Unsurprisingly, the retrospective amendment proposed to be made to sections 2 and 9 of the Income Tax Act has dominated analysis of the direct tax proposals in the budget. There is no doubt that these amendments, and particularly the validation clause in cl 113 of the Finance Bill, may be vulnerable to a constitutional challenge, and this is a subject we will discuss in more detail. Budget 2012, however, has proposed a number of other fundamental changes to the fabric of the Income Tax Act, and a recurring theme is the desire of the legislature to “clarify” what we are told was “always” its intention.
The following is a summary of the more important of these changes.
Definition of Royalty
There has been considerable controversy over the meaning of royalty under section 9(1)(vi), particularly in the context of computer software. Some decisions had taken the view that even payment for off-the-shelf software constitutes royalty, while others rejected this view on the ground that it failed to distinguish between a transaction involving a copyright from one involving the licence or sale of a copyrighted article. We have discussed this controversy here. The Finance Bill, 2012 proposes to insert Explanations 4 and 5 to s 9(1)(vi) to “clarify” that the term royalty includes, in relation to computer software, a “transfer of all or any right for use or right to use (including granting of a licence)” and more generally, that the term covers “consideration in respect of any right, property or information” regardless of the payer retaining possession or control and the location of the right.
The language of Explanations 4 and 5 is unfortunate. For one, the easy assumption of the legislature that the present formulation is what it “always intended” may be challenged because it appears to be the principal ground on which retrospectivity is justified even in the Explanatory Memorandum, and the Supreme Court has held more than once in testing the vires of retrospective legislation that it is not bound by a declaration that a provision is clarificatory (see for example NACMF v Union of India 260 ITR 548 and the oft-quoted principle of “small repairs”). Leaving aside the question of validity, the thrust of this Explanation substantially broadens the scope of the definition (compare “consideration for the transfer of any rights in respect of” with “consideration in respect of”), particularly since the relevance of possession and control is proposed to be discarded. So wide a definition of royalty may conceivably capture payments that do not in any way resemble what would ordinarily be regarded as royalty, including the sale simpliciter of off-the-shelf software.
General Anti-Avoidance Rule
A General Anti Avoidance Rule is proposed to be inserted as Chapter X-A of the ITA 1961. The language of the GAAR is similar to the GAAR in the proposed DTC and allows a transaction to be declared as an “impermissible avoidance arrangement”, if the main purpose or one of the purposes of an arrangement is a tax benefit and the arrangement creates non-arm’s length rights or obligations or it results in an “abuse or misuse” of the provisions of the Act or it “lacks commercial substance” or is entered into in a manner not ordinarily employed for “bona fide” purposes. Some of these terms are defined with more precision and if this provision is enacted into law India will have to confront some of the familiar problems a GAAR brings – the relationship between a GAAR and beneficial provisions of the ITA etc. The answers the courts have given in Australia and New Zealand show that this is no easy task. As Lord Hoffmann said in 2005, a GAAR may be a cure that is worse than the disease.
Treaty Override and Certificate of Residency
The GAAR also contains a non-obtstante clause providing that it overrides “anything contained in the Act” (thereby including section 90). Cl 31 of the Finance Bill proposes to make this explicit by adding section 90(2A) to provide that Chapter X-A applies to an assessee even if it is not more beneficial to him. Another limitation to the existing DTAA regime is the introduction of s 90(4) which provides that an assessee shall not be entitled to claim treaty benefits unless he obtains a certificate of his residency in the other contracting State from that Government or other competent authority. That means that he cannot prove residency by simply satisfying the requirements of article 6 in an Indian court, even if in reality he is a resident in those terms.
Transfer Pricing for Domestic Transactions and Advance Pricing Agreement
Section 92BA is proposed to be inserted extending the transfer pricing provisions to “specified domestic transactions”. The transactions in respect of which the domestic TP provisions would apply are enumerated in section 92B (principally deduction provisions where profit shifting is possible to claim a higher deduction for the eligible unit) and must exceed Rs. 5 crore in aggregate in the previous year.
The Advance Pricing Agreement in section 92CC is an agreement that determines the arm’s length price in advance in relation to an international transaction, and the agreement is valid for five years. There is an analogy with the AAR mechanism, for this agreement is binding on the taxpayer and the Commissioner but not if there is a change in law or facts or if it is found that the agreement was obtained by fraud or misrepresentation.
Returns, Reassessment and TDS in respect of foreign transactions
Important amendments are proposed to be made to sections 139, 147 and 195. As to section 139, the Finance Bill provides that every resident who is otherwise not required to file a return shall file a return if he has any asset outside India or signing authority in any account located outside India. As to section 149, the Finance Bill proposes to permit reopening for upto sixteen years if income in relation to “any asset located outside India” has escaped assessment. As to section 195, readers may recall that the Chief Justice held that presence is required in relation to the particular transaction out of which the tax liability is alleged to arise, and that Justice Radhakrishnan went further to hold that it can only be fastened on a resident. Cl 75 of the Finance Bill proposes to insert Explanation 2 (it goes without saying that this purports to be “clarificatory”!) to provide that s 195 applies to any person, whether resident or not, and regardless of residence, place of business, business connection or “any other presence in any manner whatsoever” in India.
In the coming days, we will have an opportunity to discuss the vires and implications of some of these amendments at length. It is certain, however, that the proposed retrospective amendments are not only liable to be tested on the element of retrospectivity, but also for territorial nexus, for the Supreme Court has confirmed last year, albeit in language that gives considerable latitude in legislation, that territorial nexus is a limitation on Parliament’s power to legislate under art 245 of the Constitution.