Tax Implications of Cross-Border Arbitral Awards: Addressing Inconsistencies in Indian Jurisprudence

[Vaibhav is a student at West Bengal National University of Juridical Sciences.]

The advent of arbitration has not only introduced a host of complexities within arbitration law but has also extended its influence into the sphere of taxation law. The author brings to light an emerging issue in the taxability of the post-award interest component of these awards through this piece. The issue revolves around the fundamental question: under which head of income in the double taxation avoidance agreement (DTAA) should post-award interest paid by a resident to a non-resident be taxed?  

Indian jurisprudence has historically treated both pre-award and post-award interest as part of the compensation, which is the principal award amount, being taxed under Article 7 of the DTAA (business profits). However, the recent Mumbai ITAT ruling in Siemens Aktiengesellschaft (Siemens) departed from this approach by classifying pre-award interest as compensation (taxable as business profits) but post-award interest as interest under Article 11 of DTAA. 

Although Siemens has disrupted the prevailing status quo, it does not delineate the difference between pre-award and post-award interest in a way that could justify the potential difference in its taxability, especially when its predecessors have treated it the same for tax purposes. Even though Article 11 is broad enough to include post-award interest, it becomes essential to examine if this inclusion is warranted at all. 

Through this piece, the author not only answers the fundamental issue, i.e. whether post-award interest is correctly differentiated from pre-award interest and included under the head of 'interest' in DTAAs, but also provides a critical evaluation of the Siemens’ case. In a nutshell, this piece attempts to bring closure to the differences in the judgments pertaining to the head classification of post-award interest for its appropriate taxability.

Introduction

An arbitration award comprises the principal amount, pre-award interest, and post-award interest. Pre-award interest refers to interest on any period that occurs between the date on which the cause of action arose till the date on which the award is made. Post-award interest refers to interest on the period between the date of the award and the payment made to satisfy the award. Whenever a resident pays an arbitration award to a non-resident, it is treated as ‘income’ of the non-resident and such non-resident is liable to be taxed on such amount as the source of income arises in India. The rate and mechanism of such taxability are determined through the provisions of the DTAA, depending on the head of the DTAA under which the ‘income’ falls.

DTAAs classify income into specific heads across Articles 6-22, each with distinct taxing rules. Article 7 of the DTAAs pertains to 'business profits' of an assessee, which is taxable only in the country of residence of the non-resident assessee. Article 11 pertains to the taxability of 'interest' income, wherein a percentage specified in the DTAA is withheld in the country where the interest arises.

In the context of taxation of arbitral awards vis-à-vis the provisions of the DTAA, it is a uniform position of law that principal amount and pre-award interest in an arbitration are compensation to the business, taxed as 'business profits' under Article 7. However, contradictions arise on the taxability of post-award interest since cases have treated post-award interest as both 'business profits' and 'interest'.

This distinction in the head of income is crucial. If post-award interest is characterized as “interest” under Article 11, the Indian revenue authorities acquire a right to levy withholding tax. In contrast, if it is characterized as 'business profits' under Article 7, the taxing right vests exclusively with the state of residence, and India would have no taxing right.

There have been conflicting positions taken by various cases and the Siemens Aktiengesellschaft of ITAT Mumbai, wherein the former treats post-award interest as 'business profits' while the latter characterizes it under “interest”. Part II analyzes the contradictions in the above-referred judgments and details the conflict. In part III, the author argues that the view taken by Siemens is correct. The author here explores the difference between pre-award and post-award interest, which allows for different taxability. This justifies the legal rationale of Siemens. Part IV offers a conclusion and details a potential approach to ending the debacle.  

Taxing Arbitral Awards: Conflicting Legal Positions

This section is further divided into two parts, by virtue of which the contradiction in the previous position of law given by the Goldcrest et. al. cases and the later position of law in the subsequent case of Siemens is discussed.

Goldcrest et al cases: The existing position 

As per Section 40(a) of the Income Tax Act 1961 (ITA), non-deduction and non-payment of TDS on a sum paid to a non-resident which is chargeable to tax in India shall lead to its disallowance as an expense. In Goldcrest, the resident assessee, believing that the arbitral award paid to the non-resident is not taxable in India (since it is “business profits”), failed to deduct TDS. However, the Income Tax Department claimed that the entire award paid to the non-resident was taxable in India and TDS ought to have been deducted. The award consisted of pre-award interest, post-award interest, and a principal amount.

Herein, the court held that the principal compensation amount as well as the entirety of interest must be taxed as 'business profits' under Article 7. The court held that the entirety of interest, i.e. both pre-award and post-award, forms a part of the 'judgement debt' and it “partakes the character of the compensation.” Therefore, such interest, being akin to a compensation, would be taxed in the same way as the principal compensation is taxed, which is as 'business profits' under Article 7. In that case, as previously mentioned, no tax liability would arise in India.  

Similarly, in Glencore International AG, a resident company, Dalmia Cements, paid an arbitral award, including post-award interest, to non-resident Glencore. The Delhi High Court, once again, held the principal amount to be non-taxable as forming part of 'business profits' and held that both pre-award and post-award interest would take the nature of principal compensation.

The issue of taxability of arbitral interest was considered again by the Delhi ITAT in Fujitsu Ltd., and upon appeal by the Delhi High Court as well. There, it has again been ruled that the pre-award interest of an arbitral award forms a part of the principal amount of compensation, which is taxed as 'business profits'. However, since the award therein did not contain a post-award interest, that question has been left open-ended.

Thus, to sum up, both pre-award and post-award interest are held to have the nature of compensation as per the above judgements, at both the ITAT and HC levels. However, the Siemens judgment casts a doubt on this position, which has been explained in the next section. 

