Linklaters v. ITO: Part I - Section 9

In the next few posts, I intend to discuss several aspects of the ruling of the Mumbai Bench of the ITAT in Linklaters LLP v. ITO. In this post, I will look at the issues in relation to Section 9; and will look at the interpretation of the Indo-UK DTAA in subsequent posts. The questions before the Tribunal pertained essentially to the taxability of services rendered by Linklaters outside India, in respect of projects in India.

The factual matrix is reminiscent of the decision of the Bombay High Court in Clifford Chance which was decided in favour of the assessee applying the Ishikawajima render + utilize formula. In Linklaters, on the basis of the retrospective amendment to Section 9, the issue was decided against the assessee. The reasoning is broadly similar to that adopted in the recent judgment in Ashapur Minichem v. ADIT. In an earlier post on Ashapur Minichem, I had submitted that while the holding of the Tribunal in correct, the specific observation that territorial nexus is relevant only for territorial systems required some more consideration. On a reading of Ashapur along with Linklaters, it would appear that the issue is perhaps merely one of terminology – the Tribunal seems to have in mind a narrower idea of territorial nexus, when it says that such form of nexus is relevant only in territorial systems. On the other hand, I was referring to a broader idea of nexus, and arguing that nexus is an essential even in source-based taxation as a matter of constitutional law. If it is the narrower, tight reading of nexus which is kept in mind, then the Tribunal’s observations are correct – as a matter of constitutional law, what matters is the existence and not the degree of nexus. Thus, if by nexus one means to a strict understanding of nexus, then that is not a prerequisite in non-territorial systems. Perhaps, it is this idea of nexus which the Tribunal in Ashapur had in mind.

In any event, coming back to the issue in Linklaters, as a matter of the text, the point is (to my mind at least) virtually unarguable – the retrospective amendment is as clear as it can be on the point that the Ishikawajima formula applied in Clifford Chance is no longer good law. The only argument might be on the basis of the constitutional validity of the amendment; but that was clearly not an argument which could be taken before the Tribunal. Perhaps because of this, counsel appearing on behalf of the assessee in Linklaters took the line of argument that Clifford Chance governed the issue insofar as the Tribunal was concerned; and the question of whether the decisions in Ishikawajima and Clifford Chance were nullified could only be gone into by the High Court. This argument is, of course, untenable as a matter of law; and the Tribunal correctly negated the argument. The Tribunal held, “the entire fees for professional services earned by the assessee, in connection with the projects in India and which is thus sourced from India, is taxable under the domestic law…” With Section 9 on the statute books as it stands at present (with the retrospective Explanations), there can hardly be any doubt about the correctness of the Tribunal’s reasoning on this point. In subsequent posts, we will look at the treaty-related aspects of the decision in Linklaters, where too the Tribunal has laid down some important propositions.

Linklaters v. ITO: Mumbai ITAT on Business Connection and PE

The decision of the Mumbai Bench of the Income Tax Appellate Tribunal in Linklaters LLP v. ITO is available (along with a summary) here. Besides reiterating that the retrospective amendments to Section 9 have nullified Ishikawajima and Clifford Chance (the same view was taken in Ashapur Minichem discussed here), the judgment by Hon’ble Pramod Kumar contains an elaborate discussion of several important questions of law in relation to international taxation, particularly on permanent establishment and attribution. Readers may refer to discussions on Legally India here and here. A fuller discussion on the judgment will follow subsequently.

Ashapur Minichem, Territorial Nexus, and the Income Tax Act

In an earlier post, I had discussed the decision of the Tribunal in Ashapur Minichem. V. Niranjan has posted a note on the same decision on the Indian Corporate Law blog. Niranjan notes, “The Tribunal correctly rejected the submission that Ishikawajma continues to be good law. Noting that the retrospective amendment inserted by the 2010 Finance Act is free from any ambiguity, the Tribunal held that the law in India is that fees for technical services paid to a non-resident are taxable when those services are utilized in India, regardless of where they are rendered. The Tribunal clearly demonstrated that this is not inconsistent with the principle of “territorial nexus”, observing that there are broadly three models of taxation of non-residents – “territorial tax systems”, such as France, Belgium and the Netherlands, where tax liability is fastened only on income earned within the borders of that country; “source” taxation, where the source of income is located within the country levying tax, and “residence” taxation, where the taxpayer is resident in the country levying tax. Most countries follow a combination of source and residence taxation, and the ensuing conflict is sought to be resolved internationally by a network of bilateral agreements, known as Double Taxation Avoidance Agreements or DTAAs. In the absence of such a treaty, there is nothing to prevent both countries from taxing the same transaction, and no legal principle is available to a taxpayer to challenge such a levy…”

