The shipping industry plays a vital role in the international trade. The recent UNCTAD report provides that more than four fifths of world merchandise trade by volume is carried by sea. Indian companies also generally use foreign vessels or avail the carriage services of foreign shipping companies for transportation and other business activities. The amount paid to these foreign shipping companies may be taxed in India if the income accrues or is received in India.
In this article, the author has discussed the nature of income of foreign shipping companies arising from a number of transactions such as operation of ships for carriage of passengers, live-stock, mail or goods; leasing of ship; operation of special vessels, and the issues arising in the taxation of such income in India.
Income from operation of ships:
The term ‘operation of ships’ is generally understood to mean operation of ship for carriage of passengers, livestock, mail or goods. The foreign shipping company involved in the business of carriage may earn freight on account of carriage of goods shipped at any port in India; and/or carriage of goods shipped at any port outside India.
The Income-tax Act, 1961 (“domestic law”) seeks to tax the freight earned on account of carriage of passengers, live-stock, mail or goods shipped at any Indian port as also any port outside India; whereas the treaties provide exclusive right of taxation to the country of residence or place of effective management of the foreign shipping co, if the carriage of passengers, live-stock, mail or goods is not confined to Indian territory/waters.
This part of the article discusses the taxability of the income from the operation of ships under the domestic law as well as treaty.
a) Income from operation of ships under the domestic law:
The income of a foreign shipping company which is received or is deemed to be received in India; or accrues or arises or is deemed to accrue or arise in India is taxable in India as per section 4 and 5 of the domestic law.
The domestic law further provides for certain special provisions i.e. section 44B and section 172 for taxation of income of foreign shipping companies on account of carriage of passengers, live-stock, mails or goods. Section 172 is a self-contained code and applies in a case where a foreign company has earned income form carriage of passengers, livestock, mail or goods shipped at a port in India. The provision deems 7.5% of the amount paid to the foreign company, whether in or outside India, as its income from such carriage.
Further, in terms of section 44B of the IT Act, the profits and gains of the foreign company from the business of operation of ships will be taken at an amount equal to 7.5% of the amount paid or payable to the foreign shipping co, on account of the carriage of passengers, live-stock, mails or goods shipped at any Indian port as also of the amount received or deemed to be received in India on account of the carriage of passengers, live-stock, mail or goods shipped at any port outside India.
Section 172 is applicable only when the shipment happens at a port in India and section 44B is applicable when shipment happens at a port in India or outside India (if amount is received or deemed to be received in India). The quantum of income determined as per these provisions (i.e. 7.5% of the freight) shall be taxed at the applicable tax rate i.e. 40% in case of a foreign company.
b) Income from operation of ships under Treaty
(i). Operation of ships in international traffic:
The income earned by foreign shipping companies by operation of ships in international traffic cannot be taxed in India if the ship was operated in international traffic. It is the country of residence of the foreign shipping company or the country where the foreign shipping company has its place of effective management, which will have a right to tax such income.
The meaning of the term ‘international traffic’ is generally defined as ‘transport by a ship operated by an enterprise of a Contracting State/which has its place of effective management in a Contracting State, except when the ship or aircraft is operated solely between places within the other Contracting State’. Therefore, if the operation of the ship is not restricted solely to the places within India, the condition of international traffic will be satisfied.
(ii). Income from operation of ship in Indian waters
A foreign shipping company may be engaged in the carriage of passengers, livestock, mail or goods in the Indian waters only. In such cases, the ship will not operate in international traffic and therefore, the relevant article of Treaty relating to shipping income will not provide any relief to the foreign company. However, the activity of carriage being the business of the foreign shipping company, the profits will be considered as business profits and will be taxable in India only if there is a permanent establishment in India and the income can be attributed to such permanent establishment.
In such cases as well, the question will arise whether the vessel itself can be said to be a permanent establishment of the foreign company. The detailed analysis as to whether a vessel can constitute a permanent establishment has been made in part IV (Income from vessels having certain specific uses) of this article.
Income from leasing of ships or vessels:
A foreign company may provide ships or vessels on lease; the nature of lease may be a full charter i.e. charter fully equipped, manned and supplied (“time charter” or “voyage charter”) or a bare boat charter. In such cases, the question of determination of nature of income and the consequent taxation may arise.
a) Income from time charter or voyage charter where the lessee operates in international traffic:
The income of a foreign shipping company from time charter or voyage charter of a ship is considered as income from operation of ship in international traffic and covered under article relating to shipping income under Treaty if the ship is used by the lessee in international traffic. Thus, if an Indian lessee company/another foreign lessee company takes a ship on time charter or voyage charter and operates it international traffic, the income of the foreign lessor company will not be taxable in India. In cases of time charter or voyage charter, the condition of operation of the ship in international traffic is mandatory for it to be covered under the article relating to shipping income under Treaty.
