ACIT vs. Clough Engineering Ltd (ITAT Delhi Special Bench)
Brief Facts:-
The assessee, an Australian company, had a PE in India from which it carried on business in India. The assessee filed the return on 28/11/2003 declaring total income of Rs.1,49,15,800/-. The assessee claimed refund of Rs. 2,64,71,450/-. The return was processed u/s 143(1) of the Income-tax Act, 1961 (the Act), on19.2.2004 and an amount of Rs. 2,37,14,680/- was refunded to the assessee. Thereafter, a notice u/s 143(2) dated 13.4.2004 was served on the assessee with a view to frame regular assessment. The assessee has declared contract receipts from ONGC Ltd.,Cairn Energy India Pvt. Ltd. and Niko Resources Ltd. The contracts are composite and turn-key in nature. The major scope of work is in respect of designing, engineering, procuring, fabricating, installing, laying pipelines, testing, pre-commissioning of off-shore platforms etc. The income declared by the assessee-company inter-alia includes interest on income tax refund. It has been submitted that this interest income is taxable at the rate of 15% on gross basis in view of the provision contained inparagraph no. 2 of Article XI of the Indo-Australian Double TaxationAvoidance Agreement (the DTAA). However, the AO has come to the conclusion that the interest income is taxable under Article VII read with paragraph no. 4 of Article XI as the interest has been paid on the refund of tax deducted at source, made from the business receipts and, thus, it isdirectly connected with the business receipt.The assessee received interest on income-tax refund of TDS. While the assessee claimed that the interest was taxable on gross basis at 15% under Article XI(2) of the DTAA, the AO & CIT(A) claimed that the interest was directly connected with the PE and so assessable under Article VII and the interest income is taxable on a net basis at the rate applicable to a foreign company.. On appeal, the issue was referred to the Special Bench.
HELD:-
The appeal is allowed.
Reason:
Under Article 11(4) of the DTAA, interest from indebtedness effectively connected with a PE of the recipient is taxable under Article 7 and not under Article 11. Though the interest was connected with the PE in the sense that it has arisen on account of TDS from the receipts of the PE, it was not effectively connected with the PE either on the basis of asset-test or activity-test. The payment of tax was the responsibility of the foreign company and the fact that it was discharged by way of TDS did not establish effective connection of the indebtedness with the PE. In order to be effectively connected, it is not necessary that the interest income has to be necessarily business income in nature. Even interest assessable under other sources can qualify.
The full judgement is as follows:
IN THE INCOME TAX APPELLATE TRIBUNAL
SPECIAL BENCH ˜B™ DELHI
BEFORE SHRI R.V. EASWAR : HON™BLE PRESIDENT,SHRI R.P.
TOLANI : HON™BLE JUDICIAL MEMBER &SHRI K.G.
BANSAL: HON™BLE ACCOUNTANT MEMBER
I.T.A No. 4771(Del)/2007
Assessment year: 2003-04
Assistant Commissioner of Income
M/s Clough Engineering Ltd.,tax, Range-I, Dehradun.
Vs. C/o S.R. Batliboi & Co.,6th floor, Hindustan
TimesBldg., K.G. Marg, New Delhi.
I.T.A No. 4986(Del)/2007
Assessment year: 2003-04
M/s Clough Engineering Ltd.,
Assistant Commissioner of Income
C/o S.R. Batliboi & Co.,
Vs.
tax, Range-I, Dehradun.6th floor, Hindustan Times Bldg
K.G. Marg, New Delhi.
Department by : Shri Ashwani Mahajan, CIT,DR
ORDER
PER K.G. BANSAL
One of the grounds in the appeal of the assessee is that- on thefacts and in the circumstances of the case and in law, the Commissioner ofIncome-tax (Appeals) [hereinafter referred to as ˜CIT(A)™] has erred intreating the interest income as business income directly connected with Permanent Establishment and taxing the same. CIT(A) has thereby erredin ignoring the provisions of Tax Treaty between India and Australia.
1.1 These appeals were heard by the division bench of the DelhiTribunal on 21.01.2010. It was concluded that apparently there is aconflict in the decisions taken by the Tribunal in the case of AssistantCIT Vs. Pride Foramer France SAS, (2008) 116 TTJ (Del) 369, and B.J.Services Co. Middle East Ltd. Vs. CIT, 2009-TIOL-387-ITAT-DEL, onthis issue. Therefore, a recommendation was made to the President,Income-tax Appellate Tribunal, for constituting a Special Bench to considerand decide the following ground:-Whether the CIT(A) erred in treating the interest incomeas business income as against 15% as provided in para 6 ofArticle 12 of DTAA between India and the UK.Accepting the recommendation, the President constituted a Special Benchon 03.12.2010 to decide the aforesaid question.
1.2 In the course of hearing, it was found that the ground requiredsome verbal change to project the real controversy. Accordingly, after consulting the rival parties, the following question has been drawn up inplace of the question referred to the Special Bench by the President:-Whether, on the facts and in the circumstances of the case,interest on income-tax refund and fixed deposits with thebank is liable to tax with reference to Article 7 read withparagraph no. 4 of Article 11 or paragraph no. 2 of Article 11of Indo-Australia Double Taxation Avoidance Agreement?
