India: Tax Street – August 2023

Focus Point

Synopsis of Reimbursements of Cost's Taxability

In the current era of globalization of businesses, interdependence among group companies has become more common. Companies within the same group share costs relating to businesses to achieve cost efficiency and streamline operations. These practices are prevalent in multinational corporations and conglomerates where different group entities collaborate closely. Some prevalent practices include allocating common costs such as information technology, procurement, personnel cross-charge, and other cost-sharing arrangements. Such recoupment of expenses is commonly known as 'reimbursement.'

Reimbursement of costs is a widely used concept and an equally debated one in India, especially in the case of payment to overseas group entities. From a corporate tax perspective, the controversy revolves around the taxability of reimbursement in the hands of the recipient, whether it is taxable as income and consequent withholding tax obligation in the hands of the payer. There are conflicting judicial decisions on this aspect, adding to the complexities of the taxability of reimbursement of cost.

The term 'reimbursement' has not been defined in the Income-tax Act, 1961 (the Act). However, it has been defined in various dictionaries like Black's Law Dictionary and Oxford Dictionary. According to these dictionary meanings, reimbursement can be described as repayment of what has already been spent or incurred. Therefore, it should not be considered a reward or compensation for a service rendered.

Taxability under the Act

Under the Act, there is an obligation on the payer to withhold tax while making payment to a non-resident of any sum chargeable to tax under the provisions of the Act. The Act seeks to levy income tax in respect of the 'income' of every person. The term' income' has been exhaustively defined to include various types of gains, accretion, value addition, etc. In the absence of any profit-related element, a receipt cannot be classified as income and, therefore, should not be subject to income tax.

In the landmark judgment in the case of GE India Technology Center Pvt. Ltd. v. CIT¹ , the Hon'ble Supreme Court of India held that the obligation to withhold tax should be limited to the appropriate proportion of such income chargeable to income tax under the Act. According to the Court, it cannot be said that the obligation to withhold tax arises the moment there is a remittance. If we were to accept such a contention, it would mean that on mere payment, income would be said to accrue or arise in India. Such an interpretation would mean the obliteration of the expression 'sum chargeable under the provisions of the Act.'

Accordingly, so far, the payment is a 'mere reimbursement of cost and does not include any profit element', it may not be subject to withholding tax under the Act. The crucial factors to consider are: (a) 'the nature of services being provided' in relation to the incurrence of cost for which reimbursement has been made and (b) the supporting documentation.

We have broadly discussed the various typical categories of reimbursements to understand the taxability in light of judicial pronouncements.

Reimbursements to and through a non-resident

As reiterated above and as per the rulings of various authorities² , it has been held that the amount received by the taxpayer by way of reimbursement cannot be regarded as income, particularly if it was found that the taxpayer had received no money in excess of the expenses it had incurred.

In the absence of the profit element, the Courts have been of the view that such payments are reimbursements that are not taxable in India. Consequently, no withholding tax needs to be applied to such payments.

However, a contrary view has been adopted by the Tribunals in some cases³ , wherein it was found that the Indian companies were availing services from a third party overseas, but payment for these services was being routed through their foreign group companies, which claimed such receipts to be plain reimbursements. In such cases, it was observed that had the Indian companies directly incurred such expenses, there would have been a requirement to withhold tax. Therefore, merely the transaction is routed through a foreign group company; it cannot alter the nature of the payment made as "reimbursement". In such cases, the Indian companies were held to be liable to withhold tax on the payments to be made to their foreign group companies.

The responsibility of proving to the satisfaction of tax authorities that the amount payable is pure reimbursement, without any provision of taxable services, will be on the Deductor.

Reimbursements under cost-sharing arrangements

Under these arrangements, the costs are incurred at a group level and thereafter allocated amongst the companies of the group on some reasonable basis or pre-agreed allocation key. The practice is widely prevalent across industries and worldwide and helps companies achieve cost efficiencies.

From the perspective of Income Tax, the issue that arises is whether the allocation or sharing of costs is taxable in the hands of the recipient entity.

The Supreme Court of India, in the case of A.P. Moller Maersk AS⁴ , while analyzing the taxability of pro-rata IT costs recharged to Indian agents by a foreign shipping company, held that once the character of the payment was found to be in the nature of reimbursement of expenses, it could not be charged to tax in India. In this case, the foreign shipping company had furnished its calculation of total costs and their pro-rata division among the agents (which was done without any markup).

