AAR : Whether consideration payable for sale of designs is taxable under the DTAA with USA (the treaty) in view of the fact that the US entity has no PE in India ?

Authority For Advance Rulings

HMS Real Estate (P) Ltd., In Re

Section 115A(1)(b), 195, DTAA between India & USA, Art. 12

P.V. Reddi, J., Chairman; J. Khosla, Member

AAR No. 832 of 2009

18th March, 2010

Counsel Appeared :

S.D. Kapila, R.R. Maurya, Sanjiv Gupta, Amit Jain & Vijay Mathur, for the Applicant

Ruling

P.V. Reddi, J., Chairman :

In this application under s. 245Q(1), the applicant seeks advance ruling on the following three questions : “1. Whether the compensation payable to Hellmuth, Obata + Kassabaum L.P., USA under cl. VA of the agreement dt. 15th Oct., 2008 can be disintegrated in three parts; viz., (a) for development and sale of designs (b) consultancy for construction documents, and, (c) for ‘construction administration’ and ‘additional services’ ?

2. If the answer to question No. 1 is in the affirmative :

(a) Whether consideration payable for sale of designs is taxable under the DTAA with USA (the treaty) in view of the fact that the US entity has no PE in India ?

(b) Whether payment of fees for technical advisory services to HMS/Indian associate architects during the Phase-2 of the project (construction document) is taxable under the art. 12(4) of the treaty even though it is to be excluded from ‘included services’ under art. 12(5)(a) of the treaty ?

(c) Whether fees for supervisory/advisory services during the construction administration phase is taxable under art. 12(4) of the treaty and, if so, would such fees attract tax @ ten per cent as prescribed in s. 115A of the Act ?

3. Whether reimbursement of expenses actually incurred by the US entity without any mark up is subject to provisions of s. 195 of the Act ?” Question No. 2 has been recast by the applicant after 1st hearing. 2. The applicant is an Indian company engaged in the business of development and management of commercial real estate. The applicant proposes to construct an international quality commercial office/hotel complex in Gurgaon. For this purpose, it has entered into an agreement on 15th Nov., 2008 with Hellmuth, Obata + Kassabaum L.P. (HOK) a limited partnership which is a resident of USA, for provision of architectural design services. The agreement also provides for appointment of a local architect as associate architect. Accordingly, M/s RSP Architects Planners & Engineers (P) Ltd. (RSP) has been appointed as ‘associate architect’. Payments to the local associate architect are to be made separately and are not under consideration in the application. As per the agreement, both, HOK – the architect and RSP -the associate architect, have been retained “to work jointly and on a co-operative basis in order to perform the entire design, construction documents and construction administration for the project, each responsible for its share of work but jointly responsible in providing the entire design, construction documents and construction administration service necessary to complete the project”.

2.1 Under the head “Scope and description of services”—’Design services’, the obligations of architect are stated as follows : The architect will participate with and assist the owner, as required, in developing and refining the general project concept for the project described in Ext. A. The architect will develop a detailed program for the project based on in-depth interviews with the owner and other parties designated by the owner. The architect shall review with the owner, as requested, alternative approaches to design and construction of the project and will prepare such schematic or conceptual drawings as may be required. After the owner has approved the general project concept and project program, the architect shall prepare, for review and approval by the owner, design development drawings and outline specifications adequate for obtaining preliminary cost and price estimates, and assist the associate architect in developing a set of construction drawings and specifications, which are adequate for complete pricing and construction of the project as required (“contract documents”). Upon completion of the construction drawings and specifications by the associate architect, and prior to submitting such documents to the owner for issuance to contractors for prices and construction, the architect review each such final construction drawing and specification with all other drawings and specifications for consistency with the approved design embodied in the design development documents, completeness and to avoid errors and omissions.

The architect shall co-operate with the associate architect in obtaining approval of Governmental authorities having jurisdiction over the project and also assist him to ensure that the contract documents shall conform to applicable restrictions, laws, and regulations in effect. The contract documents shall consist of all necessary drawings, details, plans, elevations, sections, and schedules, dimensioned, noted, and co-ordinated, as well as specifications, and the associate architect shall seal and sign the drawings and specifications as the architect of record. The architect shall assist the associate architect and owner in the preparation of any necessary bidding information, and any forms of agreement between the general contractor and the subcontractors for the project.

