The Hindu Business Line : Impact of withdrawal of Circular 23

The Central Board of Direct Taxes (CBDT) has withdrawn one of the oldest and most important circulars i.e Circular no 23, of July 23, 1969, and consequently Circulars no 163 dated May 29, 1975, and no 786 dated February 7, 2000, which provided certain further clarifications with respect to Circular no. 23.

These circulars dealt with the concept of income accruing or arising from India through or from business connections in India. Though this concept is well established by various courts, the CBDT found fit to withdraw the old circular on the ground that it was being misused.

REASONS FOR WITHDRAWAL

The Central Board of Direct Taxes (CBDT) has cited the following reasons for withdrawal of the earlier circular:

The interpretation of the circular by some of the taxpayers to claim relief is not in accordance with the provisions of Section 9 of the Income-tax Act 1961 or the intention behind the issuance of circular.

Even when the circular was in force, the Income-tax department has argued in appeals, references and petitions that (a) the circular does not apply to a particular case, or (b) that the circular cannot be interpreted to allow relief to the taxpayer which is not in accordance with the provisions of Section 9 of the Income-tax Act or with the intention behind the issuance of the circular.

SECTION 9 OF IT ACT

This circular explained the applicability of the provisions of Section 9 of the Income-tax Act 1961 and the principles of attribution of profits and principles of business connection. Section 9 of the Income-tax Act 1961 (corresponding to Section 42 of the Income-tax Act, 1922) explains the concept of income deemed to accrue or arise in India for non-residents.

The Section provides that income to a non-resident shall be deemed to accrue or arise in India through or from business connection in India. Further the Section also provides that:

In the case of a business of which all the operations are not carried out in India, the income of the business deemed to accrue under this provisions shall be only that part of the income attributable to the operations carried out in India.

In the case of non-resident, no income shall be deemed to accrue or arise in India to him or through or from operations which are confined to purchase of goods in India for the purpose of export.

It also excludes income from certain activities which are confined to collection of news and views in India for transmission out of India or from operations confined to shooting of any cinematograph film in India.

The business connection shall not include any business activity carried out through a broker, general commission agent or any agent having an independent status if such broker, general commission agent or any other agent is having an independent status acting in the ordinary course of business.

Where a business is carried on in India through a person referred to in clause (a) or clause (b) or clause (c) only so much of the income as is attributable to the operations carried out in India shall be deemed to accrue or arise in India.

APPLICABILITY OF OLD CIRCULAR

The concept of “Business Connection” was explained by Supreme Court in CIT vs R.D.Aggarwal & Co (56 ITR 20).

Post Supreme Court ruling, the CBDT made an attempt to explain the concept of business connection and taxation of non-residents arising out of business connection in various situations.

The said circulars were issued by CBDT in the context of taxation of non-residents and also in the context of taxation under the provisions of domestic tax laws i.e. under the provisions of Income-Tax Act 1961.

The basis of taxation for non-residents in India arises through business connections. The courts have held that the non-resident is liable to be taxed under the provisions of Section 9 based on the concept of business connection which involves concept of control, supervision or a continuous activity in nature.

The Courts have expressed the view unless the non-resident carries out any activity in India which contributes to the profit or revenue of the non-resident the same cannot be brought into tax into India.

The principles of Supreme Court in R.D. Agarwal were again reiterated by Supreme Court in CIT vs T.I.&M Sales Limited (166 ITR 93) and concluded that non-resident is not liable to tax in India on the basis of these principles.

It is important to note that a non-resident is liable to be taxed in India only if he carries out any activity either by himself or through agents and such activity constitutes revenue earning activity for the non-resident. The circular merely clarifies the principles in various situations and concludes that non-residents are not liable to be taxed in India. Hence mere withdrawal of circular does not negate the principles laid down by various judicial precedents in India and those judicial precedents do not become irrelevant merely because the circular is withdrawn.

