Business Connection and Income Tax Act

‘Business connection’ has for long been recognized as a mode of determining the tax liability of non-residents. [1] Although there is a passing reference to the term “business connection” in the Income Tax Act 1961, there is no explicit definition assigned to it. [2]

Incomes arising from “business connection” in India are one among a number of categories of income arising from reading together S.5 and S.9 of the Income Tax Act 1961 (hereinafter “the Act”). Both sections, read together, embody the ‘source rule’ of income taxation in India. Under S.5 of the Act, “a foreign company or any other non-resident person is liable to tax on income which is received or is deemed to be received in India by or on behalf of such person, or income which accrues or arises or is deemed to accrue or arise to it in India”. [3] Section 9 thereafter specifies certain types of income that are deemed to accrue or arise in India in certain circumstances. A non-resident’s income cannot be taxed in India unless it falls within ambit of S.5 and S.9 read together. Section 9(1) of the Act specifies that for the income to be taxed in India, it should deemed to accrue or arise in India. [4]

The business income of a non-resident (foreign company or other non-resident person) is chargeable to tax to the extent it accrues or arises through a business connection in India or from any asset or source of income located in India, and to the extent such income is attributable to the operations carried out in India. Certain income is deemed to accrue or arise in India under S.9 of the Act, even though it may actually accrue or arise outside India. [5] In other words, only the ‘Indian component’ of income is liable to income tax in India in the case of a non-resident person. Consequently, it also means that a non-resident person is not liable to pay any income tax in India on his ‘foreign income’. Therefore, an income need not necessarily actually accrue or arise in India but may be deemed to accrue or arise in India. [6]

The Hon’ble Courts have time and again interpreted the term “business connection” with reference to facts, circumstances and prevailing conditions. The settled view was that the expression limits of no precise definition. In C.I.T. v R.D. Aggarwal & Co. [7] , the Supreme Court discussed the import and connotation of the expression. The question whether a non resident has a ‘business connection’ in India from or through which income, profits or gains can be said to accrue or arise to him within meaning of section 9 of the Income Tax Act, 1961, had to be determined on the facts of each case.

In this paper, the researcher aims to visit the series of judicial pronouncements related to the term “business connection”. The researcher shall give special attention to C.I.T. v R.D. Aggarwal & Co. and its impact on the interpretation of the term “business connection”.

Part I: Judicial interpretations of “Business Connection”

In the landmark judgment of C.I.T. v R.D. Aggarwal & Co. [8] , the Supreme Court discussed the meaning of the term “business connection”. It held that although the Income Tax Act defines the expression “business” as any trade, commerce, manufacture or any adventure or concern in the nature of trade commerce of manufacture, it contains no definition of the expression “business connection”. [9]

The facts of the case are as follows. RD Aggarwal & Co (the assessees) were a registered firm having their place of business in Amritsar. The assessees were carrying on business as importers and as commission agents of non-resident exporters from Italy and Belgium, who were manufacturers of worsted woolen yarn.

The question which came up for consideration in the instant case was whether the relationship of assessee with the non residents for whom he was canvassing orders in taxable territories without authority to accept orders, amounted to business connection.

The Supreme Court, in interpreting “business connection”, has touched upon a number of ingredients or essential characteristics to establish the business connection between the non-resident and the taxable territories. These may be classified as –

Element of Continuity

In discussing the meaning of “business connection”, the Supreme Court in the instant case held that the expression “business connection” meant something more than “business” as defined under the Act. It held more specifically [10] –

“A business connection…involves a relation between a business carried on by a non-resident which yields profits or gains and some activity in the taxable territories which contributes directly or indirectly to the earning of those profits or gains. It predicates an element of continuity between the business of the non-resident and the activity in the taxable territories a stray or isolated transaction is normally not to be regarded as a business connection.”

In CIT v. Fried Krupp Industries [11] the Madras High Court held that the term ‘business connection’ postulates a continuity of business relationship between the foreigner and the Indian. A business relation cannot be regarded as a continuing business relation when a person purchases the machinery or other goods abroad and uses them in India and earns profit. Sethuraman J. further elaborated that an isolated transaction between a non-resident and a resident in India without any course of dealings such as might fairly be described as business connection does not attract S.9. [12] There is no question of continuing business relating when a person merely purchases machinery or other goods abroad or uses them in India and earns profit. [13]

In Anglo-French Textile Co. Ltd. v. CIT (No. 2) [14] , it was observed that activities which are not well defined or are of a casual or isolated character would not ordinarily fall within the ambit of this rule. In the instant case, only a few transactions of purchase of raw materials had taken place in British India, and the Court held that it could not ordinarily be said that the isolated acts were in their nature ‘operations’ within the meaning of that expression to attract S. 42(3) of the 1922 Act [15] [corresponding to S.9 of the 1961 Act].

