Satyam Computers' US investors have to pay about Rs 200 cr tax settlement: AAR

IT/ILT : Compensation paid by Indian Co. whose accounts were misstated and its auditors to settle suits in US based on tort, deceit etc. is taxable in India under section 56(1)

FACTS

• Shares of an Indian company were listed on BSE and NSE while its American Depository Receipt (ADS) were listed on New York Stock Exchange

• Price of its shares fell suddenly as a result of admission by its former Chairman from India that its accounts as on 30.9.2008 contained misstatements.

• Between January and April 2009 a number of suits were filed against the company and its auditors in US claiming damages. The suits were based on tort, misrepresentation, deceit, fraud and so on.

• In terms of US procedural laws, suits were directed to be consolidated.

• The suits were consolidated and Lead plaintiffs and Lead counsel were appointed to pilot the class action on behalf of the eligible claimants for damages. Lead plaintiffs through the lead counsel filed consolidated Class Action Complaint for alleged violation by the company and its auditors of sections 10(b) and 20(a) of the Securities Exchange Act of US

• The class action was referred for mediation or conciliation and parties arrived at a negotiated settlement of disputes subject to approval of court. Company agreed to pay $125 million and auditors agreed to pay $25 million to Qualified Settlement Fund (QSF) to be administered by Lead Counsel for distribution amongst those qualified to participate in class action.

• The amounts were transferred by company and auditors to QSF after taking RBI approval.

• US Court passed final judgement confirming the settlement as fair, reasonable and adequate

• Issue that came up before AAR was whether the compensation was taxable in India and liable to withholding tax under section 195 of the Act

HELD

• Right of action is different from cause of action

• Even though the plaintiffs had a right of action in US, their cause of action arose or accrued in India by reason of the alleged misrepresentation , tort, fraud, deceit etc practiced by the company and its auditors in India.

• The source of compensation is the alleged tort perpetrated in India. Therefore, right of compensation arose in India. Therefore, compensation accrued or arose in India within the meaning of section 5(2). The source of compensation is India.

• The compensation was neither capital receipt nor capital gains but a revenue receipt

• The compensation or damages are taxable as income from other sources under section 56(1).

[2012] 24 taxmann.com 317 (AAR - New Delhi)

AUTHORITY FOR ADVANCE RULINGS (INCOME TAX), NEW DELHI

IC, In re

JUSTICE P.K. BALASUBRAMANYAN, CHAIRMAN

A.A.R. NOS. 1045, 1060, 1078, 1087 & 1088 OF 2011

AUGUST 27, 2012

RULING

________________________________________

1. AAR No. 1045 of 2011 is filed under section 245Q of the Income-tax Act by an Indian company, for convenience referred to hereafter as IC, seeking advance rulings on the questions formulated in that application arising out of a class action filed in the United States of America represented by the applicant in AAR No. 1060 of 2011 referred to as Lead counsel hereafter, IC, the payer and Lead counsel the payee essentially want a ruling on the question whether the amount that passes from IC to Lead counsel is chargeable to tax in India.

2. Based on the same cause of action, compensation was also claimed against the auditors of IC. Money is to pass from the Auditors to Lead counsel. Lead counsel and the auditors want a ruling on whether the money that thus passes is chargeable to tax in India. Lead counsel has filed AAR No. 1078 of 2011 in that behalf. The Indian arm of the auditor, hereafter referred to for convenience, as 'A' has filed AAR No. 1087 of 2011 and the foreign arm of the auditor hereafter referred to as 'B', has filed AAR No. 1088 of 2011 seeking rulings on the transaction among them.

3. The shares of IC are listed in the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) in India. Its American Depository Shares (ADS) were listed in the New York Stock Exchange (NYS). The price of the shares of IC fell suddenly in the market as a result of an admission by its former Chairman from India that the accounts prepared as on 30.9.2008 contained some misstatements. This caused the fall in prices of its shares.

4. Between January and April, 2009 a number of suits were filed against IC and A and B in various jurisdictions in the United States claiming damages. The suits were based on tort, misrepresentation, deceit, fraud and so on. In terms of the procedural laws of the United States, the suits were directed to be consolidated. The suits were consolidated and Lead plaintiffs and Lead counsel were appointed to pilot the class action on behalf of the eligible claimants for damages. Pursuant to that, the Lead plaintiffs through the Lead counsel filed a consolidated Class Action Complaint for alleged violation by IC, A and B of sections 10(b) and 20(a) of the Securities Exchange Act of US, The Class action was filed on behalf of those who purchased or otherwise acquired IC ADSs on New York Stock Exchange, were investors residing in US who purchased or otherwise acquired shares of IC on the BSE or NSE between 4th January and 6th January 2009 (described the Class period), exercised options to purchase IC ADSs pursuant to IC Employees ADSs Plan during that class period and were US residents who exercised options to purchase IC ordinary shares pursuant to IC Employees Ordinary Share Option Plans during the Class period. It was clarified that only 0.0135% of the class represented by Lead Counsel were persons having an Indian address, 94.378% were having addresses, in the US and 5.608% are having addresses in countries other than USA and India.

