Tax Insights

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Tax Insights

3 August 2023

Inter-connectivity and bandwidth charges are not taxable as royalty under beneficial provisions of the DTAA, thus obligation to deduct tax is not required – Karnataka High Court

In brief

The Karnataka High Court¹ placed reliance on the previous court decisions and held that the payments towards inter-connectivity and bandwidth charges do not qualify as royalty under the beneficial provisions of the

applicable Double Taxation Avoidance Agreement (DTAA) given the undisputed facts that all the facilities are located outside India and service providers do not have a presence in India.

In detail

Facts

• The taxpayer, an Indian company, is engaged in the business of providing telecommunication services.

• During the years under consideration, the taxpayer availed the following services to provide seamless connectivity for international long-distance services to its customers.

- International carriage and connectivity services from non-resident telecom operators (NTOs). For such services, it paid inter-connectivity charges to NTOs.

- Acquisition of bandwidth capacity on Europe-India Gateway (EIG) f rom a Belgian entity. Under this arrangement, the Belgian entity transferred a part of its allocated capacity in the EIG cable system to the taxpayer without any restrictions through an indefeasible right to use.

• The taxpayer did not deduct tax on the abovementioned payments as the telecom services were provided outside India.

• Proceedings under section 201 of the Income-tax Act, 1961 (the Act) were initiated, and during such proceedings and further appellate proceedings, the payments were characterised as royalty and the taxpayer was treated as a taxpayer-in-default for non-deduction of taxes.

1 ITA No.160/2015, C/W ITA Nos. 161/2015, 162/2015, 163/2015, 164/2015, 64/2020, 65/2020, 66/2020

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High Court’s decision and observations

• The High Court noted the following undisputed facts prior to rendering it’s decision on the issues raised in the dispute.

- The taxpayer paid interconnectivity charges to NTOs for availing international carriage and connectivity services.

- X Limited, a member company in the EIG consortium, transferred a portion of its capacity to the Belgian company for utilisation of bandwidth, and the Belgian company, in turn, transferred a portion of its capacity to the taxpayer.

- The equipment and submarine cable system are all located outside India.

- The Belgian entity does not have a permanent establishment in India.

• In light of the above facts, the High Court proceeded to deal with the issues raised in the appeal .

Issues Observations & decision

Whether the provisions of the applicable DTAA should be considered under section 201 of the Act f or treating the taxpayer as a taxpayer-in-default for f ailure to deduct taxes?

Placing reliance on the Supreme Court’s decision in the case of GE India Technology Cen. Private Limited² and Engineering Analysis Centre of

Excellence Private Limited³, the High Court held that the taxpayer could resort to the beneficial provisions under the DTAA f or determining its obligations to deduct tax.

Whether amendments to the definition of royalty under section 9(1)(vi) of the Act results in

amendment to the relevant provisions in the DTAA?

Placing reliance on the Supreme Court’s decision in the case of Engineering Analysis Centre of

Excellence Private Limited³, the High Court held that Explanations 5 and 6 to section 9(1)(vi) of the Act have been inserted with effect from 1 June 1976 vide Finance Act, 2012. These Explanations result in expanding the scope of definition of royalty under the domestic provisions, and the same cannot impact the def inition under the DTAA.

Whether the payments made for inter-connectivity charges to NTOs and bandwidth charges to the Belgian entity are chargeable to tax as royalty?

The Income-tax Appellate Tribunal has held that tax is not deductible on such payments in the taxpayer’s case itself for subsequent assessment years (AYs).

Accordingly, the High Court held that such payments are not taxable as royalty.

Whether income-tax authorities have jurisdiction to tax income arising from extra-territorial sources?

The High Court ruled in negative by observing that the service providers do not have a presence in India and all the f acilities are also situated outside India.

Whether liability to deduct tax should be levied at a higher rate of 20%?

Relying on its decision in the case of Wipro Limited⁴, the High Court held that once tax is deducted as per the provisions of the applicable DTAA, a higher rate

2 GE India Technology Cen. Private Limited v. CIT [2010] 327 ITR 456

3 Engineering Analysis Centre of Excellence Private Limited v. CIT [2021] SCC online SC 159

4 CIT v. Wipro Limited 2023 (1) TMI 1274

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Issues Observations & decision

as prescribed under section 206AA of the Act cannot be applied.

Whether the taxpayer can be held liable for deducting tax based on the expanded definition of royalty for AYs prior to the enactment of the Finance Act, 2012?

The High Court held that an obligation which is impossible to perform cannot be fastened upon the taxpayer. Given that Explanations 5 and 6 to section 9(1)(vi) of the Act, expanding the scope of royalty, have been inserted vide Finance Act, 2012, the taxpayer need not be required to deduct tax based on such expanded definition at least for the prior AYs. Nevertheless, the High Court held that the payments are not taxable as per the beneficial provisions of the DTAA.

The takeaways

This High Court’s decision reaffirms the principle laid out by previous court decisions that amendments to domestic provisions of the Act cannot impact the relevant provisions under the DTAA, as it is a sovereign document between two countries. Moreover, it also concurs with the settled principle of lex no cogit ad impossibilia, i.e. the law does not demand the impossible. Accordingly, this decision reaffirms that a taxpayer cannot be fastened with the obligation to deduct tax on account of retrospective amendments.

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In this document, “PwC” refers to PricewaterhouseCoopers Private Limited (a limited liability company in India having Corpora te Identity Number or CIN : U74140WB1983PTC036093), which is a member firm of PricewaterhouseCoopers International Limited (PwCIL), each member firm of which is a separate legal entity.

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