Existence of ‘Business Connection’ may vary on facts of each case

The Supreme Court also held, in this respect that the business connection from or through which income arose or was deemed to accrue to a non resident would depend on the facts of each case. It specifically held in C.I.T. v R.D. Aggarwal that [16] –

“Business connection may take several forms. It may include carrying on a part of the main business or activity incidental to the main business of the nonresident through an agent, or it may merely be a relation between the business of the non-resident and the activity in the taxable territories which facilitates or assists the carrying on of that business. In each case the question whether is a business connection from or through which income, profits or gains arise or accrue to a non-resident must be determined upon the fact and circumstances of the case.”

Business Connection as a real and intimate connection

Shah J., in speaking of the nature of the business connection, stated that for a business relation to qualify as a business connection, it must be “real and intimate” and one through which income would accrue or arise directly or indirectly to the non resident. [17]

Further, the Supreme Court drew a distinction between the income charged as accruing or arising from a business connection with a non taxable territory as opposed to income arising from with a taxable territory. The Court explained this distinction in the RD Aggarwal case in the following words-

“Income received or deemed to be received, or accruing or arising or deemed to be accruing or arising within the taxable territories in the previous year is taxable by S. 4(1)(a) & (c) of the (1922) Act, whether the person earning is a resident or non-resident. If the agent of a non-resident receives that income or is entitled to receive that income, it may be taxed in the hands of the agent by the machinery provision enacted in S.40(2) (of the 1922 Act). Income not taxable under S.4 of the Act of a non-resident becomes taxable under S.42(1)(of the 1922 Act) [corresponding to S.9 of the 1961 Act] if there subsists a connection between the activity in the taxable territories and the business of the non-resident, and if through or from that connection income directly or indirectly arises.”

Mere purchase abroad and use in India is not ‘continuing business’

In CIT v. Fried Krupp Industries [18] , the court looked into the question whether principal to principal transaction amounts to any business connection.

Sethuraman J. in his observations noted that where a person was merely purchasing goods from a foreigner without anything more, and the purchased goods were utilised in commercial operations in India by the Indian, then the Indian merchant or company was earning his own or its own income. [19] The court further observed that in such cases, there could be a situation where there is no ‘continuity of business relationship’ between the foreigner and the Indian as the foreigner has no further interest in the business in India (and has nothing to do with the Indian assessee’s transaction in India) after selling his machinery abroad. The court held that there is no question of continuing business relation when a person purchases machinery or other goods abroad and uses them in India and earns profit and the part of the foreigner has been played wholly abroad, so that there is no connection as such with any business in India. [20] The Supreme Court has expressed its approval of the decision of the Bombay High Court in CIT v Tata Chemicals Ltd. [21] , wherein it was held that in order to bring in the income of a non-resident under the ambit of taxable income (through the deeming provision), the department must show that some of the operations were carried out in India in respect of which the income was sought to be assessed. Hence it was held that in respect of principal to principal transactions, no business connection can be said to arise. [22]

Capital gains derived outside India is excluded

If the words ‘business connection in India’ were wide enough to cover all transactions including transactions in capital assets, there was no reason for Parliament to specifically include income (a) through or from any property in India, (b) through or from any asset or source of income from India, and (c) through or from sale of a capital asset situate in India. [23] In CIT v Quantas Airways Ltd [24] , the Court held that the very fact that the transfer of a capital asset situate in India has been brought within the purview of S.9, the intention of Parliament was to not bring within its purview any income derived out of sale or purchase of a capital asset effected outside India. [25]

Part II: Position after C.I.T. v R.D. Aggarwal

With the introduction of the Finance Act 2003, two new explanations were inserted to the expression “business connection” under S.9(i) with effect from the assessment year 2004-05, clarifying that the expression will include a person acting on behalf of the non-resident, who: [26]

has, and habitually or regularly exercises in India, an authority to conclude contracts on behalf of the non-resident, unless his activities are limited to the purchase of goods or merchandise for the non-resident;

has no such authority, but habitually maintains in India a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the non-resident; or

habitually secures orders in India, mainly or wholly for the non-resident or for that non-resident and other non-residents controlling, controlled by, or subject to the same common control, as that non-resident.

The ‘business connection’ will, however, not include cases where the business activity is carried out through a broker, general commission agent or any other agent having an independent status, if such person is acting in the ordinary course of his business. [27] It has also been explained that were a business is carried on in India through a person referred to in clauses (a), (b) and (c) of Explanation 2, only so much of the income as is attributable to the operations carried out in India shall be deemed to accrue or arise in India. [28]

Recent Decisions

S.9 was interpreted in a relatively recent decision of the Supreme Court, Ishikawajima-Harima Heavy Industries Ltd v Director of Income Tax, Mumbai [29] . The Apex Court held: [30]

“Reading the provision in its plain sense, it can be seen that it requires two conditions to be met – the services which are the source of the income that is sought to be taxed, has to be rendered in India, as well as utilized in India, to be taxable in India. In the present case, both these conditions have not been satisfied simultaneously, therefore, excluding this income from the ambit of taxation in India. Thus, for a non-resident to be taxed on income for services, such a service needs to be rendered within India, and has to be part of a business or profession carried on by such person in India. The petitioners in the present case have provided services to persons resident in India, and though the same have been used here, they have not been rendered in India.”