2. The facts of the case, as mentioned in the assessment order, arethat the assessee-company is incorporated under the laws of Australia.The return was filed on 28.11.2003 declaring total income of Rs.1,49,15,800/-. The assessee claimed refund of Rs. 2,64,71,450/-. Thereturn was processed u/s 143(1) of the Income-tax Act, 1961 (the Act), on19.2.2004 and an amount of Rs. 2,37,14,680/- was refunded to theassessee. Thereafter, a notice u/s 143(2) dated 13.4.2004 was served onthe assessee with a view to frame regular assessment.
2.1 The assessee has declared contract receipts from ONGC Ltd.,Cairn Energy India Pvt. Ltd. and Niko Resources Ltd. The contracts arecomposite and turn-key in nature. The major scope of work is in respectof designing, engineering, procuring, fabricating, installing, laying pipelines, testing, pre-commissioning of off-shore platforms etc. The incomedeclared by the assessee-company inter-alia includes interest on income tax refund. It has been submitted that this interest income is taxable atthe rate of 15% on gross basis in view of the provision contained inparagraph no. 2 of Article XI of the Indo-Australian Double TaxationAvoidance Agreement (the DTAA). However, the AO has come to theconclusion that the interest income is taxable under Article VII read withparagraph no. 4 of Article XI as the interest has been paid on the refund oftax deducted at source, made from the business receipts and, thus, it isdirectly connected with the business receipt.
2.2 The matter was agitated before the CIT(Appeals)-I, Dehradun. Inthe operative portion of his order in paragraph no. 5.2, it has beenmentioned that it is an admitted fact that the assessee-company is carryingon business through the Permanent Establishment (the PE) in India. Theinterest income is not covered by the provision contained in section 44BBof the Act. Therefore, it has been held that the AO was right in taxing theinterest income as business income.
3. Before us, the ld. counsel for the assessee has submitted that the totalincome of Rs. 1,49,15,800/- returned by the assessee inter-alia includesinterest of Rs. 61,04,944/- received from the Income-tax department and Rs. 13,899/- received from the bank. No dispute has been raisedregarding taxability of bank interest under Article VII read withparagraph no. 4 of Article XI of the DTAA. This leaves us with thetaxation of interest of Rs. 61,04,944/- received from the Income-taxdepartment.
4. The ld. counsel briefly summarized the history of the case. It issubmitted that normally interest is taxed @ 15% on gross basis underArticle XI of the DTAA. However, if an assessee has the PE in India andthe indebtedness from which interest arises is effectively connected withthe PE, then Article VII comes into operation and the interest income istaxable on a net basis at the rate applicable to a foreign company. TheAO is of the view that the indebtedness is effectively connected with thePE as tax has been deducted at source from the business receipts. Theld. CIT(Appeals) has agreed with this view. The division bench of theTribunal, which heard the case initially, is of the view that there is aconflict in decision in the matter in the case of B.J. Services Co. MiddleEast Ltd. and Pride Foramer France SAS (supra) and, therefore, thequestion has been referred to the President for constituting a SpecialBench. The President has constituted such a bench. After consultation the question has been modified to project the real controversy and themodified question is acceptable to the assessee.
5. He referred to the provision contained in section 90(2) of theIncome-tax Act to the effect that where the Central Government hasentered into an agreement with the Government of another countryoutside India or specified territory outside India, as the case may be,under sub-section (1) for granting relief of tax, or as the case may be,avoidance of double taxation, then, in relation to the assessee to whomsuch agreement applies, the provisions of this Act shall apply to theextent they are more beneficial to that assessee. In view of thisprovision, he proceeded at the outset to examine the taxability of interestunder the Act.
5.1 In this connection, it is submitted that interest is normally taxableunder the head Income from other sources, unless the source of theinterest is the business of the assessee. He relied on the decision in thecase of Traco Cable Co. Ltd. Vs. CIT, Ernakulam, (1968) 72 ITR 503.The assessee- company claimed that the deposit of the share capital madeby the company in the bank was a business carried on by it, as empowered by a clause in its memorandum of association and, therefore,the interest income was the business income. However, the Hon™bleCourt mentioned that the clause in the memorandum merely authorizesthe company to invest and deal with the funds not immediately required,in such a manner as may be determined from time to time. Therefore, itmay be open to the assessee-company to carry on the business of investingand dealing with the funds upon securities or otherwise. However, thequestion in this case is as to whether the assessee company had carriedout such a business as a matter of fact. When examined in this light, itis found that it has not commenced business and, therefore, amounts notimmediately required in the business have been invested for earninginterest income. The receipt of interest is incidental to the deposits. Thefinding of the Tribunal is that the deposit of the share capital has not beenmade with the bank in the course of business. Therefore, it has been heldthat the interest amount is taxable under the residuary head. Further,reliance has been placed on the decision of ˜A™ bench of BangaloreTribunal in the case of Atria Power Corporation Ltd. Vs. Deputy CIT,(2011) 128 ITD 322, dealing with interest earned on income-tax refunds.It has been held that the same is taxable under the residuary head and notas a part of profits and gains of the power-generation business. This decision referred to the observations of the Hon™ble Supreme Court in thecase of Smt. Padmawati Jaikrishna Vs. Additional CIT, (1987) 166 