In another case, ABB Ltd (AAR)⁵, held that reimbursement received by the applicant was not taxable in India and noted that the resources were pooled by all the group entities for common benefit (and not for conferment of any right on the applicant). It also held that since all the participating group entities had the right to reap the benefits of research, the payment made towards their own share of costs could not be taxed in India. Tribunals have expressed similar views in other judgments⁶.

It is clear that taxability depends on the facts and circumstances of each arrangement and there is a need to evaluate various underlying factors such as the basis of allocation, the value addition by the entity pooling the costs and the benefits derived by the participating entities. It is also important to maintain strong documentary evidence to demonstrate that the amount paid is in the nature of reimbursement.

Our Comments

The issue of taxability of reimbursement is highly contentious and litigated. Considering the penal consequences for not withholding, the company needs to be extremely cautious while making payment of reimbursement of cost. Needless to say, it is imperative for the company to maintain proper documentation to support and substantiate the true nature of the transaction while claiming that the payment made is only reimbursement of cost.

From the Judiciary

Direct Tax

Can exemption be given to a Mauritius-based investment company on the disposal of shares that arose from the Conversion of Cumulative Convertible Preference shares (CCPS), which took place after 1 April 2017?

Sarva Capital LLC TS-467-ITAT-2023(DEL)

Facts

The taxpayer, a resident of Mauritius, was incorporated for making investments in India in education, agriculture, healthcare, etc. The taxpayer had made certain investments in India before 1 April 2017 in equity shares and CCPS of certain companies in India. In its return of income, the taxpayer claimed exemption from capital gains under Article 13(4) of the India-Mauritius tax treaty.

The Revenue contended that the taxpayer is a conduit company and since it has been incurring losses in Mauritius and its income is not being taxed there, it cannot be regarded as a resident as per Article 4, and thus, the tax treaty benefit cannot be provided.

For its income from the sale of CCPS, the taxpayer filed a revised return and offered the capital gains to tax as per Article 13(3B) of the tax treaty. However, it claimed before the Tribunal that the capital gains should be exempt as per Article 13(4) as the CCPS were acquired prior to 1 April 2017.

Held

The Delhi Tribunal allowed exemption under the India-Mauritius tax treaty to the taxpayer on disposal of shares that arose from conversion of CCPS where CCPS was issued prior to 1 April 2017, but conversion took place after the said date as there was no substantial change in the rights of the taxpayer.

The Tribunal relied on the Supreme Court ruling in Azadi Bachao⁷, the jurisdictional High Court ruling in Blackstone⁸ and the Co-ordinate Bench ruling in MIH India⁹ upholding the validity of Circular No. 789 of 2000 and observing that Tax Residency Certificate (TRC) is sufficient evidence to claim not only the tax residency and legal ownership but also treaty eligibility. It also observes that SC in Azadi Bachao held that 'liable to taxation' and 'actual payment of tax' are two different aspects, and merely because tax exemption is granted under the domestic tax laws of Mauritius, it cannot lead to the conclusion that the entities availing such exemption are not liable to tax.

The Tribunal also opined that Article 13(4) of the tax treaty speaks about 'shares' and shares here are to be construed in a broader sense, and it will take within its ambit all types of shares, including preference shares. Thus, the tax treaty benefit was granted to the taxpayer.

Our Comments

Despite the taxpayer revising its return to offer the capital gains to tax as per Article 13(3B) of the tax treaty, the Tribunal held that this should not stop the Revenue from granting tax treaty benefits to the taxpayer under Article 13(4) of the treaty as the shares were acquired prior to 1 April 2013.

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Footnotes

1. [2010] 7 taxmann.com 18/193 Taxman 234/327 ITR 456

2. CIT vs Siemens Aktiongesellschaft 177 taxman 81 (Bombay High Court); CIT vs IDFC Investment Advisors Ltd ITA No. 968/2014(Bombay High Court)

3. C.U. Inspection (I) P Ltd vs DCIT 34 taxmann.com 75 (Mumbai Tribunal); DCIT (TDS) vs Kodak India P Ltd 58 taxmann.com 113 (Mumbai Tribunal); Ershisanye Construction Group India P Ltd vs DCIT 84 taxmann. com 108 (Kolkata Tribunal)

4. 293 CTR 1

5. [2010] 189 Taxmann 422 (AAR - NEW DELHI)

6. Asst. CIT vs Modicon Network P Ltd 14 SOT 204 (Delhi Tribunal), Emersons Process Management India P Ltd vs Addl. CIT 13 taxmann.com 149 (Mumbai Tribunal)

7. 263 ITR 706

8. TS-67-ITAT-2023(DEL)

9. S.A No. 138/Del/2022

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.