5. The class action was referred to mediation or conciliation. The services of a Retired District Judge were obtained. The parties arrived at a negotiated settlement of the disputes subject to the approval of the court where the class action was pending. Under the proposed settlement IC agreed to pay $ 125 million to the Qualified Settlement Fund (QSF) to be administered by Lead counsel for distributing the compensation to those qualified to participate in the class action. A and B together agreed to pay $ 25 million to the QSF. Of the $ 25.5 million, ' A' the Indian resident was to pay $ 15.5. million and B, the non-resident, $ 10 million.

6. Pursuant to the settlement, subject to the approval of court, IC deposited an amount of US $ 125 million on 25.2.2011 in a segregated account in the local branch of CitiBank N.A. in India. Companies 'A' and B similarly deposited $ 25.5 million in their account. On 21.3.2011, the US court passed a preliminary order approving the settlement, on being satisfied that the pre-requisites of a class action settlement are fulfilled. On 29.3.2011, the Reserve Bank of India gave approval for the transfer of the settlement amount deposited by IC into an initial escrow account in USA. On the basis of it, the amount of $ 125 million was transferred from the segregated account to the Initial Escrow account in the New York Branch of CitiBank N.A. The amount deposited by 'A' moved similarly and the deposit by 'B' was in the Initial Escrow account in New York.

7. On 13.9.2011, the US court passed a final judgment and order confirming the settlement arrived at, finding it to be fair, reasonable and adequate. The QSF came under the control of Lead Counsel subject to the jurisdiction and control of the US court.

8. The applications before this Authority were filed even prior to the final order of approval, but after the initial order of approval. This Authority allowed the applications under section 245R(2) of the Act to render rulings on the questions formulated in these applications.

9. In AAR No. 1045 of 2011 filed by IC, the following questions were formulated for rulings while allowing the application under section 245R(2) of the Act :

1. Whether, on the facts and circumstances of the case, the Settlement Amount payable under the Stipulation pursuant to the judgment and Final approval of the US Court will be regarded as sum chargeable under the provisions of the Act as referred under section 195 thereof?

2. Where the answer to question no. 1 is in the affirmative, at what time shall be applicant be required to deduct income tax under section 195 of the Act?

3. Where the answer to question no. 1 is in the affirmative, without restricting the generality of the question no. 2 above, assuming but not admitting, whether the applicant is required to deduct income tax under section 195 of the Act at the time of (a) deposit of the Settlement Amount into the Initial Escrow Account to the final Escrow Account (the Qualified Settlement Fund), as per the Stipulation pursuant to the judgment and final approval of the US Court?

4. Where the answer to the question no. 1 is in the affirmative and the applicant is required to deduct income tax under section 195 of the Act, at what rate shall income tax is deducted?

10. It was clarified that regarding those of the claimants who were residents of India as on the date of the application, the rulings to be rendered will not be binding on them or on the authorities under the Act. In other words, the residents were excluded from the purview of the rulings.

11. In AAR No. 1060 of 2011, the following questions were formulated subject to the same exclusion :

1. Whether, on the facts and circumstances of the case, the Settlement Amount payable by IC under the Stipulation to the Qualified Settlement Fund pursuant to the judgment and Final approval of the US Court will be regarded as sum chargeable under the provisions of the Act in the hands of the QSF?

2. For the purposes of deducting tax at source under section 195 of the Act on the transfer of the Settlement Amount to the QSF, whether IC can take into account the chargeability of the Settlement Amount in the hands of the authorized claimants, as defined in paragraph 1(e) of the Stipulation?

3. Whether on the facts and circumstances of the case, Section 195 of the Act will also apply to the QSF when it distributes the Settlement Amount to the authorized claimants pursuant to the judgment and final approval of the US Court.

4. If the answer to question no. 1 or question no. 2 is in the affirmative and IC is required to deduct income tax under section 195 of the Act, at what rate shall income tax be deducted?

5. If the answer to the question no. 3 is in the affirmative and the QSF is required to deduct income tax under section 195 of the Act, at what rate shall income tax be deducted?

12. In AAR No. 1078 of 2011 filed by Lead Counsel regarding the payments by 'A' and 'B', the following questions were formulated subject to the same qualification :

1. Whether, on the facts and circumstances of the case, any portion of the Settlement Fund payable by the A & B Entities under the Stipulation to the QSF pursuant to the judgment and Final approval of the US Court will be regarded as sum chargeable under the provisions of the Act in the hands of the QSF?

2. Whether, on the facts and circumstances of the case, for the purposes of deducting tax at source under section 195 of the Act on the transfer of the Settlement Fund Initial Escrow Account to the QSF, can the A & B entities take into account the chargeability of the Settlement Fund in the hands of the Authorised Claimants, as defined in paragraph 1(d) of the Stipulation?

3. Whether on the facts and circumstances of the case, section 195 of the Act will also apply to the QSF when it distributes the Settlement Fund to the Authorised claimants pursuant to the judgment and final approval of the US Court?

4. If the answer to question no. 1 or question 2 is in the affirmative and income tax is required to be deducted from the Settlement Fund under section 195 of the Act, at what rate shall income tax be deducted?

5. If the answer to the question no. 3 is in the affirmative and the QSF is required to deduct income tax under section 195 of the Act, at what rate shall income tax be deducted?