Thus under Ishikawajima, it was not the mere place where a service was utilized which was determinative of the taxability of the fees received in lieu of the service. For the fees to be taxable, the services rendered to non-residents must have been both rendered in India and utilized in India. In effect, a territorial nexus requirement was sought to be established before the income would come within the purview of the Indian tax net.

Following this decision, the Finance Act 2007 inserted a retrospective amendment which provided:

Explanation. For the removal of doubts, it is hereby declared that for the purposes of this section, where income is deemed to accrue or arise in India under clauses (v), (vi) and (vii) of sub-section (1), such income shall be included in the total income of the non-resident, whether or not the non-resident has a residence or place of business or business connection in India.

A memorandum explaining the rationale behind the amendment made it clear that the legislative intent behind the provisions was to clarify that the requirement of territorial nexus was irrelevant under clauses (v), (vi) and (vii) of Section 9(1).

Further, in considering the effect of this amendment, the Bombay High Court in November 2008 in the case of CIT v. Siemens [31] held that the ratio of Ishikawajima was overcome by the amendment.

However, the decision of the Bombay High Court in Clifford Chance v DCIT [32] , has put the Siemens judgment under a cloud. In the instant case, Clifford Chance – a leading UK-based law firm – had provided certain advisory services for certain resident and non-resident clients who were engaged in certain projects in India. The firm had separately billed its clients for the services rendered in India and the services rendered outside India. The issue was whether the whole of the fees received for the services were chargeable in India, or whether only that part of the fees which was received for the services rendered in India was chargeable to tax in India. Under the law as laid down in Ishikawajima, although the service was utilized in India, part of it was not rendered in India and was therefore not chargeable to tax in India. The Department contended (along the same line of argument as that in Siemens) that the ratio of Ishikawajima must be considered as having been overruled by way of the Explanation inserted via Finance Act 2007. Therefore, only the place where the service was utilized would be relevant, not the place where it was rendered. The non-residents by whom the fees were payable were clearly using the services in India – as such, the fees should have been taxable. [33]

However, the Court relied on Ishikawajima and held that the fees would be taxable only where the service was both utilized and rendered in India. Moreover, the Siemens case was not cited by the Court in the Clifford Chance case. Furthermore, although the Revenue Department’s contention that the 2007 amendment nullified the effect of the Apex Court decision in Ishikwajima was noted, the Court did not substantively address this contention except for noting that the provisions of Section 9 were clear and unambiguous.

Researcher’s views

According to the researcher, there are two ways in which to interpret the Court’s decision. In the first scenario, the Court may have intended to say that the addition of an explanation under Finance Act 2007 cannot cloud the language of S.9 of Income Tax Act 1961 under principles of statutory interpretation. [34] This argument may be difficult to sustain on the wording of S.9 or on the basis of legislative intent.

Alternatively, in the second scenario, the Court’s decision may be explained by arguing that the explanation does away only with “residence or place of business or business connection in India”, and not with all the requirements of territorial nexus. [35] Thus, while the nexus need not be as deep as “residence or place of business or business connection in India”, it was still essential that the services should be rendered in India. Thus, the explanation only intended to avoid a strong nexus, but did not entirely do away with nexus. [36]

For the second approach, it would be important to differentiate between rendering services in India and maintaining a business connection in India, and would also require the Siemens case to be adequately distinguished from the Clifford Chance case. The former should not be too difficult a task. The leading decision on the concept of business connection under the Income Tax Act, CIT v. R.D. Aggarwal [37] , notes that a business connection “involves a relation between a business carried on by a non-resident which yields profits or gains and some activity in the taxable territories which contributes directly or indirectly to the earning of those profits or gains. It predicates an element of continuity between the business of the non-resident and the activity in the taxable territories.” Hence, a business connection cannot be said to exist by merely rendering of services.

On the issue of reconciliation with Siemens, it is possible to contend that what that case actually held in its factual context is that in the post-amendment scenario, it was not necessary for the assessee to have a permanent establishment or a business connection. [38] However, Siemens was decided in favour of the assessees on the ground that the assessee was entitled to relief under the relevant Double Taxation Avoidance Agreement in the case. Thus, the interpretation of Section 9 was not actually in question in the case, and the statement that Ishikawajima’s ratio was overturned by the amendment was only tentative statement and not a reasoned conclusion. [39]

Although the purpose behind the 2007 amendment might well have been to get over Ishikawajima, the decision in Clifford Chance shows that this purpose has not actually been achieved by the wording of the explanation. Ishikawajima continues to be good law on the issue, subject to the fact that the territorial nexus requirement need not be as deep as “residence or place of business or business connection in India.” Nonetheless, mere use of services in India will not attract Section 9. The services should be both used and rendered in India.