Clough Engineering Ltd

8/4/2019 Clough Engineering Ltd

http://slidepdf.com/reader/full/clough-engineering-ltd 1/10

[2011] 11 taxmann.com 70 (Delhi)(SB)

IN THE ITAT DELHI BENCH 'B' (SPECIAL BENCH)Assistant Commissioner of Income-tax*, Range-I, Dehradun

v.

Clough Engineering Ltd.

R.V. EASWAR, PRESIDENT R.P. TOLANI, JUDICIAL MEMBER AND K.G. BANSAL, ACCOUNTANTMEMBER

IT APPEAL NOS. 4771 & 4986 (DELH I) of 2007

[ASSESSMENT YEAR 2003-04]MAY 6, 2011

Section 90 of the Income-tax Act, 1961, read with articles 7 and 11 of the DTAA between India and

Australia - Double taxation relief - Where agreement exists - Assessment year 2003-04 - Assessee, a non-

resident company, was having its PE in India - It entered into contract with certain Indian Companies -Major scope of work was in respect of designing, engineering, procuring, fabricating, installing, laying pipe

lines, testing, pre-commissioning of off-shore platform, etc. - Income declared by assessee-company interalia included interest on income-tax refund - Assessee's case was that interest income was taxable at rate

of 15 per cent on gross basis in view of provision contained in paragraph No. 2 of article 11 of the Indo-

Australian Double Taxation Avoidance Agreement - However, Assessing Officer was of view that interestincome was taxable under article 7 read with paragraph No. 4 of article 11 as interest had been paid on

refund of tax deducted at source, made from business receipts and, thus, it was directly connected with

business receipt - Commissioner (Appeals) upheld assessment order - Whether even if debt was connectedwith receipt of PE, it could not be said to be effectively connected with such receipts because

responsibility to pay tax lay on shoulders of assessee-company from final profit ascertained as on last dateof previous year and on closing books of account - Held, yes - Whether, moreover, in view of fact that

interest was not effectively connected with PE either on basis of asset-test or activity-test, it was taxable

under paragraph No. 2 of article 11 of DTAA - Held, yesFACTS

The assessee was a none-resident company. It had a PE in India. The assessee entered into contract withONGC, 'C' Ltd. and 'N' Ltd. The major scope of work was in respect of designing, engineering, procuring,

fabricating, installing, laying pipe lines, testing, pre-comm issioning of off -shore platforms etc. The income

declared by the assessee-company inter alia included interest on income-tax refund. The assessee's casewas that interest income was taxable at the rate of 15 per cent on gross basis in view of the provision

contained in paragraph No. 2 of article XI of the Indo Australian Double Taxation Avoidance Agreement

('DTAA'). However, the Assessing Officer came to the conclusion that the interest income was taxableunder article VII read with paragraph No. 4 of article XI as the interest had been paid on the refund of tax

deducted at source, made from business receipts and, thus, it was directly connected with the business

receipt. On appeal, the Commissioner (Appeals) upheld the order of the Assessing Off icer.

On second appeal:

HELD

The gist of the provision of section 90(2) is that in a case where the provisions of the DTAA apply to an assessee, the provisions of this Act shall apply to the extent they are more beneficial to that assessee. It is

necessary to have proper appreciation of the words 'more beneficial'. Although this point had not been

elaborated upon by any of the contending parties, it was clear that application of the provision could be made after ascertaining - ( i ) tax payable by the assessee under the DTAA, and ( ii ) tax payable by the

assessee under the Act. If tax payable under the Act is lesser than the tax payable under the treaty, it can

be concluded 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 than the tax payable under the Act, he shall have the benefit of

the DTAA. If the income of the assessee was computed under the head 'other sources', the net income by way of interest received from the income-tax department would amount to Rs. 61,04,944. This amount

wou ld be taxed at the rate applicable to a foreign company, which was more than 15 per cent. Therefore,

on making the assessment of tax under the treaty and the under the Act, it was found that tax payable under t he Act was more than the tax payable under the treaty. Accordingly, the aforesaid provision would come to t he aid of the assessee to come to an aut omatic conclusion, wi thou t exercise of any option, that it

should get the benef it under t he DTAA. No other consideration was material for t his pur pose as ultim ately what was to be seen was whether the provisions of the Act were more beneficial to the assessee or not.

Page 1 of 10www.taxmann.com

17-08-2011http://localhost:7757/fileopen.aspx?page=caselaws&id=110520110011007000031



Accordingly, it was to be held that the assessee was entitled to the benefit under the treaty. [Para 10]

Article VII of deals with taxation of business profits and also provides for mechanism to compute the

profits of the business. Paragraph No. 4 relieves the source State from the rigors of paragraphs Nos. (1)

and (2) in case the interest is found to be eff ectively connected wi th t he PE, even if it is not in the nature of business income of the assessee but is effectively connected with the PE. If interest is the business income

as a matter of fact, such income falls automatically within the ambit of article VII without even taking recourse of paragraph No. 4. Therefore, this paragraph contemplates a different condition upon whose

satisfaction interest becomes taxable under article VII. It is an accepted cannon of interpretation that no part of t he statu te should be rendered null and void by interpretation. Therefore, some meaning has to be

placed on the contents of this paragraph. [Para 11.2]

