ANALYSIS OF THE SUPREME COURT DECISION IN CASE OF GVK INDUSTRIES

GExtra-territorial operation of the income-tax act in the light of the SUPREME COURT DECISION in the GVK industries case

Executive Summary In the recent case of GVK Industries Ltd. v. Union of India, a Five Judge Constitution Bench of the Supreme Court of India dealt with the issue of whether Parliament could legislate with respect to aspects or causes that arise or exist outside the territory of India. The Court held that Parliament did not have the power to legislate on extra-territorial aspects or causes and rejected the Attorney General’s proposition that Parliament, as a Sovereign Legislature, had full powers to enact laws having extra-territorial operation. It further held that Parliament was constitutionally restricted from enacting legislation with respect to extra-territorial aspects or causes that did not have direct or indirect impact, effect or consequences for: (a)    the territory of India, or any part of India; or (b)   the interests of, welfare of, wellbeing of, or security of inhabitants of India, and Indians The decision could have a significant impact on cases where transactions and persons outside India are sought to be brought within the tax net. Specifically, it could have a bearing on the following issues: (c)    Applicability of s. 9(1)(vii) to technical services rendered by a non-resident outside India. (d)   Taxability of 'indirect transfers' i.e. where the shares of a foreign company are sold outside India by one non-resident to another (e)    Applicability of s. 195 to non-resident payers

Background:

The issue of extra-territorial operation of laws passed by Parliament as well as State legislatures is a contentious one. It has naturally been the subject matter of several judicial pronouncements over the last several decades.

However, this issue has assumed greater significance in recent years, particularly in view of the increasing attempts by the income-tax authorities to assert jurisdiction over transactions and persons located outside India. In addition to asserting tax on overseas transactions, the tax authorities are also increasingly resorting to a literal reading of the provisions of the Income-tax Act, 1961 (‘the Act’) to impose withholding tax obligations on non-residents as in the Vodafone case.  

While the principles surrounding the extra-territorial operation of taxing statutes, have more or less remained constant over the last several decades, there are few, if any, instances of the validity of specific provisions of the Income-tax Act, 1961 (‘the Act’) being tested against such principles.

Key Judicial Pronouncements:

The principles surrounding the power of Parliament to legislate on extra-territorial matters have evolved through numerous judicial pronouncements. The key decisions on this subject are briefly discussed below:

Raleigh Investment Co. Ltd’s case

One of the earliest Indian cases to deal with the extra-territorial operation of the Indian Income-tax Act, 1922 was Governor General in Council v. Raleigh Investment Co. Ltd. 1944 (012) ITR 265 FC decided by the Federal Court.

Raleigh Investment Co. Ltd. (‘Raleigh’) was an English company which held the bulk of the shares in 11 companies which were engaged in the manufacture and sale of tobacco in India. Out of the 11 companies, 2 were incorporated in India, while the remaining 9 were English companies. The dispute in the case centered around the taxability in India of dividends paid to Raleigh by the 9 English companies.

At the relevant time, the Income-tax Act provided that dividends paid outside British India would be deemed to be income accruing and arising in British India to the extent to which it had been paid out of profits subjected to tax in British India.  Raleigh contended that dividends declared outside British India by such companies could not be regarded as income accruing or arising in British India and added that if the Income-tax Act attempted to impose a liability on such dividends, its provisions would to that extent be invalid.

The Federal Court upheld the principle that those affirming the validity of non-territorial elements of a law have to show that the country has any real concern or interest in the matter, thing, or circumstance dealt with by the legislation. It went on to hold that the source of the dividends received by Raleigh was British Indian, and that by making them liable to income-tax in India on that basis, the legislature was not giving an extra-territorial operation to the law.

The Wallace Brothers case

In Wallace Brothers & Co. v. CIT, Bombay (1948 FCR 1), the Privy Council held that in dealing with the competence of the Indian Legislature to impose tax on income arising abroad to a non-resident foreign company, the constitutional validity of the relevant statutory provisions did not turn on the possession by the legislature of extra-territorial powers, but on the existence of a sufficient territorial connection between the taxing State and what it seeks to tax.

The Electronics Corporation of India Ltd. case

In Electronics Corporation of India Ltd. v. CIT 1990 (183) ITR 43-SC, the Petitioners challenged the imposition of tax under s. 9(1)(vii) of the Act on a non-resident rendering technical service outside India. The Supreme Court reiterated the position that unless a nexus with India exists, Parliament will not be competent to enact laws having extra-territorial operation.

