TAXATION of persons owing economic allegiance to a State is the sovereign right of that State exercisable only within its boundary. The operation of the law can also extend to persons, things and acts outside the State in certain circumstances. Government of India Act, 1935, or Article 245 of the Constitution of Independent India declared that no law made by the Central Legislature or Parliament shall be deemed to be invalid on the ground that it would have extra-territorial operation. However, the general principle, flowing from the sovereignty of States, is that laws made by one State can have no operation in another State. Any municipal law made by the Legislature is supreme and cannot be challenged before court, except on the ground that it violates any superior law, viz., Constitution of India. Federal Court held that arguments as to the territorial limits of a legislative jurisdiction and to the accepted rules of international law in this behalf will be relevant only as furnishing a presumption or rule of construction against an intention to exceed the territorial jurisdiction or to violate the rules of international law, if and when the language of the statute is general¹. Where however the meaning and intent are plain, the presumption or rule of construction must give way. The pertinent question is whether the particular legislation is authorized by the Constitution. The Constitution requires that it must be possible to predicate of every valid law that it is for the peace, order and good government of the Dominion with respect to a granted subject, e.g., customs, taxation, external affairs etc. In such cases, the presence of non-territorial elements in the challenged law has to be considered upon a slightly different footing and those affirming its validity have to show not only that the Dominion has some real concern or interest in the matter, thing or circumstance dealt with by the legislation, but that the concern or interest is of such a nature that the challenged law is truly one with respect to an enumerated subject matter.

Government of India Act, 1935 and thereafter Constitution of Independent India enabled the Central Legislature and thereafter Parliament to make laws for the whole or any part of the territory of India providing for levy of “taxes on income other than agricultural income”. The issue of Interpretation of the above phrase “taxes on income” came up before Privy Council². It was observed that income-tax legislation in the United Kingdom has proceeded on the lines that there is subjected to income-tax all incomes arising within United Kingdom and some, but not all, income arising abroad belonging to a person resident in the United Kingdom. The resulting general conception as to the scope of income-tax is that, given a sufficient territorial connection between the person sought to be charged and the country seeking to tax him, income-tax may properly extend to that person in respect of his foreign income. Privy Council took the view that the above general conception will also hold good to interpret the phrase “taxes on income” in Government of India Act, 1935 or Constitution of India. This was in essence the ‘source rule’, which was prevalent all over the world.

Sections 4(1)(c) and 42 of Income-tax Act, 1922, brought in the concepts of non-resident taxation. Section 4(1)(c) provided that in case of a non-resident , the income accruing or arising or deemed to accrue or arise in India will be taxable in India. Section 42 explained the fiction employed in the above provision to point out that all income, profits or gains accruing or arising, whether directly or indirectly, through or from a business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through or from any money lent at interest and brought into British India in cash or in kind will be deemed to accrue or arise in India. These were essentially the illustrations of the concept of income sourced in India, which passed the test of sufficient territorial connection between the non-resident and India. Income-tax Amendment Act, 1939, included two unique ideas in source concept on the lines of the Commonwealth Income-tax Act in force in Australia. The first provided that a dividend paid outside India (by a foreign company) shall be deemed to be income accruing and arising in India to the extent to which it has been paid out of profits subjected to income tax in India. The second was that a foreign company would be considered as resident of India in any year, so as to be liable to global taxation, if its income arising in India in that year exceeded its income arising without India in that year. Both the provisions were upheld as constitutionally valid by Court, the first on the ground that the source of the dividends paid to the non-resident shareholder by a foreign company out of the profits earned in India was such profits only and the second on the ground that if a person can be treated as resident of India if he spends more than half of the year in India (test of territorial nexus), why cannot a company, which derives more than half of his income in India, be treated as resident of India, so as to be liable to global taxation. These provisions were however withdrawn later on.

