Turnkey Contract- Income Tax Implication for Non-residents
Turnkey Contract
Turnkey contract is an
arrangement under which a contractor completes a project and then hands it over
in fully operational form to the client, which needs to do nothing but “turn a
key”, as it were, to set it motion
In the context of turnkey
contract, where a contractor is non-resident and client is an Indian party,
being resident of India, the Turnkey contract involves the execution of
following components
1.
Design & Engineering in relation to supply
of equipment- Offshore Services
2.
Supply of Equipment- Off Shore Activity
3.
Installation- On shore Activity
4.
Commissioning – On shore Activity.
Hereinafter the turnkey
contract/project refers to contract where contractor is Non-resident and client
is Resident of India and project situs is in India
Controversy
1.
The true essence of turnkey contract is that
entire property in the project is handed over to the client upon completion and
commissioning of the project and separate execution of piecemeal component of
project is not contemplated.
2.
However at times contract is designated as
turnkey contract but it envisage separate execution of different constituents
at different point of time for which distinct consideration is stated i.e.
mainly ownership of equipment is discretely transferred and installation &
commissioning activities are also separately considered.
3. The controversy surrounding the turnkey
contracts mainly revolve around the taxability in India of profit from
off-shore supply of equipment, hereinafter refer to as off-shore profit.
4.
In land mark judgment of Hon’ble Supreme court
in Ishikawajima-Harima Heavy Industries Co 288 ITR 408,(2009) delivered by Two
judge bench, the controversy was put to rest with respect to off-shore supply
of equipment and it was held that income from off-shore supply is not taxable
in India, since all parts of the transaction in question i.e. the transfer of
property in goods as well as the payments were carried outside India.
5.
In another historical Judgment of Hon’ble
Supreme Court in Vodafone International Holdings BV Netherlands vs. Union of
India and another 345 ITR 1 (SC) (2012), delivered by Three Judge bench, it has
been advocated that transaction must be looked at and not looked through i.e.
one has to look at the transaction as a whole and not adopt a dissecting
approach.
6.
On the strength of decision of larger bench of Supreme court in Vodafone case,
Income tax authorities started taking following position:-
a)
Turnkey
contract has to be read as whole
b)
Off shore supply of equipment and Services shall
not be viewed separately based on dissecting approach approved in Ishikawajima-Harima
Heavy Industries case
c)
Since the Turnkey contract has been executed in
India, part of the profit from
offshore supply of equipment and services are also taxable in India.
7.
Though Judgment of Supreme Court in Vodafone
case was rendered altogether in different context, but authorities’ adverse
stance on turnkey contracts based on this judgment has resulted in unsettling
the settled position.
Issue analyze
In this article, an endeavor
is made to analyze the issue of taxability of off-shore profit in India in
different circumstances.
Basics revisited
The Taxability of Income in
India is dependent upon the following two factors:-
1.
Classification of Income to particular
group/category/head under relevant code (Income Tax Act/DTAA)
2.
Source rule applicable to Particular
group/category/head of Income for its taxability in India.
|
Income Classification
|
Source Rule
|
|
|
Income Tax Act
|
DTAA
|
|
|
Business Income
|
Business connection in India
and carrying out of at least part of the Business operations in India
|
Existence of Permanent
Establishment (PE) in India and attribution of Business profit to PE
|
|
Fees for
Technical Service (FTS)
|
FTS is payable by
1. Indian
Government
2. Resident
of India
3. Non-resident,
where Service are utilized for Business in India
|
FTS is payable by
1. Indian
Government
2. Resident
of India
|
|
Interest
|
Same as
above
|
Same as
above
|
Analysis
For the purpose of our
analysis, turnkey contracts are divided into following two categories:-
1.
Short
duration Turnkey Project -Turnkey Contracts with duration of project of
less than 1 year and there is no project office in India
2.
Long
Duration Turnkey Project-Turnkey Contract with long duration extending more
than 1 year and there is project office in India.
Analysis – Short
Duration Turnkey Project
Short Duration Contracts are
further categorized into categories:-
1.
