Tuesday, August 16, 2011

~TDS ON INTEREST ON REFUND FOR MNCs – DELHI TRIBUNAL SPECIAL BENCH DECIDES IN CLO

TDS ON INTEREST ON REFUND FOR MNCs – DELHI TRIBUNAL SPECIAL BENCH DECIDES IN CLOUGH ENGINEERING

The issue of TDS on interest on refund under section 244A/195 of the Income-tax Act, 1961 assumes significance for a MNC having a permanent establishment [PE] in India under the Double Taxation Avoidance Agreement [DTAA] and receiving tax refund from assessments completed under the Income-tax Act. The TDS rate on such refund can be as high as 42.23 per cent [as business profits] against say 15 per cent [as interest], thereby diluting the benefits from already tedious process to claim the tax refunds.

Recently, the Special Bench of Delhi Tribunal in the case of Asstt. CIT v. Clough Engineering Ltd. [2011] 130 ITD 137/11 Taxman 70 (Delhi)(SB) affirmed the gross basis taxation for such interest under the article dealing with taxation of 'interest' in the tax treaties, thereby settling the controversy set by divergent decisions on the subject.

This article attempts to discuss the rate of withholding tax applicable of the Act on interest on refund issued to an MNC [a tax resident of USA].

LEGISLATIVE PROVISIONS

Section 195 requires person responsible for paying to a non-resident any sum chargeable to tax in India to withhold taxes at the 'rates in force'.

Further as per section 2(37A)(iii), 'rates in force' means, for purposes of deduction of tax under section 195, the rate specified in the Finance Act or rate specified under an agreement under section 90, whichever is applicable as per the provisions of section 90.

Section 90(2) provides that in relation to the assessee to whom the agreement under section 90 applies, the provisions of the Income-tax Act shall to the extent they are more beneficial to the assessee.

As per Article 7(1) of the DTAA between India-USA,

"The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on or has carried on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to:

(a) that permanent establishment; and"

However, Article 7(6) of the DTAA provides as follows,

"Where profits include items of income which are dealt with separately in other Articles of this Agreement, then the provisions of those Articles shall not be affected by the provisions of this Article."

As per Article 11 of the DTAA,

"(1) Interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State.

(2) However, such interest may also be taxed in the Contracting State in which it arises and according to the law of that State, but if the recipient is the beneficial owner of the interest, the tax so charged shall not exceed ...a) …..b) 15 per cent of the gross amount of the interest in all other cases.

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(4) The term 'interest' as used in this Convention means income from debt-claims of every kind, whether or not secured by mortgage, and whether or not carrying a right to participate in the debtor's profits, and in particular, income from government securities, and income from bonds or debentures, including premiums or prizes attaching to such securities, bonds, or debentures. Penalty charges for late payment shall not be regarded as interest for the purposes of the Convention. However, the term 'interest' does not include income dealt with in Article 10 (Dividends).

(5) The provisions of paragraphs 2 and 3 shall not apply if the beneficial owner of the interest, being a resident of a Contracting State, carries on business in the other Contracting State in which the interest arises, through a permanent establishment situated therein, or performs in that other State independent personal services from a fixed base situated therein, and the interest is attributable to such permanent establishment or fixed base. In such case the provisions of Article 7 (Business Profits) or Article 15 (Independent Personal Services), as the case may be, shall apply."

Suppose that MNC has a permanent establishment [PE] in India under the DTAA and tax refund arises to the MNC from assessments completed under the Income-tax Act.

There are two views on whether the interest on refund can be said to be effectively connected to the PE of MNC in India or not [which impacts the withholding tax rate], which are discussed below:

VIEW 1:

TAXABILITY OF INTEREST AS 'BUSINESS PROFITS' UNDER ARTICLE 7 OF DTAA [IF HELD TO BE EFFECTIVELY CONNECTED TO THE PE IN INDIA]

The Delhi Tribunal in BJ Services Co. Middle East Ltd. v. Asstt. CIT [2009] 29 SOT 312 has held that the income tax refund was connected to the permanent establishment and it was PE's business income assessable under article 7 and not interest income under article 12 of the India – UK Tax Treaty. The relevant extract from the order is reproduced as follows:

"7. Since there is no dispute to the fact that the appellant though being a resident of UK is carrying on business in India through a PE situated in India and, the interest is effectively connected with such PE in India, therefore, in terms of para 6 of art. 12, such interest can be taxed as business profits under art. 7."

