27 November 2018

Privity of contract and locus with a source of income – A test of diversion by overriding title

By Prachi Goel & Saurav Sood

The manufacturing business can be undertaken either on own account or by way of a job work. In case the job work is chosen as an option, the manufacturer absolves itself from the whole or any part of the activities required to be undertaken. In a recent case of Pr. CIT v. Chamundi Winery and Distillery I.T.A. No 155/2016, Chamundi (the assessee) the company engaged in the manufacture and sale of liquor was denied the deduction of allocation of distributable surplus as an expenditure under the provisions of the Income-tax Act, 1961 (the Act).

In the instant case, the assessee was appointed as a job worker by Diageo India under the contract. The state excise license was in the name of Chamundi itself, thus for the purposes of manufacture, the assessee was a registered entity under the provisions of relevant law. Diageo India was the owner of license and trademarks (IP rights) of liquor brands worldwide. These IP rights were given to the assessee for the purposes of manufacture. The sale of liquor was undertaken by the assessee and the revenue was booked accordingly in its books of accounts. From this revenue, the assessee was entitled Rs. 45 per case as its share of profits and after adjustment of all expenses including taxes (indirect), the balance was available as distributable surplus to Diageo India which was offered to tax by Diageo India. This distributable surplus was claimed as expenditure under section 37 of the Act by the assessee. 

The deduction claimed by the assessee was disallowed by the income tax officer on the pretext of it being first accrued in the hands of the assessee and subsequently applied for the purposes of distribution. The fact that taxes were duly paid by Diageo India on such surplus was not even taken into consideration. This disallowance, however, was overturned by the first appellate authority and the tribunal on the grounds that assessee could be charged to tax only on the real income to which it is entitled to as per the terms of the contract i.e. the bottling fee, in the instant case. Accordingly, the department went on an appeal before the High Court on the grounds that the distributable surplus paid by the assessee to Diageo under the contract being an application of income was expenditure disallowable under section 37 of the Act.

While deciding the case, High Court referred to the contract entered between Chamundi and Diageo India, where one of the clauses of the contract provided Chamundi with an access to IP rights including blending recipes being a key step in the manufacturing of liquor. Even, the working capital requirements of the assessee were met by the Diageo India. The contract also provided Diageo a control on the bank account of the assessee including the authorized signatory being the employee(s) of Diageo itself. Such rights under the contract which were existing with Diageo, also entitled Diageo to the surplus as per the agreed mechanism of computation provided in the contract. Nowhere, the contract provided for any payment of consideration towards IP rights nor it was a contract of partnership or joint venture.
Based on this factual finding, the Karnataka High Court while deciding the case on the question of law posed before it, held that these payments been in the nature of royalty, finance charges etc., could have been naturally allowed as business expenditure, but in the instant case it is more of a device for tax avoidance rather than diversion of income by overriding title at source. The Court appreciated the legality of the contract but while deciding the issue at hand pierced into the contract for seeing the overall and actual purpose of such façade. The real purpose of commercial arrangement was held to be tax avoidance and was thus disregarded. The Court also held that in case of diversion of income by transfer of overriding title at source, it should normally have support of statutory requirements or some decretal binding character of court of law. In case of private contractual obligations also, the real purport and object of such private arrangements have to be carefully examined before giving it a blessing of diversion of income by overriding title at source.

In the instant case, due to absence of real purpose for having such contract followed with the reliance on account entries and methods of maintaining books, it cannot be held as the basis for conclusion of diversion of income at source. Thus, such expenditure was disallowed in the hands of the assessee. While deciding the case, the Court referred to various judgements wherein this issue was discussed. The judgements referred by the Court provided decisions in favour and against the assessee. This distinction between the divergence of income by overriding title at source and application of income is not on the basis of any fine parameters and is more dependent on the facts of each case.

Thus, it can be concluded that in order to decide taxability of profits, one can say that the person having locus with the source of income and privity of contract with the buyer will be the person in whose hands such income will be taxable. Alternatively, where such source is transferred even before the income is accrued or received (whichever is earlier) there still can be an argument that it is a diversion of income. The reading of this decision also allows us to say that the real purpose of the contract can be deciphered by the Courts through the mechanism of piercing the veil which is now also enshrined under the provisions of GAAR. In case such transaction would have been entered between two associated enterprises while one being a non-resident, it will be interesting to test this proposition while applying the profit split method.

Lastly, one can say that had this payment being made under the subheads of royalty or license fee, then such payments would have been available as a deduction to the assessee upright. Therefore, one can say that taking into consideration the recent trend of judiciary and the anti-abuse provisions incorporated under domestic tax laws and the treaties, the tax planning tools may not come to the rescue of the taxpayer when deeper scrutiny is undertaken by the tax department.

[The authors are Associate & Joint Partner, respectively, in Direct Tax Team, Lakshmikumaran & Sridharan, New Delhi]

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