Direct Tax Alert

BACKGROUND

Cross-border pricing arrangements between a foreign parent and its Indian subsidiary are consistently examined by India's tax authorities. It is hence important to determine that payments made by an Indian entity to its foreign associated enterprise (‘AE’) for technical know-how or expertise are at arm's length price (‘ALP’). An Advance Pricing Agreement (‘APA’) is a mechanism under which a taxpayer and the Central Board of Direct Taxes (‘CBDT’) agree in advance on the determination of the transfer pricing (‘TP’) methodology, bringing certainty and reducing future litigation. Upon successful signing of an APA, the pricing between related parties for the covered transaction gets finalised. Further, the interplay between the prohibition on downward adjustments in TP and the real income theory has largely been unaddressed. The Bombay High Court’s¹ recent ruling squarely addresses this matter, while also dealing with the issue that mere foreign parent’s controlling interest in its Indian Subsidiary does not lead to creation of a Permanent Establishment (‘PE’).

We, at BDO India, have analysed and summarised the key aspects of this judgement and provided our comments on its impact hereunder.

FACTS OF THE CASE

• The taxpayer (‘GIA US’) is a globally recognised gem grading and certification institution headquartered in the United States. It has set up a wholly owned subsidiary in India (‘GIA India’) to provide diamond grading services in India. To facilitate the Indian operations, GIA US provided equipment, technical know-how, and expertise in exchange for royalty payments.

• During Fiscal Year (‘FY’) 2010-11, GIA US received royalty of approximately INR 685.34 mn from GIA India and offered the same to tax in India while filing income tax return. Subsequently, GIA India entered into an APA with the CBDT in May 2018, wherein the ALP of royalty for FY 2010-11 was determined to be INR 490.89 mn. Resultantly, in line with the APA, GIA India raised an invoice in respect of excess royalty paid to GIA US, and accordingly, GIA US refunded the excess amount of INR 194.44 million to GIA India in July 2018.

• During the ongoing assessment proceedings, the tax authority contended that the TP provisions shall not apply in cases where ALP results in reduction of income and non-APA applicant (GIA US) cannot seek the benefit of APA and hence gross amount of royalty originally received in the hands of the taxpayer is taxable. The tax authorities further opined that taxpayer had a PE in India and accordingly assessed the total income at INR 728.86mn.

• Aggrieved by this, the taxpayer preferred an appeal to the Mumbai Income Tax Appellate Tribunal (‘ITAT’ / ‘Tribunal’), raising an additional ground claiming that the refund amount of royalty paid by it to GIA India should not be regarded as its income and hence not assessable.

• The Mumbai ITAT accepted the taxpayer's claim that the refunded amount should be excluded from its taxable income and also held that GIA India did not constitute a PE of GIA US in India. Aggrieved by the Tribunal’s order, the Revenue appealed to the Bombay High Court.

           
HIGH COURT JUDGEMENT

The Bombay High Court, while holding that only real income can be brought to tax and mere presence of a controlling interest does not render GIA India as a PE of GIA US, made the following key observations:

• Evaluation of PE formation of GIA US in India
  • Reliance is placed on the following arguments and findings of the Tribunal that lead to the conclusion that GIA India could not be termed as PE of GIA US:

  • The transaction of grading services between GIA US and GIA India cannot be construed to be in the nature of a joint venture. The arrangement was similar to assignment or sub-contracting of services, but only due to technology/capacity constraints, GIA India forwarded stones to GIA US for grading purposes.

  • All risks like credit risk, client-facing risk, risk of loss/damage and economic risks were borne by GIA India.

  • Pursuant to Article 5(6)² of the India-US Double Taxation Avoidance Agreement (‘DTAA’) and the Supreme Court’s ruling in the case of E Funds IT Solutions³, mere controlling interest by GIA US does not classify GIA India as its PE.

  • As per Article 5 of the India-US DTAA, service PE arises only if services are furnished by the employees of GIA US and the said employees stay in India for more than 90 days for the provision of such services. However, in the given case, two graders who were earlier employed by GIA US were now on the payroll of GIA India, i.e. under the control and supervision of GIA India. Accordingly, no service PE is said to be formed.

  • GIA India was an independent and separate legal entity rendering grading services to Indian clients and did not have any authority to conclude contracts on behalf of GIA US. Hence, GIA India cannot be regarded as ‘agency PE’ of GIA US in India.

• Taxability of excess royalty repaid by GIA US to GIA India
  • Section 92⁴ of the Income Tax Act, 1961 (‘the Act’) prohibits a downward adjustment in a case where a reduction in income is claimed without repayment of excess. However, since GIA US has repaid the excess amount, section 92(3) of the Act would not be applicable.

  • Once an APA is in place, it governs the determination of ALP for all the years that form subject matter of the APA and second proviso to section 92C(4)⁵of the Act do not apply. Reliance in this regard is placed on the Karnataka High Court’s ruling in the case of EYGBS (India) (P.) Ltd.⁶ held that where taxpayer voluntarily computes ALP pursuant to APA, none of the conditions set out in section 92C(3) and section 92C(4) of the Act shall apply.

  • Further, secondary adjustment⁷ gets triggered only in cases where the funds are not repatriated within the stipulated timeframe. In the given case, GIA US has refunded the excess royalty to GIA India immediately, which was within the stipulated timeframe; hence, the provisions of secondary adjustment do not apply in the instant case.

  • On real income theory, reliance is placed on the several decisions of the Supreme Court and other jurisdictional High Courts⁸ wherein it is consistently held that for an income to be taxed in the hands of a taxpayer, it must be real income which the taxpayer has actually earned and not a mere hypothetical income.

  • Further, as per Article 12 of the India-US DTAA, what can be brought to tax in India is royalties ‘paid’ to GIA US by GIA India. The term ‘paid’ denotes actually and eventually paid.

  • Accordingly, any part of the royalty which had to be refunded to GIA India could not be taxed in the hands of GIA US. The tax authorities cannot tax the same amount twice, once in the hands of GIA India (by reducing the expenditure) and again in the hands of GIA US (by declining the reduction of income). Hence, INR 490.89mn as actually paid to GIA US shall only be taxed as royalty income.

BDO INDIA COMMENTS

This ruling is a welcome ruling as it significantly reaffirms the doctrine of real income in the context of transfer pricing. It clarifies foreign parent's tax position when an APA is executed by the Indian subsidiary. The High Court has effectively held that the substance of the transaction must be looked at, and the amount which is genuinely earned and retained should be assessed to tax.

This decision would have strong relevance for the multinational groups operating through Indian subsidiaries and having arrangements comprising royalty, technical services, licensing, etc., where APAs are typically negotiated by the Indian entity. It lays down a principle that secondary adjustments do not apply where the excess amount charged has been repaid pursuant to APA and that a bona fide refund made in good faith pursuant to an APA-determined ALP should not, by itself, expose the foreign recipient to tax on income it never actually retained. Further, this ruling reinforces the principle that the mere controlling interest by the foreign AE on its subsidiaries or obtaining technical services or know-how from foreign AEs does not by itself result in formation of PE where all the economic risks are borne by the Indian subsidiary.