2.2 The architect’s basic services are classified broadly into 6 heads : (a) Master plan/concept design (b) Schematic design (c) Design development phase in which design is finalized after reviewing the detailed design prepared by the local design consultants (d) Construction document phase wherein the architect will provide co- ordination and drawing review with the associate architect, preparation of designs sketches to clarify design intent and review of specifications for design content (e) Bidding and contract selection process (f) Construction phase : (i) key selected shop drawings prepared by the associate architects; (ii) consultation and site visits; (iii) review and evaluation of cost saving proposals submitted upto start of construction of the contractor.

2.3 There is also a provision for rendering additional services not otherwise included in the agreement or not customarily furnished as per the prevailing architectural practices. For such additional services, additional payment has to be made according to an agreed formula. Reimbursable expenses are also specified in the agreement.

3. The above scope of work under the agreement has been summarized by the applicant as follows : (a) Development of program and master plan concept design; (b) Development of schematic design concepts; (c) Preparation of design development drawings; (d) Co-ordination and drawing review of documents; (e) Assisting the owner in bidding and contractor selection process; (f) Observing construction progress; (g) Review of cost saving and alternative proposals; and (h) Additional services as may be required.

3.1 In respect of the above items of work, HOK is entitled to a fixed fee (net of taxes) as per cl. V of the agreement on submission of monthly invoices and the fee will be received by HOK in US dollars outside India. It is pointed out that items (a) to (c) above which broadly fall under the first phase lead to finalization of designs and drawings. Item (d) which relates to construction documents is the second stage. Items (e) to (g), it is stated, come under the third stage i.e. technical consultancy and supervisory services. It is conceded by the learned counsel for the applicant that as far as the payments received by HOK in the third stage during construction are liable to be taxed as ‘FTS’ (‘fees for technical services’).

3.2 The agreement contemplates the retention by the architect of consultants specialized in various fields who shall participate in the design of project. The selection of consultants by the architect is subject to the approval of the owner. Clause VIIB provides : “the architect shall be responsible for contracting with the international or US based consultants and shall co-ordinate all design activities of said consultants. Compensation for the professional services rendered by each of the consultants shall be paid directly to each consultant of the architect.” It is stated that the consultants in US have been engaged in terms of this clause.

3.3 Clause V deals with ‘compensation’ which is nothing but fee payable to the architect. It is stipulated that the architect shall receive as compensation for all basic services the fixed price sum (excluding local taxes) of 2,114,000 US dollars based on a building size of 1,300,000 sq. ft. payable in response to monthly invoices based upon the amount of basic services and additional services. The counsel for the applicant has clarified that the applicant has to bear the taxes and pay TDS. The break-up of the stipulated fee of 2,114,000 US dollars is given as follows :

3.4 As per the amendment to the agreement, a further amount of Rs. 15,08,000 is payable at various stages which is by way of reimbursement of ‘compensation’ payable to the consultants in USA. Thus, the total consideration payable under the contract is 36,22,000. The applicant states that the aforesaid functions except construction administration are performed from outside India. The designs and drawings are transferred electronically to the applicant and ownership therein vests in the applicant. Development of designs is carried out by means of bi- weekly teleconferencing and video conferencing. For the purpose of developing the designs, HOK will engage specialist consultants outside India. After the delivery of designs, the preparation of detailed construction documents will take place in India by the Indian architect in consultation with HOK. HOK, it is stated, will provide advisory for preparation of construction documents.

3.5 It is stated that the employees of HOK have come to India for a maximum period of 50 days for providing supervisory services. The applicant states that the completion of the project is likely to take three years.

3.6 In the course of hearing, the applicant furnished an event summary chart starting from October, 2008 in which the details of visits of HOK personnel are set out. It is mentioned therein that the schematic design and design development work have already been completed. The applicant has also furnished a note on certain aspects relating to preparation of designs and delivery.

