- An Association of Persons ("AOP") should have the trappings of a partnership to make it amenable to taxation as a separate taxable entity, mere co-operation between members is not sufficient;
- Joint and several liability of two members (for due performance of the contract) towards the project owner is not conclusive in determining AOP;
- Separate scope of work for each member and separate payments to each member help in establishing that a consortium should not result in an AOP tax risk;
- Matter remitted back to AAR to decide on permanent establishment related issues
In a landmark decision, the High Court of Delhi ("High Court"), in Linde AG, Linde Engineering Division & Anr v. DDIT1 has provided clarity on what by now is an industry issue, by emphasizing that "mere cooperation" between consortium members should not result in an AOP tax risk in India. The High Court has held that where there is an independent / separate scope of work for each member coupled with no profit / loss or risk sharing between the members, there should be no AOP under Indian domestic law, notwithstanding that a consortium may have signed an agreement with the project owner jointly.
Typically, an Engineering, Procurement and Construction ("EPC") contract involves two or more contractors coming together to form a consortium, solely for the purpose of completion of the EPC project. The consortium model is followed to ensure that the project owner has a single point of contact with the consortium as a whole, and liability (in case of non-performance) of the consortium members towards the project owner is joint and several.
A tax issue that often arises in such a model is the taxation of the consortium members as a separate taxable entity – an "Association of Persons". An AOP is formed when two or more persons come together towards a common goal or purpose. An AOP is generally taxed at a rate of 34%, unless a member of the AOP falls within a higher tax bracket. For a non-resident, limiting AOP exposure is relevant because it could potentially result in a higher effective tax rate and non-eligibility to treaty benefits.
In the instant case Linde AG, Linde Engineering Division, Pullach, Germany ("Linde") and Samsung Engineering Company Ltd., Seoul, Korea ("Samsung") formed a consortium to bid for a particular project that was being floated by ONGC Petro Additions Limited ("Project Owner"). Linde and Samsung ("collectively referred to as the "Consortium") had technical expertise in their respective fields and had jointly submitted the bid in order to fulfil the requisite criteria.
Thereafter, the proposal submitted by the Consortium was accepted by the Project Owner and the notification of award was issued to the Consortium for execution of the project. The project involved the design, engineering, procurement, construction, installation, commissioning and handing over the plant located in India.
Linde filed an application for an advance ruling pertaining to the taxability of payments made to Linde, before the Authority for Advance Rulings ("AAR").
The AAR passed an adverse ruling against Linde stating that the liability of the Consortium for due performance of the contract towards the Project Owner was joint and several. Further, it was held that the contract was an indivisible contract incapable of being divided. On this basis, the AAR held that income received by Linde for offshore supply of equipment and designing was taxable in India.
Aggrieved by the ruling of the AAR, Linde filed a writ petition in the High Court where the following two issues were considered:
- Whether the Consortium constitutes an AOP under section 2(31) of the Income-tax Act, 1961 ("ITA"), and is hence liable to be taxed accordingly?
- Whether the income of Linde arising out of the offshore supply of equipment and preparation of related designs is taxable in India under the ITA or under the Double Taxation Avoidance Agreement entered into between India and Germany ("India – Germany DTAA")?
RULING OF THE COURT
The High Court, after hearing the contentions put forth by the parties, arrived at the following conclusions:
i. Whether the Consortium constitutes an AOP:
The High Court examined the agreement between the Consortium and the Project Owner ("Contract"), the Memorandum of Understanding between Linde and Samsung ("MoU") as well as internal agreement between Linde and Samsung ("Internal Agreement"). The following are the key factors that were considered:
- Intention of the Consortium: The MoU clearly stated that the Consortium has been established for the limited purpose of dealing with the Project Owner.
- Allocation of work: Each of the members of the Consortium has an independent, definite and separate scope of work which was allocated as per each member's field of expertise. Each Consortium member would be responsible for its share of work, and neither member had any role to play with respect to the scope of work allocated to the other member.
- There was no arrangement for sharing of profits or losses in relation to the arrangement since each member was responsible for own scope of work, and was paid separately.
- Sharing of information: The only area of co-operation was the sharing of information / material to enable the other member to perform its work. On this issue, the High Court was of the view that sharing of information would be necessary for execution of any project involving multiple agencies to enable execution of the project in a coordinated manner, and this alone cannot determine existence of an AOP.
- Project management: For the purpose of representing the Consortium to the Project Owner, each Consortium member nominates a "project director" who would have the authority to direct the execution of the project. On the joint management structure envisaged by the Consortium, the High Court held that there is no pooling of resources to form a common management, but mere sharing of information and management of each member's scope of work by their respective project directors.
- Alteration of scope: In case of alteration in scope of services for either Samsung or Linde, any additional fee payable shall only be paid to the relevant Consortium member.
- Consortium was considered as a single party in Contract with the Project Owner: For the purpose of the Contract, the Consortium was considered as a single party, in terms of liability and due performance of the Contract. However, the High Court noted that the schedules to the Contract indicated that payments were being made separately to each Consortium member, and each member's scope of work was separate, to be performed independently.
- Consortium was jointly and severally liable towards the Project Owner: The High Court held that joint and several liability towards a third party cannot be a clear indicator of existence of AOP, and it would have to be examined in light of other factors. Further, the Internal Agreement provided that each Consortium member shall be responsible for its respective scope of work in case of any deficiencies in performance of work.
