Section 5, read with section 9, of the Income-tax Act, 1961

Held Under section 4, it is total income of every ‘person’ which is taxable. Section 2(31), in turn, defines ‘person’ as including a ‘company’, which in terms of the provisions of section 2(23A), includes a ‘foreign company’ as well. Section 6(4) lays down that a company, unless it is an Indian company or unless it is controlled or managed entirely from India, cannot be said to be resident in India. A foreign company, which is not wholly controlled or managed in India, is, therefore, a non-resident so far as residential status under the Act is concerned. Section 5(2) further lays down that as far as a non-resident assessee is concerned, scope of total income of such an assessee is confined to (i) an income which ‘accrues or arises in India’ or is ‘deemed to accrue or arise in India’, and (ii) an income which is received or is deemed to be received by or on behalf of such foreign company. This elementary analysis makes it clear that under the Income-tax Act, so far as foreign companies are concerned, taxable unit is a foreign company and not its branch or permanent establishment in India, even though the taxability of such foreign companies is confined to (i) an income which ‘accrues or arises in India’ or is ‘deemed to accrue or arise in India’, and (ii) an income which is received or is deemed to be received by or on behalf of such foreign company. [Para 22] A non-resident assessee may have several incomes accruing or arising to it inside India or outside India, but, so far as taxability under section 5(2)(b) in India is concerned, it is restricted to income which accrues or arises, or is deemed to accrue or arise in India. The scope of this deeming fiction is set out under section 9. As for the income accruing or arising in India, an income which accrues or arises to a foreign enterprise company in India can essentially be only such a portion of income accruing or arising to such a foreign enterprise as is attributable to its business carried out in India. This business could be carried out through one or more branches or some other form of its presence in India. To determine income accruing or arising in India to a foreign enterprises [‘GE’], one has to compute income attributable to such branch(es) in India or other form(s) of presence in India such as office, project site, factory, sales outlet etc., [PE] of foreign enterprise. Then, the question arises as to what is the scope of income accruing or arising to a foreign company in India. As far as the expression ‘income deemed to accrue or arise in India’ is concerned, section 9 elaborately deals with the same, but, the expression ‘income accruing or arising in India’ is not defined anywhere in the Act, nor there is any judicial precedent on the scope of this expression. [Para 23] In terms of the provision of the Act, while the taxable subject is the GE, it is taxable only in respect of the income, including business profit, which accrues, or arises to that GE in India. The Act does not provide for any special mechanism for taxation of PE of a foreign enterprise, except taxation on presumptive basis for certain types of incomes such as under sections 44BB, 44BBA, 44BBB, 44D, etc. Its ironical that while the Act deals with the scope of income deemed to ‘accrue or arise’ in India, at great length and visualizing possibly all sort of deeming fictions, there is not much elaboration about the scope of income which ‘accrues or arises’ in India in the hands of a tax entity which has fiscal domicile abroad. Since there are no specific legislative provisions to keep pace with this aspect of increased cross border commerce, by providing for mechanism to compute profits accruing or arising in India in the hands of the foreign entities, the profits attributable to Indian PE of foreign enterprise are required to be computed in terms of general provisions of the 1961 Act, and the normal accounting principles. Therefore, ascertainment of a GE’s taxable business profits in India involves an artificial division of the overall profits of the GE - between profits earned in India and profits earned outside India. The Act can only be concerned with the profits earned in India and, therefore, a method is to be found to ascertain profits accruing or arising in India. The only way, it can be so done is by treating the Indian PE as a fictionally separate profit centre vis-a-vis the GE. The very concept of computation of PE profits is created as a fiction of tax law in order to demarcate tax jurisdiction over the operations of a company in a country of which it is not a tax resident. Unless the PE is treated as a separate profit centre, it is not possible to ascertain the profits of the permanent establishment which, in turn, constitute profits accruing or arising to the foreign GE in India. [Para 24] As a first step to the computation of business profits accruing or arising in India to the GE, the profits of the Indian branch or Indian PE of the German company have to be computed. [Para 25] The proposition that intra-organisation transactions are to be ignored for computing the business profits holds good only when profits of the organisation as a whole are to be computed, or when these transactions are domestic transactions within one single enterprise and within one tax jurisdiction. These intra organisation transactions, which should more aptly be termed as ‘intra organisation dealings’, have a significant impact on the determination of profits of the organizational units - whether termed as permanent establishment or by whatever other description. [Para 27] Cross border dealings within an enterprise, which necessarily concern at least two tax jurisdictions, however, need to be examined in a different perspective - the perspective of ascertaining profits taxable in each such jurisdiction as also the perspective of ascertaining the income eligible for exemption, when tax credit in GE domicile tax jurisdiction is by way of exemption in the GE domicile tax jurisdiction. [Para 28] The computation of profits in each PE State, i.e., each tax jurisdiction, thus, has a dual role. On one hand, this computation decides the quantum of income on which source country can levy the tax, and, on the other hand, this computation also decides, generally speaking, the quantum of income for which tax credit is granted in the domicile country. [Para 29] Therefore, from the point of each source country, it is necessary that the profits of the PE are computed as independent units. [Para 30] The profit neutrality theory from intra-organization transactions, within the organizational units, does not hold valid in a situation in which profits of an organizational unit, whether that unit is termed as a branch or as a PE or is given some other description, are to be computed. This is so for the simple reason that from the point of view of the taxable entity as a whole, an intra-organization transaction could be self-cancelling or profit neutral transaction because an income by one of the organizational units of the entity could be an expenditure of the other organizational unit and, since, to work out overall profits of the entity, the profits and losses of all the units are to be aggregated, the effect of the increased income of say ‘A’ unit will be offset by corresponding decrease in income of say ‘B’ unit. However, when one