4. The case of the applicant as set out in Annex. II is as follows : “The designs and drawings developed by the non-resident recipient are sold to applicant; therefore the receipts arising to the non-resident are in the nature of business profits. Since, the recipient does not have any PE in India, the receipts cannot be taxed as business profits. The receipts also are not taxable as  ‘royalty’ as defined in s. 9(1)(vi) of the IT Act, 1961 and also under art.13 of Indo-US DTAA as the said transaction involves outright sale of designs and the property in these goods vests in the applicant. This sum is also not taxable as ‘fee for technical services’ in terms of s. 9(1)(vii)(b) of the IT Act, 1961 for the reason that the recipient has used its technical expertise for preparing and selling chattels, which are designs. This being a case of sale, there could be no question of transfer of use or right to use any plant or equipment.”

4.1 Learned counsel for the applicant has reiterated the stand taken in the application. It is contended that the agreement can be disintegrated into three parts : (a) for development and sale of designs, (b) consultancy for construction documents and (c) ‘construction administration’ and ‘additional services’. It is submitted that separate price is identified for each of these items and activities. If so viewed, only the payments received at the stage of construction administration in relation to services which are basically performed in India during the phase of construction are liable to be taxed as fees for included services at the percentage of rate provided for in s. 115A(1) (b)(BB) of the IT Act, according to the counsel. The learned counsel for the applicant has strenuously contended that if the contract has to be viewed as a composite one without disintegrating it, the dominant nature and object of the contract has to be looked into. If so, it is nothing but outright sale of designs and technical documents delivered through website from outside India and on such delivery, the applicant becomes the owner as the entirety of rights over those designs has been conveyed to the applicant. Therefore it is submitted that the payments made to HOK (excepting those at the ‘construction administration phase’) do not fall within the definition of royalty under art. 12(3)(a) of the India-US DTAA. For the same reason, it is submitted that they do not fall under ‘fees for included (technical) services’ within the meaning of art. 12(4) of the India-US DTAA. Even if they are treated as ‘business profits accruing or arising in India’, the same cannot be subjected to tax under the IT Act, 1961 in the absence of PE, having regard to the treaty provision in art. 7(1). As the number of days of presence of HOK employees in India will be much less than the prescribed number of days, a service PE cannot be inferred, submits the counsel.

4.2 The applicant’s counsel has in particular drawn our attention to clause VIII of the agreement which bears the heading “Copyright assignment and ownership of documents” : “Architect hereby acknowledges and confirms the intention of architect to convey all right, title and interest it may have in and to all drawings, specifications, models, renderings and work product, excluding the pre-existing materials, prepared in connection with the project (‘products of service’), including, without limitation, the copyrights and any copyright registrations issued therefor, to owner. Architect does hereby sell, assign and transfer of owner, its successors, assigns and legal representatives, for the United States of America and throughout the world, all right, title and interest it may have in and to the products of service, including the copyrights and any copyright registrations issued therefor, the rights to prepare derivative works, the right to apply for copyright registration and future renewals or extensions of copyright terms, and the right to sue for copyright infringement, whether occurring in the past, present or future.”

4.3 The last para of the same clause provides that on termination of the agreement by the owner or on payment by owner to the architect of all sums due, all drawings, specifications, models and work product prepared in connection with the project shall become the property of the owner. “Nevertheless, it is understood by the owner that all such drawings etc. may be inappropriate for use in any other project”. Reference has also been made to cl. XIX which says that architect shall not use or disclose confidential information without owner’s prior written approval. “5. Before proceeding further, we may refer to art. 12 of the tax treaty (DTAA) : “Article 12—Royalties and fees for included services Royalties and fees for included services arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State. However, such royalties and fees for included services may also be taxed in the Contracting State in which they arise and according to the laws of that State, but if the beneficial owner of the royalties or fees for included services is a resident of the other Contracting State, the tax so charged shall not exceed : (a) in the case of royalties referred to in sub-para (a) of para 3 and fees for included services as defined in this article [other than services described in sub-para (b) of this para] : (i) during the first five taxable years for which this convention has effect,…………. (ii) during the subsequent years, 15 per cent of the gross amount of royalties or fees for included services; and (b) in the case of royalties referred to in sub-para (b) of para 3 and fees for included services as defined in this article that are ancillary and subsidiary to the enjoyment of the property for which payment is received under para 3(b) of this article, 10 per cent of the gross amount of the royalties or fees for included services.