Duration of Project is less than 6 months
2.
Duration of Project is between 6 to 12 months
This
categorization is based on the fact that in DTAA the duration of
Construction/installation PE ranges from 6 to 12 months
The typical feature of short
duration turnkey project is following:-
a)
No separate consideration is specified for
different components of turnkey contracts and
b)
The entire ownership in the project is
transferred upon completion and commissioning of project
·
Taxability – Project Duration is less than 6
months
The taxability
of Income from such type of contracts is analyzed as under:-
|
Particulars
|
Income Tax Act
|
DTAA
|
|
Income Categorization of Revenue from Turnkey Contract.
|
Business Income
|
Business Income
|
|
Source Rule
Taxability
|
Taxable, as there is
Business connection in India & Business operation are carried in India
|
Non-Taxable, as there is
neither fixed PE nor construction PE
|
|
Taxable computation
|
As per note
below
|
Not Applicable
|
Taxable Computation under Income Tax Act
a)
Normal computation- The turnkey Contract, being indivisible,
the total Revenue from contract less attributable expenditure will be deducted
to arrive at Taxable Income. To illustrate, let us assume the following
i)
Contract Revenue – Rs. 5 Cr
ii)
Cost Elements
· Equipment
Cost – Rs. 3 Cr (Equipment’s Selling price – Rs. 3.20 Cr)
· Service
cost – Rs. 1 Cr
iii)
Net Income – Rs. 1 Cr (5-3-1)
iv)
However, assessee need to produce contract
specific accounts to substantiate the above claim
Important points
·
In above case, the Net income of 1 Cr will
comprise of Rs. 0.20 Cr from sale of Equipment and Rs. 0.80 Cr from service
activities.
·
For computing net income from business
connections in India, the said business connection is not treated as separate
entity dealing independently with Head office. As a result only cost of
equipment will be allowed as deduction and not the selling price.
b)
Section 44BB- If the turnkey contract is
relating to any service or facility
provided for oil exploration industry as specified in said section, then
assessee can opt for computation methodology envisage in section and go for 10%
of total receipts as his taxable income
c)
Rule 10 provisions- In the absence of any
contract specific accounts being maintained, assessing office can invoke the
power under this rule and determined taxable income as seems appropriate to him
in the facts of the case, which is normal circumstances is based on certain
percentage of total contract revenue.
Conclusion- Short Duration project (less than 6
months)
For shorter
duration turnkey project (less than 6 months), the taxability is as under:-
a)
In case DTAA is applicable, nothing is taxable
as neither the fixed PE nor Installation PE is established
b)
In the absence of DTAA, if contract specific
accounts are maintained, net income from contract will be taxable in India, including income from off-shore supply of
equipment.
c)
In the absence of contract specific accounts,
assessee will be left at the mercy of AO, unless assessee case is covered under
section 44BB.
·
Taxability – Project Duration is between 6-12
months
The taxability of Income from
such type of contracts is analyzed as under:-
|
Particulars
|
Income Tax Act
|
DTAA
|
|
Income Categorization of Revenue from Turnkey Contract
|
Business Income
|
Business Income
|
|
Source Rule
Taxability
|
Taxable, as there is Business connection in India
& Business operation are carried
in India
|
Taxable, as
there is construction PE
|
|
Taxable computation
|
As per note above
|
As per Note below
|
Taxable Computation under DTAA
1.
The Profit attributable to PE has to be
determined by deeming the following:-
a)
PE is distinct and separate enterprise engaged
in same or similar activities under same or similar conditions and
b)
Dealing independently with the enterprise of
which it is PE
(Requirement
of Article 7(2) of UN model)
2.
The Profit of construction/installation PE will
be restricted to amount attributable to operations carried out in India.
3.
Consider a case where an independent enterprise
is awarded a turnkey contract for installation of machine/equipment. Apart from
installation activities in India, Independent enterprise’s role in procurement
of machine can either of the following:-
·
Simply procurement of off the shelf
machinery/equipment
·
Advise on design and other parameter of
machinery, based on his survey and requirement of installation site.
