The Bombay High Court has held that excess royalty refunded under Advance Pricing Agreement (APA) cannot be taxed.
The bench of Justice B. P. Colabawalla and Justice Firdosh P. Pooniwalla dealt with two major issues: whether excess royalty refunded pursuant to an Advance Pricing Agreement (APA) could still be taxed in India and whether the Indian subsidiary, GIA India Laboratory Pvt. Ltd., constituted a Permanent Establishment of GIA US in India.
The petitioner/assessee a globally recognized gem grading and certification institution headquartered in the United States, had established its wholly-owned Indian subsidiary, GIA India Laboratory Pvt. Ltd., to provide diamond grading services in India. To facilitate the Indian operations, GIA US provided technical know-how, expertise, grading methodologies, and related intellectual property to GIA India in exchange for royalty payments.
For Assessment Year (AY) 2011-12, GIA US received royalty of approximately ₹68.53 crore from GIA India and offered the entire amount to tax in India. Subsequently, GIA India entered into an Advance Pricing Agreement (APA) with the Central Board of Direct Taxes (CBDT), which determined that the arm’s length royalty payable for AY 2011-12 should have been only about ₹49.09 crore. Consequently, GIA US was required to refund approximately ₹19.44 crore to GIA India. The refund was made in July 2018 in accordance with the APA.
The department argued that the APA had been entered into only by GIA India and not by GIA US. Therefore, according to the Department, GIA US could not claim a reduction of its taxable income merely because it subsequently refunded a portion of the royalty. The Department contended that the transfer pricing provisions under Chapter X of the Income-tax Act prohibit downward adjustments that reduce taxable income and that the statutory framework existing during the relevant years did not permit a non-signatory associated enterprise to revise its income based on another entity’s APA.
The Revenue further argued that once royalty income had accrued, been received, and offered to tax, a later repayment could not retrospectively alter the taxability of that income. It also relied upon the concept that the APA’s binding effect was restricted to the taxpayer who had entered into the agreement.
On the Permanent Establishment issue, the Department asserted that GIA India functioned under the close supervision and control of GIA US, used its technology, brand, and expertise, and therefore constituted a PE of GIA US in India under the India-US Double Taxation Avoidance Agreement (DTAA).
The assessee contended that only its “real income” could be taxed. Since the APA determined that the arm’s length royalty was ₹49.09 crore and the excess royalty of ₹19.44 crore had actually been refunded to GIA India, the refunded amount could never be regarded as income retained by GIA US. It argued that Article 12 of the India-US DTAA permits taxation only of royalty that is ultimately paid and retained by the recipient.
The assessee also emphasized that the APA process had been initiated voluntarily years before any transfer pricing adjustments were proposed, demonstrating the bona fide nature of the arrangement. It relied on the well-established “real income” doctrine, under which hypothetical or notional income cannot be subjected to tax.
The ITAT had previously accepted GIA US’s claim and directed that the refunded royalty amount be excluded from its taxable income, subject to verification that the refund had actually been made. The Tribunal had also held that GIA India did not constitute a Permanent Establishment of GIA US in India and therefore the royalty income was taxable only as royalty income under the Act and DTAA rather than as business profits attributable to a PE.
The Bombay High Court affirmed these findings.
The High Court accepted the fundamental principle that taxation can only be levied on income that is actually earned and retained by the taxpayer. Since GIA US had refunded the excess royalty pursuant to the APA and ultimately retained only the arm’s length royalty amount, taxing the refunded portion would amount to taxing income that never remained with the assessee.
The Court noted that the APA had determined the appropriate arm’s length royalty and the excess amount was duly returned to GIA India. Therefore, the taxable royalty in the hands of GIA US had to be restricted to the amount that it was ultimately entitled to retain.
On the PE issue, the Court rejected the Revenue’s contention that GIA India constituted a Permanent Establishment of GIA US merely because the subsidiary used GIA’s brand, technology, expertise, and operational standards.
The department had relied upon the Supreme Court’s decision in Hyatt International Southwest Asia Ltd. to argue that GIA India was effectively at the disposal of GIA US and that GIA US carried on business through the Indian entity.
However, the Court found no basis to interfere with the Tribunal’s conclusion that GIA India was an independent corporate entity carrying on its own operations and did not constitute a PE of GIA US under Article 5 of the India-US DTAA.
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