IMPACT OF WITHDRAWAL

The situations and clarifications of the old circular and the impact of withdrawal of old circular are explained below:

Exim provisions: In the case of a non-resident exporter selling goods from abroad to Indian importer, the circular clarifies the following:

(a) No liability will arise on accrual basis to the non-resident on the profits made by him where the transactions of sale between the two parties are on a principal-to-principal basis.

Further, the circular clarifies that the transactions between the non-resident and resident are carried out on principal to principal basis if (a) the purchases made by the resident or outright on his own account; (b) the transactions between the resident and the non-resident are made at arm's length and at prices which would be normally charged to customers; (c) non-resident exercises no control over the business of the resident and sales are made by the latter on his own account, or (d) payment to non-resident is not dependent in any way on the sales effected by the resident.

The circular clarifies that even if a non-resident hands over the shipping documents against payment or acceptance, no portion of the profits will be chargeable to tax under the Income-tax Act.

Though the aforesaid principles were laid down by circular the said principles were reiterated by courts in various judicial precedents.

Notably the following observations of Supreme Court in CIT vs TI&M Sales Private Limited (116 ITR 93) are more relevant:

"It is true that the Indian company was the sole agent of the Group-B companies. But it appears from the evidence on record that in spite of being the sole agent, the Indian company had no authority given to it by the Group-B companies to accept offers on their behalf. So far as Group-A companies are concerned, there was no privy of contract at all either of agency or of any other variety. In these premises, we cannot but hold that the Indian assessee had no business connections with the non- resident companies belonging either to Group-A or Group-B within the meaning of section 42 of the 1922 Act corresponding to section 9 of the 1961 Act. "

The Explanation 1 (a) to Section 9 provides that in the case of a business which all the operations are not carried out in India, the income of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India. Hence the foreign companies cannot be taxed in India merely because of the sale of goods in India through an Indian importer. The Madras High Court in CIT vs Fried Krupp Industries (128 ITR 27) has held that no part of the activity was carried out in India and the goods were sold on principal to principal basis and the service activities are carried outside India no part of the Income is taxable in India. Hence a mere withdrawal of circular would not make the non-resident liable to be taxed in India on sale of goods to an importer.

It may also be worthwhile to note that the concept of taxation as specified in the circular is based on the provisions of domestic tax laws prior to India signing treaties and development of International Taxation. Under the provisions of the domestic tax law the provision of the act or the treaty whichever is more beneficial is applicable to tax payers. Under the provisions of the Double Taxation Avoidance Agreement the foreign company is liable to be taxed in India only if the foreign company has a Permanent Establishment in India. In respect of the above situation the foreign company by merely selling goods in India does not result in a PE in India and cannot be subjected to tax in India.

Non-Resident Company selling goods from abroad to its Indian subsidiary

The circular clarified that the dealings between a non-resident parent company and its Indian subsidiary can at all be regarded as on a principal-to-principal basis, since the former would be in a position to exercise control over the affairs of the latter. In such a case, if the transactions are actually on a principal-to-principal basis and are at arm's length and the subsidiary company functions and carries on business on its own, instead of functioning as an agent of the parent company, the mere fact that the Indian company is a subsidiary of the non-resident company will not be considered a valid ground for invoking section 9 for assessing the non-resident. Further the circular also clarified that where a non-resident parent company sells goods to its Indian subsidiary, the income from the transaction will not be deemed to accrue or arise in India under section 9, provided that (a) the contracts to sell are made outside India, (b) the sales are made on a principal-to-principal basis and at arm's length, and (c) the subsidiary does not act as an agent of the parent company. The mere existence of a business connection arising out of the parent-subsidiary relationship will not give rise to any business connection, nor will the fact that the parent company might exercise control over the affairs of the subsidiary.