is to view the same transaction from the point of view of an organizational unit, situation materially changes. An income by ‘A’ unit by earning revenues from ‘B’ unit will result in enhancement of income of ‘A’ unit and corresponding reduction in income of ‘B’ unit. However, as far as computation of profits of ‘A’ unit is concerned, it is immaterial whether there is corresponding adjustment in ‘B’ unit or not. In computation of profits of ‘A’ unit, the adjustments in profits of ‘B’ unit are not at all relevant. That aspect of the matter would be relevant only if profits of the organisation as a whole were to be computed. Similarly, when the profits or losses of ‘B’ unit are to be ascertained, it would be immaterial whether the expenditure by ‘B’ unit can be construed as income of ‘A’ unit or not, because, in that situation, the profits and losses of that unit are to be seen in isolation. [Para 31] In contemporary business situations when economic activities of an organization are spread over several tax jurisdictions, and the right of each such tax jurisdictions is restricted to the profits accruing or arising to the PE in that jurisdiction, it is necessary that profits accruing or arising in such jurisdiction are computed correctly. [Para 32] So far as the profits of the GE as a whole are concerned, the intra organization transactions are indeed profit neutral but, from the point of view of a PE, the intra-organization transactions are not profit neutral. [Para 33] Right from the initial stages, the accounting practices recognized that the intra-organization dealings are to be taken into account, though at an arm’s length price, in computation of the PE profits. That confirms that in order to arrive at the true profits of a branch or the PE, the intra-organization at the arm’s length price is to be taken into account. That is settled accounting position, so far as determination of profits of a PE is to be taken into account. [Para 38] For determination of ‘income accruing or arising in India’ in the case of a foreign GE operating in India, its Indian operations are to be treated as a hypothetically independent unit. Therefore, intra-organization interest income would have to be taken into account to arrive at the income accruing or arising to the assessee in India under section 5(2). [Para 44] The scope and nature of the expression ‘permanent establishment’ has been clarified in section 92F, introduced with effect from 1-4-2002. This section was inserted to define certain expressions, in the light of the introduction of transfer pricing regulations, and these definitions are no more than clarificatory in nature. Section 92 F(iiia) defines ‘permanent establishment’ as a fixed place of business through which the business of the enterprise is wholly or partly carried on. Section 92F(iii) recognizes a permanent establishment also as an enterprise. The effect of this position is that the transaction between a foreign company and its permanent establishment in India is to be viewed as an international transaction between two enterprises - between two associated enterprises though in the light of provisions of section 92A. [Para 61] Section 92(1), read with Explanation thereto, makes it clear that interest transaction between head office of a foreign company, i.e., GE and its permanent establishment in India, i.e., PE is to be accounted as income on arm’s length price. Accordingly, if an Indian PE receives interest from the head office at the rate of 2 per cent per annum, and the arm’s length interest price is, say, at the rate of 5 per cent per annum, the income from this transaction is to be computed at the rate of 5 per cent per annum. Transfer pricing provisions cannot, and do not, introduce new incomes in the tax net, but only provide that incomes from international transactions are to be computed at arm’s length price. The fact that head office - branch office interest transactions are also to be computed as income on the basis of transfer pricing provisions, only confirms, that interest earned by the branch office from head office is a taxable event, so far as taxability of branch office is concerned. [Para 62] Under the provisions of section 80HHC when goods or merchandise are transferred by an assessee to its foreign branch, office, warehouse or establishment [foreign PE] and are sold from such foreign PE, such transfer shall be deemed to be exports and the value of the goods or merchandise stated at the shipping bill would be treated as sale proceeds thereof. It is, thus, clear that intra-organization transactions are also taken into account for the granting of tax incentives to the assessee. When for the purposes of tax incentives PE, GE independence is maintained, taxability of an income must also proceed on PE, GE independence. Therefore, from this point of view also, the income earned by the Indian PE as interest earned from foreign GE is to be taxed in India. [Paras 63 and 68] The assessee had admittedly lent monies to the head office, in consideration of which interest credits were received. These funds were acquired by the assessee by incurring certain costs, such as interest paid to the depositors as also establishment costs. The use of these funds, however, was outside Indian tax jurisdiction and the income earned from these funds, therefore, was exigible to tax outside Indian tax jurisdiction. When the revenues generated are not taxable in India, the expenditure incurred for earning these revenues also cannot be allowed as deduction of income exigible to tax in India. The entire costs of acquiring these funds should then cease to be deductible as an expense for the purposes of business in India. [Para 69] Expenditure can be allowed as deduction only in the tax jurisdiction in which the corresponding income is taxed, or, by the same logic, income is to be taxed in the same tax jurisdiction in which corresponding deduction is to be allowed. Where economic activities to earn an income are spread over two tax jurisdictions, the income can be suitably appropriated in those two jurisdictions, and the provision for intra-organization interest charge does precisely that. [Para 70] Hence, it could not be said that since no one could be expected to make profits out of transactions with himself, intra-organization transactions were to be ignored for the purposes of computing profits accruing or arising, to an Indian PE of a foreign company, under section 5(2)(b). For the purposes of computing profits of a PE, the intra-organization transactions are to be taken into account as long as these transactions are real and bona fide transactions. It was not the assessee’s case that the interest income from the head office was without any consideration or without sufficient consideration. In other words, fact of or correctness of interest earnings from head office were not in dispute. Therefore, the interest earnings from the head office were to be taken into account for the purposes of computing profits arising in or accruing in India. [Para 71] The discussion by the lower authorities on the scope of section 9 was not really relevant, or rather premature. The question of deeming fiction could have been relevant only when the revenue’s case did not succeed on the basic chargeability of ‘income accruing or arising’ in India. Hence, the impugned order was upheld though for different reasons. [Para 73]