Taxation of engineering, procurement and construction (EPC) contracts has been a contentious issue in India.
Several issues regarding the tax treatment of parties to EPC contracts have been litigated in the past, for instance, the divisibility of an EPC contract, taxing the offshore supply portion of such a contract and taxing the parties to the EPC contract as an association of persons, which describes how, under Indian tax law, when a group of companies or individuals comes together for a project or business with a common intention of earning profits, and fulfils certain other conditions, such a group is taxed as one unit, that is, as an association of persons.
The Income Tax Appellate Tribunal (ITAT) in its recent ruling in the case of Tellabs India Private Limited (Tellabs India Private Limited v ACIT, IT(TP)A Nos. 1037 & 1038/Bang/2008) has dealt with yet another EPC contract related issue: whether an assignment of contract within group companies qualifies as an international transaction as defined under the existing Indian transfer pricing regulations, which apply to transactions between two related parties where one of such related parties is a non-resident as per Indian tax laws. After an elaborate discussion about the transfer pricing regulations and the material facts of the case, the ITAT held that an assignment of the contract between related parties would be covered within the ambit of international transactions and hence, subject to transfer pricing regulations.
Tellabs India Private Limited (TIPL) was incorporated in India as a wholly owned subsidiary of Tellabs International Inc, US (Tellabs US) and was initially set up as a sales and marketing office of Tellabs US and its group companies. Tellabs US made and sold telecommunications equipment. TIPL also provided services to do with the installation and commissioning of telecommunication equipment, on behalf of Tellabs group of companies worldwide for their customers in India.
Tellabs Denmark, a subsidiary of Tellabs US, was awarded a contract with Power Grid Corporation of India Limited (PGCIL) for the supply, installation and commissioning of telecommunications equipment. This contract consisted of two parts, that is, for offshore and onshore services. Tellabs Denmark then entered into four agreements with PGCIL: (a) two offshore agreements and (b) two onshore agreements. The offshore agreements consisted of the planning, design, engineering, manufacture, testing and CIF supply of all offshore equipment and materials including testing equipment, documentation and mandatory spares. The onshore agreements consisted of, for example, handling and custom clearance of all supplies from abroad, inland transit insurance, handling and transportation to site, unloading at site, storage and insurance.
After the above contract was awarded by PGCIL to Tellabs Denmark, the business of the Tellabs group was restructured to achieve goals including efficiency and operational realignment. Tellabs Denmark then sought the permission of PGCIL to assign a portion of the onshore contract to TIPL. PGCIL granted the permission for assignment of the contract subject to the condition that Tellabs Denmark would continue to be liable for the performance of all the contracts.
TIPL did not report the transaction with PGCIL that it undertook consequent to the assignment of the onshore contracts by Tellabs Denmark with PGCIL in the transfer pricing report (TP report) filed under the Indian tax laws. The tax authorities initiated proceedings under the TP regulations and the transfer pricing officer (TPO) came to the conclusion that the work performed by TIPL for PGCIL was akin to the services performed by it for Tellabs US. Therefore, the TPO held that the transaction entered between TIPL and PGCIL was subject to the TP regulations and made additions to the income of TIPL. In an appeal filed by TIPL, the Commissioner of Income-tax (Appeals) (that is, the first appellate authority) upheld the order of the tax authorities / TPO and held that the transaction between TIPL and PGCIL was a deemed international transaction under the TP regulations since this transaction resulted from a prior agreement between PGCIL and Tellabs Denmark.
A transaction is deemed to be an international transaction when these conditions are fulfilled:
- There must be a transaction between the taxpayer and other person who is not an Associated enterprise;
- There must be a prior arrangement in relation to the said transaction between such other person and the associated enterprise of the taxpayer, or
- The terms of the relevant transaction are determined in substance between such other person and the associated enterprise.
TIPL subsequently appealed to ITAT for an adjudication and ruling on whether the transaction entered into between TIPL and PGCIL, as a result of assignment of the contract by Tellabs Denmark, would be an international transaction and subject to TP Regulations in India.
ITAT ruled that the conclusion of the tax suthorities that the transaction between TIPL and PGCIL was a deemed international transaction was incorrect. However, ITAT, after analysing the terms and conditions of the assignment and also the conduct of all the parties involved, held that the transaction between Tellabs Denmark and TIPL (that is, the assignment agreement) was an international transaction subject to the TP regulations.
ITAT made these important observations in relation to, for example, the objective behind the introduction of the TP regulations in India, difference between assignment of an agreement and novation of an agreement. while coming to its decision:
The intention behind the introduction of TP was that there was a need to introduce a uniform and internationally accepted mechanism of determining reasonable, fair and equitable profits and tax in India in the case of multinational enterprises.
Tellabs Denmark had entered into the assignment agreements with TIPL in the manner desired by PGCIL. The key conditions/ clauses in the assignment agreement were these:
o PGCIL had granted permission for assignment of the contract;
o The assignment agreement was required to be signed on the same terms as the contracts between Tellabs Denmark and PGCIL;
o All the rights and interests under the contracts between Tellabs Denmark and PGCIL were assigned / transferred to TIPL by way of the assignment agreement;
o The contracts concluded between Tellabs Denmark and PGCIL were deemed to be amended to the extent to give effect to the assignment agreement.
PGCIL had consented to the assignment of the portion of the onshore contract by Tellabs Denmark to TIPL with a specific condition that the assignment did not amount to the novation of the contract between PGCIL and Tellabs Denmark.
ITAT analysed the provisions of the Indian Contract Act to differentiate between the concepts of assignmentand novation. The Contract Act lays down the effect of novation, rescission, and alteration of contract. If the parties to a contract agreed to substitute a new contract for it, or to rescind or alter it, the original contract need not be performed. Assignment involves the transfer of an interest or benefit from one person to another. However the burden, or obligations, under a contract cannot be transferred. If one wants to transfer the burden of a contract as well as the benefits under it, one has to novate. Like assignment, novation transfers the benefits under a contract but unlike assignment, novation transfers the burden under a contract as well. In a novation, the original contract is extinguished and is replaced by a new one in which a third party takes up rights and obligations which duplicate those of one of the original parties to the contract. Novation is only possible with the consent of the original contracting parties as well as the new party.
In the present case, there was only an assignment of a portion of the onshore agreements by Tellabs Denmark to TIPL (that is, there was no novation of the agreements between PGCIL and Tellabs Denmark). This transaction was an international transaction under the TP regulations, between associated enterprises where one of the parties was a non-resident and it also related to provision of services or had a bearing on profits, income, losses or assets. Therefore, this transaction was subject to the TP regulations.
- Regarding the position of the tax authorities on a deemed international transaction, it was held that the basis for holding the transaction as a deemed international transaction was unfounded. The transaction was with a Government of India entity (that is, PGCIL); it could not be regarded as a tainted transaction with the object of avoiding taxes. The transaction between the taxpayer and PGCIL could not, therefore, be deemed to be between two associated enterprises.
Assignment v novation
The ruling is significant as it deals with various aspects relating to the assignment of a contract in the context of the TP regulations. This is one of the ways in which MNCs structured EPC contracts using two subsidiaries, one a resident of India and the other a non-resident to achieve tax efficiency. After this ruling, one would need to keep in mind various aspects relating to assignment vis-à-vis novation of contracts at the time of drafting agreements between associated enterprises to deal with its tax implications.
This judgment will be useful guidance for determining the applicability or otherwise of the TP Regulations in the context of assignment vs novation of contracts.
Sanjay Sanghvi is a tax partner and Surajkumar Shetty is an associate of Khaitan & Co