In such cases, a question may arise as to how the condition relating to operation of vessel in international traffic has to be examined. One possible view is to go by the terms of the contract between the parties. If as per the terms of the contract, the vessel is to be used in international traffic, one can argue that the condition relating to operation of vessel in international traffic stands satisfied. However, this position is not free of ambiguities. It may so happen that even if the vessel owner has contractually agreed to use the vessel in international traffic, it may choose to operate the vessel in the Indian waters alone. Thus, it may lead to an absurd position where a vessel which is operating solely between places in India will be treated as being operated in international traffic. Also, such a conclusion may invite treaty abuse where the vessel owner may agree to operate the vessel in international traffic merely to avoid paying taxes in India. Another possible view is to look into the actual usage. However, this view will require the vessel owner to demonstrate that the use of the vessel was not restricted to places within India. According to the Author, the actual usage test is the correct approach for demonstrating that the vessel was operating in international traffic.
b) Income from bare boat charter where the lease is incidental
The income from leasing of ship on bare boat charter basis is not considered as arising directly from the operation of ship and will not be considered as income from operation of ship unless such leasing is incidental to the lessor’s business of operation of ships. In such cases, the place of use of ship (i.e. international traffic or domestic water) by the lessee is irrelevant. However, the determination of nature of such lease i.e. whether incidental or not becomes significant. For determining whether a lease is incidental or not, factors such as duration, frequency and economic significance to the foreign lessor have been considered as important.
c) Income from leases not covered above
A foreign shipping company may earn income from lease of ships or vessels, which may not be covered under above categories. Such income, for example, income from time charter or voyage charter of ship which is not operated in international traffic, will not be covered under the article relating to shipping income under Treaty. Similarly, in cases of bare boat charter, where the leasing is not incidental or casual, the income will not be covered under article relating to shipping income. In such cases, the issue of taxation of income as royalty or as business income may arise.
The provisions of section 9(1)(vi) of the domestic law classify income earned from granting use or right to use an industrial, commercial and scientific equipment as royalty. The definition to this extent is pari-materia to the definition of royalty in many of the tax treaties entered by India. Thus, it is worth examining if the income earned by the ship or vessel owner from such leasing transactions can be classified as royalty wherein India can claim a right to tax such income.
The question of taxability of income as royalty arose before the Madras High Court in Poompuhar Shipping wherein the Court held that the payment under a time charter agreement and bare boat cum demise charter represented consideration for right to use an equipment (ship) and therefore, amounted to royalty under section 9(1)(vi) of the domestic law as well as Treaty. In this case, the ships were not operated by the lessees in international waters. However, in a later decision, the Income Tax Appellate Tribunal, Chennai in Sical Logistics while dealing with the payment under time charter party held that the payment was not in nature of royalty. The Tribunal held that the essence of the agreement executed between the parties was for utilisation of the space in the vessel by the assessee and not that the assessee was authorised to operate or exercise control over the vessel. The Tribunal distinguished between ‘letting the asset’ and ‘use of asset by the owner to provide services’ and held that while in the former case the consideration paid will be royalty, in the latter case, payment relates to use of asset by its owner, the same cannot be treated as royalty. In this case as well, the ship was used in Indian waters.
Thus, in cases where the article relating to shipping income under Treaty does not apply, the taxpayer must determine whether the payment can be treated as consideration for use or right to use industrial, scientific or commercial equipment amounting to royalty.
In cases of commercial leases on bare boat charter basis (other than those covered under article relating to shipping income), the income will fall under the article relating to royalty. If the relevant treaty does not include ‘income from leasing of industrial equipment’ in the article relating to royalty, the income will be taxed in terms of the article relating to business profits and the income of lessor will be taxable only if it has a permanent establishment in India.
Income from vessels having certain specific uses:
The shipping business may also involve certain special vessels which are not used for the purpose of transportation but for certain special purposes, such as tug boats, museum ships, icebreaker ships, fishing vessels (not used for transportation), floating docks, etc. The profits from operation of these vessels will not be covered under article relating to shipping income under Treaty.
In such cases, the question of determination of nature of income will arise. It may be in the nature of royalty or business profits. If it is in nature of royalty (i.e. right to use vessel is granted), most of the treaties grant right to India to tax the royalty. However, if it is in nature of business profits, it will not be taxable in India, if the foreign shipping company does not have a permanent establishment. Moreover, if income is considered as royalty and the foreign shipping company has a permanent establishment in India, the income will be taxable under the article relating to business profits under Treaty.
The permanent establishment in such cases may be any fixed place through which the foreign shipping company carries on its business. A place is fixed if there is a link between the place of business and a specific geographical point in the source state . A vessel by its very nature is a mobile equipment and does not rest at a given physical location for long durations. Despite this, in certain cases it has been observed that presence of a vessel in India can constitute a permanent establishment. In SeaBird Exploration FZ LLC , the Authority for Advance Ruling held that the assessee had a fixed place Permanent Establishment in India in the form of its vessels engaged in seismic surveys in the Mumbai High area. In Poompuhar Shipping (Supra), the Court held that the place where the ship is docked is the place of business and the fact that the ship moved from one point to another is the result of the nature of business contract and the movement is an integrated one having business and geographical coherence.
The Author believes that the determination of permanent establishment, being a detailed factual and legal exercise, requires examination of several aspects of the transaction. In cases where the vessel is not stationary but a moving vessel, the area of operation of the vessel is also not defined or limited, the vessel is not used for any specific task, the period of operation of vessel is short, etc, the question of determination of the existence of permanent establishment becomes significant for the taxpayer.
The shipping transactions are complex web of transactions involving several issues. As discussed above, the taxation of shipping income has been subject to litigation. The Author believes that for determining the nature of income/taxability, no straight jacket formula can be applied, and the taxation will depend on the nature and substance of the transactions. The Author believes that tax payers should be cautious while determining their tax liability, especially in the borderline cases as the taxability of the income in India carries involves certain obligations on the payer of income, such as deduction of tax at source and consequent penal actions.
[The author is a Senior Associate, Direct Tax Team, Lakshmikumaran & Sridharan, New Delhi]