3. The term “royalties” as used in this article means : (a) payments of any kind received as a consideration for the use of, or the right to use, any copyright of a literary, artistic, or scientific work, including cinematograph films or work on film, tape or other means of reproduction for use in connection with radio or television broadcasting, any patent, trade mark, design or model, plan secret formula or process, or for information concerning industrial, commercial or scientific experience, including gains derived from the alienation of any such right or property which are contingent on the productivity, use or disposition thereof; and (b) payments of any kind received as consideration for the use of, or the right to use, any industrial, commercial or scientific equipment other than payments derived by an enterprise described in para 1 of art. 8 (shipping and air transport) from activities described in para 2(c) or 3 of art. 8.

4. For the purposes of this article, “fees for included services” means payments of any kind to any person in consideration for the rendering of any technical or consultancy services (including through the provision of services of technical or other personnel) if such services : (a) are ancillary and subsidiary to the application or enjoyment of the right, property or information for which a payment described in para 3 is received; or (b) make available technical knowledge, experience, skill, know-how, or processes, or consist of the development and transfer of a technical plan or technical design.” As noted earlier, the learned counsel for the petitioner submits that HOK has sold the designs and the property including copyright has wholly passed to the applicant and, therefore, it cannot be said that the consideration has been paid to HOK for permitting the use or right to use the design, model or plan. It is pointed out that once the designs and drawings relating to the project are delivered to the applicant by posting them on the project web through the ‘servers’ located in USA the applicant becomes the absolute owner thereof and the HOK is barred for making use of them for its own purpose. The payment for the designs etc. is received once and for all and the payment is not contingent on the productivity use or further alienation thereof as contemplated in the second part of cl. (a) of art. 12(3).

We are unable to appreciate the contention of the learned counsel for the applicant that on the basis of cl. VIII of the agreement conveying the right, title and interest the architect has in the drawings, specifications, models and work product (which are described as ‘products of services’), the transaction has to be regarded as one of sale of designs. The agreement cannot be read in isolation and the components of the contract cannot be placed in water- tight components. The agreement shall be read as a whole. The approach should be to ascertain what is the true scope and dominant object of the contract. One should take stock of the predominant features of the contract. The learned counsel for the applicant, in fact, does not suggest that a different approach has to be adopted. We have to take a holistic view in considering the agreement without being carried away by the apparent tenor of some of the clauses in the agreement. For instance, cl. VIII on which utmost reliance is placed shall be considered in the context of and in conformity with the spirit of the entire agreement. Viewed from that angle, can it be said, as the applicant seeks to contend, that the crux and substance of the contract is the sale of designs and drawings and the basic services enumerated in the agreement are only incidental to the sale or the inference should be the other way i.e. the transfer of designs being part of a package of architectural services undertaken by HOK under the contract ?

We are inclined to think that the reasonable view to take, on an appreciation of the agreement in its entirety, is to adopt and affirm the second line of approach indicated above. By taking the view that the essence of the transaction is the sale of designs, models and plans and everything else is incidental thereto is to distort and stultify the true nature and dominant purpose of the contract. The agreement is in reality nothing different from what is described in the opening sentence i.e. “design and consultancy services”. The architect while performing such services, will participate with and assist the owner “in developing and refining the general project concept. The architect will develop the detailed programme for the project based on in-depth interviews with the owner and others”. We have already referred to the various responsibilities to be discharged and the steps to be taken by the architect which are detailed in cl. IV. At every stage starting from the conceptual stage till construction, the applicant looks for the services and expert advice of HOK. HOK acts in close collaboration with the owner (applicant), the associate architect and the consultant. Bi-weekly meetings through teleconferencing are regularly held. The applicant’s role in the project is all-pervasive. The applicant does not go out of picture once the so-called sale of drawings and designs takes place nor can it be said on a reasonable basis that everything else done or performed by HOK is merely incidental or subordinate to the transfer of plans, drawings and designs. The fact that there is separate specification of price for convenience of payments and adhering to schedules or that a major portion of the amount is payable at the design development stage is not conclusive. We are of the view that having regard to the scope, objective and predominant features of the agreement, the HOK must be said to have received payment (‘compensation’) in the nature of FTS or included services within the meaning of cl. (b) of art. 12.4 of the treaty, irrespective of whether ‘royalty’ clause is attracted or not. In this context, we may refer to the relevant comments in the MoU concerning fees for included services under art. 12 which are arrived at between the Goverments of India and USA on 15th May, 1989. It is stated that typical categories of services that generally involve either the development and transfer of technical plans or technical designs or making technology available as described in para 4(b), include architectural services. The scope of para 4 (b) of art. 12 has been explained, thus : “This category is narrower than the category described in para 4(a) because it excludes any service that does not make technology available to the person acquiring the service. Generally speaking, technology will be considered ‘made available’ when the person acquiring the service is enabled to apply the technology. The fact that the provision of the service may require technical input by the person providing the service does not per se mean that technical knowledge, skills, etc., are made available to the person purchasing the service, within the meaning of para (b). Similarly, the use of a product which embodies technology shall not per se be considered to make the technology available.”