13. In AAR No. 1087 of 2011 filed by 'A' the following questions were formulated subject to the same qualification :

1. Whether the Settlement Funds when paid or transferred from the initial Escrow Account to the Final Escrow Account (Qualified Settlement Fund (QSF) pursuant to the judgment and final approval of the U.S. Court would be 'chargeable to tax' in terms of section 195 of the Income-tax Act, 1961?

2. Whether for the purpose of deducting tax at source under section 195 of the Income-tax Act, 1961 on the transfer of the Settlement Amount to the QSF, the applicant can take into account the chargeability of the Settlement Amount in the hands of the authorized claimants, as defined in paragraph 1(e) of the Stipulation?

3. If the answer to the question no. 1 or question no. 2 is in the affirmative and applicant has to deduct tax at source under section 195 of the Income-tax Act, 1961, at what rate shall the tax be deducted?

4. Whether a ruling of the Authority would be sufficient authorization to the applicant to credit the said amount in its books of account and/or make the payment without undertaking any further process under the Income-tax Act, 1961? :

14. In AAR No. 1088 of 2011 filed by 'B' the following questions were formulated subject to the same qualification regarding residents :

1. Whether the Settlement Funds when paid or transferred from the Initial Escrow Account to the Final Escrow Account [Qualified Settlement Fund (QSF)] pursuant to the judgment and final approval of the U.S. Court would be 'chargeable to tax' in terms of Section 195 of the Income-tax Act, 1961?

2. Whether for the purpose of deducting tax at source under section 195 of the Income-tax Act, 1961 on the transfer of the Settlement Amount to the QSF, the applicant can take into account the chargeability of the Settlement Amount in the hands of the authorized claimants, as defined in paragraph 1(e) of the Stipulation?

3. If the answer to the question no. 1 or question no. 2 is in the affirmative and applicant has to deduct tax at source under section 195 of the Income-tax Act, 1961, at what rate shall the tax be deducted?

4. Whether a ruling of the Authority would be sufficient authorization to the applicant to credit the said amount in its books of account and/or make the payment without undertaking any further process under the Income-tax Act, 1961?

15. This Authority reserved for consideration the question whether any scheme has been devised for avoidance of tax in India. Nothing significant was brought out or argued in that behalf. So, that aspect need not detain us in these Rulings.

16. Under the terms of the settlement subsequently approved by the Court, IC had first to deposit the amounts agreed to, in a segregated account in India. 'A' had to do likewise and 'B' had to deposit it in an initial escrow account in New York, Thereafter, the amount deposited by IC had to be transferred to an Initial Escrow account in New York, After the approval of the settlement, the amount had to be transferred from the initial escrow account to the final escrow account to be treated as Qualified Settlement Fund (QSF). Thereafter, it had to be distributed to the qualified claimants in the class action, after deducting the expenses including legal fees incurred and meeting the tax liability, if any.

17. The segregated account stood in the name of IC. The interest earned on the deposit belonged to IC and the principal deposited stood transferred to the initial escrow account at the conversion rate prevailing on the date of transfer of the fund. The interest was to the benefit of IC and the title to it did not pass to QSF. The benefit or detriment of the variation in exchange rate was to be that of IC Before the fund actually got transferred to QSF, rulings had to be obtained from this Authority on chargeability to tax in India and that led to these applications. This was necessary to ascertain the actual amount available for distribution to the class action plaintiffs - qualified claimants.

18. The stand of the Lead counsel on behalf of QSF is that the amounts paid by IC, 'A' and 'B' by way of settlement is not chargeable to tax in India at all. IC, A and B support this position. The Revenue takes up the position that the amounts are chargeable to tax in India and tax has to be withheld under section 195 of the Act by the payers.

19. As emphasized by counsel, there are three stages in this transaction of IC, First, when IC deposits the amount in the segregated account in India in its own name, second when it goes from the segregated account to the initial escrow account in New York and third, when it moves from the initial escrow account to the final escrow account. At what stage, if, at all, it will become chargeable to tax is one of the aspects arising for ruling.

20. In the case of A the same pattern as IC was followed. In the case of B, the amount was directly deposited in an Initial escrow account in New York. It had to move from it to the final escrow account.

21. But, before that, the question to be decided is whether it is income at all in the hands of QSF liable to be taxed in India. If it is found that it is not income chargeable to tax in India, then the question, when title passes would become academic.

22. As pointed out by Counsel for IC, A and B, the Revenue seems to have a confused stand on the nature of the deposit. Whereas in the applications relating to deposit by IC, the Revenue adopts the stand that it is revenue income, in the applications relating to the deposit by A and B the stand adopted is that it is a capital receipt. Probably the situs of the initial deposit of the amount by B led to this varying stands.

23. According to learned counsel for the applicants, the settlement amount received by QSF is not income arising in India. Nor can it be deemed to arise in India. It was an amount offered by IC and A to Lead counsel or QSF in lieu of the various claimants giving up their right to sue for damages.

24. I will first consider what is the nature of this payment by IC, A and B. According to the applicants, the amounts are amounts in respect of waiver, release and discharge of the applicants in the class action or compensation for forbearance to sue. I find it difficult to agree with this submission. This is not a case of forbearance to sue or waiver of the right to sue. Various suits had already been instituted. The court in America took note of the several suits already filed and consolidated them and permitted them to be prosecuted as a class action in terms of the procedural laws of that country. Those suits filed were for damages or compensation. The claim was based on liability in tort. The suits were no doubt consolidated into a class action for breach of the provisions of the Securities Exchange Act of that country. But, the action had its origin in tort. The prayer was for recovery of damages for that tort. The class action complaint also avers that the action 'seeks to recover damages caused by the defendants 'mis-conduct'- It further says that the complaint asserts a claim under the Securities Exchange Act and the Securities Act.

