October 15, 2005 | By Keith Martin in Washington, DC

INDIA ordered an Indian company to withhold income taxes from payments to a foreign consultant.

The consultant was in the United States and was hired to help the company secure orders for its products in the United States and also help it with strategic planning generally. The consultant was paid a monthly fee plus commissions on the sales he secured for the Indian company in the United States. The parties argued that no withholding taxes should be collected because the payments were for services performed outside India. 

Taxes are normally assessed only on income from Indian sources. However, in a September ruling, the Authority for Advance Rulings — or “AAR” — disagreed. The case has implications for infrastructure projects in India. Many project developers divide the construction work for their projects into two separate
contracts. One contract covers the engineering work and procurement that will be done outside India. The other contract covers the work that will be done at the construction site in India.

The case addressed in the AAR ruling is called Wallace Pharmaceuticals Pvt. Ltd. Indian lawyers advise that the rulings tribunal failed to consider whether India is barred from collecting taxes by the US-India tax treaty. A tax treaty may prevent a tax, depending on the facts.

Meanwhile, the Indian government is again pressing Mauritius to renegotiate the tax treaty between the two countries. Nearly 40% of foreign direct investment into India is run through Mauritius. The investors set up holding companies in Mauritius. As long as the holding companies qualify as “tax residents” in
Mauritius, then they benefit from a tax treaty provision that bars India from taxing them on their capital gains. 

India wants the treaty rewritten to include a limitation-of-benefits clause that would prevent Mauritius companies that are merely shell entities from claiming treaty benefits. It put similar language in a new tax treaty with Singapore. The language in the Singapore treaty denies treaty benefits to anyone who
structures a transaction with a “primary purpose to take advantage” of the treaty and to any “shell companies” with “negligible or nil business operations” and “no real and continuous business activities” in Singapore. Mauritius has not yet responded to the latest demands. 

In a related development, the Indian government is studying whether to treat income from the sale of shares in Indian companies as “business profits” rather than “capital gain,” at least for large institutional
investors who buy and sell Indian shares. The AAR ruled that a US-based fund — Fidelity Advisor Series VII — earned “business profits” from its trading in Indian shares. The ruling means that Fidelity does not
have to pay Indian income taxes on its gains as long as it is careful not to operate through an office or other “permanent establishment” in India. The government is examining how broadly this principle should apply. 

If the review leads to widespread adoption of the principle, then foreign institutional investors would no longer have to invest through Mauritius or Singapore in order to avoid taxes when they sell their shares.