifying the decision in Ishikawajima - Harima since in that case, the Court emphasising on the territorial nexus doctrine ruled that § 9 raises a legal fiction; but having regard to the contextual interpretation and furthermore in view of the fact that we are dealing with a taxation statute the legal fiction must be construed having regard to the object it seeks to achieve.
2.1.4 Relation and Accrual of Tax on Royalties and Technical Services
India follows the receipt basis in respect of international taxation. By this, tax liability is imposed even where the income does not accrue or arise within its borders. This is in contradistinction to the nexus basis, where nexus is ordinarily presumed only where the income is earned either directly within the territories or it is earned indirectly because of the nexus with any activity in such territories. Clauses (vi) and (vii) of § 9(1) of the IT Act provide that income shall be deemed to arise in India by way of royalties and fees for technical services respectively if the payment is payable by the Government or a resident, except in cases where such payment is payable for the purposes of a business or profession or making an earning from a source outside India. Moreover, payment by a non-resident is also included in this category if such payment is for the purposes of business or profession carried on by such person in India or for the purposes of earning any income from any source in India. To illustrate, Shyam & Co, an Indian resident, enters into a contract with Davy Inc, a resident of the US, that on payment of certain sums, Davy Inc would courier to Shyam & Co certain drawings and diagrams related to construction of iron ore melting plants. Though, in this case service has not been performed in India, still withholding tax would become due. However, if an Indian hotel chain were to set up a hotel in London, and technical services were availed in London for the purpose of setting up of the hotel, which would be a source of income to the Indian hotel chain there, such payments would not be subject to Indian withholding tax. This receipt basis of taxation is the object of much criticism on the grounds that it runs contrary to the well settled international norms of taxation and is also against the letter and spirit of various tax treaties entered into by India with foreign countries. Fortunately, the Supreme Court in a landmark judgment Ishikawajima-Harima Heavy Industries Ltd. v. DIT10 has reversed the position. The Court ruled that § 9(1)(vii) of the IT Act should be read together with § 5 thereof, which takes within its purview the territorial nexus on the basis of whereof tax is required to be levied. Therefore, the Court held that § 9(1)(vii) of the Act envisages the fulfilment of two conditions for the service to be taxed in India, viz.: (a) such services are rendered in India, and (b) such services are utilised in India, and these two conditions have to be satisfied simultaneously. And, when a technical service is rendered outside India, even if it is utilised in India, the provisions of § 9(1)(vii) of the IT Act will not be applicable. Regrettably, ratio of this judgment was sought to be nullified by the amendment of § 9 of the IT Act by the Finance Act, 2007, by which an explanation was inserted therein stating that for the purposes of the said section, where income is deemed to accrue or arise in India under clauses (v), (vi) or (vii) of sub-section 1, such income shall be included in the total income of the non-resident, whether or not the non-resident has a residence or place of business or business connection in India. It is submitted that this amendment cannot have the effect of nullifying the decision in Ishikawajima-Harima since in that case, the Court emphasising on the territorial nexus doctrine ruled that § 9 raises a legal fiction; but having regard to the contextual interpretation and furthermore in view of the fact that we are dealing with a taxation statute the legal fiction must be construed having regard to the object it seeks to achieve. What the amendment has done is just restating the old position; therefore, in light of the overriding principle of territorial nexus of taxation as was propounded by the Court, the amendment cannot nullify the ratio stated by the Court. In this regard, it should always be remembered that royalties and fees for technical services are only exceptions to the general rule that only the country of residence will be able to tax business income. Therefore, sovereignty and comity of nations demands that a country cannot go on taxing endlessly every non-resident, however tenuous the tax connection, but rather restrict itself to incomes that have a nexus with the source country. As to accrual of income, a recent decision of the Bombay High Court throws some light on the issue. In Pfizer Corporation v. CIT,11the court held that dividend accrues on remittance to the nonresident. On similar grounds, it can be argued that royalty is taxable on remittance.