DDIT v Toyo Engineering Corpn [2012] 22 taxmann.com 18 (MUM. – ITAT)

The assessee was an engineering company incorporated in and tax resident of Japan. During the year it was, inter alia engaged in executing certain Project Management Contracts with MRPL, HPL and CFCL. On the perusal of these services, it can be seen that the assessee received consideration towards project management contracts on an overall basis towards (i) Project Management Services ; (ii) Local engineering supervision ; (iii) Construction management and supervision services and ; (iv) Start-up assistance services.  These are the four categories in which the assessee has divided its services on a macro level. The breakup of the above categories is:

• Project management services.

–  planning and scheduling;
–  co-ordination with owner and other service providers;
–  cost control;
–  reporting;
–  quality assurance.

• Local engineering supervision

  –  supervision of detailed design and engineering and the procurement services performed by other service providers including, assuring consistency of and confirming the engineering basis of other service providers, checking and reviewing key documents and drawing prepared by other service providers to ensure quality and schedule control and monitoring of major work performed by the other service providers.

• Construction management and supervision services.

–  construction planning and implementation;
–  cost control;
–  material control;
–  construction supervision including testing and pre-commissioning;
–  material test, etc.

• Start-up assistance services

–  Assisting owners during pre-commissioning, commissioning, start-up and performance test of the plant;
–  pre-commissioning;
–  Commissioning and start-up;
–  Performance tests of the complex;
–  Arrangement for training of technical personnel of owner

The assessee followed taxation on net income basis (i.e. revenues less expenses) in respect of its PMC revenues from MRPL, HPL and CFCL. The Assessing Officer took into consideration the relevant clauses of the project management services contracts with MRPL, HPL and CFCL to observe that the same could not be considered as “construction activities” in India. The Assessing Officer observed that in all these contracts the assessee company was not doing any construction activity whatsoever. Accordingly, Assessing Officer held that the revenues from PMCs were liable to be considered under section 9(1)(vii) being fees for technical services. The case of the assessee was held to be covered under section 44D being special provision for computing income by way of fees for technical services on ‘gross income basis’.

HELD:

Fees for technical services under Act

Explanation 2 to section 9(1)(vii) gives the meaning to the expression “fees for technical services” as any consideration for the rendering of any managerial, technical or consultancy services’ including the provisions of services of technical or other personnel ‘but does not include consideration for any construction, assembly, mining or like project’ undertaken by the recipient. Thus one can split this Explanation into two parts viz., including and excluding – ‘including’ the fees for ‘managerial, technical or consultancy services’ and ‘excluding’ the consideration for any construction, assembly, mining or like project.

It has been fairly admitted by the assessee that the actual execution of contracts was carried out in India by local contractors who were appointed by the Indian entities but on the advice of the assessee. it was also admitted that the local contractors had entered into agreements with the Indian entities for construction/erection of the units.

On going through the above clauses of project management contracts with MRPL along with the nature of services rendered by the assessee, it becomes crystal clear that the responsibility for construction/erection of unit is solely that of the local contractor and not that of the assessee. The role of the assessee is confined to rendering managerial, technical and supervisory services in such construction done by the local contractor.

The nature of services provided by the assessee cannot be held as construction or assembly of any project so as to fall within the exclusion part of the Explanation 2. The amount received by the assessee from project management contract with MRPL, HPL and CFCL, is fees for technical services as defined in Explanation 2 to section 9(1)(vii). Resultantly only section 44D applies and hence the assessee was not justified in computing the income on net basis i.e. after claiming deduction under sections 28 to 44C.

Under the DTAA

Having considered the taxability of the amount received by the assessee towards project management services under the Act, one needs to examine the position under Agreement of Avoidance of Double Taxation with Japan (hereinafter called DTAA). The Assessing Officer has observed that since the assessee carried on business in India through a permanent establishment, the profits attributable to the permanent establishment were taxable in India. The assessee’s contention about determination of net income on the basis of article 7(3) of the DTAA was not found acceptable at the Assessing Officer’s end on the ground that there was no express provision in the DTAA providing that the Indian taxation laws will not be applicable for computing taxable income of the permanent establishment.

Since the assessee received fees for technical services which was even though in the nature of its ‘Business Profits’, but such amount being covered under Article 12 was dispatched out of the ambit of Article 7 by virtue of para 7 and came to be covered under Article 12. However, the provisions of para 5 of Article 12 have again sent such fees for technical services back to Article 7. The net effect of para 7 of Article 7 in juxtaposition to para 5 of Article 12 of the DTAA though the assessee received fees for technical services but the same shall be considered under Article 7 itself.

