ORDER
Pramod Kumar, A.M.
1. This is an appeal filed by the AO and is directed against the order dt. 14th Dec., 2004 passed by the CIT(A) in the matter of assessment under Section 143(3) of the IT Act, 1961, for the asst. yr. 2001-02.
2. The grounds of appeal, as set out in the memorandum of appeal, are as follows:
1. On the facts and in the circumstances of the case, the learned CIT(A) erred in allowing the losses of assessee’s Japan branch office amounting to Rs 53,96,061.
2. On the facts and in the circumstances of the case, the learned CIT(A) has erred in not considering the Double Taxation Avoidance Agreement (DTAA) with Japan.
3. On the facts and in the circumstances of the case, the learned CIT(A) has erred in not considering the specific provisions of Section 90 in respect of the cases where the Government of India has entered into DTAA with another country.
In substance, therefore, solitary grievance of the AO is that the CIT(A) ought to have held that loss of Rs. 53,96,061 incurred by Japan office of the assessee company is not to be taken into account while computing its income taxable in India.
3. The issue in appeal lies in a narrow compass of material facts. The assessee company is engaged in the business of development of computer software. In the relevant previous year, the assessee company had set up a trading office in Japan. In the course of assessment proceedings, the AO noted that while the assessee had opened the office in Japan, the assessee has only debited expenses in the accounts–resulting in a loss of Rs. 53,96,061. On these facts, he observed that “as per DTAA with Japan, the profit of trading office is chargeable to tax only in Japan” but “in view of the loss for the year in trading office, no amount is excludable from the total income of the company”. He further noted that “since the profit of the said trading office is taxable in Japan only, hence any loss incurred by the assessee in respect of this trading office is not allowable as deduction from the income which is taxable in India”. It was on the basis of this reasoning that the AO disallowed the loss of Japan office amounting to Rs. 53,96,061 and “added to total income as well as book profit under Section 115JB”. Aggrieved by the stand so taken by the AO, the assessee carried the matter in appeal before the CIT(A) . In appeal, the CIT(A) held that “the company is resident in India and its global income/loss is taxable in India only”. “In view of that”, according to the CIT(A), “the loss arising to Japan office should be allowed as deduction while computing the income of the appellant for the year”. The AO is aggrieved of the relief so given by the CIT(A) and is in appeal before us.
4. Shri K Srinivasan, learned Departmental Representative, submits that in terms of the provisions of the India Japan DTAA (India Japan tax treaty, in short), the profits and losses of the Japanese PEs of Indian companies are subject to taxation in Japan only. It is contended that following this broad principle, as enshrined in art. 7, any income accruing or arising to an Indian assessee’s PE in Japan is excluded from the total income of Indian company, as is exigible to tax in India. It is a natural corollary to the above principle that the losses incurred by the PE should only is assessed to tax in India and be eligible for set off against future profits of the Japanese PE in Japan. It is contended that these losses incurred by the assessee in Japan cannot be set off against income of the assessee in India, as it will be contrary to the scheme of the India Japan tax treaty. It is further pointed out that since the assessee has not given up his claim to avail the benefits of the India Japan tax treaty, the acceptance of the claim of the assessee will result in an absurdity inasmuch as while profits of assessee’s PE in Japan will be taxed in Japan, the losses incurred by its PE in Japan will be set off against incomes taxable in India. Learned Departmental Representative further submits that it is clear from the language of art. 7 of the India Japan tax treaty that the right to tax profits attributable to the PE is exclusive right of the source country. It is also submitted that in case the assessee does not want to have his income assessed on the basis of treaty provisions in one year, it cannot be open to him to avail of the treaty provisions in the other years as well. As the assessee has availed the treaty provisions in the other years, it cannot be open to him to disregard the treaty provisions for this year. On the strength of these arguments, as also on the basis of learned Departmental Representative’s vehement reliance on the order of the AO, we are urged to vacate the relief given by the CIT(A) and restore the order of the AO on the issue in appeal before us. Shri S.P. Joshi, learned Counsel for the assessee, argues that nowhere in the India Japanese tax treaty, it is provided that the profit of the PE of an Indian company in Japan, will not be taxed in India. He submits that as per the clear provisions of the IT Act, all the profits and losses of an Indian resident, irrespective of wherever they arise, will be taxed in India. There are no exceptions to this general rule. On the basis of this reasoning, Shri Joshi submits that the CIT(A) was quite justified in directing the AO to take into account the loss, incurred by Japan office of the assessee company, while computing taxable income in India. He also places strong reliance on the order of the CIT(A). We are thus urged to confirm the relief given by the CIT(A) and decline to interfere in the matter. In rejoinder, learned Departmental Representative merely reiterated his arguments.
