1. Cross-border payments: Achieving balance between Withholding Tax and Service Tax December 13, 2008 K R Sekar Krupa Venkatesh

2. Withholding Tax- Scope of Section 195 Any person Responsible for paying to a Non-resident, not being a company or a foreign company Any interest or any other sum chargeable under the provisions of the act (not being income chargeable under the head salaries) Shall at the time of Credit of Such income to the account of payee Or at the time of payment of cash or by cheque or by any other mode, whichever is earlier Deduct income-tax thereon at the rates in force 2

3. Scope of Section 195 Any person - Meaning  Section 195- refers to any person  The definition of “person” under section 2(31) includes  Individual, HUF, Company, firm, AOP, local authority, and every artificial judicial person  Payments from resident to non-residents – provisions applicable  Payments from non-residents to non-residents  SC in Electronics Corporation of India Limited (183 ITR 43)  AAR in P-13(228 ITR 487)  Payments from Branches of foreign company to non-resident  Circular no 740 dated 17-4-1996  Special Bench decision in ABN Amro Bank (98 TTJ 295)  Citi Bank vs CIT (259 ITR 377)  Does it apply in respect of payments by agents  Post 1-6-1987 it applies 3

4. Scope of Section 195  Applies to Income  Scope of the meaning “Income” Status of RBI Approval  United Breweries Limited vs ACIT (83 Taxmann 263)(Kar)  Pfizer Limited vs CIT (259 ITR 391) Status of reimbursement of expenses  Nature of reimbursement of expenses  What is the contractual responsibility  Difference between Administrative expenses and services  If it is towards service no reimbursement argument  The decision is always on facts  Calcutta High Court in Dunlop Limited  AAR rulings -Decta Limited, Danfoss Industries and Timken Limited 4

5. Scope of Section 195 Marketing fees/agency Commission  Circular no 63 dated 23 rd July 1969  CIT vs Toshoku Limited (125 ITR 525) Payment of Salaries  195 is not applicable  HCL Infosystems Limited vs CIT (274 ITR 261) ( Del) Payment of Royalty and Technical Services  9 (1) (vii) vs DTAA  DTAA shall apply if it is beneficial Responsibility of person paying  SC in Transmission Corporation Case (293 ITR 587) Rates in force  DTAA rates vs Finance Act rates whichever is more beneficial 5

6. Vodafone Case - Facts 6 Mauritius Company HEL 100% shares Sale of shares of CGP to Vodafone CGP HTIL Vodafone JV - 67% owned by Hutch group balance by Essar Group Revenue’s Contention: Vodafone liable to Withhold tax

7. OBSERVATIONS / JUDGEMENT OF BOMBAY HIGH COURT Subject matter of transaction between Vodafone and HTIL is transfer of interests, tangible and intangible in Indian companies of Hutch Group in favour of Vodafone and not an innocuous acquisition of shares of CGP Prima facie, HTIL has earned income liable for capital gains tax in India as the income was earned towards sole consideration of transfer of its business / economic interest as a Group, in favour of Vodafone Under the share transfer agreement, FIPB approval was mandatory and Vodafone reserved the right to cancel agreement if FIPB does not grant approval Under FIPB approval, Vodafone bound to comply with all Indian laws including Indian Income-tax Act Although shares may be an asset, they also may be merely a mode or vehicle used to transfer some other asset(s) (as in the present case) Vodafone becomes a successor in interest in the JV between HTIL and Essar Group and also becomes a co-licensee with the Essar Group to operate mobile telephony in India 7

8. OBSERVATIONS / JUDGEMENT OF BOMBAY HIGH COURT Purpose of transaction was:  To enable Vodafone to acquire controlling interest in HEL by acquiring direct and indirect equity and loan interest  To acquire the right to manage HEL by appointing its own directors on the board  To enable Vodafone to successfully pierce the Indian mobile market to enlarge global presence Controlling interest must necessarily be preceded by extinguishment of right, title and interest in the shares of the Indian group Divestment in interest of enormous value in shares by HTIL would result in enduring benefit and acquisition of a capital asset in India by Vodafone, resulting in capital gains in the hands of HTIL chargeable to tax in India On question of extra-territorial jurisdiction, Reference to ‘Effects Doctrine” in US – any state may impose liabilities, even upon persons not within its allegience, for conduct outside its borders that has consequences within its borders which the state represents Having admitted that HTIL has transferred 67% interest in HEL qua shareholders, FIPB, statutory authorities in USA/ Hong Kong, neither Vodafone not HTIL can take a different stand before Indian tax authorities 8

9. Validity of show cause notice Vodafone has not submitted primary / original agreement, subsequent documents / agreements with HTIL; constitutional validity of the income tax provisions cannot be gone into Question on taxability can be gone into only by concerned authorities and cannot be determined on the basis of affidavits / counter affidavits in writ proceeding. Vodafone has not been able to demonstrate that show cause notice is totally non-est in law for absolute want of jurisdiction of the authority to even investigate into the facts, by issuing a show cause notice The case involves investigation into voluminous facts on the basis of which the question of chargeability to tax and the question of duty to deduct tax can be determined Rights of Vodafone are fully safeguarded u/s 195(2), 195(3) and 197 of ITA Show cause notice cannot be termed extraneous/ irrelevant / erroneous/not based on any material at all 9