4.
In the above case, the profits of Independent enterprise
should comprise of the following:-
a)
Profits attributable to installation activities
in India
b)
Profit attributable to advice on design and
other parameter of machine, if any.
5.
Based on above example of Independent
enterprise, consider the case of following installation PE
a)
Contract Revenue – Rs. 5 Cr
b)
Machine Cost – 3 Cr and Machine’s Selling Price
(SP) – Rs. 3.20 Cr
c)
Service Cost – Rs 1 Cr
Case 1: PE had simply procured
machine from head office without any input in its designing etc.
a)
PE is treated as separate entity dealing
independently with head office at Arm’s length.
b)
In this case, the profits attributable to
installation PE will be Computed as Contract Revenue less SP of machine and
service cost i.e. Rs. 0.80 Cr (5 – 3.20 -1)
Case 2: PE has contributed to
designing of machine.
a)
In this case the Arm length Price for machine
will be less than 3.20 Cr, as the PE had also contributed to its fabrication.
Let assume that profit attributable towards this service is Rs. 0.10 Cr and in
this case, the ALP of equipment for construction PE will be 3.10 Cr
b)
Thus Profit attributable to Construction will be
Rs. 0.90 Cr (5-3.10-1)
Conclusion- Short Duration project (6-12 months)
In case
shorter duration turnkey project (6-12 months), the taxability is as under:-
a)
In case DTAA is applicable,
Construction/Installation PE will be taxable in India to the extent operations
are carried out in India as illustrated above. Though example was taken in
extremely simplistic manner, but assessee must maintain the comprehensive
documents to justify the relevant claim. Thus
based on facts, proportionate profit from off-shore sale of equipment/machine
could be taxable in India.
b)
As this
point, it is also worth mentioning that construction/installation PE cannot
claim that its activities relating to equipment are of preparatory/auxiliary in nature and as a
result nothing is taxable on account of Machinery profit. The reason being, for
non-taxability of profits from preparatory/auxiliary activities, PE should be
engaged SOLELY in that activity and in no other activity.(Requirement of
Article 5(4) as per UN model)
c)
In the absence of DTAA, if contract specific
accounts are maintained, net income from contract will be taxable in India, including income from off-shore supply of
equipment.
d)
In the absence of contract specific accounts,
assessee will be left at the mercy of AO, unless assessee case is covered under
section 44BB.
In short duration turnkey project,
where execution of different components are contemplated separately, the tax
treatment of same is dealt in later on under analysis of long duration projects.
Analysis – Long Duration
Turnkey Project
From taxation perspective, the
long duration contract can be broadly divided in two categories as under:-
|
S.No
|
Criterion
|
Category-1
|
Category-2
|
|
1.
|
Transfer of
Ownership
|
Execution of each component
is contemplated separately i.e ownership in equipment is transferred
off-shore separately.
|
Ownership in entire project
is transferred upon completion and commissioning thereof
|
|
2.
|
Consideration
|
Consideration of each
component is mentioned separately in contract and for off-shore supply,
payment is made outside India.
|
Consideration of each
component may or may not be mentioned explicitly.
|
In typical long duration
Turnkey Project, Post the project is awarded to Contractor, following steps are
generally taken by him
1.
Setting up a project office for coordination,
liaising and other incidental activities
2.
Technical survey of site
3.
Designing & supplying the equipment at site
4.
Installation and commissioning of equipment at
site by Project office team.
·
Taxability – category 1 Long Duration
project
1.
In such type of contract, though the contract is
christen as turnkey contract, but taxability will be determined according to
source rule applicable to each component of contract, as the parties to
contract expect separate execution of different activities involved in
contract. This case could be compared with situation where parties enter into
separate contract for each activity, in which scenario, the taxability of each
activity will be judged independently.
2.
For off-shore supply of equipment, the profit
therefrom will be proportionately taxable in the India, if PE in India has
contributed to earning of such profits, if any.
3.
In such type of contracts, the role of project office
is confined to supply the basic information of site to enable Head office to
design and fabricate the equipment.