5. In order to properly appreciate the controversy requiring our adjudication, in our considered view, it is necessary to appreciate the position prevailing before the judgments of Hon’ble Karnataka High Court, in the case of CIT v. R.M. Muthaiah and of Madras High Court in the case of CIT v. SRM Firm and Ors. were delivered, which have now been specifically approved by the Hon’ble Supreme Court in the case of Union of India v. Azadi Bachao Andolan (2003) 184 CTR (SC) 450 : (2003) 263 ITR 706 (SC), and the impact of these decisions on the same.
6. Until the decisions in the cases of Muthaia (supra) and SRM Firm (supra), and till these decisions had the seal of approval of the Hon’ble Supreme Court in Azadi Bachao Andolan’s case (supra), a school of thought existed that in terms of the provisions of the Indian IT Act, 1961, all the resident assessees were taxable in India on their worldwide income. The basis of this school of thought was this. Sec. 5(1) of the Act categorically provides that total income of a resident assessee includes “all income from whatever source derived”. It was quite in contrast with the territorial basis of taxation followed by some tax jurisdictions, such as notably Hong Kong, which permits taxation of only such income as is sourced from that particular tax jurisdiction. This distinction was considered to be important from the point of view whether or not losses of a foreign branch can be relieved against the domestic profits of a taxpayer. In case worldwide basis of taxation is followed, as was unambiguously followed under the scheme of the Indian IT Act, the total income is computed by taking into account all business operations of the assessee, wherever located, and thus total profits and losses are aggregated on current basis. Undoubtedly, in such a situation, certain incomes sourced in other tax jurisdictions can be subjected to double taxation–in source country as also in residence country. To mitigate the hardship on account of such double taxation, relief was granted either by way of income-tax exemption of income sourced abroad or by way of granting deduction for the income-tax paid abroad. The basis of relief from double taxation, i.e. exemption or deduction, would obviously depend upon whether the case is governed by the provisions of the Act or a tax treaty, and in case the case is governed by a tax treaty, the provisions of the said tax treaty. In contrast with this worldwide basis of taxation, in case a tax jurisdiction is following the territorial basis of taxation, its concern is obviously confined to the profits and losses accruing or arising in the territory over which it has taxing jurisdiction, and, therefore, an income–positive or negative–sourced outside that tax jurisdiction may not have any relevance in computation of taxable income of the tax subject. In effect, therefore, under the scheme of the Indian IT Act, an income sourced abroad, was includible in total income of a resident taxpayer and the relief from double taxation of income was granted by way of corresponding tax exemption of income or by way of tax credit for the income-tax paid in the source country.