While I hope that the decision is not read to mean that nexus is irrelevant (but is only read to mean that the test for nexus is changed by the amendment); it is noteworthy that the judgment of the Tribunal states, “the concept of territorial nexus, for the purpose of determining tax liability, is relevant only for a territorial tax system in which taxability in a tax jurisdiction is confined to the income earner within its borders…” It is submitted that nexus is relevant not only for territorial systems – nexus is required in all systems and what the retrospective amendment does is that it changes the test for nexus. What the amendment does is that it clarifies that the nexus test will be satisfied by a threshold lesser than the Ishikawajima formula (render + utilize). The fact that territorial nexus is required for Indian tax legislations stems from a constitutional requirement; and this can be confirmed by reference to the decision of three Judges of the Supreme Court in Electronics Corporation v. CIT, AIR 1989 SC 1797. For an argument as to how nexus remains relevant for Union laws despite Article 245(2), please see this post. In any event, as a matter of precedent, it is submitted that Electronics Corporation settles the issue.

The Supreme Court in that case was concerned with the validity of Section 9(1)(vii) as it then was. The matter was referred to a Constitution Bench (the decision of the Constitution Bench is not available). It may be argued that as the Constitution Bench has not yet pronounced on the subject, the issue is still not conclusively settled. It is submitted that this argument is misconceived. The 3 Judge Bench undoubtedly referred the matter to a larger Bench. Yet, what was referred was the constitutionality of Section 9(1)(vii) [as it then stood] specifically; not the issue of extraterritoriality in general. With the amendments to Section 9, that particular reference would become academic. The Court makes specific observations on extraterritorial operation of the Income Tax Act in general, and then makes specific reference in relation to a specific Section to a larger Bench. In the absence of a contrary opinion by a larger Bench, the observations of the three Judge Bench on extraterritorially in general must be taken to be the present position. It is submitted therefore that the Court’s observations on the extraterritorial application of the Act must be taken as settling the law of the land in this regard. The Bench stated [emphasis supplied]:

… Now it is perfectly clear that it is envisaged under our constitutional scheme that Parliament in India may make laws which operate extra-territorially. Article 245(1) of the Constitution prescribes the extent of laws made by Parliament. They may be made for the whole or any part of the territory of India. Article 245(2) declares that no law made by Parliament shall be deemed to be invalid on the ground that it would have extraterritorial operation. Therefore, a Parliamentary statute having extra-territorial operation cannot be rule out from contemplation. The operation of the law can extend to persons, things and acts outside the territory of India. The general principle, flowing from the sovereignty of States, is that laws made by one State can have no operation in another State… while the enforcement of the law cannot be contemplated in a foreign State, it can, nonetheless, be enforced by the courts of the enacting State to the degree that is permissible with the machinery available to them. They will not be regarded by such courts as invalid on the ground of such extraterritoriality…

But the question is whether a nexus with something in India is necessary. It seems to us that unless such nexus exists Parliament will have no competence to make the law. It will be noted that Article 245(1) empowers Parliament to enact law for the whole or any part of the territory of India. The provocation for the law must be found within India itself. Such a law may have extra-territorial operation in order to subserve the object, and that object must be related to something in India. It is inconceivable that a law should be made by Parliament in India which has no relationship with anything in India. The only question is then whether the ingredients in terms of the impugned provision indicate a nexus. The question is one of substantial importance, specially as it concerns collaboration agreements with foreign companies and other such arrangements for the better development of industry and commerce in India. In view of the great public importance of the question, we think it desirable to refer these cases to a Constitution Bench, and we do so order.” 