4.
Thus role of project office seems to fall in the
domain of activities relating to preparatory and auxiliary in nature and hence
with respect to off-shore supply of equipment, the project office does not
constitute PE. Other activities of PE relating to liaising and co-ordination
are purely the activities of auxiliary in nature. Thus project office seems to
SOLEY engaged in the activities of preparatory and auxiliary in nature.
5.
Thus in
the absence of PE, the profits from off-shore supply of equipment is not taxable
as reiterated in Ishikawajima-Harima Heavy Industries Co 288 ITR 408,(2009).
6.
However, it is important to mention that
consideration for different components should be at Arm’s length. If the
parties deliberately inflate the off-shore profit and suppressed the on-shore
profit (from installation activities), the courts can ignore the sanctity of
terms of contract and restore the position on Arm’s length position.
The crucial aspect is
determination from terms of contract whether supply of equipment is distinctly
intended in the contract or not. In National Petroleum Corporation, ITA No.
5168/Del/2010, the Delhi Tribunal arrived at this finding from termination
clause of contract.
·
Taxability – category 2 Long Duration
Contract.
1.
For analysis the taxation of turnkey contracts
in said category, it is assumed that contractor belongs to the country with
whom India has DTAA
2.
Under DTAA, the contractor’s profits from
execution of turnkey contract will be classified as profits of enterprise
3.
For taxability of Profits of enterprise in
India, it is essential to determine the existence of enterprise’s PE in India
and attribution of profit to such PE.
4.
In case of turnkey contracts, there are
possibilities of existence of two PEs of enterprise: Fixed PE in terms of
Project office and Installation PE.
5.
The taxability of profit from supply of
equipment in India depends upon the role played by respective PE in this
activity.
6.
In case of turnkey contracts, for off-shore
supply of equipment, the role in India is confined generally to following:-
a)
Survey of site to provide preliminary inputs to
HO to enable it to design and fabricate the equipment
b)
Take delivery of equipment in India
c)
Transportation of equipment to project site
7.
In view of above, the following two scenarios
can be envisaged with respect to above-stated supply of off-shore supply of
equipment:-
a)
The various stated activities are performed by
fixed PE, which could be the case, where installation PE is commenced post
arrival of equipment at Site
b)
The activities related to technical inputs for
fabrication of equipment is done by installation PE and other stated activities
are done by fixed PE, which could be fixed where installation PE exist from
inception of contract
8.
Stated activities are performed by fixed PE as
per above clause 7(a)
a)
One view is that such activities of PE falls in
the domain of preparatory and auxiliary activities, since all the major
activities like, fabrication of equipment and receipt of consideration was done
outside India by HO and as result no part of profit from supply of equipment
can be taxable in India
b)
Other view is that such activities are not
preparatory and auxiliary activities. But in that scenario, only miniscule
profits from supply of equipment would be attributable to fixed PE.
9.
Stated activities are performed by Installation
PE as per clause 7(b)
a)
Where PE is carrying on multiple activities,
partly relating to main operations of HO and partly relating to preparatory and
auxiliary activities, then profit attributable to all activities will be
taxable in India
b)
The exemption from existence of PE is there only
where PE is solely engaged in preparatory and auxiliary activities
c)
Even if activities relating to technical inputs
for fabrication of equipments are in the nature of preparatory an auxiliary
activities, small proportion of profits from supply of equipment would be
taxable in India, since Installation PE are also carrying on other activities
i.e installation activities.
10.
Thus in case, where both Fixed PE and
Installation PE exist immediately after signing of turnkey contract, there is
possibility of being small part of off-shore profit being taxable in India,
depending upon the role played by PE in off-shore supply of equipment.
I have tried to capture my
thoughts on taxability of profits from off-shore supply of equipment in
execution of Turnkey contract in India, but it’s my request to reader to come
up with viewpoints on the above-mentioned vexed subject.
The turnkey contract is going
to assume importance of paramount significance in view of ensuing
infrastructure development envisaged in India.
The clarity on this precarious
aspect will do the benefit to all concerned.