The issue that need to be examined is whether the withdrawal of circular would make the foreign company liable to be taxed in India merely because the foreign company has a subsidiary in India. The principles laid down in the above paragraph are equally applicable in the case of sale of goods to Indian subsidiary too. Further it has been clarified that in article 5.6 of the DTA that mere existence of the subsidiary by itself will not constitute a permanent establishment. Hence mere withdrawal of circular would not make the foreign company liable to be taxed in India.

Principal to principal relation and Arm's length basis

The CBDT circular laid down emphasis on the concept of principal to principal relation in respect of transactions between non-resident and resident in India and the transactions should be carried on arm's length basis. The issue that need to be examined is whether the withdrawal of the circular would negate the principles of taxation of foreign company in India.

The AP High Court in CIT vs Hindusthan Shipyard Limited (109 ITR 158) held and observed that "Whether it is goods that are supplied or services that are rendered, the common thread of mutual interest must run through the fabric of the trading activities carried on outside and inside the taxable territories. That is what has been described by judges as a " real and intimate connection ". The commonness of interest may be by way of management control or financial control or by way of sharing of profits. It may also come into existence in some other manner. But there must be something more than a mere transaction of sale and purchase between principal and principal. Even assuming that the transactions between the foreign company and Indian company are not on principal to principal basis and it is on agency basis does it expose the foreign company liable to be taxed in India. It has rightly been pointed out by the Supreme Court in Carborandum &Co vs CIT (108 ITR 335) the Bombay High Court in Commissioner of Income-tax v. Tata Chemicals Ltd. [1974] 94 ITR 85 (Bom) with reference to the similar or almost identical provisions in section 9(1) of the Income-tax Act, 1961, that in order to rope in the income of a non-resident under the deeming provision it must be shown by the department that some of the operations were carried out in India in respect of which the income is sought to be assessed. Hence in the absence of any activity carried out by foreign company in India merely on account of sale of goods in India the taxation of foreign company in India cannot be justified. In respect of transactions between foreign company and the independent party, the proviso to explanation 2 excludes such transaction. Hence even under the provisions of the Act, the foreign company is subject to tax only if the transaction takes place with a party who is not independent. One of the important tests laid down for establishing the dependency and independence is whether the transaction is carried on principal to principal basis.

The circular laid down emphasis on the arm's length basis between the foreign company and the Indian company whether it is an agent or a subsidiary. The transactions between foreign company and the subsidiary are covered by the provisions of Transfer Pricing regulations and hence it is essential that the transaction should be demonstrated to be at ALP under the TP regulations. In the absence of ALP, under TP regulations, the subsidiary will be subject to adjustment and hence the provisions of the circular to the extent have become redundant.

The principle of arm's length price is a litmus test for the concept of attribution of profits. Hence the compensation at ALP is a significant principle behind the attribution of profits. Explanation 3 to Section 9 provides that where business is carried on in India through the agency relation, so much of income as is attributable to the operations carried out in India shall be deemed to accrue or arise in India. The Supreme Court in CIT vs Hyundai Heavy Industries Limited (291 ITR 482) observed that "The scope of this deeming fiction is mentioned in section 9 of the Act. Therefore, as far as the income accruing or arising in India, income which accrues or arises to a foreign enterprise in India can be only such portion of income accruing or arising to such foreign enterprise as is attributable to its business carried out in India. This business could be carried out through its branch(es) or through some other form of its presence in India such as office, project site, factory, sales outlet etc., (hereinafter called "PE of foreign enterprise"). It is, therefore, important to note that under the Act, while the taxable subject is the foreign general enterprise (for short, "GE"), it is taxable only in respect of the income including business profits, which accrues or arises to that foreign GE in India" The Supreme Court in Morgan Stanley ruling observed that "It is correct in principle in so far as an associated enterprise, that also constitutes a PE has been remunerated on an arm's length basis taking into account all the risk-taking functions of the enterprise. In such cases nothing further would be left to be attributed to the PE" Hence if the agent through whom the business connection is established is compensated for the activities carried out in India based on the combined reading of principles laid down by Supreme Court Hyundai and in Morgan Stanley there could not be further attribution to foreign company in India.

