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Royalty from permanent establishment taxable on net profit

HP Agrawal 

Fees for Technical Services (FTS) is taxable in India on gross basis, but if FTS arises through a Permanent Establishment (PE) in India, then FTS assumes the characteristics of business income. In such a case, FTS is taxed as business income @40% on net profit basis.

While working out the taxable income on account of FTS (through PE), the following two types of expenses are to be deducted from the gross income:

i) Expenses incurred for earning FTS, subject to the provisions of the Indian Income-tax law, and

ii) Executive and general administrative expenses whether incurred in India or outside India.

While calculating the deductible expenses against FTS, the issue for consideration is whether the restrictions and limitations placed in the IT Act will apply or not. For example, there is a special provision contained in section 44D relating to FTS. As per this section, FTS is taxable @20% on gross receipt basis. Therefore, if section 44D is to be applied, then the rate of tax on FTS will be 20%. On the other hand, where the relevant tax treaty provides a lower rate of tax, then the issue is whether FTS would be taxed @20% on the gross basis as per section 44D or at the rate as provided in the relevant tax treaty.

This issue has been considered by the Hon'ble Delhi High Court in the case of DIT v Rio Tinto Technical services [340 ITR 507].

In the instant case, the assessee computed its net taxable income after claiming the expenses incurred towards rendering the services. The assessee claimed expenses as per the provisions contained in the Indo-Australia Tax Treaty. However, the Ld. AO held that the sums received were taxable as FTS under section 9(1)(vii) of the IT Act, the rate of tax being 20% of the gross amount in view of section 44D of the Act.

The Hon'ble Delhi High Court after detailed discussion held that business income in India is taxable under chapter IV-D "Profits and gains of business or profession" containing sections 28 to 44DB.

Section 44D, which is part of chapter IV-D begins with a non-obstante or an overriding provision, provides that provisions of sections 28 to 44C shall not apply and no deduction shall be allowed in case an assessee, being a foreign company, earns income by way of Royalty/FTS from an Indian concern or Indian Government. Accordingly, the FTS which arose through a PE was finally held as taxable @20% on the gross receipt basis as per the provision of section 44D of the IT Act.

The impact of the aforesaid judgment is that if a foreign company or a non resident is earning FTS/Royalty income from India through a PE situated in India, then such FTS/Royalty shall be taxed as business profits, but the tax will be charged @20% on the gross amount.This interpretation is very harsh towards foreign enterprises earning FTS/ Royalty through PE in India.

The foreign enterprises may however take note of the fact that the aforesaid decision will not have any impact on taxability of FTS/ Royalty earned after 31.03.2003. This is because the above decision has been rendered under the provisions of erstwhile section 44D. The said section has been replaced by section 44DA wef 01.04.2003. Section 44DA provides that in case a non-resident or a foreign company earns Royalty/FTS through a PE in India, then the profit shall be computed under the head profits and gains from business or profession determined in accordance with the provisions of the IT Act.

In other words, the income shall be computed after allowing the deduction available under the IT Act without any limitation that FTS/ Royalty will be taxed @20%.

Therefore, under the law existing at present, despite the aforesaid decision, the FTS/ Royalty earned through a PE in India will be taxed on net profit basis after allowing the deductions as per the normal provisions of the IT Act.

H.P. Agrawal the author is a Sr. Partner in S.S. Kothari Mehta & Co.e-mail:  

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First Published: Mon, March 05 2012. 00:41 IST