7.1 It is significant to note that the latter part of cl. (b) of para 4 speaks of “development and transfer of a technical plan or technical design”. This limb of cl. (b) is squarely attracted to the present case because technical services rendered by HOK resulted in the development and transfer of technical plan and design to the applicant. If an outright transfer of a design or plan for consideration has to be treated as an independent transaction unrelated to the services, the scope of latter part of cl. (b) will be considerably diluted and the very purpose for which the said words were included in the definition of FTS will be defeated. In one sense, there could a transfer of designs and in another sense the development and transfer of technical plan/design can be viewed as a sequel to and integral part of the services undertaken by HOK. In the present case, cl. (b) of para 4 is attracted having regard to the true nature and purport of the agreement. The architectural services rendered by HOK can also be brought within the fold of the first part of cl. (b) starting with the expression “make available”. However, it is unnecessary to express a final view in the matter. We would also not like to express an opinion on the question whether the consideration attributable to the transfer of designs and plans can be brought within the scope of the clause— “payment received for information concerning industrial, commercial or scientific experience” occurring in the definition of ‘royalty’ vide art. 12.3(a). According to the OECD commentary, this term alludes to the concept of know-how and information that is not publicly available. The fact that there was sale of designs may not preclude the application of this limb of ‘royalty’ definition. Suffice it to say that it is a moot point and it is unnecessary for us to express a view on this aspect.

8. We are, therefore, of the view that basic(design) services which include preparation of master plan, concept design, schematic design, design development and construction documents, assistance in bidding and contractors’ selection process and consultancy during construction phase are all part of architectural services undertaken by the HOK as per the agreement and the payment received by HOK for furnishing all these documents and services to the applicant fall appropriately within the meaning of ‘fees for included services’ under art. 12.4(b) of the India-US Treaty. They cannot be disintegrated and viewed in water-tight compartments. We reject the contention of the applicant that the payments attributable to the sale of designs, plans and other construction documents cannot be subjected to tax in India as they do not fall within the purview of art. 12 of the treaty.

9. The learned counsel for the applicant has relied on the decision of Division Bench of Calcutta High Court in CIT vs. Davy Ashmore India Ltd. (1991) 190 ITR 626 (Cal). That was a case in which the assessee arranged for the import of concept designs and drawings from UK on the strength of import licence for the purpose of enabling the purchaser to make use of them in the preparation of detailed manufacturing drawings. The question arose whether the payment made to the foreign company which supplied the designs was ‘royalty’ and to be taxed under the IT Act, 1961. The learned Judges held that it was a case of sale and no royalty was generated. The following passage is relevant : “Having regard to the facts and circumstances of this case, it must be held that the present case is not a case where the non-resident is retaining the property in the designs and drawings. Such designs and drawings are imported under the import policy and with the approval of the RBI on the basis of the letter of intent. The importation of the designs and drawings postulates an out and out transfer or sale of such designs and drawings and the non-resident company does not retain any property in them leaving the grantee to use or exploit them. The consideration paid for transfer, therefore, cannot be treated as royalty falling under art. 13 of the Agreement for Avoidance of Double Taxation between India and the UK. The consideration paid is for an outright transfer of the drawings and designs by the non-resident company and such consideration cannot be termed as royalty.”