In the instant case, the fundamental question was as to whether the debt-claim in instant case could be said to be eff ectively connected wit h the PE. As already held t hat the claim was connected wi th t he PE in

the sense that i t had arisen on account of tax deduction at sour ce from t he receipts of the PE. How ever, it

was also a fact that payment of tax was the responsibil ity of the foreign company. The same is determ ined after computation of its income and the tax forms not an expenditure for earning the income but an item

of appropr iation of prof it . Therefore, even if t he debt was connected wi th r eceipt of the PE, it could not be said to be effectively connected with such receipts because the responsibility to pay the tax lay on the

shoulders of the assessee-company from the final profit ascertained as on the last the date of previous

year and on closing the books of account . It was for the company to pay the tax f rom any source available with it. It so happened in instant 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 was only the appropriation of profit of the assessee company.However, it cannot be said that the interest income has to be necessarily business income in nature for

establishing the effective connection with the PE because that would render provision contained in

paragraph 4 of article XI redundant. Thus, there may be cases where interest may be taxable under the Act under the residuary head and yet be effectively connected wi th the PE. The bank interest in this case

was an example of effective connection between the PE and the income as the indebtedness was closely

connected wi th the funds of t he PE. How ever , the same could not be said in r espect of interest on income- tax r efund. Such interest was not effectively connected wi th PE either on the basis of asset-test or acti vity-

test. Accordingly, it was to be held that this part of interest was taxable under paragraph No. 2 of article

XI. [Para 11.4]

CASES REFERRED TO

Asstt. CIT v. Pride Foramer France SAS [2008] 22 SOT 204 (Delhi) (para 1.1), B.J. Services Co. Middle East

Ltd. v. Asstt. CIT [IT Appeal No. 2230 (Delhi) of 2007 dated 27-3-2009] (para 1.1), Traco Cable Co. Ltd . v. CIT [1969] 72 ITR 503 (Ker.) (para 5), Atria Power Corpn. Ltd. v. Dy. CIT [2011] 128 ITD 322 / [2010] 7

taxm ann.com 58 (Bang.) (para 5.1), Smt. Padmavati Jaikr ishna v. Addl. CIT [1987] 166 ITR 176 / 32 Taxman321 (SC) (para 5.1), CIT v. Samir Diamond Exports Ltd. [2000] 245 ITR 548 / [2001] 118 Taxman 506 (Bom.)

(para 5.1), Collis Line (P.) Ltd. v. ITO [1982] 135 ITR 390 / 9 Taxman 129 (Ker.) (para 5.1), Madhya Pradesh

State Industries Corpn. Ltd. v. CIT [1968] 69 ITR 824 (MP) (para 5.1), Hapag & Lloyd Container Linie GmbH v. Asstt . DIT (IT) [IT Appeal No. 6214 (Mum.) of 2007 dated 27-12-2010] (para 6.1),ABC, In re [1999]

236 ITR 637/ 102 Taxman 574 (AAR) (para 6.1), Sumi tomo Corpn. v. Dy. CIT [2008] 114 ITD 61 / [2007] 17SOT 197 (Delhi) (para 6.2) and Worley Parsons Services (P.) Ltd., In re [2009] 312 ITR 273 / 179 Taxman

347 (AAR - New Delhi) (para 6.2).

Ashwani Mahajan for the Appellant. Girish Srivastava, Arijit Chakravorty and Manoneet Dalal for the

Respondent.

ORDER

Per K.G. Bansal, Accountant Member. - 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 of Income-tax (Appeals)

[hereinafter referred to as 'CIT(A)'] has erred in treating the interest income as business income directly

connected with Permanent Establishment and taxing the same CIT(A) has thereby erred in ignoring theprovisions of Tax Treaty between India and Australia."

1.1 These appeals were heard by the Division Bench of the Delhi Tribunal on 21-1-2010. It was concluded

that apparently there is a conflict in the decisions taken by the Tribunal in the case of Asstt. CIT v. Pride

Foramer France SAS [2008] 116 TTJ (Delhi) 369 / 22 SOT 204, and B.J. Services Co. Middle East Ltd. v.Asstt. CIT [IT Appeal No. 2230 (Delh i) of 2007 dated 27-3-2009], on this issue. Therefor e, a recomm endation

was made to the President, Income-tax Appellate Tribunal, for constituting a Special Bench to consider

and decide the following ground:-

"Whether the CIT(A) erred in treating the interest income as business income as against 15 per cent asprovided in para 6 of Art icle 12 of DTAA between Ind ia and the UK."

Accepting the recommendation, the President constituted a Special Bench on 3-12-2010 to decide the

aforesaid question.

1.2 In the course of hearing, it was found that the ground required some verbal change to project the real





controversy. Accordingly, after consulting the rival parties, the following question has been drawn up in

place 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 fixeddeposits 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 Indo-Australia Double Taxation Avoidance Agreement?"

2. The facts of the case, as mentioned in the assessment order, are that the assessee-company is

incorpor ated under the laws of Australia. The return w as f iled on 28-11-2003 declaring total i ncome of Rs.

1,49,15,800. The assessee claimed refund of Rs. 2,64,71,450. The return was processed under section 143(1)of the Income-tax Act, 1961 (the Act), on 19-2-2004 and an amount of Rs. 2,37,14,680 was refunded to the

assessee. Thereafter, a notice under section 143(2) dated 13-4-2004 was served on the assessee with a viewto frame regular assessment.

2.1 The assessee has declared contract receipts from ONGC Ltd., Cairn Energy India (P.) Ltd. and Niko

Resour ces Ltd. The contracts are composite and tur n key in nature. The major scope of w ork is in respectof designing, engineering, procuring, fabricating, installing, laying pipe lines, 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 submit ted that this interest income is taxable at the rate of 15 per cent ongross basis in view of the provision contained in paragraph No. 2 of Article XI of the Indo-Australian

Double Taxation Avoidance Agreement (the DTAA). However, the Assessing Officer has come to the

conclusion that the interest income is taxable under Article VII read with paragraph No. 4 of Article XI asthe interest has been paid on the refund of tax deducted at source, made from the business receipts and,

thus, it is directly connected w ith the business receipt.2.2 The matter was agitated before the CIT(Appeals)-I, Dehradun. In the operative portion of his order in

paragraph No. 5.2, it has been mentioned that it is an admitted fact that the assessee-company is carryingon business through the Permanent Establishment (the PE) in India. The interest income is not covered bythe provision contained in section 44BB of the Act. Therefore, it has been held that the Assessing Officer

was right in taxing the interest income as business income.