ITR176, to the effect that the court is inclined to agree with the High Courtthat so far as meeting the liability of income-tax and wealth-tax isconcerned, it is indeed a personal one and payment thereof cannot atall be said to be expenditure laid out or expended wholly and exclusivelyfor the purpose of earning income. Reliance has also been placed on thedecision of Hon™ble Bombay High Court in the case of CIT Vs. SamirDiamond Exports Ltd., (2000) 245 ITR 548, in which it is mentionedthat there is merit in the contention advanced on behalf of the assessee.Firstly, both the Commissioner of Income-tax(Appeals) as well as theTribunal have followed the judgment dated January 8, 1993, in the case ofRoyal Cushions Vs. CIT (unreported). Secondly, both the aboveauthorities have found that both the items, namely, interest on refunds andinterest on loans fall under a different head of income, viz., Income fromother sources. Reliance has also been placed on the decision in the caseof Collis Line Pvt. Ltd. Vs. ITO, ˜A™ Ward, Company Circle, Ernakulam,(1981) 135 ITR 390 (Ker.). It is mentioned that the assessee is not abanking company. It had not deposited the money by way of moneylendingas a business. That is not its object. The interest arose from amounts deposited in bank otherwise than by way of business. The amountwas deposited because money was lying idle and it was safer and wiserto put it in the bank. The interest thereby earned was incidental to mainpurpose of the deposit, which was safe keeping and not earning profits.Such income is rightly found to be the income from other sources.Reliance has also been placed in the case of Madhya Pradesh StateIndustries Corporation Ltd. Vs. CIT, (1968) 69 ITR 824. It has beenmentioned that the ld. counsel appearing for the assessee did not pressthe argument that the interest received by the assessee from the bank isreceipt of income from money-lending activity. He, however, contendedthat share monies were monies relating to the business of the assesseeand any interest thereupon would be the business income as the assesseewas authorized by its memorandum of association to invest in and dealwith the money of the company in any securities, investments etc. It isfurther mentioned that for determining whether an act was done in thecourse of carrying on the business, it is not sufficient to look at thememorandum of association only but to find out whether the act donewas in pursuance of the objects enumerated in the memorandum.Therefore, it is necessary to see whether the objects have been pursued.On the facts, it cannot be urged that the bare fact that the assessee deposited money in the bank is by itself sufficient to show that thedeposits were made with a view to carry on the business. Accordingly, ithas been held that the interest received by the assessee is chargeable u/s 56as income from other sources.
5.2 Our attention has also been drawn towards the provision containedin section 2(28A) where the term interest has been defined to meaninterest payable in any manner in respect of any monies borrowed or debtincurred (including a deposit, claim or other similar right or obligation)and includes any service fee or other charge in respect of moniesborrowed or debt incurred or in respect of any credit facility, which has notbeen utilized. Therefore, it is contended that interest received fromIncome-tax Department falls within the definition.
5.3 The case of the assessee on the basis of the aforesaid jurisprudence isthat the tax deducted at source is the source on which interest has beenreceived. The tax has been deducted by operation of law and, therefore, theindebtedness cannot be said to arise in the course of carrying on thebusiness. Accordingly, under the Act the assessee is liable to be taxedon the amount under the residuary head and not under the business head. In view thereof, the indebtedness cannot be said to be effectivelyconnected with the business carried on by the PE. The domestic law isequally applicable to the assessee and, therefore, it cannot be said that theindebtedness is connected with the PE of the assessee. Further, theassessee is entitled to the beneficial provision of or interpretation underthe domestic law in view of the provision contained in section 90(2) ofthe Act.
6. Coming to the DTAA, the ld. counsel explained the contents ofArticle XI dealing with taxation of interest. We will paraphrase therelevant paragraphs of the article, which have been referred to by the ld.counsel, taking into account the facts of our case. Paragraph no. 1provides that the interest arising in India to which the assessee isbeneficially entitled may be taxed in Australia. Paragraph no.2 providesthat such interest may also be taxed in India, according to the laws ofIndia, but the tax so charged shall not exceed 15% of the gross amountof the interest. Paragraph no. 3 defines the term interest to includewithin its ambit interest from Government securities or from bonds ordebentures and interest from any other form of indebtedness as well asall other income assimilated to income from money lent by the law, relating to tax in India. The case of the ld. counsel is that provisionscontained in these paragraphs are applicable to the facts of the case.However, he also drew our attention towards paragraph no. 4 whichprovides exceptions to the contents of paragraphs nos. (1) and (2). It isprovided that these paragraphs shall not apply if the assessee carries onbusiness in India, in which the interest arises, through a PE situated inIndia, and the indebtedness in respect of which the interest is paid iseffectively connected with such PE. In such a case, the provisions ofArticle VII shall apply. It is submitted that the AO has invoked theprovision contained in paragraph no. 4 and held that the indebtednessfrom which the interest arises is effectively connected with the PE. Thecase of the ld. counsel is that the payment of tax is the responsibility of theforeign company and not that of the PE. Therefore, the PE is not the creditorof the income-tax department. Accordingly, the indebtedness is noteffectively connected with the PE.