10. Refund of Tax withheld u/s 195 Possible under limited circumstances: (a) the contract is cancelled and no remittance is made to the non-resident; (b) the remittance is duly made to the non-resident, but the contract is cancelled Circular No 769 Circular No 790 dated 20/04/00 10

11. Discussion on specific issues: A. Software Expenses B. Data Connectivity C. Secondment Charges D. Management Charges

12. Software Expenses

13. 13 Sources of Income in Software Industry Development of software (copyright rights) Reproduction and licensing of software (as an industry norm, software are sold through license agreements and the rights in software generally remain with the developer) Implementation services Regular maintenance services Updation services Warranty Services.

14. 14 Software Types Shrink wrapped software Example: 1. Microsoft Vista 2. Microsoft Office Customized software Example: 1. Specialized billing software for a company 2. Inventory management software software Customization services Example: 1. Customization of ERP Software

15. Copyright Rights Copyright rights refers to the legal right to control the production and selling Per the Internal Revenue Service, USA, copyright rights refer to  the right to make copies for distribution to the public  the right to prepare derivative programs  the right to make a public performance of the program, and  the right to publicly display the program Copyright is a capital asset of intangible nature Grant of right to use of copyright for further production and/or selling amounts to royalty income Outright sale of copyright amounts to capital gains 15

16. Copyrighted Articles Copyrighted articles refer to the final products developed from the use of copyright Per the Internal Revenue Service, USA if a person acquires a copy of a computer program but does not acquire any of the four copyright rights, the transfer is classified as a transfer of a copyrighted article It further provides that a copyrighted article as a copy of a computer program from which the work can be perceived, reproduced, or otherwise communicated, either directly or with the aid of a machine or device Shrink wrapped software are generally copyrighted articles Income from sale of copyrighted articles is generally treated as business income 16

17. Whether royalty or business income - OECD Commentary after amendments to Article 12 Arrangement between software copyright holder and a distributor intermediary Distributor gets right to distribute copies of the program without the right to reproduce the program In these transactions, the rights acquired in relation to the copyright are limited to those necessary for commercial intermediary to distribute copies of software program In such transactions, distributor is paying only for the acquisition of the software copies and not to exploit any right in software copyrights Hence the rights of the distributor should be disregarded for the purpose of analyzing the transactions Payments for these transactions should be covered under Article 7 and not under Article 12 17

18. India’s position on Article 12 India has reserved the right to include in the definition of royalties payments for the use or right to use, industrial, scientific or commercial equipment India has reserved the right to tax royalties and FTS on source basis India has reserved the right to define these by reference to domestic tax law India may define the ‘source’ which may extend beyond the source as mentioned in Para 5 of Article India does not agree with the position on Royalty on Software as explained in various examples. India is of the view that the same is considered as “royalty” India does not agree with the interpretation that information concerning industrial, commercial or scientific experience is confined only to previous experience 18

19. Data Connectivity

20. Connectivity charges Software Developer Outside India India Customer VSNL AT & T SingTel STPI International portion India portion Earth stations uplink downlink HOTLINE

21. Tax Issues Is it taxable as Royalty  Right to use Equipment  Right to use process Is it taxable as Fees for Technical Services 21

22. Right to use Equipment There must be physical contact between the user and the equipment Use or right to use depends on the relation which exists as a matter of fact between the person and the property. (Tourapark Pty Ltd v FCT (12 ATR 842) Criteria for Determination of Right to Use or Use of Equipment (OECD TAG Report)  Customer has physical control/possession over the equipment  Customer has significant interest in the equipment  Provider does not guarantee revenues  Provider does not use the property concurrent to provide services to others Hence payment for connectivity charges cannot be termed as use of process 22 Recent AAR Decisions : Dell International Services Pvt Ltd (172 Taxman 418) & ISRO Satellite Centre (AAR no. 765 of 2007)

23. Right to use Process Process for the purpose of royalty should be understood and interpreted with regard to the process as understood under Patents Act. Under Patent Law, process indicates secret processes, formulas and techniques connected with the manufacture. The transaction of connectivity charges is not for process but for getting the signals. The user does not get any knowledge on process or acquainted with the process Hence payment for connectivity charges cannot be termed as use of process 23

24. 24 Fees for Technical Service Technical service contemplates rendering of a “service” to the payer of a fee. Fees for technical services could only be meant to such things as are capable of provided by way of a service or fee. Mere collection of fee for use of standard capacity does not amount to fee for having been provided for technical services. The fact Telephone Service Provider has installed sophisticated equipment in the exchange to ensure quality connectivity does not on that core make it as a provision of technical service.