3. Befor e us, the ld. counsel f or the assessee has submit ted that t he total incom e of Rs. 1,49,15,800 retur nedby the assessee inter alia includes interest of Rs. 61,04,944 received from the Income-tax department and

Rs. 13,899 received from the bank. No dispute has been raised regarding taxability of bank interest under

Art icle VI I r ead wi th paragraph No. 4 of Art icle XI of the DTAA. This leaves us with the taxation of interestof Rs. 61,04,944 received from the Income-tax Department.

4. The ld. counsel br iefly summar ized the history of the case. It is subm itt ed that nor mally interest is taxed

@ 15 per cent on gross basis under Art icle X I of the DTAA. However , if an assessee has the PE in India and

the indebtedness from which interest arises is effectively connected with the PE, then Article VII comesinto operation and the interest income is taxable on a net basis at the rate applicable to a f oreign company.

The Assessing Officer is of the view that the indebtedness is effectively connected with the PE as tax has

been deducted at source from the business receipts. The ld. CIT(Appeals) has agreed with this view. TheDivision Bench of the Tribunal, which heard the case initially, is of the view that there is a conflict indecision in the matter in the case of B.J. Services Co. Middle East Lt d. ( supra ) and Pride Foramer France SAS (sic) ( supra ) and, therefore, the question has been referred to the President for constituting a Special

Bench. The President has constituted such a bench. After consultation the question has been modified to

proj ect the real cont roversy and the modif ied question is acceptable to the assessee.

5. He refer red to the provision contained in section 90(2) of the Income-tax Act to the eff ect t hat where theCentr al Government has entered into an agreement w ith the Government of another countr y outside India

or specif ied terr itor y out side India, as the case may be, under sub-section (1) for granting r elief of tax, or

as the case may be, avoidance of double taxation, then, in relation to the assessee to whom suchagreement applies, the provisions of this Act shall apply to the extent they are more beneficial to that

assessee. In view of this provision, he proceeded at the outset to examine the taxability of interest underthe Act.

5.1 In this connection, it is submitted that interest is normally taxable under the head "Income from othersources", unless the source of the interest is the business of the assessee. He relied on the decision in the

case of Traco Cable Co. Ltd. v. CIT [1969] 72 ITR 503 (Ker.). The assessee-company claimed that the

deposit of the share capital made by the company in the bank was a business carried on by it, asempowered by a clause in its memorandum of association and, therefore, the interest income was the

business income. However, the Hon'ble Court mentioned that the clause in the memorandum merely

authorizes the company to invest and deal with the funds not immediately required, in such a manner asmay be determined fr om t ime to time. Therefore, it m ay be open to the assessee-company to car ry on the

business of investing and dealing with the funds upon securities or otherwise. However, the question inthis case is as to whether the assessee company had carried out such a business as a matter of fact. When

examined in this light, it is found that it has not commenced business and, therefore, amounts notimmediately required in the business have been invested for earning interest income. The receipt of

interest is incidental to the deposits. The f inding of the Tr ibunal is that t he deposit of the share capital hasnot been made with the bank in the course of business. Therefore, it has been held that the interest





amount is taxable under the residuary head. Further, reliance has been placed on the decision of 'A' Benchof Bangalore Tribunal in the case of Atria Power Corpn. Ltd. v. Dy. CIT [2011] 128 ITD 322 / [2010] 7

taxmann.com 58, dealing with interest earned on income-tax refunds. It has been held that the same is

taxable under the residuary head and not as a part of profits and gains of the power-generation business.This decision referred to the observations of the Hon'ble Supreme Court in the case of Smt. Padmavati

Jaikrishna v. Addl. CIT [1987] 166 ITR 176 / 32 Taxman 321, to the ef fect that the cour t is inclined to agree

with the High Court that so far as meeting the liability of income-tax and wealth-tax is concerned, it isindeed a personal one and payment thereof cannot at all be said to be expenditure laid out or expended

wholly and exclusively for the purpose of earning income. Reliance has also been placed on the decision ofHon'ble Bombay High Court in t he case of CIT v. Samir Diamond Exports Ltd. [2000] 245 ITR 548 / [2001]118 Taxman 506 , in which it is mentioned that there is merit in the contention advanced on behalf of the

assessee. Firstly, both the Commissioner of Income-tax (Appeals) as well as the Tribunal have followed the

judgment dated January 8, 1993, in the case of Royal Cushions v. CIT (unreported). Secondly, both theabove authorities have found that both the items, namely, interest on refunds and interest on loans fall

under a different head of income, viz., "Income from other sources". Reliance has also been placed on thedecision in the case of Collis Line (P.) Ltd. v. ITO [1982] 135 ITR 390 / 9 Taxman 129 (Ker.). It is mentioned

that the assessee is not a banking company. It had not deposited the money by way of money-lending as a

business. That is not its object. The interest arose from amounts deposited in bank otherwise than by wayof business. The amount was deposited because money was lying idle and it was safer and wiser to put it

in the bank. The interest thereby earned was incidental to main purpose 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 State Industries Corpn. Ltd. v. CIT [1968] 69ITR 824 (MP). It has been mentioned that the ld. counsel appearing for the assessee did not press the

argument that the interest received by the assessee from the bank is receipt of income from money-lending activity. He, however, contended that share monies were monies relating to the business of the

assessee and any interest thereupon would be the business income as the assessee was authorized by its

memorandum of association to invest in and deal with the money of the company in any securities,investments etc. It is further mentioned that for determining whether an act was done in the course of

carrying on the business, it is not sufficient to look at the memorandum of association only but to find out

whether the act done was in pursuance of the objects enumerated in the memorandum. Therefore, it isnecessary to see whether t he 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 the deposits were made

with a view to carry on the business. Accordingly, it has been held that the interest received by theassessee is chargeable under section 56 as income f rom other sour ces.