6.1 In this connection, reliance has been placed on the decision of LBench of Mumbai Tribunal in the case of M/s Hapag Lloyd ContainerLinie GmbH for assessment year 2004-05 in ITA No. 6214/Mum./2007dated 27.12.2010, a copy of which has been placed in the paper book (2/3) on pages 59 to 74. The question before the Tribunal was-whether, theCIT(Appeals) erred in holding that interest of Rs. 12,44,428/- granted onincome-tax refund is covered by Article 11 of the DTAA and, therefore,taxable in India? The question was raised in a situation where the casewas covered under Article 8 of the Tax-Treaty between India andGermany. It has been mentioned that interest on funds which areconnected with operation of ships or aircraft in international traffic iscovered within the ambit of paragraph (3) for assuming the character ofprofit from operation of ships or aircraft in international traffic. It doesnot and cannot refer to any interest other than that. Interest on income-taxrefund does not have relation with operation of ships or aircraft in theinternational traffic and, therefore, it cannot be brought within the purviewof article 8. A reference was made to the ruling of Authority for AdvanceRulings in ABC, (1999) 236 ITR 637, being a U.K company, in which ithas been held that the interest amount in dispute has not arisen out of anybusiness operation in India. It is the statutory interest granted on delayedrefund under the provisions of the Act. There cannot be any dispute thatthe interest has been paid on delayed refund. Refund due and payable tothe assessee is the debt owed and payable. The debt-claim is notconnected in any way with any activity of the PE or base in India. The right to get interest arises because of delay in making refund of theexcessive collection of tax. This is clearly a case falling under paragraphno. 2 of Article 12 of the U.K. DTAA. In the decision, it has beenmentioned in paragraph no. 11 that the Authority is reminded of the maximgeneralia specialibus non derogant, according to which a specialprovision overrides the general provision. Therefore, the mandate of anarticle dealing with a distinct item of income has overriding effect over thatof general article. Adverting to the facts of the case, it has been noted thatalthough Article VII covers business profits but since Article VIIIspecifically deals with shipping or air transport in international traffic,it is only Article VIII which shall apply in relation to taxability ofprofits from operation of ships or aircraft in international traffic. Whenthe contents of Article VIII(3) are examined in conjunction with thecontents of Article XI, it emerges that interest income of every kind asreferred to in Article XI arising in India and paid to a resident ofGermany shall be subject to tax in India and the mandate of Article VIIIshall not apply unless it is specifically covered under Article VIII(3).This exception extends only to interest income on funds which areconnected with operation of ships in international traffic. Naturally,interest on income-tax refund cannot have any relation with operation of ships or aircraft in international traffic and hence cannot be broughtwithin the purview of Article VIII.
6.2 Our attention has been drawn towards the OECD commentary onthe model convention. It is mentioned therein that certain states considerthat dividends, interest and royalties arising from sources in theirterritory and payable to individuals or persons who are residents of otherStates fall outside the scope of the arrangement made to prevent themfrom being taxed in both the States. Paragraph no. 4 is not based on sucha conception which is sometimes referred to as the force of attraction ofthe permanent establishment. It does not stipulate that interest arisingto a resident of a Contracting State from a source situated in the otherState, must by a kind of legal presumption or fiction, be related to apermanent establishment which that resident may have in the latter State,so that the said State would not be obliged to limit its taxation in such acase. The paragraph merely provides that in the State of source theinterest is taxable as a part of profits of the PE, if it is paid in respect ofdebt-claims forming part of the assets of the PE or otherwise effectivelyconnected with that PE. In that case, paragraph no. 4 relieves the Stateof source of the interest from any limitation under the Article. It is further mentioned that a debt-claim in respect of which interest is paidwill be effectively connected with the PE and will form part of itsbusiness assets, if the economic ownership of the debt-claim is allocatedto the PE. In this very connection, our attention has been drawn to theextract of OECD commentary furnished by Shri D.P. Mittal in his book,which is the same in content as mentioned above. It has also beensubmitted that the words effectively connected with have not beendefined either in the DTAA or the Act. However, our attention hasbeen drawn towards the USA analysis, in which it is mentioned that ingeneral, U.S. treaties expressly exclude from the scope of interest articleinterest that is attributable to or effectively connected with either the PEin the source Contracting State through which the obligor carries onbusiness, or a fixed base from which the obligor performs independentpersonal services. Such interest is considered taxable under the BusinessProfits or Independent Personal Services articles. This standard issubstantially stricter than that in Article 11(4) of the U.N. Model treaty,under which interest that is effectively connected with business activitiescarried on in the source State that are of the same or a similar kind as thoseeffected through a permanent establishment are taxable as businessprofits. The term attributable to, which is used in the U.S. Model Treaties and effectively connected with, which is used in OECDModel Treaties, generally are not defined in U.S. income-tax treaties.Therefore, their meaning generally must be determined in accordancewith the law of the Contracting State imposing the tax. Nothing suggeststhat the two terms are intended to have different meanings under thetreaties. It is also mentioned that if a non-U.S person is consideredengaged in U.S. trade or business, the enquiry becomes whether theinterest is effectively connected with the trade or business. In the caseof U.S-source interest other than in the case of banking, financing orsimilar business, is effectively connected with a U.S. trade or business ifthe obligations on which the interest is paid or used in, or held for usein, the conduct of U.S. trade or business, which is the asset-use test; orthe activities of the U.S. trade or business is a material factor inrealization of the interest, which is the business-activities test. Thus, it isargued by the ld. counsel that for determining whether the indebtednessis effectively connected with the PE one of the two tests need to besatisfied. However, if all interest incomes are brought