Accordingly, the income tax on the same would be applicable at the rate of 40 per cent plus surcharge and education cess (effective withholding tax rate being 42.23 per cent1).

Given that taxability under article 7 is on net basis i.e. brought forward losses, if any, would be available be set off against the refund to determine the income attributable to the PE. However, while withholding tax, the benefit of brought forward losses is not likely to be allowed by the tax officer though MNC can claim the taxes withheld on interest on refund while filing the corporate income-tax return for year in which refund is received. This claim may be allowed by the tax authorities, upon completion of revenue audit of the tax return so filed.

This is a practical problem being faced by MNCs and resulting into cash flow issues resulting from time lag in issuance of refund [with consequent TDS on interest] and refund of TDS [in view of brought forward losses, on completion of assessment few years later].

VIEW 2:

TAXABILITY OF INTEREST UNDER ARTICLE 11 of DTAA [IF HELD NOT TO BE EFFECTIVELY CONNECTED TO THE PE IN INDIA]

The Delhi Tribunal in Asstt. CIT v. Pride Foramer France SAS [2008] 22 SOT 204 has held that interest on income-tax refund is taxable under the head 'Income from other sources' since it cannot be said to be derived or attributable to the business activity of the assessee. Hence the same was taxable under article 12 of the India-France DTAA [dealing with taxation of interest on gross basis].

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Further, reference in this regard is made to the decision in ABC, In re [1999] 236 ITR 637/102 Taxman 574 (AAR) wherein interest on income-tax has been held by the AAR to be not connected with the activity of permanent establishment in India. It was held that the right to interest arose because of the delay in making refund of the excessive collection of the tax and it was a case falling under article 12 of the India – UK DTAA [dealing with taxation of interest on gross basis]. The relevant extract of the ruling is as under:

"The interest amount in dispute has not arisen out of any business operation in India. It is statutory interest granted on delayed refund under the provisions of section 244/243 of the Income-tax Act. There cannot be any dispute that the interest has been paid on delayed refund. Refund due and payable to the assessee is debt owing and payable. For delayed payment of this debt, interest will have to be paid by virtue of the provisions of section 243/244 of the Income-tax Act The debt claim is not connected in any way with any activity of a permanent establishment or base in India. The right to get interest arose because of the delay in making refund of excessive collection of the tax. This is clearly a case falling under paragraph 2 of article 12 of the DTAA."

It is worth noting that the provisions of article 12(5) of the India France DTAA and article 12(6) of the India UK DTAA are pari materia to the provisions of article 11(5) of the India-USA DTAA.

In view of the above, an alternate view existed that the interest on refund is taxable in the hands of MNC under article 11 of the DTAA at the rate of 15 percent on gross basis. Since taxation is on gross basis, no set-off of brought forward losses shall be allowed to MNC.

Recent judgment of the jurisdictional Delhi Tribunal in the case of Clough Engineering Ltd. (supra).

(I) Facts of the case

The facts of the case were that Clough Engineering Ltd.'s case (supra) ('the assessee') had entered into a contract with ONGC Ltd., Cairn Energy India (P.) Ltd. and Niko Resources Ltd. The contract was composite and turnkey in nature. The assessee while filing the return of income declared the proceeds of the contract, interest on income tax refund and bank interest.

No dispute was raised regarding the taxability of bank interest under article VII read with paragraph (4) of article XI of the DTAA between India and Australia. However, with regard to interest on income tax refund, the contention of the assessee was that it is taxable at the rate of 15 per cent on gross basis in view of the provisions contained in paragraph (2) of article XI of the DTAA. The tax officer assessed the same under article VII read with paragraph (4) of article XI of the DTAA as the interest has been paid on the refund of tax deducted at source, made from business receipts and thus, it is directly connected with the business receipt.