25. The suit having been filed for damages, any settlement arrived at therein without specifically admittedly or not admitting liability for payment of compensation, cannot be considered to be compensation for forbearance to sue. The amount agreed to be paid can only be understood as damages agreed to be paid by way of settlement without going to trial and without admitting guilt or liability. I have, therefore, no hesitation in finding that the sums of $ 125 million and $ 25.5 million agreed to be paid to Lead plaintiffs would be in the nature of damages or compensation.

26. A compromise is only a contract. It becomes a decree or order of court when it receives the approval of the court and it is accepted. It is a contract with the imprimatur of the court. Here, when the settlement was arrived at, it remained a mere contract for payment of damages and on the initial approval followed by the final approval, the rule of court. So, nothing turns on the procedure followed in the American court for making the settlement an enforceable one on behalf of a class of claimants.

27. If it is damages or compensation, then the question arises, damages or compensation for what. Here, it is compensation for the loss suffered by the class plaintiffs because of the alleged fraud perpetrated by the defendants in the suit, IC, A and B. The question then is, where did the cause of action arise. A cause of action is a bundle of facts giving rise to an action The right to sue arose out of the misrepresentation of IC, by the alleged manipulating of the financial statements of IC with the alleged connivance of A and B, followed by the confession of the Managing Director of IC about the inaccuracy of the financial statements. All these took place in India. The suit could be filed in India. The claimants in the United States could also invoke the Securities Exchange Act and the Securities Act of U.S., but based on this cause of action. They acquired a right to sue in U.S. because of a statute providing a remedy. So, they sued in U.S. They exercised a right of action. A right of action is different from a cause of action. Even though the Lead Plaintiffs had a right of action in U.S., their cause of action arose or accrued in India by the alleged misrepresentation, deceit or fraud practiced in India by IC, A and B. Therefore, I am not in a position to agree that the cause of action was all in the U.S. In my view, the cause of action arose in India.

28. Based on a cause of action that arose in India, a class action suit was filed in US. On a settlement of the class action, the sums were agreed to be paid. The source of the compensation is the alleged tort perpetrated in India. Therefore, the right to the compensation arose in India. The source of the compensation is the alleged tort in India. The plaintiffs represented by Lead Counsel [as clarified by the order under section 245R(2) of the Act] are non-residents. In the language of section 5(2) of the Act, the income by way of compensation or damages accrued or arose in India. This is because, the entitlement to receive and the receipt is based on the alleged tortuous act committed in India. The source is India.

29. The argument that the source must be taken to be the class action filed in US and the orders of court giving approval to the settlement is by ignoring the cause of action that gave rise to the action. If the income is relatable to the cause of action leading to the claim, it can only be held that the action and settlement in US was only a mode of securing that compensation arising out of a cause of action that has roots in India.

30. It is argued that the income does not accrue to the QSF in India since on depositing it in the segregated account in India, QSF does not get title to it. Since IC has title to the funds even after depositing the amounts in the segregated account, the amount does not get credited to the QSF account. The title to the fund also does not pass. What I find on a consideration of the scheme adopted, is that the fund that leaves IC reaches the QSF on the orders of Court. The adopting of the three stage procedure does not alter the fact that once the fund goes from the segregated account in India, IC loses its control over it and its right to it is solely dependant on the court not approving the settlement. On the approval of the court, the title to the fund vests in QSF with effect at least from the date it gets transferred to the initial escrow account, if not on the deposit in the segregated account itself. I have already noticed that IC would lose its right to the fund once it goes into the segregated account on the terms of the settlement unless there is a breach of the settlement itself. Here, the transfer from the segregated account in India to the initial escrow account in US itself was based on an interim or preliminary approval by court of the settlement. That approval was subsequently confirmed by the final approval. I, therefore, hold that the title to the fund passed to QSF in any event, when it got transferred from the segregate document to the initial escrow account.

31. The question then is what is the nature of the income. It has been argued on behalf of the applicants that the settlement amount is a not a capital asset. Though the Revenue, in the applications by A and B raised the plea that it is a capital asset, the main argument on behalf of the Revenue before me was that it was a revenue receipt. Considering the nature of the payment, I am inclined to accept the argument of learned counsel for the applicants that the settlement amount is not a capital receipt. It can be treated only as a revenue receipt.

32. What is the character of the receipt? it is not capital receipt as I have found. Then, the income arising cannot generate any capital gain as sought to be contended by the Revenue in the applications by A and B. In the context of the definition of income in the Act read with Section 56(1) of the Act, the income can be held to be income from other sources. In other words, the settlement amount in the hands of QSF would be income from other sources in terms of the Act. Damages received by way of settlement or otherwise, cannot but be income in the hands of the receiver.

