Connectivity charges paid to foreign companies

"Under international tax practices, payments for the use of industrial, commercial or scientific equipment are regarded as equipment royalty"

Recently, the Hyderabad Income-tax Appellate Tribunal (ITAT) in the Frontline Soft Ltd vs DCIT (2008-TIOL-422-ITAT-HYD) case held that an Indian company utilising connectivity facility from a foreign company was liable for tax withholding on payments to such foreign company.

The argument of the Revenue was that such payments were within the definition of royalty under the Income-Tax Act, 1961 as well as under the India-US tax treaty.

What’s royalty?

Under the I-T Act, the term royalty, inter alia, includes consideration for the “use or right to use any industrial, commercial or scientific equipment…” The definition of the term is similar in the India-US tax treaty.

In the aforesaid case, Frontline had taken connectivity facility through co-located equipment using switches located in the US.

The foreign company only provided certain switches and ancillary equipment located in the US to Frontline. The issue was in relation to tax withholding obligations on use of linking infrastructure provided by the foreign company to Frontline.

From the facts available on record, the foreign company had exclusive rights over certain equipment and granted usage rights thereof to Frontline; such equipment was regarded as commercial or scientific equipment and, hence came within the meaning of the term ‘royalty’.

The essential question in relation to taxability of connectivity facility provided by foreign companies ought to therefore rest on the meaning to be given to the words “use or right to use”.

Equipment royalty

Under international tax practices, payments for the use of industrial, commercial or scientific equipment are regarded as equipment royalty, where the customer has possession or control over equipment.

Where the service provider allows use of equipment along with other customers as well and does not part with possession or control of such equipment to one customer, the payments made are ordinarily not regarded as towards use of equipment; hence, not within the meaning of equipment royalty.

In such circumstances, payments are ordinarily regarded as for use of services.

For example, where a person books a ticket aboard a ship, such person cannot be regarded as paying for use or right to use the ship; all he gains is the transportation facility provided to him by the shipping company.

It would be relevant to mention the decision of the Supreme Court in the Bharat Sanchar Nigam Ltd. & Anr. vs UOI & Ors. (282 ITR 273) wherein it was held that to constitute a transaction for transfer of right to use goods, the transaction must possess certain attributes such as:

goods being available for delivery;

agreement with regard to identity of goods;

transferee having a legal right to use such goods, and all legal consequences of such use including any permissions or licences required thereof to be available to the transferee;

for the period during which the transferee has such legal right, it has to be the exclusion to the transferor (this is the necessary concomitant of the plain language of the statute — viz., a “transfer of the right to use” and not merely a license to use the goods); and

having transferred the right to use the goods during the period for which it is to be transferred, the owner cannot again transfer the same rights to others.

It was held that where such attributes were not present in the relationship between the telecom service provider and customer of such services, the transaction would be regarded as one rendition of services.

Is it FTS?

The question of whether connectivity facility provided by foreign companies could be regarded as Fees for Technical Services (FTS) under the I-T Act has been decided upon earlier. Under the I-T Act, FTS means “any consideration (including any lumpsum consideration) for the rendering of any managerial, technical or consultancy services (including the provision of services of technical or other personnel)....”

It has been held earlier that mere installation of sophisticated equipment for provision of quality connectivity facility of a certain bandwidth to subscribers (customers) in exchange of fees could not be regarded as within the meaning of FTS under the I-T Act and hence, not subject to tax withholding (Skycell Communications Ltd. & Anr. vs DCIT & Ors. — 251 ITR 53; Wipro Ltd vs ITO (80 TTJ 191), and CIT vs Estel Communications Pvt. Ltd — 2008-TIOL-331-HC-DEL-IT).

The differentiating factor in the case of Frontline was perhaps that the foreign company was not a telecom service provider but only a linking infrastructure provider; hence, the service relationship between Frontline and the foreign company was not akin to a telecom service provider and a subscriber to such services. Although the decision may be of significance in the case of infrastructure (equipment) providers, the ratio ought not to have universal application in case of connectivity service providers.

(Gautam Dalvi ,The author is assistant manager, PricewaterhouseCoopers)