5.2 Our attention has also been drawn towards the provision contained in section 2(28A) where the term"interest" has been defined to mean interest payable in any manner in respect of any monies borrowed or

debt incurred (including a deposit, claim or other similar right or obligation) and includes any service feeor other charge in respect of monies borrowed or debt incurred or in respect of any credit facility, which

has not been utilized. Therefore, it is contended that interest received from Income-tax Department falls

wit hin the defini tion.

5.3 The case of t he assessee on the basis of t he aforesaid jur isprudence is that the tax deducted at sour ce is

the source on which interest has been received. The tax has been deducted by operation of law and,

therefore, the indebtedness cannot be said to arise in the course of carrying on the business. Accordingly,under the Act the assessee is liable to be taxed on the amount under the residuary head and not under the

business head. In view thereof, the indebtedness cannot be said to be effectively connected with the

business carried on by the PE. The domestic law is equally applicable to the assessee and, therefore, itcannot be said that the indebtedness is connected with the PE of the assessee. Further, the assessee is

entitled to the beneficial provision of or interpretation under the domestic law in view of the provision

contained in section 90(2) of the Act.

6. Coming to the DTAA, the ld. counsel explained the contents of Article XI dealing with taxation of"interest". We will paraphrase the relevant paragraphs of the art icle, which have been r eferred to by t he ld.

counsel, taking into account the facts of our case. Paragraph No. 1 provides that the interest arising in

India to which the assessee is beneficially entitled may be taxed in Australia. Paragraph No. 2 provides thatsuch interest may also be taxed in India, according to the laws of India, but the tax so charged shall not

exceed 15 per cent of the gross amount of the interest. Paragraph No. 3 defines the term "interest" to

include within its ambit interest from Government securities or from bonds or debentures and interestf rom any other form of i ndebtedness as well as all other income assim ilated to income f rom money lent by

the law, relating to tax in India. The case of the ld. counsel is that provisions contained in these paragraphs

are applicable to the facts of t he case. How ever, he also drew our attention towards paragraph No. 4 whichprovides exceptions to the contents of paragraph Nos. (1) and (2). It is provided that these paragraphs shall

not apply if the assessee carries on business in India, in which the interest arises, through a PE situated in

India, and the indebtedness in r espect of wh ich t he interest is paid is ef fectively connected with such PE. Insuch a case, the provisions of Article VII shall apply. It is submitted that the Assessing Officer has invoked

the provision contained in paragraph No. 4 and held that the indebtedness from which the interest arises is

effectively connected with the PE. The case of the ld. counsel is that the payment of tax is the





responsibility of the foreign company and not that of the PE. Therefore, the PE is not the creditor of the

income-tax depart ment. Accordingly, the indebtedness is not effectively connected with the PE.

6.1 In this connection, reliance has been placed on the decision of "L" Bench of Mumbai Tribunal in the

case of Hapag & Lloyd Container L inie GmbH v. Asstt. DIT (IT) [IT Appeal No. 6214/ (Mum.) of 2007 dated27-12-2010], a copy of wh ich has been placed in the paper book (2/ 3) on pages 59 to 74. The question

before the Tribunal was whether, the CIT(Appeals) erred in holding that interest of Rs. 12,44,428 granted

on income-tax r efund is covered by Art icle 11 of the DTAA and, therefor e, taxable in India? The question

was raised in a situation where the case was covered under Ar ticle 8 of the Tax-Treaty between India andGermany. It has been mentioned that interest on funds which are connected with operation of ships or

aircraft in international traffic is covered within the ambit of paragraph (3) for assuming the character ofprofit from operation of ships or aircraft in international traffic. It does not and cannot refer to any

interest other than that. Interest on income-tax refund does not have relation with operation of ships or

aircraft in the international tr affi c and, therefore, it cannot be brought wit hin t he purview of article 8. Areference was made to the ruling of Authority for Advance Rulings in ABC, In re [1999] 236 ITR 637/ 102

Taxman 574 , being a U.K company, in which it has been held that the interest amount in dispute has notarisen out of any bu siness operation in I ndia. It is the statu tory int erest granted on delayed refund under

the provisions of the Act. There cannot be any dispute that the interest has been paid on delayed refund.

Refund due and payable to the assessee is the debt owed and payable. The debt-claim is not connected inany way with any activity of the PE or base in India. The right to get interest arises because of delay in

making refund of the excessive collection of tax. This is clearly a case falling under paragraph No. 2 of

Art icle 12 of the U.K. DTAA. In the decision, it has been mentioned in paragraph No. 11 that the Authori ty

is reminded of the maxim "generalia specialibus non derogant" , according to which a special provisionoverrides the general provision. Therefore, the mandate of an article dealing with a distinct item of

income has overriding effect over that of general article. Adverting to the facts of the case, it has beennoted that although Article VII covers "business profits" but since Article VIII specifically deals withshipping or air transport in international traffic, it is only Article VIII which shall apply in relation to

taxability of profits from operation of ships or aircraft in international traffic. When the contents ofArticle VIII(3) are examined in conjunction with the contents of Article XI, it emerges that interest income

of every kind as referred to in Article XI arising in India and paid to a resident of Germany shall be

subject to tax in India and the mandate of Article VIII shall not apply unless it is specifically coveredunder Article VIII(3). This exception extends only to interest income on funds which are connected with

operation of ships in international traffic. Naturally, interest on income-tax refund cannot have any

relation w ith operation of ships or aircraft in international traffic and hence cannot be brought w ithin thepurview of Article VIII.