However, on the specific question of whether the provisions of s. 9(1)(vii) indicated such a nexus with India, the Court referred the matter to a Constitution Bench, having regard to the substantial importance of the question involved.

The appeal, though, was withdrawn before the Constitution Bench could consider and decide on the issue of validity of s. 9(1)(vii).  

The Ishikawajma-Harima Heavy Industries case

In the case of Ishikawajma-Harima Heavy Industries Ltd. v. DIT 2007 (288)ITR 0408 SC, the Supreme Court had occasion to deal with the taxability of offshore services under s. 9(1)(vii) of the Act. In this connection, the Court applied the nexus theory outlined above, and held as under:

“Having regard to the internationally accepted principle and DTAA, it may not be possible to give an extended meaning to the words 'income deemed to accrue or arise in India' as expressed in s. 9 of the Act. Sec. 9 incorporated various heads of income on which tax is sought to be levied by the Republic of India. Whatever is payable by a resident to a non-resident by way of fees for technical services, thus, would not always come within the purview of s. 9(1)(vii) of the Act. It must have sufficient territorial nexus with India so as to furnish a basis for imposition of tax. Whereas a resident would come within the purview of s. 9(1)(vii) of the Act, a non-resident would not, as services of a non-resident to a resident utilized in India may not have much relevance in determining whether the income of the non-resident accrues or arises in India. It must have a direct live link between the services rendered in India, when such a link is established, the same may again be subjected to any relief under DTAA. A distinction may also be made between rendition of services and utilization thereof.

Sec. 9(1)(vii)(c) clearly states "where the fees are payable in respect of services utilized in a business or profession carried on by such person in India." It is evident that s. 9(1)(vii), read in its plain, same envisages the fulfilment of two conditions : services, which are source of income sought to be taxed in India must be (i) utilized in India and (ii) rendered in India. In the present case, both these conditions have not been satisfied simultaneously.”

Subsequent to the decision of the Supreme Court, Parliament inserted an Explanation to section 9, which sought to clarify that income of a non-resident shall be deemed to accrue or arise in India whether or not the non-resident has rendered services in India.

The GVK Industries case: the background and the decision

The Background:

GVK Industries engaged a Swiss company to prepare a scheme for raising finances and providing services in connection with obtaining a loan. It approached the tax authorities for a "no objection certificate" under section 195 for making a remittance to the Swiss Company in connection with such services.

It challenged the refusal of the tax authorities to issue the certificate by filing a Writ Petition before the Andhra Pradesh High Court. The High Court ruled that the payments were in the nature of “fees for technical services” and were therefore taxable in India under Section 9(1)(vii) of the Act. The Court also rejected the Petitioner’s argument that Section 9(1)(vii) was unconstitutional for want of legislative competence.

On appeal before the Supreme Court, the matter was referred to a Constitution bench in view of the far-reaching constitutional questions raised in the petition. While making the reference to the Constitution bench, the Supreme Court was influenced by the fact that the Electronics Corporation of India Ltd. case on this issue could not be heard by the Constitution Bench.

Questions before the Constitution Bench:

The Supreme Court in the GVK Industries Case appears to have misconstrued the question which was referred to the Constitution Bench in the Electronics Corporation of India Ltd. case. Instead of dealing with the question of whether 9(1)(vii) has a sufficient nexus with India, it took upon itself the mandate to clarify whether Parliament could only legislate with respect to aspects or causes that arise within India, or whether it was permissible for it to also legislate on aspects or causes that had a significant impact or effect in India.

Based on this, the Constitution Bench framed the following questions of law:

  

(1) Is Parliament constitutionally restricted from enacting legislation with respect to extra-territorial aspects or causes that do not have, nor expected to have any, direct or indirect, tangible or intangible impact(s) on, or effect(s) in, or consequences for: (a) the territory of India,

or any part of India; or (b) the interests of, welfare of, wellbeing of, or security of inhabitants of India, and Indians?

(2) Does the Parliament have the powers to legislate "for" any territory, other than the territory of India or any part of it?

