AAR re-iterates that intention of parties is supreme in determining whether contracts can be dissected
Recently, the Authority for Advance Rulings (“AAR”) in the case of Mero Asia Pacific Pte Ltd1., has dealt with taxation of payments received by non-residents under a contract involving designing, engineering, supply, fabrication, assembly, erection and installation of goods and materials. The AAR held that in case of such contracts, in the absence of clear demarcation in the contract between supply of goods and services to be performed, the contract has to be looked at as a whole, i.e., as a composite contract. Further, in the context of determining whether payments received under such contract is taxable in India, the AAR analyzed whether or not the sale of goods and materials under the contract was completed outside India. In this case, the sale of goods and materials was made on CIF (cost insurance and freight) basis and invoice for sale was raised when goods and materials were located outside India. However, based on certain factors, the AAR held that the sale could not be considered to have been completed outside India.
In this case, even though the ruling was decided against the taxpayer in light of specific facts involved, on a broader level, the established principle re-iterated by this ruling (that contracts involving sale of goods and supply of services cannot be demarcated unless the intent of the parties to make such demarcation is clear from the terms of the contract) is important from a taxpayer’s perspective.
The Delhi International Airports Private Limited (“DIAL”) floated a global tender for various works in connection with the design and construction of the Terminal 3 at Delhi Airport which was won by Larsen & Toubro (L&T). L&T later sub-contracted the work under another contract (“Sub-Contract”) to Mero Asia Pacific Pte. Ltd. (“Taxpayer”). The Taxpayer is a company incorporated under the laws of Singapore and is engaged in the business of executing contracts in relation to structural glazing and wall cladding works. The Taxpayer has project offices in India for execution of such works contracts. However, in relation to the Sub-Contract, its project offices were not involved except as outlined below.
As per the Sub-Contract, the Taxpayer’s scope of work comprised “Supply of all the materials, shipment and/or transportation, prefabrication/fabrication, erection, installation, inspection, testing and commissioning, including all the necessary enabling and allied activities for the entire subcontracts works.”
Important terms of the Sub-Contract: The Sub-Contract does not expressly indicate when the title to the goods are intended to pass from the Taxpayer to L&T. It provides that the Taxpayer shall provide commercial invoice and certain other documents within 6 days post shipment. It also provides that within 6 days of such documents being provided, L&T and DIAL shall execute a “high seas purchase contract” for the shipment. On arrival of the consignment in India, payment of customs duty and customs clearance are required to be undertaken by the Taxpayer as an agent of DIAL. Further, the Taxpayer has been made responsible for “the timeliness, cost and risk of the shipmen’s delivery to the Project Site” in India. Lastly, consideration is to be paid in parts on completion of identified milestones. The consideration payable is expressed in Indian rupees and the place of payment is Delhi; at the option of the Taxpayer, payments were be made in Singapore dollars in Singapore.
Important events: An invoice dated October 10, 2009 was issued by the Taxpayer to L&T in relation to goods for shipment from Shanghai to New Delhi on CIF basis. Bills of lading show the Taxpayer as shipper and L&T as consignee. A certificate of insurance dated October 12, 2009 shows that insured person is the Taxpayer till the goods reach the site in India. High sea sale invoice dated October 22, 2009 shows that L&T has made high sea sale for same goods to DIAL. The Taxpayer received consideration under the Sub-Contract from L&T in Singapore dollars in Singapore.
Whether the revenue earned by the Taxpayer was subject to income tax in India as per the provisions of the Income Tax Act, 1961 (“ITA”) read with the India Singapore Double Taxation Avoidance Agreement with regard to that part of the contract which related to an offshore supply of goods by the Taxpayer to L&T?
The Taxpayer contended that the scope of work under the contract can be divided into supply of goods and the installation and other works to be executed in the airport. The Taxpayer also contended that the title to the goods passed to L&T outside India and payment for goods was made outside India and therefore, the proceeds attributable to the supply of goods should not be taxable in India owing to a lack of territorial nexus as per Section 9(1)(vii) of the ITA.
The Revenue contested that this was a composite contract and was not divisible into offshore and onshore components. Further, it argued that the title to the goods did not pass to L&T outside India.
In the context of the terms of the Sub-Contract, the AAR held that there was no demarcation in the contract between supply of goods and services to be performed. Therefore, it held that the contract has to be looked at as a whole, i.e., as a composite contract. The AAR distinguished this case form the landmark judgment of the Hon’ble Supreme Court of India in Ishikawajima Harima Heavy Industries Limited2 where supply of goods and provision of services were held to be taxable separately. In that case, the contract itself clearly made a demarcation between offshore supply of goods and onshore supply of services, including demarcation of consideration attributable to both. Further, in that case, insurance was in the name of the owner of the goods. In this case, while it was contended by the Taxpayer that title in goods passed outside India, insurance was taken with the Taxpayer as the insured person till goods reached the site in India.
