INSIGHT: Offshore Supply of Equipment Income Not Taxable Under India–Japan Tax Treaty

Nippon Steel Engineering Co (Nippon or Applicant), a Japanese resident, is engaged in supplying environmental steel plants and delivering Coke Dry Quenching (CDQ) units across the globe. JSW Projects Limited (JSW), in India, tendered two independent offshore contracts for supply of equipment from Japan and China (equipment contract) with Nippon. The applicant had a distinct contract for supervisory, training, supply of drawings and documents of equipment.

In order to determine taxability of the amount received from JSW towards the equipment contract under the Indian domestic law or India–Japan tax treaty (tax treaty) the applicant filed an application before the Authority for Advance Ruling (AAR).

Nippon stated that sale consideration from supply of CDQ and spares was received in foreign currency under an irrevocable letter of credit for title of goods passed outside India.

The bill of lading, commercial invoice and marine insurance policy for any damage/loss during transit was in favor of JSW as consignee of the goods. Accordingly, it was emphasized that transfer or title and risk of equipment was passed to JSW offshore. Hence, relying on the Supreme Court rulings of Pushalal Mansinghka and Mahabir Commercial, no portion of income accrued directly or indirectly to the applicant in India.

Nippon also confirmed to have no business connection or operations carried out in India arising from the equipment contract to JSW that was concluded on a principal-to-principal basis outside India. Further, the applicant was not responsible for the installation of CDQ units, but was assigned to an Indian subcontractor with an overall responsibility for testing, commission and performance guarantee test, etc., with JSW.

As the primary condition of transfer of goods and payment thereof received by the applicant offshore was satisfied, no income was liable to tax in India under the tax treaty. Arriving at this conclusion, Nippon relied on a plethora of jurisprudence dealing with identical transactions of income arising from equipment contract being treated as tax exempt in India.

The Indian tax authority (revenue) challenged the AAR application on the administrative ground of taking two transactions collectively, where operative guidelines permit only one transaction at a time in the AAR application. The revenue also alleged that, the equipment contract is composite in nature as other supervisory, drawing and training activities are interconnected with equipment installation.

The revenue stated that to execute turnkey projects, Nippon employees traveled to India for pre-bid activities of supply and installation, where senior officers of Nippon visited and stayed in India in connection with negotiations and execution of the equipment contract to create a fixed place permanent establishment (PE) of the applicant in India from such activities under Article 5(1) of the tax treaty.

The revenue argued that Nippon employees traveling to India for negotiations, and exclusive meetings in all post-bid activities, had the authority to conclude contracts with JSW on behalf of the applicant, and satisfied the habitual condition to create a dependent agency permanent establishment (DAPE) under Article 5(4) of the tax treaty. The revenue accepted that supply of equipment was carried on outside India but treated the equipment contract as composite and inextricably linked to supervisory PE of the applicant in India.

The revenue also contested that the equipment contract transaction and other contract was artificially split and inflated with additional price allocation to other contracts. Therefore, the revenue treated income arising to Nippon from the equipment contract as liable to be assessed as business profits in India under Article 7 read with Article 5 of the tax treaty and Indian domestic tax laws.

AAR Ruling

Maintainability of AAR for Multiple Transactions

The AAR on the administrative objection of revenue that only one transaction is admissible at a time in the application, rejected the plea and confirmed that the AAR operative guidelines unambiguously interpret “a transaction” to include more than one transaction.

The analogy is fortified by reliance placed on applicable Notes to the Form for AAR rules, CBDT Office Memorandum dated August 28, 2019 and on various rulings like Sony Ericsson Mobile Communication, United Electrical Industry, and Fidelity North Star Fund. The AAR confirmed that, since the present transactions are identical and emanate from the related set of activities/contract and not distinct from each other, a single AAR application is maintainable for such multiple transactions.