to taxation underArticle VII, it will create anomaly in the sense that paragraph nos. (1) and(2) will be left with no content. Further, under Article VII only thatprofit is taxed as business profit which is attributable to the PE. In order to support this contention, a reference has been made to paragraph no. 60 ofthe decision in the case of Sumitomo Corporation Vs. Dy. CIT, (2007) 114ITD 61, in which it is mentioned that the term effectively connectedused in Article XII(5) of the DTAA is not to be construed as the oppositeof legally connected, but in the sense of something really connected.This connection has to be seen not in form but in real substance. Theincome-producing activity should be closely connected in terms ofrelationship besides being connected economically also with the PE.Reliance is also placed on the ruling of Authority for Advance Rulings in thecase of Worley Parsons Services (P) Ltd., (2009) 312 ITR 273, a ruling inthe case of an Australian company. It is inter-alia mentioned that theeffective connection should be between the royalty generating servicesand the permanent establishment. The expression services issignificant and should be given due weight. It is not enough that there is aPE of the non-resident in the source country carrying out some activitiesin connection with the project or the work. The PE may be effectivelyconnected with the project and the contract from a broader prospectivebut the connection contemplated by paragraph no. 4 of Article XII is inrespect of services that fall within the purview of royalty. The PE or thefixed base set up in the source country should be engaged in the performance of royalty generating services, irrespective of what otheractivities it performs. At least, it should facilitate the performance ofsuch services. The terminology effective connection denotes a real andintimate connection. Coming to the facts of the case, it is mentioned thatit has to be ascertained whether the PE set up in India in connection withpipelines project work is effectively connected with the servicesperformed by the applicant under the two agreements. On a deepconsideration, the AAR are of the view that the applicant has not been ableto make out the effective connection in the sense in which it has beenexplained earlier. It has further been mentioned that in order to seewhether the payments in the nature of royalties received by the applicantare taxable in India, the particular agreement under which the royaltieshave been received should be considered on stand-alone basis. A lumpsumconsideration with a break up of phase-I and phase-II, isstipulated under the agreement and the scope of works/services as well asrights and obligations in the agreements are clearly separate and distinct,though related to one project. It is also mentioned that the effectiveconnection contemplated by Article XII(4) must be between the servicesgiving rise to royalty and the PE. That there is overall connection of suchservices to the project and the fact that such services are essential for the execution of the project is a different aspect. The case of the ld. counsel isthat the same logic shall apply mutatis mutandis while interpretingparagraph no. 4 of Article XI.
7. In reply, the ld. DR submitted that although the interest has notarisen out of the business transactions, but it is also a fact that tax wasdeducted from the monies receivable in the course of the business of thePE and, therefore, there is a direct nexus of the indebtedness with theassets of the business.
7.1 Coming to the analogy taken from the domestic law, it issubmitted that if the assessee opts to be taxed under the DTAA, theclassification of income is not required to be done under the five heads.In fact, no head of income has been prescribed under the treaty. Therefore,it cannot be said that the provisions contained in paragraph no. 2 ofArticle XI are analogous to the provisions contained in the Act regardingcomputation of income under the residuary head. Elaborating further, it issubmitted that if such an analogy is to be adopted, it should be carried toits logical conclusion. Under the domestic law, the rate of tax is thesame for business head and the residuary head of income. However, if the interest is to be assessed under Article XI (2), it will get taxed on agross basis at the rate of 15%. If it is to be taxed under Article VII readwith Article XI(4), the normal rate of tax will be applicable on the netincome. Thus, the analogy breaks down when we look to the rate oftaxation. The analogy also breaks down for the simple reason that ArticleXXII of the DTAA is in the nature of a residuary article, dealing withincomes not covered under any other provisions. If at all any analogy canbe drawn from the Act, it could be only between Article XXII of theDTAA and the residuary head of income in the Act.
7.2 Coming to the treaty, it is elaborated that the expression used is tothe effect that indebtedness is effectively connected with the PE and notthat the interest income is effectively connected with the PE. Asmentioned earlier, the debt arose because of tax deduction at source fromthe business receipts of the PE. Therefore, if the FAR analysis is carriedout, the asset will have to be allocated to the PE. Accordingly, it can bevery well said that economic ownership of the debt lies with the PE.Thus, asset-test is satisfied in this case. Further, since the tax wasdeducted from the business receipts of the assessee, even the activity-teststands satisfied because it was in the course of the business transactions of the assessee that the debt arose. Accordingly, it is argued that both thetests are satisfied.
7.3 It is submitted that the taxation of interest-receipt does not dependupon the reason on account of which the income arose. It may be due todelay on the part of the revenue to grant refund but nonetheless theincome remains the income and there is satisfaction of asset-test as wellas activity-test. Elaborating further, it is submitted that the DTAA is notbased on U.S model but it is based on OECD model. The U.S. model isaltogether different. Therefore, U.S. technical explanation cannot berelied upon for interpreting the provisions of the DTAA. Coming to theOECD commentary, it is submitted that it is mentioned that if the interestis paid in respect of debt-claim forming part of the assets of the PE orotherwise effectively connected with the PE, paragraph no. 4 relievesthe source State from the limitation imposed under paragraph nos. (1)and (2) of Article XI. The commentary contemplates economic ownershipof the debt-claim. As mentioned earlier, if FAR analysis is made, thededuction from monies receivable as tax would fall under the economicownership of the PE. Therefore, the commentary supports the case of therevenue. Accordingly, it is urged that the case of lower authorities regarding taxation under Article VII read with Article XI(4) may beupheld on the ground of economic ownership of the asset held by the PE.