When one reads para 1 of Article 7 in conjunction with paragraph 6 of Protocol, it becomes manifest that these provisions provide for the chargeability of business profits of the Japanese GE in India as are directly or indirectly attributable to its PE in India. However, para 3 of Article 7 read with paras 7 and 8 of Protocol provides a mechanism for determination of the profits chargeable as are attributable to the PE in India as referred to in para 1 of Article 7. Para 3 of Article 7 states that the profits of the PE shall be determined by allowing deduction for expenses which are incurred for the purposes of the PE including executive and general administrative expenses. Even though under the Act there is special provision for computing income by way of fees for technical services in the case of foreign enterprises as per section 44D on gross basis, but such restriction has not been adopted by the DTAA which simply provides that the expenses shall be allowed as deduction which are incurred for the purpose of the PE. Article 7 has been worded in several treaties with other countries providing a limit on the deductibility of expenses subject to the limitations of the domestic law. For example the DTAA with Netherlands provides in para 3A of Article 7 that : “in determining the profit of a PE there shall be allowed as deductions, expenses which are incurred for the purposes of the PE, including executive and general administrative expenses so incurred, whether in the State in which the PE is situated or elsewhere, in accordance with the provisions of and subject to the limitations of the taxation laws of that State. When one compares para 3 of Article 7 of DTAA with Japan and para 3A of Article 7 of DTAA with Netherlands it is observed that the language of this para in both the Treaties is almost similar but for the exclusion of : ‘in accordance with the provisions of and subject to the limitations of the taxation laws of that State’ in the DTAA with Japan. The addition of the last part of para 3A of Article 7 of DTAA with Netherlands has made it clear that all the expenses incurred for the purposes of the PE shall be allowed as deduction but these deductions will have to be within the limits provided under the Act. Thus it can be noticed that in the DTAA with Japan there is no reference to the granting of deductions subject to the limitations provided under the Act. The Assessing Officer applied the provisions of section 44D by taking support from no negative covenant in Article 7(3) about the non-applicability of the provisions of the Act. There is a basic fallacy in this understanding. It is axiomatic that there is difference between ‘deducting the expenses’ and ‘computing the income’. In fact, the process of ‘computation of income’ is a wider concept, which may encompass the ‘deducting of expenses’. However, the deducting of expenses does not include the determination of income, though it may only be a step in such determination of income. In no case can it be said that both are one and the same thing. Scope of Article 7 contains the chargeability at the first instance and then the determination of the such chargeable amount. Para 3 of Article 7 deals with the deductibility of expenses in determining the profits of permanent establishment. When one talks of granting deduction for expenses in terms of Article 7(3), it should not be confused with the computation of income per se. Section 44D is a provision for computation of income and not for granting specific deduction for expenses. Obviously section 44D can have no operationwhen the question is deduction of expenses in computing the business profits.

The expenses mentioned to in para 8 cannot be allowed as deduction in computing the business profits earned by the PE. At the same time, para 7 of the protocol stipulates that in India the deductions in respect of the executive and general administrative expenses shall be allowed in accordance with the domestic law of India. Thus para 7 of the Protocol places restriction in respect of the executive and general administrative expenses by providing that in India the deduction shall be allowed as per the provisions of the Act. At this stage it is pertinent to note that executive and general administrative expenses can be classified into two parts, viz., (i) the head office expenses incurred as per section 44C of the Act incurred by the PE and (ii) other than such head office expenses. Section 44C deals with deduction of head office expenses in case of non-residents.

Thus the effect of paras 7 and 8 of the Protocol read with para 3 of Article 7 is that the total expenses incurred by the PE need to be divided into three broad categories.First category comprising of the expense which are covered under para 8 of the protocol shall not be allowed as deduction.Second category comprising of the expenses in the nature of executive and general administrative expenses shall be sub-divided into further two categories, viz., those incurred outside India referred to as the head office expenses, which shall be restricted as per section 44Cand incurred in India, which shall be allowed deductionas per the limits contained in the relevant sections under the Act. This exercise will give effect to paras 7 and 8 of the Protocol. All remaining expenses shall be covered under the third category which are incurred for the purposes of the PE. Such expenses shall be allowed as deduction in full without any limit as per the provisions of the Act.

The summary of conclusion on this ground is as under:-

A.  Under the Act :

(i)  The receipts from project management contracts are in the nature of fees for technical services covered under section 9(1)(vii).

(ii)  Income from such fees for technical services is required to be computed under section 44D.

B.  As per section 90(2), the assessee is entitled to be governed by the provisions of the Act or DTAA whichever is more beneficial to him. In the present case the provisions of the DTAA are more beneficial and hence the assessee shall be entitled to the computation of its income from PMCs as per the DTAA.

C.  Under DTAA :

(i)  The amount received by the assessee on account of PMC is chargeable as business profits under Article 7.

(ii)  Business profits are to be computed in terms of para 3 of Article 7 read with paras 7 and 8 of the Protocol.