33. Considerable arguments were raised by Senior Counsel for IC that there is no receipt of income by QSF until, by the final order of the court, the amount gets transferred and becomes available for distribution. He even contended that the income would accrue to the class plaintiffs only on the amount being distributed in the US by the Lead Plaintiffs from the QSF. As I see it, the Lead Plaintiffs represent all the qualified claimants in the class action. The lead plaintiffs are their representatives. When the title to the funds passes to the QSF or Lead Plaintiffs the title passes to the qualified claimants. The Lead Plaintiffs on receiving the funds would be holding it for the qualified claimants in the class action.

34. By the settlement arrived at by the parties and the deposit of the fund in the segregated account, subject to breach of the settlement by IC or non-approval by Court, the title to the fund is lost to IC. Even if that be not the position, the title would be lost when the funds are transferred to the initial escrow account. Once it went to that account, only a disapproval of the settlement by court can revive the right of IC over the fund. Here, preliminary approval by court of the settlement was followed by the transfer into the initial escrow account after getting the permission of the Reserve Bank of India for such transfer. Since the settlement was finally approved by US court the title to the funds vested with QSF with effect from the date of it being credited to the initial escrow account, if not from the date of deposit in the segregated account itself. When a settlement is arrived at subject to the approval of Court and steps are taken thereunder, then the approval of court will be approval of each step taken as part of the settlement. That would mean that IC would lose its title to the fund from the date of deposit once the court approved the settlement subject to the terms of the settlement, like the stipulation regarding interest earned in the segregated account and the right to withdraw the taxes that may be found payable in India from the initial escrow account.

35. I, therefore, come to the conclusion that the amount deposited by IC as part of the settlement of the class action dispute with Lead counsel is income from other sources in the hands of Lead counsel or the QSF and that income arises in India.

36. The QSF or Lead counsel being a resident of US is entitled to claim the benefit of the India-US Double Taxation Avoidance Convention (DTAC). It is argued by Counsel that if the income is regarded as income from other sources, under Article 23 of the DTAC, the income not having arisen in India, it can be taxed only in the United States. He relied on paragraph 1 of Article 23 read with paragraph 2 thereof. The Revenue on the other hand argued that the income arises in India and the same can be taxed in India in view of paragraph 3 of Article 23 of the DTAC. I have found that the income arises in India or the source from which it arises is in India. Paragraph 1 of Article 23 provides that items of income of a resident of US, wherever arising, which are not expressly dealt with in the foregoing articles shall be taxable only in US. This is subject to paragraph 2. Paragraph 2 clarifies that paragraph 1 shall not apply to income other than income from certain sources specified therein. Paragraph 3 of Article 23 reads:

"3. Notwithstanding the provisions of paragraph 1 and 2, items of income of a resident of a contracting State not dealt with in the foregoing articles of this Convention and arising in the other Contracting State may also be taxed in that State."

Elaborate arguments were raised whether an income deemed to arise in India in terms of Section 9 of the Act, can come within the purview of this paragraph or it is confined only to the income actually arising in India. In view of my finding that the income here arises in India, this controversy need not detain me in this ruling, On my finding of its being income from other sources arising in India, paragraph 3 of Article 23 of the DTAC has application. The income is chargeable to tax in India in terms of the DTAC.

37. Once it is found chargeable to tax in India, IC will have the obligation to withhold tax on the amount under section 195 of the Act. I have found that the title to the fund passed from IC to the QSF or Lead Counsel when the fund moved from the segregated account in India to the initial escrow account in the US. For that transfer the permission of the Reserve Bank of India was also needed and IC could not thereafter deal with the amount and what it earned unless the court refused to accept the settlement. That contingency did not happen. So, I am satisfied that it would be appropriate to hold that the obligation of IC to withhold tax under section 195 would arise on the transfer of the fund from the segregated account in India to the initial escrow account in the U.S.

38. Some procedural aspects regarding withholding and deposit of tax was relied on by Senior Counsel for IC in support of the contention that no withholding of tax by IC was called for. With great respect to Counsel, once it is found that IC has to withhold the tax, the obligation of IC does not get destroyed by the aspects pointed out by him. After all, Lead counsel or the QSF represents the qualified claimants, the ultimate beneficiaries and even according to the order of approval of the settlement by Court, Lead Counsel have to deduct the expenses incurred including counsel fee payable and the taxes due on the fund. The withholding tax has therefore to be deducted from the fund before it is distributed. The rules and forms referred to by Counsel are adequate to meet the situation. The fund would get the credit for the tax paid and the obligation will be to distribute the balance only. IC will have to withhold the tax as enjoined by the Act.

39. Regarding the rate of tax to be withheld, the Revenue submitted that it is at 30% of the amount. This is not contradicted.

40. Now coming to the transaction relating to A and B, it is clear that the position regarding A, a resident in India is identical. Here also, the sum of $ 15.5 million was first deposited in a segregated account in the name of A in HDFC Bank in India. It followed the same route as the deposit of IC. The position obtaining is, therefore, the same.

41. 'B' is a non-resident. The application by Lead Counsel, AAR No. 1078 of 2011 asserts that the sum of $ 10 million was directly transferred into the initial escrow account by some or all remaining B entitles who are not based in India. I have found the source of income for the QSF to be India. I have also held that the liability to be taxed in India exists by virtue of paragraph 3 of Article 23 of the DTAC. No separate argument was raised on the existence or non-existence of an obligation under section 195 of the Act in the case of B. Since, the whole settlement fund is found to be liable to be charged to tax in Act, the deduction will be made from the fund in terms of Section 195 of the Act on this amount also and deposited before the fund is distributed to the qualified claimants.