25. Secondment Charges

26. Secondment of Personnel Creation of a PE  Fixed Base  Service PE Options to mitigate PE Risk  Transfer of payroll to the Indian company  Cross Charge of salary 26 Supreme Court decision in the case of Morgan Stanley (292 ITR 416)

27. Secondment of Personnel Cross charge of salary- Issues  Withholding tax on the cross charge  Adverse AAR Ruling in the case of AT&S India Private Limited (287 ITR 421) Service Tax on Secondment 27 Important consideration in secondment Employer-Employee relationship

28. Management Charges – Transfer Pricing Issues

29. Management Charges - Meaning 29 Marketing + Sales Support Customer Service Support Legal and Related Support Services Finance, Accounting & Service Support Management Charges Taxability : FTS / Make Available

30. Transfer Pricing Officer’s stand Contend that the payment of management charges were unjustifiable The broad premise for adopting such a stance are:  No “tangible” evidence of benefits accruing from such services;  Inadequate proof of “tangibility” in rendering the services;  None of the comparable companies identified pay such charges 30

31. Justification for Management Charges Management fees are consideration for expertise availed by a business operating in a nascent market/niche segment Charges for services rendered by the parent for improving a subsidiary’s prospects; Payments for lending skill sets unique to the business in question Sweden Supreme Court Decision - Dow Sverige AB vs. Swedish tax authorities : The Supreme Court held that a deduction is allowed for costs attributable to shared services received and paid for by a Swedish subsidiary from its foreign parent. The Supreme Court also noted that that all related Companies applied the same allocation method. 31

32. Service Tax

33. Import of Services – Evolution of the concept 33 DateSignificance 16 th Aug 02Insertion of Clause (iv) in Rule 2(1)(d) to include the recipient of service in the definition of ‘person liable to pay’ service tax 1 st Jan 05Issue of Notification 36/2004 dated 31 st Dec. 2004, effective 1 st January 2005 16 th June 05Explanation to Section 65(105) inserted 18th April 06Taxation of Services (Provided from outside India and received in India) Rules, 2006; Explanation to Section

34. Effective date – the raging controversy 16 th August 2002 virtually ruled out Current controversy is on account of decisions in  Hindustan Zinc Ltd. Vs.  Foster Wheeler 2007-TIOL-785-CESTAT-AHM  Referred to Larger Bench 34

35. Taxation of Services (Provided from Outside India and Received in India) Rules, 2006 Commonly known as Import of Services Rules  With effect from 19.04.2006  Services placed in three categories for determining ‘import’  Recipient of service liable to pay tax  The amount has to be paid in cash; no adjustment against CENVAT credit can be done  Service tax paid as a recipient is available as credit for future liability Largely inspired by the UK Place of Supply Rules 35

36. Classification of Import of Services 36 Taxable services are divided into three categories for determining import Category I Category II Category III Based on location of Immovable Property Based on Performance Based on location of recipient Rule 3 (i) Rule 3 (ii) Rule 3 (iii) Common condition: Receipt of consideration in foreign exchange

37. Some typical examples

38. Management Re-charges 38 Parent company Subsidiary Outside India India Management re-charges One of the most common form of re-charges Generally flows from a management services agreement Cost allocated usually on some rational basis, most common of which are head count, time spent, turnover, etc. on cost-plus basis Services are generally in the nature of advice on day-to-day operations of Indian subsidiary

39. Service Tax Implications 39 More often than not services categorized as ‘management consultant’ services Placed in Category III service Onus to discharge tax on recipient of service Tax paid available as credit for set off or refund, as the case may be

40. Secondment of Personnel 40 Parent company Subsidiary Outside India India Secondment of personnel Common arrangement with expatriate employees Assignees continue to be on the rolls of the parent company for continuation of social security benefits

41. Service Tax Implications 41 Would create a client-service provider relationship between the Indian subsidiary and parent company Leviable to service tax under the category ‘manpower supply’ Payable on entire salary Creation of an employee-employer relationship may be the answer Dual employment

42. Parent company Subsidiary Outside India India Cost allocation Service provider enters into a global agreement for providing data connectivity to group entities all over the world Charges for connectivity paid centrally Cost allocated to Indian subsidiary on the basis of usage/headcount, etc. Service provider Global agreement services Data Connectivity Charges

43. Service Tax Implications 43 Services provided by a person who has been granted a licence under the Indian Telegraph Act, 1885 If last mile service provider is Indian service provider, he is liable to charge service tax If the service provider is not in India, then possible to take a position that the reverse charge will not apply as he is not a person licenced under the Indian Telegraph Act Same position can be adopted when parent company allocates connectivity charges based on usage

44. Service Tax Implications 44 Raging controversy over levy of service tax on software downloads Customs Duty Vs. Service Tax  Valuation issues where paper licenses are imported and software is downloaded Whether ‘goods’ or service?  Decision in TCS and recent Madras HC decision in Infosys Technologies Sustainability of the levy itself Industry practice  Levy of both service tax and VAT  Service tax on VAT component or vice-versa?

45. Maintenance of Sotware - Service Tax Implications 45 Recently introduced IT services covers maintenance services Overlap with maintenance & repair services Effective date  1 st July 2003 or 7 th October 2005 or 16 th June 2008? Effective date Decision of Tribunal in Nokia case  Whether argument under consulting engineer is still available? Remote maintenance  If software resides in India, then the maintenance service is imported, irrespective of where the service is performed from

46. Thank you