Income-tax in India is levied by the Central Government. A Government elected by the Indian Citizens to protect and safeguard them. Hence, it is natural that the Central Government demands tax from its inhabitants (and the businesses carried on in India). It is possible for the government to collect taxes from others (ie non-Indians or people who don’t inhabit in India - let’s call these people non-residents for easier understanding) as well? Surprisingly, yes!
We like analogies – Let us look at it in two ways. Would you be happy to bear the expenses of the person sitting next to you at a restaurant just because you happen to be in the same place? No, I guess. But if you are going down a highway, and you have to pay entry taxes/toll for every state you pass by (even if you do not stay there), you wouldn’t mind it, would you? Why the difference?
Let’s discuss this concept from a taxation perspective.
Residence vs Source
In the long-gone days, Kings collected land revenue from the land-owners in their respective Kingdoms to fund the wars waged/ welfare schemes run in their Kingdom. The practice of levying tax on one’s subjects (‘tax resident’ in modern day parlance) is called ‘residence-based taxation’. In other words, the state levies tax on its residents who benefit from the civilised society the State had to offer.
At times, the Kings also levied taxes on the merchants who visited their Kingdom from the other States. The reason – well, the merchants made a lot of money doing trade in their Kingdom of articles they brought from their homeland and the King just wanted a share of the pie.
This practice of the King in levying taxes on the non-resident merchants doing business in one’s Kingdom is called ‘source based rule’ of taxation. It was justifiable as the business of the travelling merchants had some nexus with the State to which they paid the taxes. Hence, they didn’t seem to complain too much. However, recent developments on the source based taxation in India may not put a smile on the non-residents whom we eagerly invite to invest/ make in India.
Modern day tax law – interest, royalties and service income
The old principle on levying tax on non-residents was later codified in the Indian tax law at the time it was enacted. Non-residents were required to pay tax in India if they did business in India/ derived income from assets or sources in India/ transferred assets located in India.
Until the year 1976, non-residents rendering services from overseas and receiving payments from India were not treated as income having sufficient ‘nexus’ to suffer tax in India. The Supreme Court also upheld that no part of a non-resident’s income can be taxed in India so long as the non-resident rendered his services exclusively from outside India.
Realising a significant scope for increasing tax base, the Legislature promptly amended the Income-tax Act. Conditions under which certain service fees received by non-residents would be taxed in India were provided. A similar rule was provided for non-residents receiving royalty income and interest income from Indian residents as well. Further, under certain circumstances, payments made by non-residents to other non-residents also attracted taxability in India (more on this later).
Even after the above amendment, the Supreme Court in a different occasion held that mere utilisation of services in India does not attract source rule taxation for a non-resident. The Supreme Court added that the services need to be rendered in India as well for the ‘source based’ rule of taxation to kick-in. As one would expect, the Legislature promptly amended the Law to state that it is not necessary for the non-resident to render services in India/ have presence in India to be subject to the aforesaid rule. You have started to see a pattern here, haven’t you?
The Vodafone-Hutch tale
Levying tax on gains made by a non-resident who transfers assets situated in India seems just and equitable. But, it was the case of Vodafone buying Hutch that brought all new focus to this rule. Vodafone acquired the single and only share of a company incorporated in Cayman Islands – that company through a series of subsidiaries held Hutch India which operated the Hutch mobile network in India.
According to the parties, they had not transferred an Indian company’s shares, and, hence the Indian Government lacked the power to tax the transaction. The Income-tax department however, sought to tax the transaction as the shares that were transferred derived its value from the mobile network operating in India. Further, the motive for the transaction was also Vodafone’s acquisition of Hutch.
In a great relief to Vodafone, the Supreme Court held that the transaction does not result in capital gains arising to Hutch, and, consequently Vodafone was absolved of the requirement to withhold tax on the payment made by it to acquire Hutch. The Supreme Court specifically observed that the provisions of the Income-tax Act do not have authority to tax transactions such as the one undertaken by Vodafone – Hutch.
Any guesses on what happened next? Again, the Law was amended (of course, with retrospective effect) to bring transactions such as the Vodafone – Hutch deal within the source rule for taxing capital gains. This was done by deeming the shares of a foreign company to be situated in India so long as such shares derived value substantially from assets situated in India.
Another curious case – Indian tax on a non-resident to non-resident royalty payment
‘OEM’ (non-resident) was a manufacturer of CDMA handsets. ‘OEM’ supplied mass manufactured CDMA handsets to Indian mobile network operators for sale to the customers along with a subscription plan. ‘OEM’ had actually manufactured the handsets under a licence granted to it by ‘Q’, the owner of a particular patent relating to CDMA technology.
The Indian tax authority raised a tax demand on the royalty payments made by ‘OEM’ to ‘Q’, as the CDMA handsets manufactured by OEM were sold in India constituting business activity for OEM in India. The argument was further fortified by the fact that OEM, at the time of manufacture itself had locked the phones to being used only on the network of the Indian CDMA operator(s) to which it sold the phones. The matter went up in litigation to the Tax Tribunal, which has now directed the lower level assessing officer to look at certain facts before arriving at a conclusion.
Conclusion
The above instances only show the eagerness of the Indian tax administration to have a share in whatever has nexus with India, however remote it may be. Someone once said ‘the Government is a 30 percent sleeping partner in whatever business you do’ seems to be a very appropriate view (it is 40 percent for non-residents!). With every country’s tax administration pulling no stops to expand and increase their revenue base, there can never be any shortfall of surprises on this front.
Views expressed are their personal; the writers are senior tax professionals at EY India