42. The rulings can now be summarised.

In AAR No. 1045 of 2011, I rule on question no. 1 that the Settlement amount payable will be regarded as sum chargeable under the provisions of the Act as referred to under section 195 of the Act. On question no.2, I rule that the applicant is required to deduct income-tax when the settlement amount moves from the segregated account to the initial escrow account. In view of the ruling on question no. 2, no separate ruling is called for on question no.3. On question no. 4, I rule that the deduction should be at the rate of 30%.

In AAR No. 1060 of 2011, I rule that the settlement amount will be regarded as sum chargeable under the provisions of the Act as required under section 195 of the Act. On question no. 2, I rule that the time to deduct the tax is when the amount is moved from the segregated account in India to the initial escrow account in the US. In view of the ruling on question no. 2, no separate ruling on question no. 3 is called for. On question no. 4 I rule that the rate at which the tax is to be deducted is at 30%.

In AAR No. 1078 of 2011, I rule on question no. 1 that the amount payable to the Settlement fund by A and B will be regarded as sum chargeable under the provisions of the Act in the hands of QSF. On question no. 2, I rule that for the purpose of deduction under section 195, the entities A and B are not entitled to take into account the chargeability of the settlement fund in the hands of the authorized claimants. Question no.3 raised has to be raised before the tax authorities in US. Once the tax is deducted on the fund as a whole, in the present context, the obligation of QSF will come to an end. The other aspect is not for consideration now. On question no. 4, I rule that the deduction of tax will be at the rate of 30%.

In AAR No. 1087 of 2011, I rule on question no. 1 that the amount would be chargeable to tax in terms of Section 195 of the Act at the point of time as specified in the rulings in the other applications. On question no. 2, the ruling given in AAR No. 11078 of 2011 will be the ruling here also. On question no. 3, I rule that the deduction will be at 30%.

Question no. 4 cannot be ruled on since no specific arguments were raised on it. I leave it open .

In AAR No. 1088 of 2011, the four questions raised are identical to the four questions raised in AAR No. 1077 of 2011. The rulings are also the same and as set out above while ruling in AAR No. 1077 of 2011.

43. Accordingly, the ruling is pronounced.

Income on account of upfront appraisal fees is not FTS

The submission that the upfront appraisal fee constitutes fees for technical services within the meaning of those words in Article 13(4)(c) is unsustainable. The said fees did not constitute payment in consideration of the respondent rendering any technical or consultancy services to the applicant/borrowers. As we have noted earlier, the entire appraisal process was to enable the respondent to take a decision as to whether the credit facilities ought to be advanced to the applicants or not. The respondent did not thereby or even while doing so, impart any technical or consultancy services to the applicants. Understandably, the appellants were unable to indicate anything that even remotely suggested that during the appraisal or by the appraisal report, the respondent made available to the applicants or the borrowers, any technical knowledge, experience, skill, know-how or processes or that the same consisted of development and transfer of any technical plan or technical design. In fact, it was quite the contrary. The process involved the respondent appraising itself of various aspects of the applicant for the credit facilities which would obviously involve an appraisal of the applicants existing assets, tangible as well as intangible, including its technical knowledge, experience, skill, know-how and the quality of its processes and technical abilities. By no stretch of imagination can it be said that the respondent imparted to the applicants or the borrowers, any technical services, much less technical services of the nature referred to Article 13(4)(c) of the DTAA.

The Tribunal thus rightly upheld the findings of the CIT (Appeals) that the income on account of the upfront appraisal fees was business income and as the respondents did not have a permanent establishment in India, the same could not be charged to tax in India under Article 7 of the DTAA.

HIGH COURT OF BOMBAY

Director of Income tax (International Taxation) v. Commonwealth Development

IT APPEAL NO. 1058 OF 2011

JULY 9, 2012

JUDGMENT

S.J. Vazifdar, J. – This is an appeal under section 260-A of the Income Tax Act, 1961, against the order of the Income Tax Appellate Tribunal dated 25th February, 2010, in respect of the assessment year 1998-99, dismissing the appellant’s Income-tax Appeal No. 1987/Mum/2006 and the respondent’s cross-objections.

2. The appeal is admitted on the following substantial question of law :

“Whether the ITAT erred in deleting the addition made by the Assessing Officer amounting to Rs. 77,14,828/- on account of up front appraisal fees under section 143(3) of Act ?”

3. The respondent is a statutory company established under the laws of of the United Kingdom. It filed its return of income for the assessment year 1998-99 on 5th August, 1999, declaring an income of Rs. 13,17,82,890/-. After taking into account, the TDS, a refund of Rs. 21,78,079/- was claimed. The Joint Commissioner of Income-tax passed an order under section 143(3) and served a notice of demand under section 156 for Rs. 30,86,180/-. The Assessing Officer, inter-alia, added to the total income, the sum of Rs. 77,14,828/- received by the respondent towards upfront appraisal fee.