In view of this position, it is submitted that while Ashapur Minichem did reach the correct result, the specific observation that “territorial nexus… is relevant only for a territorial tax system…” may require some more consideration. Of course, the Tribunal rightly held that Ishikawajima is no longer good law on the point – it is nonetheless submitted that the above observation of the Tribunal should not be used to foreclose a possible argument for the reading in of a nexus requirement in a taxing statute.

Takeover Regulations and 'Persons Acting in Concert'

A three-Judge bench of the Supreme Court has delivered its judgment (per Aftab Alam J.) in Daiichi Sankyo v. Chigurupati and Daiichi Sankyo v. Narayanan (Civil Appeal No. 7148/2009 and Civil Appeal No. 7314/2009, judgment dated 8 July, 2010). The Court has in a common judgment allowed appeals against orders of the SAT in cases involving interpretation of the phrase 'persons acting in concert' in the Takeover Regulations. I have briefly summarised the judgment in this post on the Indian Corporate law blog.

DLF Universal: Capital Contribution and Section 45(3) - Part II

In an earlier post, I had discussed the majority judgment of the Special Bench of the Income Tax Appellate Tribunal in the case of DLF Universal v. DCIT, [2010] 123 ITD 1 (Delhi - SB). The question in that case was in relation to the taxability of certain land held by assessee as its stock-in-trade, and introduced in the partnership firm as its capital contribution when the assessee became partner of the firm. The majority held, as summarised in the earlier post, that there is no transfer of land held by the assessee as stock-in-trade when the same was merely revalued at a market value in its books. No profit or gain accrues or arises merely on revaluation at a higher value in the books or on mere conversion from stock-in-trade to a capital asset. However, the position is different in cases where on or after conversion of stock-in-trade into a capital asset (either by implication of law or by act or conduct of the assessee), the asset is contributed to a firm as capital contribution. In such a case, there is a transfer of the assets. In such cases, the value of the asset recorded in the books of the firm shall be deemed to be the full value of consideration received or accruing as a result of the transfer of the asset.

It is submitted that the view of the dissenting member is more persuasive. The learned dissenting member held, “Under the Income-tax Act what is chargeable to tax is the income accruing to the assessee. The income can be said to have accrued provided the assessee either receives the sum or any legally enforceable right is acquired. Such right should be accruing immediately and should not be inchoate or contingent…” Support for this proposition is available in several cases – for instance, see CWT v Girija Ammal,  282 ITR 614; National Handloom Development Corporation v DCIT 266 ITR 647; CIT v Orissa State Financial Corporation 262 ITR 350.

Following from this proposition, the dissenting judgment held that when an asset is brought into the partnership as a capital contribution, “The amount credited to the account of the partner is not a debt due by the firm to the partner. The partner cannot legally enforce the claim to receive the amount standing to the credit to his account in the books of the firm. Thus, the amount due by the firm to the partner standing to the credit of partner's account whether by way of capital or by way of loan will not be a legally enforceable right in favour of partner against the firm or the other partners constituting such firm…” The only right which the partner has is of sharing in the profits of the partnership. Only on the dissolution of the partnership will the partner have any enforceable rights in the partnership assets as such. Accordingly, when an asset is brought into the partnership and an entry is passed in the books of account, in reality, no income has accrued to the partner. Furthermore, Section 45(3) of the Act which was relied on in the majority judgment is specifically limited to cases where a capital asset has been brought into the partnership. In the case of a stock-in-trade being brought in as capital contribution, there does not appear to be any warrant for applying the section. The majority decision effectively means that in every case where a stock-in-trade is brought into a partnership by a partner, the stock-in-trade is deemed to be a capital asset. There does not appear to be any warrant for such a fiction.

Consequently, it is submitted with respect that the dissenting judgment appears to be based on sounder reasoning; and the majority view may require some reconsideration.

Bits of Interest

1. The judgment of the Supreme Court in CIT v. Walfort Share & Stock Brokers is available here. The Court revisits the debate on tax avoidance. A summary is also available at the link.

2. Readers may be interested in guest posts by Shantanu Naravane and V. Niranjan on the Lex Arbitri blog. Shantanu has discussed Section 9 of the Arbitration & Conciliation Act, 1996. In particular, he discusses the question, ‘Against whom can remedy under Section 9 lie?’ Niranjan discusses ‘Recent Developments on the Scope of Section 11’.