INTERNATIONAL TAX: Interest to be taxable as business income under article 7 needs to be effectively connected to such Permanent Establishment (PE)

Facts of the Case:

  • The Assessee is a company incorporated in Japan, having various streams of income like business income from PE in India, income earned as fees from technical services, income from shipping business and income from interest on suppliers’ credit etc.
  • The interest income received by the Assessee from its customers on supplier’s credit on sale of goods (manufactured by other company) by the Assessee or one of its controlled entities. This income was offered to tax @10% as per Article 11(2) of Indo-Japanese DTAA.
  • However, assessing officer (AO) noted that Assessee has a PE in India therefore, lower rate of 10% is not applicable on interest income as per Article 11(6) of Indo-Japanese DTAA and the same should be taxed at 40% as per Article 7 of DTAA.
  • AO’s view was challenged by the Assessee before Ld. CIT(A) and Ld. CIT(A) upheld that the interest income in question is required to be taxed @10% in terms of the provisions of the Article 11(2) of DTAA as there is no connection between the interest income and the permanent establishment.
  • Hence this appeal before ITAT by AO: –
  • Whether interest income is taxable as per Article 11(2) of DTAA knowing the fact that Assessee has a Permanent Establishment in India?
  • Whether interest income was not “effectively connected” with the PE in India knowing the fact that the interest income on loans in the form of supplier’s credit given to those Indian parties who were also the clients of the Assessee in India with whom contracts were executed through the Permanent Establishment.

Hence ITAT Held:

  • As per Article 11(2) of DTAA, interest may also be taxed in the Contracting State in which it arises, and according to the laws of that Contracting State, but if the recipient is the beneficial owner of the interest the tax so charged shall not exceed 10 per cent of the gross amount of the interest.
  • However, as per Article 11(6) of DTAA, the provisions of Article 11(2) will not apply if the beneficial owner of the interest, being a resident of a Contracting State, carries on business in the other Contracting State in which the interest arises, through a permanent establishment situated therein and the interest is “effectively connected” with such permanent establishment. In such a case, provisions of Article 7 of DTAA shall apply.
  • As per Article 7(1) of DTAA, the profits of an enterprise of a Contracting State shall be taxable only in that Contracting State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. And such income is directly or indirectly attributable to that permanent establishment.
  • “Attribution of an income to the permanent establishment” is a degree higher than mere “Connection of an income with the permanent establishment”. While every income attributable to a permanent establishment inherently has a connection with that permanent establishment, the converse is not necessarily and universally correct, as there can be incomes which may have some connection with the permanent establishment and yet the connection may not be material enough to hold that such an income is attributable to that permanent establishment.
  • Article 11(6) does not explicitly provide for taxation of interest income at a rate higher, it only provides a situation in which the interest is “effectively connected” with a PE or a fixed base, the provision of Article 7 will come into play. Hence, unless the taxability under Article 7(1) comes into play, the exclusion clause under Article 11(6) is meaningless.
  • An interpretation of Article 11(6) to make the exclusion clause under article 11(6) meaningless will result in an interpretation contrary to the well-settled principle of interpretation “ut res magis valeat quam pereat”, i.e., to make a legal provision workable rather than redundant.
  • The scheme of Article 11(6) does not visualize a situation in which the source jurisdiction taxability of an interest income under Article 11(2) will be ousted because of the enterprise having a permanent establishment in the source jurisdiction, and such an interest income will also not be taxable under article 7(1) as the interest income is not attributable to the permanent establishment.
  • Therefore, the connotations of the expression “Effectively Connected”, in respect of Article 11(6) read with Article 7(1), must be such that unless the interest income cannot be held to “directly or indirectly attributable to a PE”, the taxation of such an interest income, at a rate higher than article 11(2), does not come into play.
  • In conclusion of the above discussion, an interest income can only say to be effectively connected with a permanent establishment only when such connection leads to taxability in the hands of the taxpayer under Article 7(1).
  • Unless that taxability comes into play, there cannot be any overlapping in the scope of article 11 visà-vis Article 7 and, unless there is such an overlapping of the treaty provisions, there is no occasion for exclusion of one of the overlapping treaty provisions by Article 11(6).
  • Hence, the taxability under Article 7 is a “Sine Qua Non” for triggering the exclusion clause under Article 11(6)
  • Since AO had already indicated that the Assessee had a PE in India and there was presumably some connection between the interest income of the Assessee and the existence of the PE however, AO failed to provide any conclusive evidence as to whether such interest income is effectively connected with the PE in India.
  • Therefore, even if the interest income is connected with the Assessee company’s PE, it can only be brought to tax in India, under Article 7 of DTAA (at a higher rate), when the interest income is directly or indirectly attributable to that PE and hence decision of Ld. CIT(A) was upheld.

Case Law:
Deputy Commissioner of Income Tax,
International Tax Circle 3(2)(1), Mumbai
Marubeni Corporation (Japan)

Lakshay Prakash Jonwal, Tax Associate, SW India