Relevant Constitutional Provisions:

Article 245:

Extent of laws made by Parliament and by the Legislatures of States:

(1) Subject to the provisions of this Constitution, Parliament may make laws for the whole or any part of the territory of India, and the Legislature of a State may make laws for the whole or any part of the State

(2) No law made by Parliament shall be deemed to be invalid on the ground that it would have extra territorial operation

Attorney General’s Propositions:

a)      There is a distinction between a Sovereign Legislature and a Subordinate Legislature. A Sovereign Legislature has full power to make-extra territorial laws.

b)      The fact that a Sovereign Legislature does not make extra-territorial laws arises not from a constitutional limitation on its power, but from a consideration of applicability.

c)      Domestic Courts cannot set aside legislation passed by a Sovereign Legislature on the ground that it has extra-territorial effect.

Court’s observations:

·        No organ of the State may arrogate to itself powers beyond what is specified in the Constitution.

·        Article 245(1) empowers Parliament to make laws for the whole or any part of the territory of India. Two limitations flow from the use of the word ‘for’ in Article 245(1).

              i.            All powers vested in any organ of the State, including Parliament, may only be exercised for the benefit of India

            ii.            As a logical corollary, the exercise of legislative powers by Parliament with regard to extra-territorial aspects or causes that do not have any nexus with India, transgresses the first condition

·        Article 245(2) cannot be read as an independent source of legislative power of Parliament to enact laws for territories beyond India where, neither the aspects or causes have a nexus with India, nor the purposes of such laws are for the benefit of India. Such an interpretation would result in Article 245(1) becoming mere surplassage.

·        Article 245(2) only carves out a specific exception that a law made by Parliament pursuant to Article 245(1) may not be invalidated on the ground that such a law may need to be operated extra-territorially. 

·        In as much as any extra-territorial aspects or causes may have an impact on or nexus with India, they would legitimately be within the domain of legislative competence of Parliament, so long as the purpose or object of such legislation is to benefit the people of India.

·        On the basis of the above, the Court answered the questions before it, as under:

              i.            Parliament is constitutionally restricted from enacting legislation with respect to extra-territorial aspects or causes that do not have, nor expected to have any, direct or indirect, tangible or intangible impact(s) on, or effect(s) in, or consequences for:

(a)  the territory of India, or any part of India; or

(b)  the interests of, welfare of, wellbeing of, or security of inhabitants of India, and Indians

            ii.            Parliament does not have the power to legislate for any territory other than the territory of India or any part of it. Laws enacted by Parliament with respect to extra-territorial aspects or causes that have no impact or nexus with India would be ultra vires and would be laws made ‘for’ a foreign country.

The GVK Industries case: the impact

Significance of the GVK Industries decision

In many ways, the GVK decision merely re-states the law laid down over several decades by the Federal Court, the Privy Council and the Supreme Court of India. Nonetheless, it assumes significance on account of two key reasons:

a)      it emphatically rejects the Government’s claim that Parliament, as a sovereign legislature, has unfettered power to legislate on extra-territorial matters; a contrary finding on this issue would have eliminated all challenges to the extra-territorial assertion of jurisdiction by the income-tax authorities.

b)      it explicitly sets out the extent and scope of Parliament’s power to legislate on extra-territorial matters, and provides the legal framework against which all challenges to extra-territorial laws must be tested.

After answering the questions on the constitutional issues set out above, the bench in GVK Industries directed that the matter be listed before a regular bench for disposal. The critical question of whether s. 9(1)(vii) is within the legislative competence of Parliament was thus not answered by the Constitution Bench.

Impact of the GVK Industries decision on specific provisions of the Act

a)      s. 9(1)(vii) – Fees for Technical Services

The application of s. 9(1)(vii) to services rendered by a non-resident outside India has frequently been the subject matter of challenge before the Courts. Both the Electronics Corporation of India Ltd. case and the GVK Industries case centered around the competence of Parliament to levy a tax on services rendered outside India by non-residents.

In both cases, the constitutional validity of s. 9(1)(vii) was upheld by the High Courts. In the Electronics Corporation of India Ltd. case, the High Court observed that since the technical services/know-how were being used in a business in India, there was sufficient territorial connection with India. However, the Supreme Court referred this specific question to a Constitution bench, where the petition was withdrawn before the matter could be decided. 