7.4 It is further submitted that cases dealing with Royalties underArticle XII are not applicable under Article XI.
8. In the rejoinder, the ld. counsel clarified that there is no question ofopting for taxation under the DTAA. Section 90(2) of the Act provides inexpress-terms that if any provision of the Act is more beneficial to theassessee, the same shall be given effect to. It was further clarified thatprovisions of Article XII are analogous to provisions of Article XI and,therefore, it will not be correct to argue that the cases dealing with royaltyor fees for technical services are not applicable. The ratio of thesecases shall be applicable mutantis mutandis to the provisions containedin Article XI. It is also clarified that the treaty does not contain headsof income. The scheme is that prescription has been made in respect ofcertain incomes and what is not covered under the prescription is to beconsidered under Article XXII. Since there is no effective connection between the PE and the debt-claim, the provisions contained in Article XI(4) cannot be invoked.
9. We have considered the facts of the case and submissions madebefore us. The facts are that the assessee received interest on income-taxrefund amounting to Rs. 61,04,944/- from the income-tax department. Italso received a sum of Rs. 13,899/- as interest from the bank on the fixeddeposits placed with it. No dispute has been raised by the ld. counsel inrespect of the bank interest. Therefore, the only question left now iswhether,the sum of Rs. 61,04,944/- is taxable on gross basis @ 15% oron net basis at the rate applicable to a foreign company?10. We may deal with the question from the stand point of section90(2) of the Act. The provision reads as under:-(2) Where the Central Government has entered into anagreement with the Government of any country outside Indiaor specified territory outside India, as the case may be,under sub-section (1) for granting relief of tax, or as thecase may be, avoidance of double taxation, then, in relationto the assessee to whom such agreement applies, theprovisions of this Act shall apply to the extent they are morebeneficial to that assessee
10.1 The gist of the provision is that in a case where the provisions ofthe DTAA apply to an assessee, the provisions of this Act shall apply tothe extent they are more beneficial to that assessee. According to us, itwill become necessary to have proper appreciation of the words morebeneficial. Although this point has not been elaborated upon by any of thecontending parties, it is clear to us that application of the provision canbe made after ascertaining- (i) tax payable by the assessee under theDTAA, and (ii) tax payable by the assessee under the Act. If tax payableunder the Act is lesser than the tax payable under the treaty, it can beconcluded that the provisions of the Act are more beneficial to the assessee.However, if the tax payable by the assessee under the treaty is lesser thanthe tax payable under the Act, he shall have the benefit of the DTAA.If we compute the income of the assessee under the head othersources, the net income by way of interest received from the income-taxdepartment shall amount to Rs. 61,04,944/-. This amount will be taxedat the rate applicable to a foreign company, which is more than 15%.Therefore, on making the assessment of tax under the treaty and theunder the Act, it will be found that tax payable under the Act is morethan the tax payable under the treaty. Accordingly, the aforesaidprovision will come to the aid of the assessee to come to an automatic conclusion, without exercise of any option, that it should get the benefitunder the DTAA. No other consideration is material for this purpose asultimately what is to be seen is whether the provisions of the Act aremore beneficial to the assessee or not. Accordingly, it is held that theassessee is entitled to the benefit under the treaty.
11. Coming to the treaty, the facts are that the tax was deducted atsource from the business receipts of the PE. Therefore, indebtedness isconnected with the PE. However, the treaty uses the words effectivelyconnected with the PE . The question was referred to the Special Benchfor the reason that there is an apparent conflict of views in the case ofPride Foramer France SAS and B.J. Services Co. Middle East Ltd.(supra). The admitted position in the case of B.J. Services Co. MiddleEast Ltd. is that no dispute existed on the facts that-(a) the assessee is anon-resident having a PE in India; (b) the assessee is carrying on thebusiness in India through the PE; and (c) the interest is effectivelyconnected with such PE in India. Thus, there was no dispute in this caseregarding existence of effective connection. The Tribunal mentionedthat in ordinary circumstances paragraph no. 2 would have been madeapplicable. However, in terms of paragraph no. 6 of Article XII, the provisions of paragraph no. 2 shall not be applicable if thebeneficial owner of the interest carries on business in India, in whichinterest arises through a PE situated in India and the debt-claim in respectof which interest is paid is effectively connected with such PE in India.As the factual position regarding effective connection was not underdispute, it was but natural for the Tribunal to come to the conclusion thatArticle XII (6) shall be applicable read with Article VII. However, inthis case, the factual position regarding effective connection is underdispute. In the case of Pride Foramer France SAS, the assessee hadreceived interest on income-tax refund. It was pleaded that no consciouseffort was made through the PE to earn the interest except for pursuingthe matters before the authorities. It was further pleaded that as theinterest was sui generis, it could not be considered within the purviewof Article XII(5). The Tribunal mentioned that Article XII of the DTAAwith UK and France are in pari-materia. There is no dispute that theinterest was paid on account of delay by the revenue in grant of incometaxrefund. Reference was made to an earlier decision of the Tribunal inthe case of the assessee in which it was held that the expenses incurredcannot be set off against interest on income-tax refund because suchinterest cannot be termed as business income. Therefore, it could not be said to be attributable to the business activities or derived from suchactivities. It was merely a fallout of profits earned and appropriation ofprofits. Taking a cue from this decision, it has been held that the interestincome could not be brought to tax under Article XII(5) read with ArticleVII. Another argument was advanced to fortify this decision, namely,that the assessee is not in the business of obtaining income-tax refund andearning interest thereon. It is merely the fallout of appropriation of profitand when excess amount is paid to the revenue than what is due underthe Act, the assessee gets the fund and when there is a delay ingranting refund, the assessee gets the interest. Therefore, the case of theassessee was accepted by mentioning that it was not business income butincome from other sources. We find that the assessee had disputed theexistence of effective connection between the PE and the interest.However, the Tribunal allowed the appeal by drawing analogy fromvarious heads of income. We are of the view that such analogy is notappropriate. The reason is that if aforesaid decision is accepted, only thatinterest which is in the nature of business income will go out of thepurview of paragraph no. 4 of Article XI of the DTAA. This is not theintent of the paragraph. Therefore, we will have to examine as to whether the test of effective connection is satisfied in this case or not. And thisbrings us to the provisions of the DTAA and jurisprudence thereon.