The concept of source was explained by Privy Council in a case under the Taxation Ordnance of Southern Rhodesia of 1918 (presently South Africa)³. The ordnance provided that in the case of a non-resident any income received or accrued from any source within that territory will be taxable. Various examples were given of income derived from a source within the territory, like sale of goods in the territory, carrying on various income-producing activities or provision of services in the territory etc. In this case an UK company under liquidation had sold some mining rights owned by it in Southern Rhodesia to another UK company. The court quoted from Ingram’s work on income-tax –“Source means not a legal concept but something which a practical man would regard as a real source of income” (which does not take us any further) and pointed out that in the case of a business of a railway company whose railway is situated abroad, the profits earned from running the railways was received from the source situated where the railways were run. In this case the court held that when the company under liquidation had purchased mining claims in Southern Rhodesia and had sold them after development, the profit must be treated as received or accrued from a source in Southern Rhodesia. The above decision explains source as the income-producing activity, which generated the income. In cases of passive income, the position is not clear. In case of interest generated from a bank deposit, the source is the actual deposit and the contract of interest, whether existing or new, under which the deposit was made⁴. In case of sale or letting out of tangible property, the source for the profit or income is the location of the property sold or let out. But it is not clear in case of license or sale of intangible property to a customer abroad, where does the source lie, because such property does not have a physical situs.

After Independence, there were several transactions of technology transfer from developed world to Indian concerns. The issue arose whether the royalty income earned by the foreign entities from transfer of technical know-how was taxable in India. Supreme Court held in several cases that if the know-how in the form of design, drawings etc has been transferred abroad for a lump sum price, such amount will not be taxable in India. For the purpose of taxation in India, the income producing activity should be carried on India. In other words, ‘source’ in India will only mean some income-producing activity or asset in India. Normally without having a foot print in India or an income generating asset, a non-resident cannot be said to have a source of income in India⁵.

With the technological revolution since World War I, the nations of the developed world started looking outwards for markets for their products, first within the developed world and thereafter in the developing world. The source rule of taxation, which so far held the fort, in the absence of sizeable cross border commerce, came under challenge from the developed countries, who pressed for Residence State taxation. The dispute first arose within the developed world and there after spread to developing world. The conflict between Residence State and Source State taxation and resulting double taxation of cross-border commerce came to be more and more prominent, as the developed world spread their economic interests all over the world. League of Nations in the twenties started the international dialogue for reaching a consensus for avoidance of double taxation, which gained momentum after World War II. In the sixties OECD came out with its Model Convention for Avoidance of Double Taxation for its members to be adopted in agreements with other countries, so as to restrict their taxation rights on a mutually agreed basis to avoid double taxation. OECD being an organization of the developed countries, the model was in a way biased towards Residence State taxation and gave the primary right of taxation to the Source State only where a business is carried on in the Source State through a fixed place of business or in respect of profit from lease or sale of an immovable property situated in the Source State. It gave a secondary right of taxation subject to a limit in respect of dividend earned from a company resident of the Source State and interest payable by a resident of the Source State in respect of a debt claim (including money lent abroad and brought into Source State). It also denied the right of taxation to the Source State in respect of capital gains from alienation of assets situated in the Source State except immovable property and assets belonging to a permanent establishment. The last three are clear examples of income generated from Sources in the State and one may argue that the primary right of taxation should have been allotted to the Source State. The U.N. Model Convention, which was published in 1980, sought to support the cause of the developing world, by pitching for the source rule. It sought to provide that a foreign insurance company which collected insurance premium in the Source State will be deemed to have a permanent establishment in that State even if it did not have a fixed place of business therein (provision dropped later on). It also granted secondary right of taxation subject to a limit in respect of income from royalty and fees for technical services to the Source State, if royalty etc is paid by a resident of the Source State. Similarly for other incomes also, it gave primacy to Source State. Presently both the models, as revised, are identical, except that the UN Model carries a secondary right of taxation of royalty and fees for technical services in favour of Source State and some source state rights in respect of capital gains and other incomes. USA seeks to follow its own model, which is more or less identical with OECD model. India, starting from late sixties, has entered into a large number of Conventions for avoidance of double taxation with other countries mainly on the lines of UN model. USA was not comfortable with granting of secondary right of taxation in respect of royalty and fees for technical services earned from USA and as such agreed to only a very truncated right of secondary taxation in its treaty with India. Several countries followed suit, namely UK, Netherlands, Australia, Canada, Singapore etc.