In the GVK Industries case, before the Constitution Bench, GVK Industries withdrew the challenge to the constitutional validity of s. 9(1)(vii) and requested the Court to proceed only on the question of whether the payment made by them qualified as fees for technical services. Nonetheless, the Court, at the instance of the Attorney General agreed to reconsider the decision of the three-judge bench in the Electronics Corporation of India case.  Given this, it is unlikely that the constitutional validity of s. 9(1)(vii) will be addressed before the regular bench of Supreme Court in this case.

In the Ishikawajima-Harima Heavy Industries case, the Supreme Court inter alia made the following observations on the extent and scope of s. 9(1)(vii):

(1)   Sufficient territorial nexus between the rendition of services and the territorial limits of India is necessary to make income taxable in India

(2)   For s. 9(1)(vii) to be applicable, it is necessary that the services not only be utilized within India, but also be rendered in India or have such a ‘live link’ with India that the entire income becomes taxable in India.

Even though the Court did not explicitly comment on the constitutional validity of s. 9(1)(vii), it nonetheless reiterated the importance of a sufficient territorial nexus with India. In this connection, it went on to hold that in order to fall within s. 9(1)(vii) it was necessary that the services should be both (i) utilized in India; and (ii) rendered in India. More importantly, it also observed that the location of the source of income within India would not render sufficient nexus to tax the income from that source.

The ratio of the decision in GVK Industries, when read in conjunction with the observations in the Ishikawajima-Harima Heavy Industries case could end up having a significant bearing on:

(1)   the applicability of s. 9(1)(vii) to technical services rendered outside India by non-residents; and

(2)   the constitutional validity of the Explanation added to s. 9 to overturn the decision in Ishikawajima-Harima Heavy Industries Ltd.

b)      s. 9(1)(i) – Indirect Transfers

The applicability of capital gains tax in India on transfers of overseas holding companies having Indian subsidiaries is an issue of relatively recent origin. In most cases where capital gains on such transfers is asserted, the dispute has largely centered around the interpretation of s. 9(1)(i) rather than on its constitutional validity (e.g. the Vodafone case)

The decision in GVK Industries could have an impact on such cases as well. The issue to be decided in such cases would be whether s. 9(1)(i) (if held as applying to indirect transfers) would be constitutionally valid in the light of the test laid down in the GVK Industries case. A similar issue would exist under the Direct Taxes Code as well.

The Constitutional test to be applied in this case would be whether a transfer of shares of an overseas company having an Indian subsidiary can be treated as having an impact, effect or consequence for India or on the well-being of Indians.

While this test is fairly broad in its scope, it nonetheless remains to be seen how this issue will eventually be decided by the Courts if this argument is taken up.

c)      s. 195 – Withholding tax obligations on non-residents

The issue of whether s. 195 imposes an obligation to withhold tax on non-residents has been raised in the Vodafone case. In this case, it was contended by Vodafone that even though s. 195 applies to ‘any person’, it should nonetheless be read down so as to restrict its application only to residents of India or non-residents having a presence in India. However, the constitutional validity of the provision was not challenged.

However, the Bombay High Court rejected this argument and held that even though the revenue laws of a country may not be enforceable in another that does not imply that the Courts of a country shall not enforce the law against the residents of another within their own territories.

Even if Parliament’s power to levy a tax on such overseas transactions falls meets the test laid down in the GVK Industries decision, it may be a matter of debate whether it automatically follows that withholding tax obligations can also be imposed on non-residents in respect of such transactions.

The provocation for the liability to deduct tax is the ‘credit’ or ‘payment’ of amounts chargeable to tax.  Also, the taxability of a transaction is not necessarily dependent on the actual payment of sums under such transactions. Based on this, it may be useful to examine whether the mere taxability of such transaction in India under the criteria laid down by the Supreme Court above will be sufficient to justify the extra-territorial operation of withholding tax provisions under the Act.

Conclusion:

Even though the test laid down by the Supreme Court in the GVK Industries case is a broad one, nonetheless, when read in conjunction with other judicial pronouncements on the subject, it may have significant utility in countering some of the arguments advanced by the tax authorities to assert extra-territorial jurisdiction.

Particularly, strong arguments could be made to assert that in view of the Ishikawajima Harima Heavy Industries case, non-residents rendering services from outside India should not be subject to the Indian tax net under s. 9(1)(vii) and that the Explanation added to the section is by virtue of the GVK Industries case is unconstitutional. Similarly, it may be worthwhile to rely on this decision to challenge the extra-territorial operation of s. 9(1)(i), s. 195 and other provisions of the Act.