It is clear that commercial requirements (especially the interests of the Indian client) and tax efficiency do not intersect.
India, being one of the major developing economies, has seen significant growth in the infrastructure sector in the last few years. Such infrastructure projects usually require expertise and specialised resources in specific arenas within the project, mooting for the parties to enter into Engineering Procurement and Construction (EPC) contracts. This has led to several global players entering the EPC market either individually or collectively by forming a consortium. The consortium space has struggled with several tax dilemmas impacting either the foreign supplier or the Indian buyer. Therefore, it is significant for the parties to clearly understand the attendant tax red flags and accordingly carefully structure their EPC contracts. A Generally, EPC contracts with global players are bifurcated into various separate contracts. The tax cursors surrounding these contracts vary depending upon their type:
Offshore supply of equipment: Normally, the offshore supply of equipment forms a predominant portion of the total contract value. Taxes on the offshore supply contract can be saved if the foreign supplier transfers the title in the equipment and receives the consideration for such sale of goods outside India. While this seems to be the most ideal approach from the foreign party's perspective, it is often seen that the Indian buyer client prefers that the offshore party continues to assume the risk and responsibility and the title of goods till delivery in India. In such a situation, the offshore supplier can be taxed in India on such income provided he has a business connection or in case a tax-treaty is applicable, if he has a permanent establishment in India. The tax implications in such a scenario are huge, given that the supplier will be taxed in India @ 40 per cent (exclusive of applicable surcharge and cess) on a net income basis on the income from the offshore supply. A midway approach which strikes the balance between commercial and tax objectives would be incorporation of a milestone based payment system, rather than upfront payment schedule for the offshore supply.
Offshore service: It could be a combination of designs and drawings and/or ancillary services related to the supply of the equipment. Generally, offshore services are taxed in India either as a service fee or royalty, subject to any relief available to the consortium members under an applicable tax treaty. If however, the services are inextricably linked to the sale or supply of equipment, in India, then the taxability of these services may take the same colour as that of the supply of the goods. The tax rate may vary from 10 per cent to 40 per cent (exclusive of surcharge and cess) depending on creation of a permanent establishment of the concerned consortium member in India.
Onshore service and supply: Such services/supply are usually performed by an Indian arm and would be taxed in India @ 30 per cent (exclusive of surcharge and cess). But if in substance the Indian arm is seen as an extension of the foreign contractor itself and is viewed as carrying on the business of the foreign arm and not its own and does not itself have the wherewithal to perform the contract; then the Indian arm can expose the foreign supplier to a PE risk in India.
Other tax speed breakers affecting the infrastructure highway
Consortium members being exposed to Association of Person (AOP): While from a tax perspective it is ideal to have separate contracts for different components of an EPC project, from a commercial perspective, the Indian client may insist on having a single point of contact and that the members be jointly and severally liable to the client, despite having a clear distinction in role, scope of work, responsibilities and liabilities inter se the consortium members.
Such a single contract structure may expose the consortium to be taxed as AOP, which would result in certain adverse consequences as such (i) subjecting the income to a higher tax rate of 40 per cent (exclusive of surcharge and cess), if the global player is also part of the consortium; (ii) restricting the deductibility of certain expenses incurred by the AOP. This is indeed the pain area in the EPC space.
In order to bring certainty to the taxability of EPC contracts, the Central Board of Direct Taxes ('CBDT'), recently issued a circular 07/2016 (dated 7 March 2016) ('Circular')clarifying that a consortium arrangement may not be treated as AOP if it has the following features, namely: (i) Members have a clear demarcation of scope of work and associated costs; and (ii) Profits/loss based on scope of work of each consortium member;(iii) Risk and control of resources for specific scope of work with respective consortium members (iv) No unified control and management of the consortium exists.
The clarifications contained in the Circular serve as guiding principles to the tax authorities, and thus reduce the inconsistency in the approach adopted by them while evaluating consortium structures. The Circular however is not be applicable where two or more of the consortium members are 'related parties'.Given that a majority of the large EPC players have Indian subsidiaries, including related parties/associated enterprises would have brought greater clarity to the vexatious issue of AOP exposure in EPC contracts.
Foreign parties exposed to PE risk
In case the EPC project requires the foreign contractor to be present in India, then such presence can expose the foreign contractor to a PE risk in India. PE essentially is a concept under tax treaties that establishes the economic nexus of the business profits of a foreign enterprise with the 'source state' and thus enables the 'source state' to tax the business profits of the said foreign enterprise. In case a PE is created in India, the foreign party can be exposed to a tax as high as 40 per cent (exclusive of surcharge and cess) on the income attributable to the PE.
The implications of higher tax liability necessitates a careful assessment of PE risk. So, if the foreign contractor is present in India for the erection/installation (including for supervision of the project in India) and his presence in India exceeds the thresholds specified in the applicable tax treaty, he risks creating a PE in India.
Further, some tax treaties, (e.g the India-Italy tax treaty) also contain an additional threshold of the quantum of consideration exceeding certain percentage of the sale price of the equipment while determining the existence of an installation PE of the foreign company. Likewise, if the foreign contractor through its employees/personnel provides certain services like managerial/consultancy in nature in India for a specified threshold, even then the foreign company may be exposed to constituting a Service PE. At times, the presence of a sub-contractor or an Indian arm of the foreign contractor may also create a PE exposure for the foreign party. All in call, if a PE is created it is followed by a web of tax issues such as higher tax incidence, increased compliance and needless to say, the determination of the income attributed to the PE is also very complex. For foreign EPC players, it is always advisable to steer clear of constituting a PE.
Do the tax issues affect the Indian buyer?
Although it is true that the complexity surrounds the taxability of the payments received by the EPC contractors, the Indian buyer needs to be sufficiently safeguarded as well. More so, given that the Indian tax laws mandate that the buyer deduct appropriate taxes while making payments to the foreign contractors and a buyer failing to do so is likely to face adverse and penal consequences. Lastly, it is often the case that the tax burden of the foreign contractors is contractually shifted to the Indian buyers. In such cases, it is all the more important for the players to carefully structure their contracts and minimise tax leakage.
It is clear that commercial requirements (especially the interests of the Indian client) and tax efficiency do not intersect in EPC contracts. However, it is important to establish a delicate balance between the two objectives while structuring EPC contracts, paving the way for a win-win outcome for all players alike. Thus, the documentation should capture the interests of the Indian buyers and at the same time, should not unnecessarily increase Indian tax exposure for the consortium members.
Furthermore, various legal implications such as indirect taxes, arbitration and dispute resolution mechanisms also play vital role. The terms of EPC contracts should adequately protect the interests of all parties in this regard. Finally, these contracts should be tightly drafted to clearly outline who exactly bears the financial burden of the tax liability. The provisions must also incorporate a mechanism to plug-in chances of double benefits obtained by a foreign member under its domestic law in its state of residence and simultaneously in India.
The article has been authored by Vinita Krishnan and Ankit Namdeo of Khaitan & Co. The views expressed do not necessarily reflect the views/position of the firm and are solely those of the author(s).