6a. According to this school of thought, so far as specific provisions of the India Japan tax treaty are concerned, the relief from double taxation of an income in India was to be granted, under art. 23 of the tax treaty which provides for tax credit in respect of taxes paid in Japan to the extent of Indian income-tax liability in respect of the said income. Therefore, even under the India Japan tax treaty, it was not the income of Indian PE in Japan which is exempted from tax in India, but only a credit in respect of tax paid in Japan in respect of such an income which is available for adjustment while computing Indian income-tax liability. Viewed in this perspective, the stand of the AO is not even in the interest of the Revenue anyway. In case this stand was to be followed by the AO vis-a-vis the profits earned by Japanese PE, the revenue loss would be inevitable. As the effective tax rate in India on the assessee was approx. 40 per cent in the relevant year, which, according to the AO, was not leviable in respect of Japanese sourced income. However, in case the corporation tax rate in Japan was less in the relevant period, which is say 30 per cent, there will be a loss of revenue to that extent of 10 per cent. The reason is that as per this method, entire income, including income of the PE in Japan, is to be taxed in India but while computing the tax payable, however, credit is also to be given to the extent of tax paid in Japan. As regards learned Departmental Representative’s apprehension regarding double benefit of losses incurred by the PE which is termed as ‘double dip’ of losses in international taxation parlance, the question of double dip of losses can only arise when the benefit in respect of the loss incurred by the foreign branch is claimed in the residence country by offsetting the same against domestic incomes, the loss set off is also claimed in the source country by setting off the same against the profits in the subsequent years, and yet entire foreign income, i.e. pre-such set off is taken outside the ambit of taxability in the residence country. Let us assume that in the case before us, the assessee earns an income of Rs. 2 crores from PE in Japan in the immediately subsequent year, but, as a result of set off of loss incurred in this year, pays tax on only Rs. 1.47 crores. In such a situation, in case the assessee is to claim exemption of income of Rs. 2 crores earned in Japan, that would amount to double dip, or double benefit of the losses incurred by the PE. However, as per the legal position above, such an eventuality will never arise for the simple reason that the benefit from double taxation is to be given in India, in this case, by giving credit for the taxes actually paid in Japan, and since such taxes will be paid only on the income actually taxed in Japan, the grant of set off in Japan will be neutralized by the correspondingly lower tax credit in India. The subsequent recapture of loss by the PE, in such a situation, only creates a tax deferral or a timing issue in the residence State. In case the PE losses cannot be carried forward for whatever reason, there is obviously no tax relief in the source country in the subsequent year, and, no issue arises on account of tax recapture in the home State. Whichever way one looks at, as long as the legal position as set out above was to be followed, there would have been no possibility of allowing a double dip to the assessee, i.e. double benefit on account of losses incurred by the PE, in respect of loss of Japan office being allowed to be set off against domestic income of the assessee.
7. In view of some significant developments by the virtue of Judge made law, this school of thought does not, however, hold good in law any longer. We may at this stage deal with a diametrically opposite school of thought which has also now found judicial acceptance before higher judicial authorities. While dealing with India Malaysia DTAA, Hon’ble Karnataka High Court in the case of CIT v. R.M. Muthaia (supra) and Hon’ble Madras High Court in the case of CIT v. SRM Firm and Ors. (supra), have held that when it is provided that tax may be charged in a particular State in respect of the specified income it is implied that tax will not be charged by the other State. In the case of Muthaia (supra), it was held that since India Malaysia tax treaty recognized that right to tax certain incomes belonged to Malaysia, this fact, by itself, acted as a bar on the powers of Government of India to tax the same income. Hon’ble High Court observed that “this bar would operate on Sections 4 and 5 of the IT Act, 1961”. According to the Hon’ble High Court, the question of tax credit would only be relevant when the same income, in terms of the provisions of the tax treaty, is to be taxed twice. In the case of SRM Firm (supra), Hon’ble Madras High Court has held that “the contention on behalf of the Revenue that wherever the enabling words such as ‘may be taxed’ are used, there is no prohibition or embargo upon the authorities exercising powers under the IT Act, from assessing the category or class of income concerned cannot be countenanced as of substance or merit”. In other words, according to the Hon’ble High Courts, powers of one of the contracting State to tax the income oust the other Contracting State’s jurisdiction to tax the same income. Hon’ble Supreme Court, in the case of Union of India v. Azadi Bachao Andolan (supra), have upheld the reasoning of these decisions by referring to these decisions and then observing as follows:
We approve of the reasoning of the decisions which we have noticed. If it was not an intention of the legislature to make a departure from the general principles of chargeability under Section 4, and the general principles of ascertainment of total income under Section 5 of the IT Act, then there was no purpose of making those sections ‘subject to the provisions of the Act’. The very object of grafting the said two sections with the said clause is to enable the Central Government to issue a notification under Section 90 towards implementation of the terms of the DTAA which would automatically override the provisions of the IT Act in the matter of ascertainment of chargeability to income-tax and ascertainment of total income, to the extent of the inconsistency with the terms of DTAA.