The Commissioner (Appeals) also concurred with the finding of the tax officer. Against the same, the assessee filed appeal before the Income Tax Appellate Tribunal, Delhi ("ITAT"). In the course of hearing before the ITAT, it was observed that apparently there is a conflict in the decisions taken by the ITAT in the case of Pride Foramer France SAS (supra) and BJ Services Co. Middle East Ltd.'s case (supra). Therefore, a recommendation was made to the President, ITAT for constitution of Special Bench which after constitution framed the following question:

"Whether, on the facts and in the circumstances of the case, interest on income-tax refund and fixed deposits with the bank is liable to tax with reference to Article 7 read with paragraph no. 4 of Article 11 or paragraph no. 2 of Article 11 of the Indo-Australia Double Taxation Avoidance Agreement?"

The following arguments were placed by the assessee and the Indian Revenue Authorities before the ITAT:

(II) Arguments of the assessee

The assessee placed the following arguments before the ITAT in support of its position that interest on income tax refund is taxable under article XI of the DTAA at the rate of 15 per cent on gross basis:

l In various judicial precedents, it has been held that interest is normally taxable under the head 'Income from other sources' unless the source of the interest is the business of the assessee.

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l The income producing activity should be closely connected in terms of relationship besides being economically connected with the PE.

(III) Arguments of the Indian Revenue Authorities

The arguments of the Indian Revenue Authorities in support of the position adopted by the tax officer that interest on income tax refund is taxable under the provisions of article VII of the DTAA are as follows:

l Although the interest has not arisen out of the business transactions, but it is also a fact that tax was deducted from the monies receivable in the course of business of the PE and, therefore, there is a direct nexus of the indebtedness with the assets of the business.

l Expression used in the DTAA is to the effect that indebtedness is 'effectively connected with the PE' and not that the interest income is effectively connected with the PE. As the debt arose because of tax deduction at source from the business receipts of the PE, if the FAR analysis is carried out, the asset will have to be allocated to the PE. Further, since the tax was deducted from the business receipts of the assessee, even the activity test stands satisfied because it was in the course of the business transactions of the assessee that the debt arose. Therefore, both the asset use test and business activity test are satisfied.

l The OECD Commentary contemplates the economic ownership of the debt claim for taxability of interest under article VII. In the present case, if FAR analysis is made, the deduction from monies receivable as tax, would fall under the economic ownership of the PE.

(IV) Judgment of the ITAT Special Bench

After hearing the above arguments placed by the assessee and the Indian Revenue Authorities, the ITAT observed as followed:

l The real test to be examined for determining the taxability of interest under article XI or Article VII of the DTAA, is to examine whether the 'test of effective connection' is satisfied in this case or not.

l The judgment of the Delhi ITAT in the case of Pride Foramer France's2 case (supra) does not lay down the law in entirety as it misses the point of examination i.e. whether interest on indebtedness is effectively connected with the PE;

l The judgment of the Delhi ITAT in the case of BJ Services Co. Middle East Ltd.3 (supra) also does not help in deciding the said issue as in that case, there was no dispute that – (i) the assessee is a non-resident having a PE in India; (ii) the assessee is carrying on business in India through a PE situated in India; and (iii) the interest is effectively connected with such PE in India.

On the basis of the above observations, the ITAT Special Bench held as follows:

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l It is for the company to pay the tax from any source available with it. It so happened in this case that the tax got automatically deducted from the receipts of the PE by operation of law. Such collection of tax by force of law would not establish effective connection of the indebtedness with the PE as ultimately it is only the appropriation of profits of the assessee company.

l The bank interest in this case is an example of effective connection between the PE and the income as the indebtedness is closely connected with the funds of the PE. However, the same cannot be said in respect of interest on income tax refund. Such interest is not effectively connected with the PE either on the basis of asset test or activity test.

Accordingly, it was held that interest on income tax refund is taxable under paragraph (2) of article XI of the DTAA between India and Australia at the rate of 15 per cent on gross basis.

1. Tax is charged on net basis i.e. after deduction of expenses incurred to collect the interest of refund which shall be minimal.

2. The ITAT has held that interest on income-tax refund is taxable under the head 'Income from other sources' since it cannot be said to be derived or attributable to the business activity of the assessee.

3. The ITAT held that the interest on income tax refund is effectively connected with the PE and therefore taxable under article 7 of the DTAA.

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