Taxability of Offshore Supply of Equipment

The AAR observed that the scope of equipment contract as per the letter of intent was comprehensive, to include manufacture, supervision, supply, erection, testing service, etc. segregated in different contracts as per the requirement of Nippon at specific costs. The AAR analyzed two separate contracts signed for supply of CDQ units and spare parts for Japan and China, being identical except for the contract price, to state that under the terms of the equipment contract:

• equipment is delivered on freight on board (FOB) berth terms from Japanese, Korean Chinese and/or other international seaport according to Incoterms 2000 in the prescribed period;
• JSW to arrange the vessel for carriage of equipment from shipment port to India on its own and with self-responsibility;
• marine insurance policy is on JSW and not on the applicant;
• contract prescribes liquidated damages for delay in delivery beyond grace period and for non-achievement of performance guarantee;
• responsibility for erection of equipment and preparation for performance tests is on JSW;
• Nippon did not retain or reserve the right of disposal of goods during transit or control over the goods particularly, since the invoice and the bill of lading was in favor of JSW and not in the name of the applicant or any agent, emphasizing that title and property in goods shipped to India was already transferred outside the territory of India;
• installation and commission of equipment was to be carried out by JSW under the guidance of the applicant as per minutes of the meeting;
• JSW is not in charge of the equipment for the purpose of erection and installation, but is the owner of it before the goods reach an Indian port; and
• responsibility of Nippon for quality and satisfactory performance of equipment is not a condition to postpone transfer of title of goods in India but a warranty provision.

On a comprehensive assessment of the above facts and relying on landmark rulings of Ishikawajina Harima Heavy Duty, Hyosung Corp. including cases distinguished referred by the revenue of Ansaldo Energia SPA, Roxar Maximum Reservoir, Alstom Transport, the AAR concluded that Nippon did not have a fixed place of business in India through which its business was wholly or partly carried under Article 5(1) of the tax treaty.

The AAR also disregarded the revenue’s contention to treat independent employees of the applicant as dependent agents under Article 5(7) of the tax treaty treating the employees as responsible persons of the applicant to sign a contract on its behalf.

The AAR confirmed that Nippon had supervisory PE under Article 5(4) of the tax treaty and income from training, engineering and supervision services was already offered to tax in India. Since JSW was responsible for providing the applicant data, drawing and details to implement the contract did not result in any fees for technical services from the equipment contract.

The revenue could not produce evidence to prove that supervisory PE was involved for the equipment contract but stated that supervisory PE can be established later only when supervision activity is conducted after the equipment has reached the site.

The AAR observed that the installation contract was assigned to an Indian party and not executed by Nippon. Also, work at the pre-bid stage is not decisive to award a contract, by relying on the case of Toshiba Corporation. Hence, in absence of no material to prove that work relating to the equipment contract was executed from a supervisory PE of Nippon in India, the equipment contract is not connected with any business of the applicant.

In light of the above arguments, the AAR concluded that the amounts received by Nippon under the equipment contract for CDQ units for Japan and China are not chargeable to tax in India under Indian domestic law or the tax treaty.

Planning Points

The ruling provides vital guidance relating to the concept of inter-connectivity of business activities, especially where the supervisory PE is regarded as unrelated to the offshore supply of equipment and disjoints the activity for integrating the concept of PE.

It comes at a time when India and Japan have released a synthesized text of the multilateral instrument (MLI) under the tax treaty. The MLI to the tax treaty prescribes anti-fragmentation rules as per the OECD BEPS Action Plan 7 to address the issue of fragmentation of activities between different places of business or entities to artificially prevent constitution of PE.

As a trend, the issue of PE is widely disputed by the revenue largely based on the Supreme Court ruling in the case of Formula One World Championship Ltd where the conditions to constitute a PE were elaborately explained.

Interestingly, OECD BEPS Action Plan 7 deals with “preventing the artificial avoidance of PE status” and recommends expansion of the scope of PE under the MLI to the tax treaty restricting foreign company and its group companies from fragmenting contracts, provided that the business activities carried on by the two enterprises at the same place, or by the same enterprise or closely related enterprises in two places, constitute complementary functions that are part of a cohesive business operation.

Though the AAR ruling has persuasive value for similar cases, it would be worthwhile to plan transactions considering the MLI is effective from October 1, 2019.

Shailendra Sharma is a Chartered Accountant associated with a multinational financial services firm, India.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.