Lease line charges are not royalty – Pune Tribunal

Where the Transfer Pricing Officer had accepted that payment for bandwidth services was an international transaction in nature of reimbursement and was at arm’s length price, the Assessing Officer cannot treat the same as royalty taxable in India and disallow expenditure u/s 40(a)(ia) of the Income-tax Act, 1961 [T-3 Energy Services India Pvt Ltd, ITAT order]

A. Facts of the case

The assessee is engaged in the business of the manufacturing of Industrial valves & valve components. During the relevant assessment year 2010-11, the assessee paid certain sums to its parent company (“associated enterprise”) as reimbursements for bandwidth services in respect of Indian operations. The associated enterprise had entered into contract with a foreign service provider for availing bandwidth services and the associated enterprise in turn, passed on services to its subsidiaries. The associated enterprise made payment to the foreign service provider as per its contract and thereafter, amount in respect of Indian operations was reimbursed by the assessee to associated enterprise. The revenue authorities disallowed the said expenditure of reimbursement u/s 40(a)(ia) of the Income-tax Act, 1961 (“Act”) for non-deduction of tax stating that the payment was in nature of royalty/fees for technical services taxable in India.

B. Contentions of the taxpayer

  • The Transfer Pricing Officer (“TPO”) had accepted that the transaction was an international transaction in nature of reimbursement of expenses at arm’s length price. The order of the TPO is binding on the Assessing Officer (“AO”) and therefore, the payment cannot be treated as royalty.
  • The lease lines charges paid to the associated enterprise did not amount to royalty under Double Taxation Avoidance Agreement between India and USA and therefore, no tax was required to be deducted.
  •  The reimbursement was made on cost-to-cost basis and there was no element of profit embedded in it and therefore, no liability to withhold tax arise.
  •  The assessee was not privy to the contract between the associated enterprise and the foreign service provider but one of the beneficiaries of the contract for which amount was reimbursed to associated enterprise.

C. Contentions of the revenue authorities:

  •  The lease line charges were payment for use of ‘process’ falling in the definition of royalty under Section 9 of the Act. The amended definition is also applicable to the year under consideration by virtue of retrospective effect of the amendment.
  •  The provisions of the DTAA in respect of royalty are in consonance with the provisions of the Act and therefore, the same is taxable under DTAA also.
  •  Mere routing of payment through associated enterprise cannot change the character of service which falls under definition of royalty.

D. Order of the Tribunal

  • Extension of amended definition in the Act to DTAA

The Tribunal, relying on the judgment of the Hon’ble High Court of Delhi in Director of Income-tax v. New Skies Satellite BV1 (“New Skies Satellite”) held that the amendment in Section 9(1)(vi) cannot be extended to the DTAA by unilateral amendment in domestic legislation. Since, the definition of royalty under the DTAA does not include payment made for lease line services in its ambit, the said sum is not taxable in India in absence of Permanent Establishment.

  •  Acceptance of international transaction to be at arm’s length price by the TPO

The Tribunal held that once an international transaction has been accepted by the TPO to be in nature of reimbursement of expenses and at arm’s length price, the order of the TPO is binding on the AO, not only in respect of determination of arm’s length price of transaction but also with respect to character of international transaction. The AO was not justified in treating it as royalty taxable in India.

  •  Reimbursement of charges not including any income element is not subject to tax in India

The Tribunal held that the assessee had reimbursed the expenses having no element of income and therefore, there is no requirement to withhold tax out of such payment. The Tribunal rejected the argument of the revenue authorities that it was a payment of royalty to third party routed through its associated enterprise. The tribunal noted that the privity of contract was between the associated enterprise and the foreign service provider, the assessee had only reimbursed the associated enterprise for services passed on it.

E. Our Comments

  •  While, this decision follows the view favourable to assessees, that the amendment in definition of royalty in the Act cannot be extended to the DTAA unless a corresponding amendment is made thereto. However, contrary view still exists as taken by the Hon’ble High Court of Madras in Verizon Communications Singapore Pte ltd. v. Income-tax Officer, International Taxation2 where the Hon’ble High Court had held that consideration paid for bandwidth services is 'royalty' within the meaning of Explanation 2(iva) or in the alternative under Explanation 2(iii) of section 9(1)(vi) of the Act as well as under Article 12(3) of the DTAA between India and Singapore as the provisions of the Act and DTAA are pari materia. It is however not out of context to mention that the appeals against both the judgments are pending adjudication before the Hon’ble Apex Court.
  •  Moreover, the decision affirms the view of the Hon’ble High Court of Bombay in Vodafone India Services (P) Ltd v. Union of India, Ministry of Finance, New Delhi3 that the order of the TPO is binding on the AO in all respects and the AO cannot sit over order of TPO. However, it is pertinent to note that the similar issue also came up before the Hon’ble High Court of Delhi in Commissioner of Income-tax v. Cushman and Wakefield India (P) Ltd4 where the High Court left the issue ‘whether the assessing officer had jurisdiction to re-examine the character of international transaction accepted by the TPO to be at arm’s length price’ open given its wide ramifications and importance.
  •  Further, it is significant to note that discussion over the routing of payment through associated enterprise as a veil to shadow profit element remains academic if the payment cannot be treated as royalty/fees for technical services taxable in India as per DTAA.