4. It is necessary first to indicate what the upfront appraisal fee is. The assessee advances loans, inter-alia, to Indian companies. Before doing so, it examines the creditworthiness of the borrower and the financial efficacy of advancing the credit facilities. To do so, it appraises the applicant for the loan. The report is then considered by the respondent’s various departments to enable them to decide whether or not to advance the loan/credit facilities. The respondent charges the applicants, a fee for carrying out the appraisal. This fee is termed as the upfront appraisal fee (hereinafter referred to as “the said fee”). It covers the cost of the appraisal and expenses incidental thereto and in connection therewith.

5. It is important to note two things. Firstly, the applicant for the facility is normally not furnished a copy of the report. Secondly, the fee is charged irrespective of whether the loan/credit facility is advanced to the applicant or not. The following table demonstrates this :

S. No. Name of Investee Amount (Rs) Nature of proposed investment Status of the deal

1. DLF Power Ltd 11,85,175 Preference Shares and Senior Debt Failed

2. Gujarat Pipavav Port Limited 9,74,250 Equity. Successful

3. Punjab Wireless Systems 12,08,151 Equity and/or Quasi Equity and Senior Debt Failed

4. STI India Limited 19,28,426 Convertible Bonds and Equity Successful

5. Kondapalli Power Corporation 24,18,826 Equity and Senior Debt Successful

Total 77,14,828

The upfront appraisal fees were received by the respondent from the applicants at Sr. Nos. 1 and 3, but the loan transactions were not entered into with them.

6. These upfront appraisal fees were brought to tax under the head “Income from other sources”. The JCIT held the receipts to be either interest as defined in Article 12 or in the nature of fees for technical services as defined in Article 13 of “The Convention Between The Government Of The Republic Of India And The Government Of The United Kingdom Of Great Britain And Northern Ireland For The Avoidance Of Double Taxation And The Prevention Of Fiscal Evasion With Respect To Taxes On Income And Capital Gains” (hereinafter referred to as “the DTAA”).

7. Mr. Suresh Kumar, the learned counsel appearing on behalf of the appellant firstly submitted that the upfront appraisal fees (hereinafter referred to as “the fee”) fall within the definition of “interest” under Section 2(28A), which reads as under :-

“Definitions. – In this Act, unless the context otherwise requires.

…………..

(28A) “interest” means interest payable in any manner in respect of any moneys borrowed or debt incurred (including a deposit, claim or other similar right or obligation) and includes any service fee or other charge in respect of the moneys borrowed or debt incurred or in respect of any credit facility which has not been utilised;”

8. The submission is not well founded. The fee is not payable in respect of any moneys borrowed or debt incurred. It is the debt itself. If any money was payable in respect thereof, it could have been held to be interest. However, admittedly, no amount was paid by the applicants in respect of the said fee.

9. Nor can the payments be said to be service fees or other charges “in respect of moneys borrowed or debt incurred or in respect of any credit facility which has not been utilized”. This is so irrespective of whether or not the loan transactions were entered into between the respondent and the applicants.

10. (A) Where the loan transaction was not entered into, the said fee could not be said to have been in respect of moneys borrowed for moneys were not even lent. It was, therefore, not in respect of a debt incurred for it was the debt itself. Nor could the said fee be said to have been charged or made in respect of any credit facility which had not been utilized for the credit facility had not even been sanctioned, leave alone advanced.

(B) The position would be the same even where the loan transactions had been entered into between the respondent and the applicants. The said fee was charged prior to and entirely independent of the loan transaction that was subsequently entered into. The parties had agreed that the respondent would be entitled to the said fee irrespective of whether the loan transaction was entered into or not. Interest was separately charged by the respondent in respect of the moneys lent pursuant to the agreements that were entered into. Nor can the fee be said to be in respect of credit facilities granted but not utilized for the said fees preceded the credit facility and had nothing to do with it. It was paid towards the appraisal work which by its very nature was entirely different from the loan transaction. It was to enable the respondent to decide whether the loan ought to be granted to the borrower or not.

11. Mr. Suresh Kumar submitted that a single agreement had been entered into between the respondent and the applicants for the payment of the said fee as well as the terms and conditions of the credit facilities to be granted by the respondent. He submitted, therefore, that the said fee must be deemed to be in respect of the loan granted.

12. We will assume that a single agreement was entered into. It is, however, not disputed that the respondent was not thereby bound to sanction the credit facilities. Admittedly, the respondent was entitled to appraise the project and decide whether or not to sanction the credit facilities. In some cases, it decided to sanction the same and in some cases, it decided not to do so. Obviously, the terms and conditions in respect of the credit facilities would come into effect only upon and in the event of the respondent deciding to sanction the credit facility and the applicant agreeing to avail of the same. The payment of the said fee was fixed and mandatory and neither dependent upon nor connected with the loans advanced. It had to be paid even if the loan transaction was not entered into. It did not vary even if the loan transaction was entered into. The fact that a single agreement was entered into, therefore, would make no difference.

13. It is pertinent to note that it was not the department’s case that the upfront appraisal fee was a camouflage for interest. Indeed, even the assessment order does not suggest the same. The facts on record militate against the same. The assessment order itself recognises the fact that the respondent examined the creditworthiness of the Indian companies and its projects for which the loans were required.