6.2 Our attention has been drawn towards the OECD commentary on the model convention. It ismentioned therein that certain states consider that dividends, interest and royalties arising from sources

in their territory and payable to individuals or persons who are residents of other States fall outside thescope of the arr angement made to pr event them f rom being taxed in both the States. Paragraph No. 4 is

not based on such a conception which is sometimes referred to as "the force of attraction of the

permanent establishment". It does not stipulate that interest arising to a resident of a Contracting Statefrom a source situated in the other State, must by a kind of legal presumption or fiction, be related to a

perm anent establishment w hich t hat r esident may have in the latter State, so that the said State would notbe obliged to limit its taxation in such a case. The paragraph merely provides that in the State of source

the interest is taxable as a part of profits of the PE, if it is paid in respect of debt-claims forming part of

the assets of the PE or otherwise effectively connected with that PE. In that case, paragraph No. 4 relievesthe State of source of the interest from any limitation under the Article. It is further mentioned that a

debt-claim in respect of which interest is paid will be effectively connected with the PE and will form part

of its business assets, if the economic ownership of the debt-claim is allocated to the PE. In this veryconnection, our attention has been drawn to the extract of OECD commentary furnished by Shri D.P.

Mittal in his book, which is the same in content as mentioned above. It has also been submitted that the

words "effectively connected with" have not been defined either in the DTAA or the Act. However, ourattention has been dr awn t owards the USA analysis, in w hich i t is mentioned that in general, U.S. treaties

expressly exclude fr om the scope of interest ar ticle interest t hat is att ributable to or eff ectively connected

with either the PE in the source Contracting State through which the obligor carries on business, or afixed base from which the obligor performs independent personal services. Such interest is considered

taxable under the Business Profits or Independent Personal Services articles. This standard is substantially

stricter than that in Article 11(4) of the U.N. Model treaty, under which interest that is effectivelyconnected wit h business activ it ies carri ed on in the source State that are of the same or a simi lar k ind as

those effected through a permanent establishment are taxable as business profi ts. The term "att ributableto", 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 accordance with the law of the Contracting State imposing the tax. Nothingsuggests that the two terms are intended to have different meanings under the treaties. It is alsomentioned that if a non-U.S. person is considered engaged in U.S. trade or business, the enquiry becomes

whether the interest is effectively connected with the trade or business. In the case of U.S. source interest





other t han in the case of banking, f inancing or similar business, is ef fectively connected wit h a U.S. trade

or business if the obligations on which the int erest is paid or used in, or held f or u se in, the conduct of U.S.

trade or business, which is the asset-use test; or the activities of the U.S. trade or business is a materialfactor in realization of the interest, which is the business-activities test. Thus, it is argued by the ld. counsel

that for determining whether the indebtedness is effectively connected with the PE one of the two tests

need to be satisfied. However, if all interest incomes are brought to taxation under Ar ticle VII , it w ill cr eateanomaly in t he sense that paragraph nos. (1) and (2) will be left wi th no content. Further , under Art icle VI I

only that profit is taxed as business profit which is attributable to the PE. In order to support thiscontention, a reference has been made to paragraph No. 60 of t he decision in the case of Sumitomo Corpn.v. Dy. CIT [2008] 114 ITD 61 / [2007] 17 SOT 197 (Delhi), in which it is mentioned that the term "effectively

connected" used in Article XII(5) of the DTAA is not to be construed as the opposite of "legally connected",

but in the sense of something "really connected". This connection has to be seen not in form but in realsubstance. The income-producing activity should be closely connected in terms of relationship besides

being connected economically also with the PE. Reliance is also placed on the ruling of Authority forAdvance Rulings in the case of Worley Parsons Services (P.) Ltd., In re [2009] 312 ITR 273 , a ru ling in the

case of an Australian company. It is inter alia mentioned that t he eff ective connection should be betw een

the royalty generating services and the permanent establishment. The expression "services" is significantand should be given due weight. It is not enough that there is a PE of the non-resident in the source

country carrying out some activities in connection with the project or the work. The PE may be effectively

connected with the project and the contract from a broader prospective but the connection contemplatedby paragraph No. 4 of Article XII is in respect of services that fall within the purview of royalty. The PE or

the fixed base set up in the source country should be engaged in the performance of royalty generatingservices, irrespective of what other activities it performs. At least, it should facilitate the performance ofsuch services. The terminology "effective connection" denotes a real and intimate connection. Coming to

the facts of the case, it is mentioned that it has to be ascertained whether the PE set up in India in

connection with pipelines project work is effectively connected with the services performed by theapplicant under the two agreements. On a deep consideration, the AAR ar e of t he view t hat the applicant

has not been able to make out the effective connection in the sense in which it has been explained earlier.

It has further been mentioned that in order to see whether the payments in the nature of royaltiesreceived by the applicant are taxable in India, the particular agreement under which the royalties have

been received should be considered on stand-alone basis. A lump-sum consideration with a break up of

phase-I and phase-I I, is stipu lated under the agreement and the scope of work s/ services as well as ri ghtsand obligations in the agreements are clearly separate and distinct, though related to one project. It is also

mentioned that the effective connection contemplated by Article XII(4) must be between the services

giving rise to royalty and the PE. That there is overall connection of such services to the project and thefact that such services are essential for the execution of the project is a different aspect. The case of the ld.

counsel is that the same logic shall apply mutatis mutandis while interpreting paragraph No. 4 of Article

XI.

7. In reply, the ld. DR submit ted that although the interest has not ari sen out of t he business transactions,but it is also a fact that tax was deducted fr om the monies receivable in the course of the business of the

PE and, therefor e, there is a dir ect nexus of t he indebtedness with the assets of the business.