11.1 Before proceedings with the determination of the issue, theprovisions of Article XI of the DTAA are reproduced below:-Article XI-Interest-
1. Interest arising in one of theContracting States, being interest to which a resident of theother Contracting State is beneficially entitled, may be taxedin that other State.
2. Such interest may also be taxed in the Contracting State inwhich it arises, and according to the law of that State, butthe tax so charged shall not exceed 15 per cent of the grossamount of the interest.
3. The term interest in this Article includes interest fromGovernment securities or from bonds or debentures,whether or not secured by mortgage and whether or notcarrying a right to participate in profits, and interest fromany other form of indebtedness as well as all other incomeassimilated to income from money lent by the law, relatingto tax, of the Contracting State in which the income arises, butdoes not include interest referred to in paragraph (1) ofArticle 8.
4. The provisions of paragraphs (1) and (2) shall not apply ifthe person beneficiary entitled to the interest, being aresident of one of the Contracting States, carries on businessin the other Contracting State, in which the interest arises,through a permanent establishment situated therein, orperforms in that other State independent personal servicesfrom a fixed base situated therein, and the indebtedness inrespect of which the interest is paid is effectively connectedwith such permanent establishment or fixed base. In such a case, the provisions of Article 7 or Article 14, as the casemay be, shall apply.
5. Interest shall be deemed to arise in a Contracting Statewhen the payer is that State itself or a political subdivisionor local authority of that State or a person who is aresident of that State for the purposes of its tax. Where,however, the person paying the interest, whether the person isa resident of one of the Contracting State or not, has in one ofthe Contracting States or outside both Contracting States apermanent Establishment or fixed base in connection withwhich the indebtedness on which the interest is paid wasincurred, and such interest is borne by such permanentestablishment or fixed base, then such interest shall bedeemed to arise in the State in which the permanentestablishment or fixed base is situated.
6. Where, owing to a special relationship between the payerand the person beneficially entitled to the interest, orbetween both of them and some other person, the amount ofthe interest paid, having regarding to the indebtedness forwhich it is paid, exceeds the amount which might have beenexpected to have been agreed upon by the payer and theperson so entitled in the absence of such relationship, theprovisions of this Article shall apply only to the lastmentionedamount. In that case, the excess part of theamount of the interest paid shall remain taxable according tothe law, relating to tax, of each Contracting State, butsubject to the other provisions of this Agreement.
11.2 In the case of Traco Cable Co. Ltd. (supra), the decision under theAct is that for an income to be business income, the actual activities andnot the clauses of memorandum of association have to be looked into. Inthe case of Ataria Power Corporation Ltd., it has been held that theinterest earned on income-tax refund is assessable under the residuaryhead and it does not form part of profits and gains of power-generationbusiness. In the case of Samir Diamond Exports Ltd. (supra), it has beenheld that interest on refund and loans are taxable under the residuaryhead and, therefore, do not form part of the profits of the businesscomputed for the purpose of the deduction u/s 80HHC. In the case ofCollis Line Pvt. Ltd., it has been held that the main purpose of deposit wasto keep idle money safe by depositing into the bank, therefore, the earningof interest was incidental to the main purpose of keeping the money safe.Such income is taxable under the residuary head. In the case of MadhyaPradesh State Industries Corporation Ltd., the decision is that the interestearned on share money is chargeable to tax under the residuary head. Thecase of the ld. counsel, on the basis of the aforesaid jurisprudence, is thatinterest received by the assessee on income-tax refund is not the businessincome. Similar consideration will be applicable while interpretingparagraph no. (4) of Article XI in respect of the words effectivelyconnected with such permanent establishment. On the other hand, thecase of the ld. DR is that paragraph no. (4) overrides paragraph nos. (1)and (2) of this article. The assessee has a PE in India. Theindebtedness arose as tax was deducted from the business receipts of thePE and, therefore, on asset-test the indebtedness is effectively connected with the PE. Similar provision exists in the U.K. and France DTAAs. Itis further argued that the provision contained in paragraph no. (4) readwith Article VII cannot be equated with the provisions contained inChapter IVD regarding profits and gains of business or profession. Ifthat is done, the paragraph no. 4 will become redundant. The real test is notwhether the interest is business income or not, but whether the indebtednessis effectively connected with the PE. Therefore, the jurisprudence underthe Income-tax Act, which nowhere contains similar words, cannot betaken recourse to for interpreting the provision. Having consideredthese matters, we agree with the ld. DR that since the words effectivelyconnected with such permanent establishment do not find a place in theAct anywhere, therefore, the decided cases thereunder cannot form thebasis for understanding the real import of the expression. Article VIIdeals with taxation of business profits and also provides for mechanismto compute the profits of the business. Paragraph no. 4 relieves the sourceState from the rigors of paragraphs nos. (1) and (2) in case the interest isfound to be effectively connected with the PE, even if it is not in thenature of business income of the assessee but is effectively connectedwith the PE. If interest is the business income as a matter of fact, suchincome falls automatically within the ambit of Article VII without even taking recourse of paragraph no. 4. Therefore, this paragraphcontemplates a different condition upon whose satisfaction interestbecomes taxable under Article VII. It is an accepted canon ofinterpretation that no part of the statute should be rendered null and voidby interpretation. Therefore, some meaning has to be placed on thecontents of this paragraph. Accordingly, we proceed with the othercases relied upon by the rival parties.
