From Yatin’s Desk: Impact on oilfield service providers-Delhi High Court rules on deemed tax regime applicability u/s 44BB on software service contracts

The Delhi Court in a significant decision on applicability of Sec. 44BB of the Income Tax Act, 1961 (Act) has ruled that income in the nature of “royalty” would not be covered under the deeming provisions applicable to non resident taxpayers engaged in prospecting, extraction or production of mineral oil. However in relation to fee for technical services (FTS), where the dominant purpose of the agreements is prospecting, extraction or production of mineral oils, based on the doctrine of “pith and substance” the activities would fall within the ambit of “mining or like projects”, which are specifically excluded from the scope of FTS.  Such technical services would be subject to deemed profit tax under Sec. 44BB.

To set the context, u/s 44BB of the Act, income of a non resident engaged in providing services or facilities in connection with prospecting, extraction or production of mineral oil is subject to tax at deemed profit rate of 10%. However, income falling within the purview of section 44DA [which covers Royalty and FTS connected with the Permanent Establishment (PE) in India] is excluded from the ambit of deemed tax regime and is subject to net basis taxation. While at first instance, the provisions seem innocuous, the interpretation has been subject to much litigation over years. Tax payers have often argued that income earned by non resident taxpayer engaged in oilfield service will fall within the scope of Sec. 44BB being a specific provision applicable to oilfield service.

The Delhi High Court (HC) in the recent case of PARADIGM GEOPHYSICAL PTY LTD. had the occasion to examine taxability of software related service contracts under the deeming provisions. In the case before the court, the taxpayer was engaged in the business of developing and providing customized software enabled solutions and annual maintenance services used in oil and gas industry in relation to prospecting, extraction, production and seismic analysis. The tax payer, placing reliance on the decision of the Hon’ble Supreme Court in the case of Oil and Natural Gas Corporation Ltd (ONGC) v. CIT (2015) 376 ITR 306 contended that Sec. 44BB of the Act being a special provision, its income being in connection with prospecting, extraction or production of mineral oils, should be taxed under deeming provision.

The HC took note of the changes effective 01.04.2011 whereby through parallel amendments in Sec. 44BB and Sec. 44DA it was stipulated that provisions of Sec. 44BB shall not apply in respect of income falling under the provisions of Sec. 44DA and vice-versa. The court went on to hold that both provision (Sec. 44BB and Sec. 44DA) are special in nature and operate in their own clearly defined spheres.  Accordingly once a receipt of income qualifies as Royalty/FTS, it cannot be taxed u/s 44BB and has to be taxed u/s 115A/44DA of the Act. The court held that the controversy surrounding the interplay of the two provisions stands resolved by virtue of the amendments and further the question of interplay of the two provisions was not dealt with in the case of ONGC (supra).

The court went on to hold that it was incumbent on the tax authorities to determine whether the nature of income was Royalty or FTS. This aspect has importance since FTS has a restricted scope on account of specific carve out of “payment received for construction, assembly, mining or like project”. In other words, if the consideration received falls within the exclusion, the payments would not be regarded as FTS and hence outside the scope of Sec. 44DA but taxable u/s 44 BB. It is the proximity of the work contemplated under an agreement executed with a non-resident taxpayer with mining activity or mining operations that would be crucial for the determination of the question whether the payments made is to be assessed u/s 44BB or otherwise. If the services provided by the taxpayer constitute services for “mining or like project”, the consideration thereof would be excluded from the scope of FTS and would be taxable u/s 44BB.

Importantly, the HC rejected the arguments of the tax authorities that the scope of expression “mining or like project” has to be confined only to situations where services are performed onsite i.e. at the site of mining/drilling. Relying on the doctrine of “pith and substance”, the court opined that the same has to be applied in respect of each contract/agreement, to ascertain whether the dominant purpose of the agreements was prospecting, extraction or production of mineral oils, in which case the same would fall within the ambit of “mining or like project”.

In context of specific facts of the case, the HC has ruled that if the income from services provided by the taxpayer from the supply of software as well as ancillary services such as maintenance and installation is regarded as “Royalty”, deeming provision of Sec. 44BB would not apply. On the contrary, if the payments are for technical service, the income would be taxable under section 44BB since it is excluded from the definition of FTS being covered under the exception relating to “mining or like” activities (basis dominant purpose of the contract). The court however did not examine the nature of income in absence of any such determination by the tax authorities.

The decision of the court has significant bearing on the oil & gas industry. The ruling does provide clarity and to an extent certainty for oilfield service providers engaged in provision of technical service (whether on-site or remote) having dominant purpose of prospecting, extraction or production of mineral oil with respect to taxability under Sec. 44 BB. However service providers providing software license and incidental services or receiving other payments which may fall under the purview of “Royalty” under the Act will have to brace for re-calibrated tax positions. Importantly, where the tax payer now argue non taxability of software related payment under favorable Double Tax Avoidance Agreement (DTAA) provisions, it may still have to deal with business profit tax where the taxpayer has a PE in India. The ruling perhaps make it incumbent for tax payers to evaluate the possibility of restructuring software licence and incidental contracts (typically impacting data processing and analysis activities) as technical service contracts.

All in all a sound judgement on interpretation of deeming provisions u/s 44BB of the Act.