7.1 Coming to the analogy taken from the domestic law, it is submitted that if the assessee opts to be taxedunder the DTAA, the classification 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 of Article XI are analogous to the provisions contained in the Act regardingcomputation of income under the residuary head. Elaborating further, it is submitted that if such an

analogy is to be adopted, it should be carried to its logical conclusion. Under the domestic law, the rate of

tax is the same for business head and the residuary head of income. However, if the interest is to beassessed under Article XI (2), it will get taxed on a gross basis at the rate of 15 per cent. If it is to be taxed

under Article VII read with Article XI(4), the normal rate of tax will be applicable on the net income. Thus,

the analogy breaks down when we look to the rate of taxation. The analogy also breaks down for thesimple reason that Article XXII of the DTAA is in the nature of a residuary article, dealing with incomes

not covered under any other provisions. If at all any analogy can be drawn from the Act, it could be only

between Art icle XXII of the DTAA and the residuary head of income in the Act.

7.2 Coming to the treaty, it is elaborated that the expression used is to the effect that indebtedness iseffectively connected wi th t he PE and not that the interest income is eff ectively connected wit h the PE. As

mentioned earlier, the debt arose because of tax deduction at source from the business receipts of the PE.

Therefore, if the FAR analysis is carried out, the asset will have to be allocated to the PE. Accordingly, itcan be very well said that economic ownership of the debt lies with the PE. Thus, asset-test is satisfied in

this case. 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 debtarose. Accordingly, it is argued that both the tests are satisfied.

7.3 It is submitted that the taxation of interest-receipt does not depend upon the reason on account of

which the income arose. It may be due to delay on the par t of the revenue to grant refund bu t nonetheless





the income remains the income and there is satisfaction of asset-test as well as activity-test. Elaboratingfurther, it is submitted that the DTAA is not based on U.S. model but it is based on OECD model. The U.S.

model is altogether different. Therefore, U.S. technical explanation cannot be relied upon for interpreting

the provisions of the DTAA. Coming to the OECD commentary, it is submitted that it is mentioned that ifthe interest is paid in respect of debt-claim forming part of the assets of the PE or otherwise effectively

connected with the PE, paragraph No. 4 relieves the source State from the limitation imposed under

paragraph Nos. (1) and (2) of Ar ticle XI . The commentary contemplates economic ownership of the debt-claim. As mentioned earlier, if FAR analysis is made, the deduction from monies receivable as tax would

fall under the economic ownership of the PE. Therefore, the commentary supports the case of the

revenue. Accordingly, it is urged that the case of lower authorities regarding taxation under Article VIIread wit h Ar ticle XI(4) may be upheld on the ground of economic ownership of the asset held by t he PE.

7.4 It is further submitted that cases dealing with "Royalties" under Article XII are not applicable under

Article XI.

8. In the rejoinder, the ld. counsel clarified that there is no question of opting for taxation under the DTAAsection 90(2) of t he Act pr ovides in express-terms that if any provision of t he Act i s mor e beneficial to the

assessee, the same shall be given effect to. It was further clarified that provisions of Article XII are

analogous to provisions of Article XI and, therefore, it will not be correct to argue that the cases dealingwith royalty or fees for technical services are not applicable. The ratio of these cases shall be applicable

mutatis mutandis to the provisions contained in Article XI. It is also clarified that the treaty does not

contain heads of income. The scheme is that prescription has been made in respect of certain incomes and

what is not covered under the prescription is to be considered under Article XXII. Since there is noeffective connection betw een the PE and the debt-claim, the provisions contained in Ar ticle XI (4) cannot

be invoked.

9. We have considered the facts of the case and submissions made before us. The facts are that theassessee received interest on income-tax refund amounting to Rs. 61,04,944 from the income-tax

department. It also received a sum of Rs. 13,899 as interest from the bank on the fixed deposits placed

with it. No dispute has been raised by the ld. counsel in respect of the bank interest. Therefore, the onlyquestion left now is whether, the sum of Rs. 61,04,944 is taxable on gross basis @ 15 per cent or on net

basis at the rate applicable to a foreign company?

10. We may deal wi th t he question f rom the stand point of section 90(2) of the Act. The provision reads as

under:-

"(2) Where the Central Government has entered into an agreement with the Government of any 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 whom

such agreement applies, the provisions of this Act shall apply t o the extent they are more beneficial t o thatassessee."

10.1 The gist of the provision is that in a case where the provisions of the DTAA apply to an assessee, the

provisions of this Act shall apply to the extent they are more beneficial to that assessee. According to us, itwi ll become necessary t o have proper appreciation of the words "more beneficial". Although this point has

not been elaborated upon by any of the contending parties, it is clear to us that application of t he provision

can be made after ascertaining- ( i ) tax payable by t he assessee under t he DTAA, and ( ii ) tax payable bythe assessee under the Act. If tax payable under the Act is lesser than the tax payable under the treaty, it

can be concluded 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 than the tax payable under the Act, he shall have thebenefit of the DTAA. If we compute the income of the assessee under the head "other sources", the net

income by way of interest received from the income-tax department shall amount to Rs. 61,04,944. This

amount will be taxed at the rate applicable to a foreign company, which is more than 15 per cent.Therefore, on making the assessment of tax under the treaty and under the Act, it will be found that tax

payable under t he Act is more than the tax payable under the tr eaty. Accordingly, the aforesaid provision

will come to the aid of the assessee to come to an automatic conclusion, without exercise of any option,that it should get the benefit under the DTAA. No other consideration is material for this purpose as

ultimately what is to be seen is whether the provisions of the Act are more beneficial to the assessee or not.

Accordingly, it is held that the assessee is entitled to the benefit under the treaty.

11. Coming to the treaty, the facts are that the tax was deducted at source from the business receipts ofthe PE. Therefore, indebtedness is connected with the PE. However, the treaty uses the words "effectively

connected with the PE". The question was referred to the Special Bench for the reason that there is anapparent conf lict of views in the case of Pr ide Foramer France SAS ( supra ) and B.J. Services Co. Middle East Ltd. ( supra ). The admitted position in the case of B.J. Services Co. Middle East Ltd. ( supra ) is that

no dispute existed on the facts that - ( a ) the assessee is a non-resident having a PE in India; ( b ) the

assessee is carrying on the business in India through the PE; and ( c ) the interest is ef fectively connectedwith such PE in India. Thus, there was no dispute in this case regarding existence of "effective connection".

