Two landmark Supreme Court judgements that may have a big impact on businesses: Dinesh Kanabar

The supreme court recently delivered two landmark judgements that will have ramifications for taxpayers. The first is whether licence fees paid by telecom operators are capital or revenue expenditure. The second concerns the Most Favoured Nation (MFN) clause that appears in the Double Taxation Avoidance Agreements entered into by India.

In the case of licence fees, the issue was whether the revenue share telecom operators paid to the government was capital expenditure. The operators were granted licences under the National Telecom Policy of 1994. It had two components: a lump sum and an amount calculated depending on the number of subscribers. Telecom operators had accepted that the payment of such licence fees was a capital expenditure under the Income Tax Act (I-T Act), 1961, which could be amortised under Section 35ABB of the I-T Act.

In 1999, the government came out with a new policy under which telecom operators could pay a revenue share computed as a percentage of their annual gross revenues (AGR), if they had paid lump sum fees under the old policy until August 1999.

Telecom operators contended that revenue share paid constituted revenue expenditure, which was tax deductible. The tax authorities treated it as capital expenditure covered by Section 35ABB of the I-T Act. The operators’ contention was upheld by the Commissioner (Appeals), the Income Tax Appellate Tribunal, and the Delhi High Court. The revenue department carried the matter to the Supreme Court. Apart from the Delhi High Court, the Bombay High Court and the Karnataka High Court, too, held it as revenue expenditure.

Before the Supreme Court (SC), the revenue department contended that the licence fees were paid to ‘establish, maintain, and operate’ telecom services. The taxpayers’ contention was that while the initial payments under the 1994 policy were made to establish the telecom business and were, therefore, capital expenditure, the later payments by way of revenue share from AGR were made to maintain and operate the business and were revenue expenditure.

In a 127-page verdict, the SC held that the words ‘establish, maintain, and operate’ were indivisible. Once a licence fee is paid to establish a telecom service, it cannot be broken up into portions relating to maintaining and operating the licence. The SC said that since a telecom operator could not establish the service but for a licence, and since that could be cancelled by the government if the fees were not paid, it showed that the fees in their entirety were paid to establish, maintain, and operate the services. It held that the entire expenditure would be treated as capital and would be covered by the provisions of Section 35ABB of the I-T Act. The apex court said the operators had admitted that the amounts payable under the 1994 policy were capital. All that the 1999 policy did was substitute the amounts payable with a revenue share. There was no change in the character of the payment merely because the lump sum was substituted with the revenue share.

With due respect to the Supreme Court, the reason it has adopted seems flawed. Once it is accepted that the payment of licence fees is not merely to establish a business but has components that are towards operating and maintaining it, only the part used to establish a business can be considered capital. The parts that are for operating and maintaining the business would be revenue expenditures and tax-deductible. To hold that the entirety of such expenditure is capital in nature would be tantamount to not recognising that a significant portion of such expenditure relates to day-to-day operations.

The judgement is likely to create a controversy over amounts payable by way of similar licence fees for operating mines, production sharing contracts of oil exploration companies, and also payments under commercial contracts with a revenue sharing plan. We will then need to consider whether such expenditure would be a capital asset, which could be eligible for depreciation.

The second judgement concerns the interpretation of tax treaties. The judgement here has widespread implications. Several treaties India has entered into have an MFN clause. Such treaties seek to define how the income of a non-resident would be taxed in the source country. Treaties provide a beneficial rate of tax on certain categories of income, the exchange of information, and the elimination of double taxation. The MFN clause provides that if India enters a tax treaty with another country containing more beneficial provisions, those provisions would also apply to the earlier treaty. For instance, treaties India signed with the Netherlands, France, and Switzerland contained MFN clauses that said if India entered a treaty with another OECD member country that had lower tax rates or more restrictive provisions, those would apply to these three too.

The issue was whether the MFN clause applies as soon as India enters a favourable treaty with another country or whether it should be specifically notified. The moot point is whether India can refuse to notify an MFN provision, notify only a part, or delay the notification. A plain reading of the MFN clause would suggest that the beneficial provisions would become applicable immediately, and there is no need for a notification. Indeed, this is what the lower courts held. The issue here was the reduction in the tax rate on dividends under the three treaties, given that it was lower in other treaties.

The Supreme Court held that the power given to the government to enter into tax treaties emanates from Section 90 of the I-T Act. This section states that a treaty can be effective only after it is notified. The SC held that the application of the MFN clause would lead to a modification of the treaty, and unless notified, it cannot come into effect.

As mentioned earlier, once it is held that without notification, the MFN clause has no effect, it follows that the government can decide when and whether to notify the clause and to what extent.

The reason this judgement is likely to become a cause for concern is that tax treaties are bilateral agreements entered into under the Vienna Convention. They override domestic law. By giving the government the right of notification, the SC has effectively permitted an override. That sets a dangerous precedent.

As a consequence, taxpayers will now be called on to pay a differential tax. This would be so even in cases where remittances have been made abroad after obtaining a certificate for lower tax without having the ability to recover the taxes from the recipients.

Both of these judgements pose challenges to taxpayers in different spheres.

The writer is CEO of Dhruva Advisors LLP. (Views are personal)