PUNIT SHAH & JAYESH KARIYA [SUNDAY, SEPTEMBER 21, 2003 12:43:36 AM]

Foreign companies establish a presence in India either by establishing branch offices, project offices or subsidiary companies. This leads to a `permanent establishment’ (PE) of the company in India.

According to Article 7(1) of the Double Taxation Avoidance Agreement (DTAA) of many Indian Tax Treaties, in the case of a foreign PE in India, business income is taxable in India, but only so much of them as is attributable to a PE in India. Further, Article 7(2) provides that the profits of a PE is to be determined as if the PE were a distinct and independent enterprise operating in India under arms’ length conditions.

Article 7(3) provides that while computing the profits attributable to a PE, deduction is allowed in respect of expenses which are incurred for the purpose of the business of PE, including a reasonable allocation of executive and general administrative expenses, research and development expenses, interest and other expenses incurred for the purpose of the enterprise as a whole, (that is, head office expenses) whether incurred in India or outside India, in accordance with the provisions of and subject to limitations of Indian tax laws.

However, no such deduction shall be allowed in respect of amounts, if any, paid (otherwise than towards reimbursement of actual expenses) by the PE to the head office of the enterprise or any of its other offices, by way of royalties, fees or other similar payments for the use of patents, know-how or other rights or by way of commission or other charges for specific services performed or for management.

Accordingly, the allow ability of head office expenses in the hands of the PE is subject to the limitations prescribed in Indian tax laws.

Indian tax laws provide that business income of any entity (including a PE of a foreign company) is to be computed in accordance with Section 28 to 44D of the Indian Income-Tax Act, 1961 (I-T Act).

Section 44C is a restrictive section, which restricts allow ability of head office expenses in the nature of general and administrative expenses up to 5% of the adjusted total income of the tax payer for the relevant year, provided such expenses are relatable to the business of the enterprise in India.

On a plain reading of Section 44C, it appears that allowance for head office expenses is restricted to 5% of the adjusted total income in determining the taxable income of a PE of a foreign company in all cases. A careful analysis of Section 44C read with clarificatory circulars and judicial precedents reveal various facets. The first question is whether restrictions contained in Section 44C applies in all PE situations such as such as agency PE, service PE etc.

The language of Section 44C suggests that the restriction applies in all cases of a PE in India. However, the Memorandum explaining the provisions of the Finance Bill, ‘76 and the CBDT Circular dated July 5, ‘76 are relevant.

The circular clarifies the purpose of introducing restrictions by stating that it is extremely difficult to scrutinise and verify claims in respect of head office expenses, particularly in the absence of account books of the head office, which are kept outside India and this could lead to foreign companies trying to reduce taxes in India by inflating claims of head office expenses.

This view has been reiterated by various High Courts including the Bombay High Court in its recent judgement in the case of CIT vs. Emirates Commercial Bank (262 ITR 55).

This suggests that the restrictive provisions in Section 44C with regard to allow ability of head office expenses should apply only in case of a branch scenario. An issue arises whether the restrictive provisions could apply in case of a project office scenario, where a project office is established for carrying out some projects in India.

Under the I-T Act as well as Fema, practically, a project office is considered at par with branch office and consequently, restrictive provisions could also apply to a project office. This aspect was considered and examined by the Authority for Advance Rulings (AAR) in the case of Bechtel, French (228 ITR 487).

Rule 10 of the Income-Tax Rules, 1962 (the Rules) is applied by the tax authorities, if they believe that the actual income accruing or arising in India to any non-resident (say a foreign company) through any business connection in India or through or from some source of income in India is not possible.

Rule 10 prescribes the mechanism for determination of income attributable to business operations in India. Different methods are prescribed for determination of income and the income so determined will be taxable without any further allowances. Accordingly, where Rule 10 is applied, the world income and expenses, whether incurred in India or outside India are considered to proportionately determine the income attributable to Indian operations.

Rule 10(ii), incidentally also refers to the fact that the profits and gains should be computed in accordance with the provisions of the I-T Act. Therefore, an issue would arise as to whether the restrictive provisions of Section 44C should apply in such a case.

The Bombay High Court in the case of CIT vs. Saudi Arabian Airlines (155 ITR 65) had the occasion to consider this issue. Considering the purpose and intent of introducing Rule 10 as well as the mechanism applied for determining the profits of operations in India, the court held that the application of Section 44C is not warranted where the computation is made under Rule 10(ii). In view of the above, the issue appears to be quite litigative.

It can be observed that the applicability and restrictive provisions of Section 44C is debatable. Therefore, in order to reduce the disallowance exposure, it is critical to structure the arrangement between the head office and its branch having regard to the protection provided in the Tax Treaty and various judicial pronouncements on the issue.

Courtesy: RSM and Co