The Tribunal mentioned that in ordinary circumstances paragraph No. 2 would have been made

applicable. How ever , in terms of paragraph No. 6 of Art icle XII , the provisions of paragraph No. 2 shall not





be applicable if the beneficial owner of the interest carries on business in India, in which interest arises

through a PE situated in India and the debt-claim in respect of which interest is paid is effectivelyconnected with such PE in India. As the factual position regarding "effective connection" was not under

dispute, it was but natural for the Tribunal to come to the conclusion that Article XII (6) shall be

applicable read with Article VII. However, in this case, the factual position regarding "effectiveconnection" is under dispute. In the case of Pride Foramer France SAS ( supra ), the assessee had received

interest on income-tax refund. It was pleaded that no conscious effort was made through the PE to earn

the interest except for pursuing the matters before the authorities. It was further pleaded that as theinterest was sui generis , it could not be considered within the purview of Article XII(5). The Tribunalmentioned that Ar ticle XII of the DTAA with UK and France are in pari materia . There is no dispute that

the interest was paid on account of delay by the revenue in grant of income-tax refund. Reference wasmade to an earlier decision of the Tribunal in the case of the assessee in which it was held that the

expenses incurred cannot be set off against interest on income-tax refund because such interest cannot be

termed as business income. Therefore, it could not be said to be attributable to the business activities orderived from such activities. It was merely a fallout of profits earned and appropriation of profits. Taking

a cue from this decision, it has been held that the interest income could not be brought to tax underArticle XII(5) read with Article VII. Another argument was advanced to fortify this decision, namely, that

the assessee is not in the business of obtaining income-tax refund and earning interest thereon. It is

merely the fallout of appropriation of profit and when excess amount is paid to the revenue than what isdue under the Act, the assessee gets the fund and when there is a delay in granting refund, the assesseegets the interest. Therefore, the case of the assessee was accepted by mentioning that it was not business

income but income f rom other sources. We fi nd t hat t he assessee had disputed t he existence of effectiveconnection between the PE and the interest. However, the Tribunal allowed the appeal by drawing

analogy from various heads of income. We are of the view that such analogy is not appropriate. The

reason is that if aforesaid decision is accepted, only that interest whi ch is in t he nature of business incomewill go out of the purview of paragraph No. 4 of Article XI of the DTAA. This is not the intent of the

paragraph. Therefore, we wil l have to examine as to w hether the test of effective connection is satisf ied in

this case or not. And this brings us to the provisions of t he DTAA and jur isprudence thereon.

11.1 Before proceedings with the determination of the issue, the provisions of Article XI of the DTAA arereproduced below:-

"Article XI - Interest-1. Interest arising in one of the Contracting States, being interest to which a

resident of the other Contr acting State is beneficially enti tled, may be taxed in that other State.

2. Such interest may also be taxed in the Contracting State in which it arises, and according to the law

of that State, but the tax so charged shall not exceed 15 per cent of the gross amount of the interest.

3. The term "interest" in this Article includes interest from Government securities or from bonds ordebentures, whether or not secured by mortgage and whether or not carrying a right to participate in

profits, and interest from any other form of indebtedness as well as all other income assimilated to

income from money lent by the law, relating to tax, of the Contracting State in which the incomearises, but does not include interest referred to in paragraph (1) of Ar ticle 8.

4. The provisions of paragraphs (1) and (2) shall not apply if the person beneficiary entitled to the

interest, being a resident of one of the Contracting States, carries on business in the other ContractingState, in which t he interest ar ises, through a permanent establishment situated therein, or per for ms in

that other State independent personal services from a fixed base situated therein, and the

indebtedness in respect of which the interest is paid is effectively connected with such permanentestabl ishment or f ixed base. In such a case, the provisions of Ar ticle 7 or Ar ticle 14, as the case may be,

shall apply.

5. Interest shall be deemed to arise in a Contracting State when the payer is that State itself or apolitical sub-division or local authority of that State or a person who is a resident of that State for thepurposes of its tax. Where, however, the person paying the interest, whether the person is a resident of

one of the Contracting State or not, has in one of the Contracting States or outside both Contracting

States a permanent establishment or f ixed base in connection w ith which the indebtedness on w hichthe int erest is paid w as incur red, and such interest is borne by such perm anent establishment or fi xed

base, then such interest shall be deemed to arise in the State in which the permanent establishment or

f ixed base is situated.

6. Where, owing t o a special r elationship betw een the payer and the person benefi cially ent itled to theinterest, or between both of them and some other person, the amount of the interest paid, having

regarding to the indebtedness for which it is paid, exceeds the amount which might have been

expected to have been agreed upon by the payer and the person so entitled in the absence of suchrelationship, the provisions of this Art icle shall apply only to the last-mentioned amount . In that case,

the excess part of the amount of the interest paid shall remain taxable according t o the law, relating totax, of each Contracting State, but subject to the other provisions of this Agreement."