8. The law laid down by the Hon’ble Supreme Court is binding on us under Article 141 of the Constitution of India. The prevailing legal position, therefore, is that once an income is held to be taxable in a tax jurisdiction under a DTAA, and unless there is a specific mention that it can also be taxed in the other tax jurisdiction, the other tax jurisdiction is denuded of its powers to tax the same. To that extent, the worldwide basis of taxation in the scheme of the Indian IT Act is no longer applicable in a situation provisions of a DTAA entered into under Section 90 apply. The next question then arises whether in a loss situation in the PE State, as is the case before us, can the assessee be forced to go for taxation in accordance with the provisions of the treaty with the said PE State. The provisions of Section 90(2) of the Indian IT Act are quite unambiguous and categorical in this regard. Sec. 90(2), inter alia, provides that when the Government of India has entered into a DTAA with Government of any other country, “in relation to an assessee to whom such agreement applies, the provisions of this Act shall apply to the extent these are more beneficial to that assessee”. Sec. 90 only grants relief; it does not impose any liability. Even without such provisions, Courts in US and Germany, as indeed in other parts of the world, have held that a treaty cannot act to the disadvantage to the taxpayer. In other words, therefore, merely because India has entered into a DTAA with a foreign country, the assessee cannot be denied the taxability under the scheme of the Indian IT Act. The scheme of the DTAA cannot, therefore, be thrust upon the assessee. In this particular case, it is obviously to the advantage of the assessee that he is taxed in India on the basis of his worldwide income, which includes losses incurred abroad, and not to invoke the provisions of the India Japan tax treaty. The provisions of the Indian IT Act must, therefore, apply to that extent. Then comes the objection of the Revenue that in the event of the assessee not opting for treatment on the basis of India Japan tax treaty this year, he will be shut out from availing the benefits of the said treaty in the subsequent years. We see no support for this proposition. Under the IT Act, every year is an independent unit and it is for the assessee to examine whether or not, in the light of the applicable legal provisions and in the light of the precise factual position, the provisions of the IT Act are beneficial to him or that of the applicable DTAA. There is no specific bar on such an approach of the assessee and in the absence thereof, we cannot impose the same. In any event, this question is relevant only in the year in which the assessee claims the treaty benefits and not in this year in which the provisions of the Act are clearly more beneficial to the assessee, and, therefore, the assessee does not claim the treaty protection. Just because the assessee may, in AO’s perception, claim treaty protection in a subsequent year, the treaty provisions cannot be thrust on the assessee this year as well. In this view of the matter, the assessee was indeed eligible to claim taxation on worldwide basis, disregard the scheme of taxability under the India Japan tax treaty, and, in effect, claim deduction of loss incurred by the PE in Japan. The CIT(A) was thus justified in his conclusion to the effect that losses of assessee’s PE in Japan are to be taken into account while computing assessee’s total income liable to tax in India.
9. It is interesting to note that, as per the law which prevails now in the light of the judicial precedents discussed above, a double dip of foreign losses may indeed occur. When the assessee incurs losses abroad in a country with which India has entered into a tax treaty, the assessee may as well go for taxation of worldwide income and thus effectively claim deduction of loss abroad from its total income liable to tax in India. The scheme of Section 90(2), as we have discussed above, permits so. When the assessee makes profits in the subsequent years, and whether or not the assessee recaptures loss in the subsequent years, its entire PE income remains outside the scope of ‘total income’ under Section 5 of the Act. This is so in the light of the judicial precedents discussed above. In effect, therefore, the loss of the PE abroad is deducted twice. This position may be unintended or even undesirable, as evident from the global concern to neutralise such dual benefits in the international taxation, but that is an inevitable corollary to the legal position existing now. The present legal position is also somewhat anomalous inasmuch as the scheme of tax credits under the various tax treaties, which India has entered into, has become unworkable to a large extent due to availability of tax exemption to the most of the foreign income of Indian residents, which is taxed in the source country–something which was obviously not envisaged when these treaties were entered into. The remedy, however, does not lie with us.
10. For the reasons set out above and even as we have traversed along a different dialectic to reach the conclusion arrived at by the CIT(A), we approve the conclusion arrived at by the learned CIT(A). His having arrived at right conclusion may have been somewhat fortuitous, in the sense it was without really analyzing the nuances of relevant legal position, but what is material is that he reached the right conclusion. We approve his conclusion and decline to interfere in the matter.
11. In the result, the appeal filed by the AO is dismissed.