Non-resident purchasing goods in India

The circular provides that - A non-resident will not be liable to tax in India on any income attributable to operations confined to purchase of goods in India for export, even though the non-resident has an office or an agency in India for this purpose. Explanation 1(b) to Section 9(1) provides that in the case of a non-resident, no income shall be deemed to accrue or arise in India to him through or from operations which are confined to purchase of goods in India for the purpose of export. The Bangalore Tribunal in Nike Inc vs CIT detailed the applicability of the above provision. The tribunal observed that "This Explanation says that no income shall be deemed to be accrued to the non-resident through or from operations that are confined to purchase of goods in India for export. The tribunal observed that "There are three ways of purchase. (1) Purchase of goods and receipt of goods at the same time at one place where the office of the assessee is located. (2) Purchase information sent by the assessee but goods dispatched to the various places as directed by it which may be where its sale outlets are located. (3) The assessee as an agent of buyers indicates to the manufacturer the rate at which the goods will be supplied, the names of the buyers and the address of the buyers where the goods have to be sent under intimation to it and that the person so indicated will be the purchaser on whom the bill should be raised and such person shall make the payment also. The Tribunal observed that the purchase by the agent for its, principal is always an activity of purchase by the principal only. The emphasis is on the purchase of goods in India for the purpose of export by the non-resident. Therefore purchase by principal directly or through an agent results in purchase only and hence, according to Tribunal both situations would equally be covered by this provision.

Payment of Marketing Commission

Circular no 23 and Circular no 786 has clarified that where the non-resident agent operates outside the country, no part of his income arises in India. Further, since the payment is usually remitted directly abroad it cannot be held to have been received by or on behalf of the agent in India. Such payments were therefore held to be not taxable in India. The relevant sections, namely section 5(2) and section 9 of the Income-tax Act, 1961 not having undergone any change in this regard, the clarification in Circular No. 23 still prevails. No tax is therefore deductible under section 195 and consequently, the expenditure on export commission and other related charges payable to a non-resident for services rendered outside India becomes allowable expenditure. The circular is based on the principles of income deemed to accrue or arise in India. Mere withdrawal of the circular does not negate the principles of income deemed to accrue or arise in India or outside India. The Supreme Court observed in CIT vs Toshoku Limited (125 ITR 525) held that the non-resident assessees did not carry on any business operations in the taxable territories. They acted as selling agents outside India. The receipt in India of the sale proceeds of tobacco remitted or caused to be remitted by the purchasers from abroad does not amount to an operation carried out by the assessees in India as contemplated by cl. (a) of the Explanation to s. 9(1)(i) of the Act. The commission amounts which were earned by the non-resident assessees for services rendered outside India cannot, therefore, be deemed to be incomes which have either accrued or arisen in India. The said decision of Supreme Court was not based on the provisions of the circular but based on the principles of income deemed to accrue or arise in India and outside India.

Conclusion

The Mumbai High Court in UTI vs PJ Unny (249 ITR 612) concluded that the benevolent circular is binding and even if they are withdrawn, they cannot operate retrospectively, because circulars do not constitute law, which can be retrospectively undone, since they are only in the nature of instructions or guidelines. Further since the principles of income deemed to accrue or arise in India has been well established by courts in various judicial precedents, a mere withdrawal of circular does not negate the principles. The Supreme Court judgement in N.N.Bhagwathi vs CIT (247 ITR 206) and in His Highnes Sir Rama Verma vs CIT( 205 ITR 433) supports the view that the circulars cannot override the judicial precedents. Hence the mere withdrawal of circular does not negate the principles of income deemed to accrue or arise in India and taxation of non-residents due to presence of business connection which has been established by the principles laid down by various judicial precedents.