EPC contracts: New tax tangle

In the past few years, India has witnessed significant industrial development and rapid progress towards development of infrastructure.

Project owners are offering infrastructure and industrial projects to Engineering Procurement & Construction (‘EPC’) contractors. EPC contracts require multiple skill-sets and involve high risk due to the large size of such projects. Hence, various EPC contractors form a “consortium” to bid for such projects. The consortium appoints one of its members as lead member who coordinates with the project owner. Typically, each consortium member executes the work it specialises in.

Divorced of these realities and the business models, the taxman wants to treat these consortiums differently i.e. as an “Associations of Persons” (‘AOP’). In other words, the revenue authorities are taking a position that the income earned by a consortium should be taxed in its hands and not in the hands of each member individually.

 

The term AOP is not defined under tax law. Hence, reference needs to be made to judicial precedence to interpret the same. According to the courts, largely three conditions need to be met for a consortium to be considered as an AOP viz. common scope of work, profit sharing and joint and several liability of members.

The Authority for Advance Ruling (‘AAR’) considered the matter in the case of Van Oord Acz, BV and concluded that the consortium in that case could not be considered as an AOP. The AAR looked into the agreement between consortium members as primary evidence. It observed on the basis of the agreement that there was no intention to carry on business in common with a view to earn profits. The parties formed the consortium solely for coordination in executing the contract. Sharing of profits or losses was not an objective of the consortium.

In a recent case of Geo Consult, the AAR has held that the consortium in that case results in an AOP even where Consortium members were sharing revenue and not profits. AAR emphasised that the preamble of agreement entered into between consortium members shows intention of parties to collaborate for all project work. This project work is to be managed on joint basis and members are to assist each other in completion of the work.

In order to determine whether a consortium constitutes an AOP, Revenue authorities typically scrutinise the manner in which such consortium operates with the project owner. The emphasis is essentially on the extent of coordination between parties to execute the collective scope of work. Does one member provide overall guarantee for project (including for scope of other members)? Are payments for the consortium’s work being made to one member on behalf of all members? Does the scope of work of members overlap? These are just some of the questions that are looked into for determining the extent of co-ordination.

An important aspect which merits attention in this regard is the business arrangement between consortium members. It provides fairly good insight into judging whether elements of AOP are present in the Consortium or not. In addition, there are other related aspects which need consideration. Whether the coordination between members is only for providing a single output to Project Owner? Between members, is each member responsible for completing his own separate scope of work? Is the overall guarantee by one member backed by counter guarantees from other members? Can the members clearly identify their share of revenue in the single payment received from the project owner? Does each consortium member account separately for its own profits/ losses?

To make a fair assessment of whether a consortium should be taxed as an AOP, a detailed analysis is required. The analysis needs to be comprehensive and should take into account the arrangement between the consortium and the project owner on one hand and amongst the consortium members on the other. What is also important is to determine the applicability of AOP as per the provisions of tax law and not from the perspective of how the project owner views the consortium.

This issue also merits further significance as an AOP is considered to be a tax resident of India unless its control and management is situated wholly outside India. Where a consortium is regarded as resident in India, the worldwide income of AOP would be taxable in India. An AOP status can also have a cascading effect since benefits under tax treaties with other countries may not be available to an AOP.

Further, recent judicial rulings have held that income arising to a foreign contractor from offshore supply of equipment is not taxable in India where the foreign contractor establishes that no economic nexus exists between offshore supply and India. In these rulings, the issue of AOP was not raised before Courts. If a foreign contractor is a part of a consortium which is treated as an AOP resident in India, its income from off shore supply may also become taxable in India.

Given that the infrastructure sector is of extreme significance to the country, a move by the government to come up with a position on the status of EPC contractors would be highly welcomed. The government has, in the past, come out with notifications clarifying the status position in case of turnkey power projects and projects involving production of mineral oil. Such a step in the case of EPC contractors would go a long way in encouraging participation of foreign players in infrastructure and industrial development in the country. Above all, it would mitigate unwarranted litigation on this account.

The author is a tax partner in Ernst & Young’s infrastructure practice