9.1 That case is distinguishable for more than one reason. Firstly, whether the payment was within the scope of ‘fees for technical services’ was not considered. Secondly, that was not a case of rendering any service. Outright transfer of drawings and designs which were required by the purchaser for the purpose of preparing detailed manufacturing drawings of cold rolling mill was involved in that case. It was a stand alone transaction unconnected with any service. Moreover, it does not appear to be a case of tailor-made designs and drawings. Those which were available with UK company were sold out to the Indian buyer.

10. The learned counsel for the applicant has also drawn our attention to a recent ruling of this Authority in International Tire Engineering Resources LLC, In re (2009) 227 CTR (AAR) 21 : (2009) 30 DTR (AAR) 161 : (2009) 319 ITR 228 (AAR). Reliance is placed on para 15 in which the item relating to transfer of ownership of tread and side-wall design was considered. It was held that the ownership therein having been transferred absolutely to Ceat Ltd., the consideration paid cannot be brought within the scope of art. 12.3 of the treaty.

10.1 In that case the transfer of know-how of technology for the manufacture of radial tyres and the transfer of ownership of tread and side-wall design were dealt with separately in the agreement. The tread and side-wall design was distinct from that part of the agreement which related to transfer of know-how. It was specifically observed in para 15 that this part of the transaction cannot be viewed to be merely incidental to the conferment of right to use the know-how granted under cl. (2) of the agreement. Therefore, the factual position was different in that case. On the other hand, the contention that even in respect of first part of the agreement (i.e. transfer of technical know-how), there was sale of technical documentation and such sale having taken place outside India was not liable to be taxed under the IT Act was rejected. The following observations in para 9.1 are pertinent : “Assuming that there was sale of technical documentation, that is not the end of the matter. Such sale is, in reality and in substance, incidental to the grant of right to use the know-how in various ways specified in cl. 2.1. The transfer of technical documentation was only a step in aid for making the technical know-how available to the transferee Ceat.”

10.2 This reasoning is equally applicable here. The said ruling far from supporting the applicant’s case, goes against the applicant’s contention.

11. There is one more point to be considered i.e. about the payments made to consultants in USA. The remittances to HOK for the purpose of making payments to consultants under the agreement can also fall under art. 12(4)(b) as they also render architectural services. However, since HOK is not the beneficiary of the said payments and they are to be passed on to the consultant in USA for the services rendered outside India such payments will not attract tax liability under the IT Act in India. But, it is made clear that the actual payments made to the consultant can be verified by the Department and, if any, adverse material comes to light, appropriate steps according to law can be taken. On the facts presented by the applicant, we must hold that the receipts by HOK on account of consultancy fee payable to consultants in USA on actual basis will not give rise to taxable income in India. So also, the payments made towards the other reimbursable expenses cannot be considered to be income falling under art. 12. However, they are also subject to verification.

12. In the result, the questions are answered as follows :

Question No. 1 : This question is too general in nature. However, it is answered by stating that the agreement is to be viewed as a whole and the three components of the contract (referred to in the question) cannot be considered in water-tight compartments.

Question No. 2 : The preface to the question—”if the answer to question No. 1 is in the affirmative” is deleted as it would be inappropriate. Paras (a), (b) and (c) of the question No. 2 are answered together as follows : The entire consideration receivable by HOK from the applicant is liable to be taxed in India ‘as fees for included services’ as per art. 12.4 of the tax treaty. However, as stated in para 11, the amount payable as consultancy fees to the consultants in USA has to be excluded while computing the chargeable income.

As regards the payment of fees for technical advisory services at the construction document stage, it cannot be considered to be ancillary and subsidiary to the sale of property and, therefore, does not get excluded from para 4 of art. 12 by virtue of cl. (a) of art. 12.5 of treaty.

As regards payment for “additional services” to HOK, no view is expressed as the details thereof are not available. The rate of 10 per cent as per s. 115A(1)(b)(BB) is applicable in regard to the taxation of income arising from fees for technical/included services as the said rate is less than the rate specified in the treaty.

Question No. 3 : The question is answered in the affirmative. The payment of amounts to the architect HOK by way of reimbursement of expenses actually incurred by it does not constitute chargeable income and withholding tax under s. 195 is not necessary.

[Citation : 325 ITR 71]