Indian Legislature, in 1976, most probably took inspiration from UN Model Convention (India was a member of the ad-hoc group of experts engaged in drafting of the model) and introduced deeming provisions in the Act, allegedly following ‘source rule’ seeking to tax interest, royalty and fees for technical services paid to non-residents from India, if the money borrowed, know-how etc and technical services are utilized in a business carried on in India. This is for the first time the source rule was extended to cases of payments from India and utilization of the benefits for the purpose of the business carried on India. There was no necessity for any activity or income generating asset in India. The above provisions rather followed the principle of recovery of tax base, which is different from the principle of source, which needed sufficient territorial nexus between the non-resident and the Source State. Constitutional validity of these provisions was challenged in the case of Electronic Corporation of India before Supreme Court. The Court observed that there must be some nexus between the non-resident and India or some provocation must be found for the law within India, otherwise the Parliament will have no competence to make the law. In view of the great public interest of the question, the court had referred the question to the Constitution Bench⁶. The petitioner, however, withdrew the petition later. The issue was again raised more than fifteen years later before Supreme Court⁷. The Court held that section 9(1)(vii)(c) in its plain sense requires two conditions to be met—the services resulting in income must be rendered in India as well as utilized in India. Sufficient territorial nexus of the non-resident with India would be created only if the services are rendered in India. It was not brought to the notice of the Court that the same issue had earlier been referred to the Constitutional Bench in an earlier case. Legislature sought to repair the damage with an amendment in the law, but the constitutional validity of the provision still remained an open question. Emergence of Electronic Commerce created further problems for all the Source States. The old concept of permanent establishment, which was considered sufficient for traditional brick and mortar model of business, was no longer adequate. A foreign entity could do business through communication lines in any country without having a foot print in the said country. OECD did not feel any need for changing the rules of the game. India and Australia protested but to no avail.

Basically the conflicts with Indian tax administration, as perceived by foreign enterprises doing business with India, are off shoots of the central conflict of Residence versus Source State taxation. When business activities were traditional and no business could be carried out with a country without setting up of a shop in the said country, when cross-border transactions were very few, the position was different, but with the growth of technology in the developed nations and of global business activities of multinationals with the aid of such technology, using developing countries as low cost manufacturing or service base and at the same time exploiting the markets of such countries for their products, the concern for taxation of income generated from India to prevent erosion of own tax base is gaining ground. Vodafone case is perhaps the most telling example of such concerns. However, in such attempts, the Indian tax administration is handicapped by the existing treaties and how far will it succeed is an altogether different matter. It seems that such efforts may go on till India becomes a developed nation with net foreign investments and probably falls in line with the developed nations to champion the cause of Residence State taxation, which may well be thirty or forty years later. In any case, there does not seem to be any great future for ‘Source State taxation’ in this world any more.

(1) The Governor General in Council v Raleigh Investment Co. (12 ITR 265, 281-82) (Federal Court)

(2) Wallace Brothers & Co. Ltd v Commissioner of Income-tax (2002-TII-31-SC-INTL)

(3) Rhodesia Metals Ltd (Liquidator) v Commissioner of Taxes (9 ITR Suppl. 45, 51-52)(P.C)

(4) Hart v Sangster (34 ITR 303) (Court of Appeal, UK)

(5) Carborandum Co. v Commissioner of Income-tax (2002-TII-18-SC-INTL)

(6) Electronic Corporation of India Ltd v Commissioner of Income –tax (2002-TII-29-SC-INTL)

(7) Ishikaajima-Harima Heavy Industries v Director of Income-tax (2007-TII-01-SC-INTL)