Income from onsite development exempt only when carried out by offshore liaison office
In a recent case1, the Delhi High Court (“Court”) was faced with a question on the availability of tax exemptions to software companies engaged in exporting software under Section 10A of the Income Tax Act (“Act”), for on-site development activities undertaken by export oriented units (“EOU”) outside India. The Court has agreed with the Revenue’s contention that on-site development should only be carried out by a liaison office in order to be eligible for Section 10A exemption.
Background
Interra Software India Pvt. Ltd. (“Taxpayer”) is a company engaged in the business of development and export of computer software and is registered as an EOU with Noida Export Processing Zone (NEPZ), India. The Taxpayer is entitled to benefit of tax exemption provided under Section 10A of the Act, in the relevant year. Pursuant to an agreement with a company in Japan, the Taxpayer, with the approval of the Reserve Bank of India (“RBI”), set up a non-trading branch in Tokyo, Japan (“Japan Branch”) to facilitate communication between the NEPZ unit and the company in Japan, assist in marketing efforts, help procure orders, render assistance to professionals deputed there on off-shore assignments, attend to validation and testing of the products, if required and providing other requisite comforts to customers. The Taxpayer sought to avail Section 10A benefits over profits of the Japan branch.
The Revenue rejected the Taxpayer’s claim and contended that the Taxpayer had step-up a trading branch in Tokyo which was undertaking ‘full-fledged marketing activities’ and incurring expenses which were borne by the Taxpayer in India. The Revenue further argued that Section 10A benefits could be extended to onsite development when undertaken by a liaison office and not a branch office working independently and carrying out ‘full-fledged marketing operations’ as such activities could not fall within the ambit of ‘onsite development’, as in the present case.
Section 10A of the Act
Section 10A provided a ten-year tax holiday to companies engaged in inter alia software development and export and registered as an EOU. Explanation 3 to Section 10A also extended this exemption to profits derived from on site development of computer software (including services for development of software) outside India. These exemptions are no longer available from April 1, 2011.
Ruling
The Court agreed with the Revenue’s contention that for profits from onsite development of software outside India to be eligible for Section 10A benefits, such onsite software development should be undertaken only by a liaison office set up by the Indian company, and acting as an intermediary between the enterprise and the customers. Where, on the other hand, such office operates as an independent unit meeting all commercial requirements, profits arising therefrom are not eligible for Section 10A benefits.
While the Court agreed with the above interpretation, it was of the view that the documents submitted by the Taxpayer were not examined properly by the lower authorities and thus, remanded back to the lower authorities to re-examine the said documents and to determine whether the Japan Branch constituted an independent branch office or a liaison office.
Analysis
As mentioned above, in the ruling, the Court agrees with the Revenue that a liaison office would be eligible and not a full-fledged branch office. A liaison office by definition acts as a communication channel and marketing office for the parent and undertakes no commercial activity with the object of earning income. A branch office, on the other hand, is an extension of the parent entity in another jurisdiction which undertakes commercial activities for or on behalf of the parent; a branch office is thus engaged in commercial activity with an objective to generate income. This gives rise to an unreasonable situation whereby tax exemption under Section 10A is available for a liaison office which would not typically undertake onsite development and generate no profits, and disallowed for branch office which would undertake such activity and generate income. Based on the aforesaid, it appears that reliance on the generic definition of liaison office or branch office would not prove very useful in understanding the scope of services that the office should or should not carry out in order to be eligible for the exemption.
Moreover, onsite development with respect to computer software contemplates creation, customization and integration of software on the client site as opposed to being a mere communication link or intermediary, as suggested in the ruling. Having said that, inclusion of marketing activities in on-site development may be stretching the concept too far.