11.3 In the case of Pride Foramer France SAS (supra), it was held thatinterest on income-tax refund was sui generis and it was neitherderived from nor attributable to the business activities of the assessee. Itwas also contended that the assessee is not in the business of obtainingincome-tax refund and earning interest thereon. Therefore, it was heldthat the same is taxable under the residuary head of income under the Act.Consequently, it was concluded that the same cannot be related to theactivity of the PE. We have already held that paragraph no. (4) bringswithin its ambit not merely the interest earned from the business butsomething more, i.e., interest on indebtedness which is effectivelyconnected with the PE. Interpreting this expression on the basis of theheads of income would render this paragraph null and void. Therefore, without commenting on the merits of the decision, it can be said that thiscase does not lay down the law in entirety as it misses the point mentionedabove. The case of B.J. Services Co. Middle East Ltd., (supra) does nothelp us in deciding this issue as in that case there was no dispute that-(i)the assessee is a non-resident having PE in India; (ii) the assessee iscarrying on business in India a through a PE situated in India; and (iii)the interest is effectively connected with such PE in India. However, thisdecision does not proceed on the footing that only that interest which ispart of the business profits can be brought within the ambit of paragraphno. (4). In the case of Worley Parsons Services Pte. Ltd. (supra), theruling is that for bringing to tax the royalties received under ArticleVII read with Article XII, there must be effective connection betweenthe earning of the income and the PE or the fixed base. This ruling alsodoes not help us incoming to appropriate conclusion for the reason thatroyalty is, in general, the business income, although taxable atconcessional rate in absence of PE or its effective connection with thePE or the fixed base. Such is also the position in the case in the caseof Sumitomo Corporation (supra). In the case of Hapag & LoydContainer, interest on income-tax refund was excluded from Article 8 as ithad no connection with the shipping business. Therefore, it was held to be taxable under Article 11. But this case also does not take us anyfurther in regard to controversy before us.
11.4 Thus, we are again left with the fundamental question as towhether the debt-claim in this case can be said to be effectivelyconnected with the PE. We have already held that the claim is connectedwith the PE in the sense that it has arisen on account of tax deductionat source from the receipts of the PE. However, it is also a fact thatpayment of tax is the responsibility of the foreign company. The same isdetermined after computation of its income and the tax forms not anexpenditure for earning the income but an item of appropriation of profit.Therefore, even if the debt is connected with the receipts of the PE, itcannot be said to be effectively connected with such receipts becausethe responsibility to pay the tax lies on the shoulders of the assesseecompanyfrom the final profit ascertained as on the last date of the previousyear and on closing the books of account. It is for the company to pay thetax from any source available with it. It so happened in this case thatthe tax got automatically deducted from the receipts of the PE byoperation of law. Such collection of tax by force of law would notestablish effective connection of the indebtedness with the PE as ultimately it is only the appropriation of profit of the assessee company.However, we may add that we do not venture to say that the interestincome has to be necessarily business income in nature for establishingthe effective connection with the PE because that would render provisioncontained in paragraph 4 of Article XI redundant. Thus, there may becases where interest may be taxable under the Act under the residuaryhead and yet be effectively connected with the PE. The bank interest inthis case is an example of effective connection between the PE and theincome as the indebtedness is closely connected with the funds of the PE.However, the same cannot be said in respect of interest on income-taxrefund. Such interest is not effectively connected with PE either on thebasis of asset-test or activity-test. Accordingly, it is held that this part ofinterest is taxable under paragraph no. 2 of Article XI. Thus, the groundreferred to the Special Bench is partly allowed. The Division Bench shalldispose off the appeal in conformity with this order.The order was pronounced in the open court on 6th May, 2011.Sd/- sd/- sd/-(R.P. Tolani) (R.V. Easwar) (K.G.Bansal)Judicial Member President Accountant Member
Date of order: 6th May, 2011.
SP Satia
Copy of the order forwarded to:-
M/s Clough Engineering Ltd.,
New Delhi.ACIT,
Range-I, Dehradun.
CIT(A)CITThe DR, ITAT,
New Delhi.
Assistant Registrar.
