Background
Nokia Networks OY (Nokia), a telecommunications systems and equipment manufacturer based in Finland, supplied GSM (Global System for Mobile Communications) equipment to various Indian telecom operators from outside the country on a principal-to-principal basis.
Between 1997 and 1999 Nokia maintained a Liaison Office (LO) in India and also had a subsidiary in India, Nokia India Private Limited (NIPL).
The LO carried out advertising and other preparatory and auxiliary activities in India. In accordance with RBI (Reserve Bank of India) regulations, the LO was not permitted to carry out any business activity.
NIPL carried out installation of equipment supplied by Nokia under independent contracts with the Indian telecom operators.
An amendment to section 9(1)(vi) of the Income Tax Act, 1961, led the Director of Income Tax (DIT) to argue that the sale of software by Nokia was taxable as royalty.
Nokia relied on the definition of royalty under the India-Finland DTA to defend its position. This is a narrower definition than the domestic law definition which was significantly widened by Finance Bill 2012 to include all use of software as being royalty.
The DIT also argued that the supply contract between Nokia and the Indian telecom operator; the installation contract between NIPL and the Indian Telecom Operator; and the marketing and support agreement should be treated as one composite agreement.
Ravishankar Raghavan, of Majmudar & Partners, said by clubbing the offshore supply and the installation contract in Nokia’s case, the tax authorities wanted to treat the entire transaction as a composite contract by showing a common intent of Nokia and its Indian subsidiary.
“The DIT wanted to levy income tax on the entire consideration for the contract – which included the contract for supply of hardware which was concluded outside India – which could be attributable to the functions of Nokia’s Indian subsidiary in India,” said Raghavan.
“Proving that the contracts were but one and showing that a common intention existed between the various parties to the agreement would effectively enable the DIT to argue that part of the consideration for the sale of the hardware was attributable to activities undertaken by Nokia’s Indian subsidiary,” he added.
The court was asked to consider the following questions:
· whether Nokia had a permanent establishment (PE) or business connection in India in the form of a LO or its subsidiary; and
· whether any part of Nokia’s income raised through supply of software embedded in equipment was taxable as a royalty under Section 9(1)(vi) of the ITA or the relevant provision of the DTA.
Ruling
The court held that the LO did not constitute a PE of Nokia in India because its role had only been to assist in preliminary and preparatory work.
The issue of whether NIPL constituted a PE was referred back to the Income Tax Appellate Tribunal because of factual errors in the arguments.
The court said the embedded software was treated as part of the equipment even if there was evidence to separate the components of price between software and hardware, and the right to use the software was not held to be income from royalty and therefore was not taxable under the India-Finland treaty.
The equipment was not subjected to tax in India since the property in the goods was established to have passed outside India and therefore did not lead to a taxable event in India.
Implications
Vikram Bapat, of PwC, said the ruling confirms that DTAs override the provisions of the Income Tax Act and therefore even if the Act is amended, the beneficial provisions contained in the DTAs will continue to prevail.
“The judgment also helps to give clarity that if a LO is found to be genuinely engaging in preparatory and auxiliary activities only, the tax authorities cannot allege that an LO gives rise to a taxable presence merely because an LO is in existence,” said Bapat.
“This helps non-resident companies to rest assured that the tax authorities cannot indulge in frivolous allegations. However, non-resident companies need to be careful that they do not expand or enhance the extent of activities that their LOs in India carry out,” he added.
For an in-depth analysis of the worrying trend of using retrospective amendments, look out for the cover story in International Tax Review’s October magazine.