Based on the above mentioned factors that emerged from examination of the various agreements as well as judicial precedents on the same issue, the High Court held that the Consortium would not constitute an AOP. Importantly, while reaching this conclusion, the High Court stated that mere existence of a common arrangement cannot determine an AOP and it should also exhibit some trappings of a partnership as well. Thus, the association amongst members must be real and substantial which is sufficient to treat the association as a separate homogenous taxable entity.
After an analysis of judicial precedents on this subject2, the High Court stated that a consortium should exhibit the following essential features to be considered as a separate taxable entity: (a) An AOP must be constituted by 2 or more persons who have come together for a common purpose, (b) The association must move by common action and there must be some scheme of common management, (c) The cooperation and association amongst the members must not be perfunctory and/or merely in form.
Earlier view of the AAR: The High Court also examined the facts and commercial terms of arrangement between the parties in In re Hyundai Rotem3, wherein an earlier bench of the AAR held in favor of the applicant. The High Court noted that the facts were substantially similar to that of the instant case. Certain aspects common to the two cases include – separate scope of work and skill sets of each of the members, no profit/ cost sharing and separate payments made to the members.
On this basis, the High Court held that in the absence of a material change in law, the AAR was bound to follow the legal principles applied in Hyundai Rotem. In this regard, the High Court's view was that the AAR should maintain consistency in its rulings, and if the AAR is of the view that the previous view is erroneous, the AAR should refer the matter to a larger bench.
ii. Whether the designing and supply of equipment by Linde is taxable in India:
Under the Contract, Linde performed the following functions: a) Design and engineering of equipment for manufacture outside India, and b) supply of equipment and related materials outside India. While the High Court made key observations on the taxability of payments made to Linde, the matter was remanded back to the AAR for determination of whether Linde has a permanent establishment ("PE") in India or not.
Some key observations of the High Court on this issue are as follows:
Taxability under ITA
- The issue of taxation of onshore and offshore transactions as under a composite contract, or as separate transactions (divisible contracts) was put to rest by the Supreme Court in Ishikawajima-Harima Heavy Industries Ltd v. DIT4, wherein it was held that a turnkey contract can be considered as a divisible contract and the onshore / offshore elements can be taxed separately. The AAR has sought to differentiate from this decision on grounds of factual dissimilarities. However, the High Court has observed that the Supreme Court's decision should squarely apply to the instant case (since the payments are being processed for each leg of the work, and taxability would depend on whether services were rendered offshore or in India).
- As regards the taxation of offshore services, the High Court observed that the question whether offshore services were linked to the supply of equipment is a question of fact, and would need to be determined accordingly. In order to fall outside the scope of chargeability under section 9(1)(vii) dealing with fee for technical services, the link between offshore supply of services and equipment should be strong and interlinked such that the services cannot be said to be rendered on a standalone basis.
Taxability under India-Germany DTAA
- The High Court noted that under the India-Germany DTAA, fees for technical services (not linked inextricably with offshore supplies of equipment) are liable to be taxed where these services arise i.e. in Germany, under Article 12 of the India-Germany DTAA. However, if the fees are attributable to PE in India, taxation shall be according to Article 7 of the India-Germany DTAA.
In light of this, with respect to the second issue, the High Court remanded the matter back to the AAR to determine income attributable to Linde's PE in India (if any).
The risk of taxation as an AOP is often one of the key tax risks that foreign taxpayers face in joint venture structures, or consortium based businesses such as EPCs.
For a foreign taxpayer, disadvantages of being taxed as an AOP include non-eligibility to treaty benefits and taxation of the AOP at the maximum marginal rate. Once an association is taxed as an AOP, distributions made from the AOP to the member cannot be taxed again. The downside to this tax treatment is that the losses of an AOP cannot be set off in the hands of its members.
Since AOPs are considered Indian tax resident, even if partially controlled from India, there is a risk that the AOP (having non-resident members) is treated as an Indian tax resident. Accordingly, it will be taxed on its worldwide income, as opposed to only Indian-sourced income which would have been the case otherwise.
The ITA does not define the term AOP, and it has been interpreted through judicial precedents over the years. In the past couple of years, there have been a host of rulings dealing with AOP taxation in consortium run EPCs, primarily at the AAR level, which have not maintained a consistent legal trend. Considering this, the Delhi High Court's decision comes as a great relief to taxpayers since it examines the commercial arrangements between the members in great detail, and provides the much needed clarity to taxpayers on this subject.
In the present case, the High Court has examined the commercial terms of the EPC contract, as well as the terms of the internal agreements between the consortium members to understand and conclude its findings on AOP formation. Profit & loss sharing, cost & risk sharing, exercise of control over scope of work of other consortium member, common management of consortium members are key considerations for AOP determination.
Interestingly, the High Court also noted as per Article 14 of the Constitution of India (dealing with equal protection), the AAR is bound to take a consistent view while laying down judicial precedents. This comes as positive takeaway especially since there have been instances where the AAR has taken divergent views on the same legal issue.
Despite the Supreme Court's verdict in Ishikawajima-Harima Heavy Industries, the issue on taxation of indivisible contracts still plagues the EPC sector. On this issue, the Delhi High Court has rightly observed that the Supreme Court's findings are squarely applicable to the instant case.
All in all, the decision of the High Court is a well - reasoned one that should provide much needed clarity on the subject of taxation as AOP in the sphere of turnkey transactions.
1 W.P. (C) NO. 3914/2012 & CM No.8187/2012
2 N.V. Shanmugham and Co. v. CIT: (1970) 2 SCC 139, G. Murugesan and Brothers v. Commissioner of Income Tax, Madras: (1973) 4 SCC 211, B.N. Elias [(1935) 3 ITR 408]
3 (2005) 279 ITR 165 (AAR)
4  288 ITR 408 (SC)
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