14. Mr. Suresh Kumar then submitted that the said fee falls within Article 12(5) of the DTAA.

15. We intend relying upon our judgment dated 9th July, 2012 in Income Tax Appeal No.1026 of 2011 in The Director of Income Tax v. M/s. Credit Suisse First Boston (Cyprus) Ltd., in which we construed Article 11(4) of the India-Cyprus DTAA which is similar to Article 12(5) of the India-UK DTAA. The difference between the two Articles is not material to the question before us. The difference in Article 12(5) is the addition and the absence of certain words which we will underline.

“INDIA – UK DTAA

ARTICLE 12 – Interest

………….

5. The term “interest” as used in this Article means income from debt-claims of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtor’s profits, and in particular, income from Government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures but, subject to the provisions of paragraph 9 of this Article, shall not include any item which is treated as a distribution under the provisions of Article 11 (Dividends) of this Convention.”

NOTE : The underlined words do not appear in Article 11(4) of the India-Cyprus DTAA.

“INDIA-CYPRUS DTAA

ARTICLE 11 – Interest -

1. ……………..

4. The term “interest” as used in this Article means income from debt-claims of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtor’s profits, and in particular, income from Government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures. Penalty charges for late payment shall not be regarded as interest for the purpose of this Article.”

NOTE : The underlined words do not appear in Article 12(5) of the India-UK DTAA.

16. In our judgment dated 9th July, 2012 in Income Tax Appeal No.1026 of 2011 in The Director of Income Tax v. M/s. Credit Suisse First Boston (Cyprus) Ltd., we held as under :-

“25. Clause (4) of Article 11 defines interest. The principal or governing words in Article 11(4) are “interest means income from debt-claims of every kind”. These words predicate the existence of a debtor-creditor relationship. Clause 4 relates to interest “from” debt-claims. In other words, the income must arise out of, on account of a debt-claim. It is important to note the difference between the debt-claim itself and any accretion thereto, such as interest. Once this distinction is noted, it is easy to appreciate that the price realised upon the sale of the debt-claim itself is not interest. Interest arises from and on the terms of the debt-claim/security and would be on revenue account. The sale proceeds upon a transfer or assignment of the security arise not from but on account of and represents the debt claim/security itself.”

The observations apply equally to Article 12(5) of the India-UK DTAA. The differences between the two Articles are not material to the ambit of the term “interest” for the purpose of this case. The upfront appraisal fee is not income from a debt-claim. It is the debt itself. It is rightly not even suggested that it arises out of or on account of a debt-claim. The said fee, therefore, does not fall within the ambit of Article 12(5) of the DTAA.

17. Mr. Suresh Kumar then submitted that the said fee falls within Article 13(4)(c) of the DTAA, which reads as under :-

“ARTICLE 13 – Royalties and Fees for Technical Services.

………….

4. For the purposes of paragraph 2 of this Article, and subject to paragraph 5 of this Article, the term “fees for technical services” means payments of any kind to any person in consideration for the rendering of any technical and consultancy services (including the provision of services of technical or other personnel) which ;

…………….

(c) make available technical knowledge, experience, skill, know-how or processes, or consist of the development and transfer of a technical plan or technical design.

18. He firstly submitted that the Tribunal had not dealt with this aspect at all. This would not be entirely fair as it appears that the point was not pressed before the Tribunal. The Commissioner of Income Tax (Appeals) dealt with this issue. The order of the Tribunal does not refer to this point. No application was made to the Tribunal in this regard. The appeal memo filed by the appellant before the Tribunal states only this:

“On the facts and circumstances of the case and in law, the ld. CIT(A) has erred in deleting the addition made by the A.O. Amounting to Rs. 77,14,828/-”

This is an omnibus ground. On the basis of this ground, we are unable to accept the contention that the point was raised before the Tribunal. In any event, we permitted Mr. Suresh Kumar to address us on this aspect of the matter and have decided the same.

19. The submission that the upfront appraisal fee constitutes fees for technical services within the meaning of those words in Article 13(4)(c) is unsustainable. The said fees did not constitute payment in consideration of the respondent rendering any technical or consultancy services to the applicant/borrowers. As we have noted earlier, the entire appraisal process was to enable the respondent to take a decision as to whether the credit facilities ought to be advanced to the applicants or not. The respondent did not thereby or even while doing so, impart any technical or consultancy services to the applicants. Understandably, the appellants were unable to indicate anything that even remotely suggested that during the appraisal or by the appraisal report, the respondent made available to the applicants or the borrowers, any technical knowledge, experience, skill, know-how or processes or that the same consisted of development and transfer of any technical plan or technical design. In fact, it was quite the contrary. The process involved the respondent appraising itself of various aspects of the applicant for the credit facilities which would obviously involve an appraisal of the applicants existing assets, tangible as well as intangible, including its technical knowledge, experience, skill, know-how and the quality of its processes and technical abilities. By no stretch of imagination can it be said that the respondent imparted to the applicants or the borrowers, any technical services, much less technical services of the nature referred to Article 13(4)(c) of the DTAA.

20. The Tribunal thus rightly upheld the findings of the CIT (Appeals) that the income on account of the upfront appraisal fees was business income and as the respondents did not have a permanent establishment in India, the same could not be charged to tax in India under Article 7 of the DTAA.

21. The appeal is, therefore, dismissed. There shall be no order as to costs.