Passing of Title and Risk in the Goods: The AAR considered the provisions of the Sale of Goods Act, 1932 to determine whether the sale of goods was completed in India or abroad. The AAR concluded that the intention of the parties regarding the time and place of transfer of title in the goods should be ascertained by considering the terms of the contract, the conduct of the parties and the circumstances of the case. As a general rule, the risk in the property passes along with the title in the property and the seller or supplier of the goods continues to bear the risk of any damage caused to the goods till the time the title is transferred to buyer. In the instant case, the AAR concluded that the parties to the Sub-Contract intended that the property or title in the goods supplied would only pass when the installation and erection of the entire project works is completed. The AAR came to such conclusion, amongst other things, on the basis that: (i) the insurance for the goods was procured by the Taxpayer with itself (and not L&T) as the insured person till the goods reach the site in India, and hence, the risk continued to be borne by the Taxpayer (and not L&T or DIAL) till the time the goods reached the constructions site in India; and (ii) the Taxpayer has been made responsible in the Sub-Contract for “the timeliness, cost and risk of the shipmen’s delivery to the Project Site” in India. The fact that the Taxpayer was responsible for customs clearance and for paying customs duty was also considered as signifying the Taxpayer’s title over the goods till they reached the site in India, even though such responsibility was required to be discharged by the Taxpayer as an agent of DIAL.
Further, the AAR noted that the payment terms were linked to the various stages of completion of the project as opposed to being demarcated on the basis of supply of goods and services as was the case in Ishikawajima Harima. In view of this and other factors outlined above, the AAR held that the Contract is composite and indivisible and cannot be bifurcated into two different transactions.
Role of Project Office Permanent Establishment: The AAR held that the project office of the Taxpayer played an important role in the transaction and was instrumental in the design and selection of the goods which were supplied by the Taxpayer to L&T abroad.
Further, this project office permanent establishment (“PE”) was also responsible for paying customs duty in India to clear the import of the goods sold to L&T abroad once they reached India. As a result the AAR, concluded that all transactions relating to the supply of goods to L&T under the contract were not completed outside India.
In light of the above, the AAR held that the entire amount received by the Taxpayer from L&T is taxable in India.
Analysis and Key Takeaways:
This conclusion of this ruling in the context of composite contracts is an important positive development in several ways. In the context of several contracts for cross-border sale of goods, services such as installation, testing, commissioning, etc., are actually incidental to the sale of goods. Such services, by themselves, generally do not hold any significance for the buyer in the absence of such sale of goods. Therefore, it has generally been an accepted principle that no consideration is separately attributable to such services and the entire consideration payable under the agreement relates to the sale of goods. Therefore, if such sale take place outside India, no part of the consideration is generally taxable in India. This has been re-iterated in several ruling and has also been recognized (through examples) in the memorandum of understanding (MOU) to the India-US tax treaty. Consequently, in the absence of a PE in India, no consideration can be attributable to such onshore services and taxable as “fees for technical services”.
In such contracts, often, PE exposure can be mitigated by several means, for example, if services are performed by sending employees to India for a very short duration or if the performance of such services are outsourced on a principal-to-principal basis (i.e., independent contractor basis) to an Indian individual / entity.
Further, the ruling of the AAR in relation to whether a sale of goods is an offshore sale emphasizes the importance of contracts and other documents being carefully drafted / filled-in / executed to properly reflect the intent of the parties without any inconsistencies.
It is commercially well-known that, in case of sales on ‘CIF’ basis, title in goods pass to the buyer after the goods pass the ship’s rail at the port of shipment and the risk of loss of or damage to the goods are transferred from the seller to the buyer. However, the seller has to make payment for the costs, freight and insurance till the goods reach the named port of destination. The insurance required to be taken by the seller is actually against the buyer's risk of loss of or damage to the goods during the carriage. If the buyer wishes to have insurance protection of greater cover, it is possible, if both parties agree to the same expressly. In that context, the fact that insurance was paid by the Taxpayer and that the insurance cover was applicable till the goods reached the site in India should not, by itself, have led to the conclusion that the sale of goods was not completed outside India. However, mistakes such as the certificate of insurance showing the insured person as the seller (and not the buyer) till the goods reach the site in India and imprecise drafting language (such as the Sub-Contract indicating that the Taxpayer is responsible for “the timeliness, cost and risk of the shipmen’s delivery to the Project Site” in India), can lead to the intention of the parties being misconstrued.
On a related note, in the case, the AAR has not ruled on the continued application of the principles enunciated in the landmark Ishikawajima Harima case, even though the tax authorities argued on this issue. The Ishikawajima Harima ruling held that supply of goods and provision of services were held to be taxable separately (if the contract demarcated the two). This principle becomes important in cases where the parties intend to demarcate scope of work in such contracts, particularly, where only one part faces risk of PE exposure in India and the other part is not taxable. The AAR distinguished the facts in this case from the facts in Ishikawajima Harima. In previous cases,3 the AAR has taken a view that principles outlined in the Ishikawajima Harima ruling has been indirectly overruled by the Supreme Court through its judgment in Vodafone International Holdings BV v. DIT.4 Therefore, an ambiguity prevails on this aspect.
Therefore, from a risk mitigation perspective, where the scope of the contract involves both an onshore and offshore component and a PE in India is involved in executing the onshore leg of the works, it may be preferable to have separate contracts for the goods sold and the services provided, as was the case in Director of Income Tax v. Nokia Networks OY,5 Linde AG, Linde Engineering Division v. Deputy Director of Income Tax,6 and Director Of Income Tax v. L.G. Cable Ltd.7.
1 AAR No. 981 of 2010. Judgment dated August 17, 2016.
2 288 ITR 408 SC
3 ABC, In re,  345 ITR 119; Roxar Maximum Performance WLL, In re  349 ITR 189 (AAR); Alstom Transport SA, In re  349 ITR 292 (AAR)
4  341 ITR 1 (SC)
5  358 ITR 259 (Delhi)
6  365 ITR 1 (Delhi)
7  197 Taxman 100 (Delhi)