11.2 In the case of Traco Cable Co. Ltd. ( supra ), the decision under the Act is that for an income to bebusiness income, the actual activities and not the clauses of memorandum of association have to be





looked into. In the case of Atria Power Corpn. Ltd. ( supra ) it has been held that the interest earned on

income-tax refund i s assessable under the residuar y head and it does not for m par t of prof its and gains of

power-generation business. In the case of Samir Diamond Exports Ltd. ( supra ), it has been held thatinterest on refund and loans are taxable under the residuary head and, therefore, do not form part of the

profits of the business computed for the purpose of the deduction under section 80HHC. In the case of

Collis Line (P.) Ltd. ( supra ), it has been held that the main purpose of deposit was to keep idle money safeby depositing into the bank, therefore, the earning of interest was incidental to the main purpose of

keeping the money safe. Such income is taxable under the residuary head. In the case of Madhya Pradesh

State Industr ies Corpn. Ltd. ( supra ), the decision is that the interest earned on share money is chargeableto tax under the residuary head. The case of the ld. counsel, on the basis of the aforesaid jurisprudence, is

that interest received by the assessee on income-tax refund is not the business income. Similar

consideration will be applicable while interpreting paragraph No. (4) of Article XI in respect of the words"effectively connected with such permanent establishment". On the other hand, the case 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.The indebtedness arose as tax was deducted from the business receipts of the PE and, therefore, on asset-

test the indebtedness is effectively connected with the PE. Similar provision exists in the U.K. and France

DTAAs. It is further argued that the provision contained in paragraph No. (4) read with Article VII cannotbe equated with the provisions contained in Chapter IVD regarding "profits and gains of business or

profession". If that is done, the paragraph No. 4 will become redundant. The real test is not whether the

interest is business income or not, but whether the indebtedness is effectively connected with the PE.Therefore, the jurisprudence under the Income-tax Act, which nowhere contains similar words, cannot be

taken recourse to for interpreting the provision. Having considered these matters, we agree wi th the ld. DRthat since the wor ds "effectively connected wi th such permanent establishment" do not f ind a place in theAct anywhere, therefore, the decided cases thereunder cannot form the basis for understanding the real

import of the expression. Article VII deals with taxation of business profits and also provides for

mechanism to compute the profits of the business. Paragraph No. 4 relieves the source State from therigors of paragraph Nos. (1) and (2) in case the interest is found to be effectively connected with the PE,

even if it is not in the nature of business income of the assessee but is effectively connected with the PE. If

interest is the business income as a matter of fact, such income falls automatically within the ambit ofArticle VII without even taking recourse of paragraph No. 4. Therefore, this paragraph contemplates a

different condition upon whose satisfaction interest becomes taxable under Article VII. It is an accepted

canon of interpretation that no part of the statute should be rendered null and void by interpretation.Therefore, some meaning has to be placed on the contents of this paragraph. Accordingly, we proceed with

the other cases relied upon by t he rival parties.

11.3 In the case of Pride Foramer France SAS ( supra ), it w as held that interest on income-tax r efund w assui generis and it was neither derived f rom nor attr ibutable to the business activ iti es of the assessee. It wasalso contended that the assessee is not in the business of obtaining income-tax refund and earning interest

thereon. Therefore, it was held that the same is taxable under the residuary head of income under the Act.

Consequently, it was concluded that the same cannot be related to the activity of the PE. We have alreadyheld that paragraph No. (4) brings within its ambit not merely the interest earned from the business but

something more, i.e., interest on indebtedness which is ef fectively connected wi th t he PE. Interpreting thisexpression on the basis of the heads of income would render this paragraph null and void. Therefore,

wi thout comm ent ing on the merits of the decision, it can be said that this case does not l ay down the law

in entirety as it misses the point mentioned above. The case of B.J. Services Co. Middle East Ltd. ( supra )does not help 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 is carrying on business in India a through a PE situated in

India; and ( ii i ) the interest is effectively connected with such PE in India. However, this decision does notproceed on the footing that only that interest which is part of the business profits can be brought within

the ambit of paragraph No. (4). In the case of Worley Parsons Services Pte. Ltd. ( supra ), the ru ling is thatfor bringing to tax t he royalties received under Arti cle VII read w ith Arti cle XII, there must be eff ectiveconnection between the earning of the income and the PE or the fixed base. This ruling also does not help

us incoming to appropriate conclusion for the reason that royalty is, in general, the business income,

although taxable at concessional r ate in absence of PE or its effective connection wi th the PE or the fixedbase. Such is also the position in the case of Sumit omo Corporation ( supra ). In the case of Hapag & Lloyd

Container Linie GmbH ( supra ), interest on income-tax refund was excluded from Article 8 as it had no

connection with the shipping business. Therefore, it was held to be taxable under Article 11. But this casealso does not t ake us any fu rt her in r egard to controversy before us.

11.4 Thus, we are again left wi th t he fundamental question as to w hether the debt-claim in this case can be

said to be ef fectively connected wi th t he PE. We have already held that the claim is connected w ith the PEin t he sense that it has arisen on account of t ax deduct ion at source f rom the receipts of t he PE. However ,it is also a fact that payment of tax is the responsibility of the foreign company. The same is determined

after computation of its income and the tax forms not an expenditure for earning the income but an itemof appropr iation of prof it . Therefore, even if the debt is connected with the receipts of the PE, it cannot besaid to be effectively connected with such receipts because the responsibility to pay the tax lies on the

shoulders of the assessee-company from the final profit ascertained as on the last date of the previous





year and on closing the books of account. It is for the company to pay the tax from any source availablewi th i t. It so happened in th is case that the tax got automatically deducted fr om 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 profit of the assessee company.However, we may add that we do not venture to say that the interest income has to be necessarily

business income in nature for establishing the effective connection with the PE because that would

render provision contained in paragraph 4 of Article XI redundant. Thus, there may be cases whereinterest m ay be taxable under the Act under the residuary head and yet be ef fectively connected with the

PE. The bank interest in this case is an example of effective connection between the PE and the income asthe indebtedness is closely connected with the funds of the PE. However, the same cannot be said inrespect of interest on income-tax refund. Such interest is not effectively connected with PE either on the

basis of asset-test or activity-test. Accordingly, it is held that this part of interest is taxable underparagraph No. 2 of Article XI. Thus, the ground referred to the Special Bench is partly allowed. TheDivision Bench shall dispose of f t he appeal in confor mit y wi th t his order.

*In favour of assessee.


Documents

Clough Engineering Ltd