The Siemens case and reconsideration of taxing post-award interest

Much like other cases, in Siemens Aktiengesellschaft as well, the arbitral award received by the non-resident from a resident company comprised of Principal compensation amount, pre-award interest, and post-award interest.

The assessee, being a non-resident, did not pay tax in India on any of the amounts, arguing that the entire award must be taxed under 'business income' as per Article 7, with taxability arising only in the resident country. While the ITAT upheld the existing position of law about taxability of principal compensation and pre-award interest, it held post-award interest as taxable under Article 11 of the DTAA as 'interest' income. The critical appraisal of the reasoning is done in the subsequent section of the piece.

Recalling the Goldcrest and Glencore International, the courts allowed non-deduction of TDS to the resident companies based on the finding that the entire amounts, including post-award interest, would not be taxable in India. Contrarily, Siemens holds taxability of pre-award in line with existing jurisprudence but taxability of post-award distinctly. Thus, a distinction between post-award and pre-award interest in terms of its taxability is created by Siemens. This distinction comes without a proper legal reasoning in the judgment, which the subsequent section attempts to resolve. The section evaluates whether Siemens is correct. 

The Correctness of Siemens: A Legal Appraisal

The ruling in Siemens while distinguishes taxability between pre-award and post-award interest, it does not provide reasons for the same. The ITAT merely provides that the nature of post-award interest qualifies that of the 'interest' under Article 11 of the DTAA, while for pre-award interest, it does not. Although the ITAT provides various precedents that justify the taxability of pre-award interest in the way envisaged, it does not provide a proper rationale for post-award interest. Basically, the ruling does not answer why post-award interest cannot be treated as business income just like pre-award interest. The author attempts to analyze in this section whether a difference in treatment exists, thereby making Siemens's case justified. 

The difference in taxability of pre-award and post-award interest arises owing to the distinctiveness in the source of obligation. Under the Arbitration and Conciliation Act 1996, the right of pre-award interest is only available to the award creditor at the discretion of the court. In contrast to this, post-award interest is a statutory right. Therefore, its obligation flows not from the court but from the Act because it is statutorily mandated.

Moreover, the parties can waive the obligation of pre-award interest by contracting out of the same; in such a case, the court would be precluded from providing such interest. However, the use of the expression 'shall' in Section 31(7)(b) underscores that post-award interest is a statutory right having no bearing on the contract between the parties.

Hence, there is a clear difference, such that pre-award interest is discretionary on the court and dependent on contract, whereas post-award interest is statutory and independent of contractual obligations. This distinction in nature pertinently becomes the reason for the difference in taxability of pre-award and post-award interest. This is clearly established through the rationale of the Supreme Court (SC) in TNK Govindaraju Chetty (Chetty).

In this case, enhanced compensation along with interest thereon was awarded by the court under the Requisitioned Land (Continuance of Powers) Act 1947. The issue was whether the interest awarded forms part of the compensation and therefore must be taxable along with it as a capital receipt, or should it constitute a separate income and be taxed as 'interest'.

The SC in Chetty distinguished between two types of interest obligations to determine their taxability. It ruled that if the obligation to levy interest emanates from a statute, interest retains its character and shall be taxable as interest income. Contrarily, in a case wherein the interest is awarded at the discretion of the court, it is a form of compensation. For the sake of our convenience, we shall refer to this distinction as a statutory/discretionary test. This position has been upheld in a plethora of cases.

Followed by Chetty in 1967, a catena of land acquisition cases of the SC, such as KS Krishna Rao in 1989, as well as Bikram Singh in 1990, upheld this distinction. Moreover, these judgments have precedential value to date, considering they are applied by various ITATs and High Courts recently to differentiate between the taxation of statutory interest and non-statutory interest in Land Acquisition matters. Reliance on the statutory/discretionary test to decide if an interest income is taxable has also been applied in cases apart from land acquisition.

In the case of National Insurance Company Limited, a compensation claim was made under the Motor Vehicles Act 1988 (MVA). Section 171 of the MVA mandates the payment of interest on the principal amount of compensation. The Calcutta High Court, relying on the above SC cases and the statutory/discretionary test, held such interest to be taxable, considering its statutory nature. The Delhi AAR in 1998 made a similar statutory/ non-statutory distinction in the context of interest on refunds provided to a non-resident by the ITD. The court held that a statutory interest paid on a delayed tax refund would be taxed as 'interest' under the DTAA. Similar rulings have been given by the Madras HC in Ansaldo Energia, Mumbai ITAT in Warner Bros et al.

Hence, it is abundantly clear that the taxability of interest depends significantly on whether it is statutory or discretionary. Considering that this test has been consistently applied in various contexts, across a plethora of judgements, the same must be applied to pre-award and post-award interest. Its application aptly justifies the difference in taxability by Siemens.

Since pre-award interest is completely discretionary upon the court and can also be waived off by the parties, it should be regarded as compensation that justifies such interest, taking the character of the principal compensation. Whereas, post-award interest being a statutory obligation independent of the will of the parties and the court, its nature has been envisaged as income.

Even though Siemens neither delves into such a test nor satisfactorily justifies its deviation from the pre-existing position in Goldcrest et al., this analysis entails that post-award interest is rightly taxed separately from pre-award interest in Siemens. In this sense, Siemens reaches the correct conclusion, although through an analytically unsatisfactory route.

Such a solidified existence of distinct tax treatment for statutorily and discretionary interest within the judicial discourse calls into question the Goldcrest et al. If various SC cases have already refrained from applying the same tax treatment to statutory interest and discretionary interest, then pre-award and post-award interest based on the statutory/discretionary test must have been treated distinctively by these cases. These cases, considering the vast contextual differences, although not per in curium to the SC cases, are however, ignorant of a prominent legal rationale of the SC.

Conclusion

A complete analysis of the Siemens position has revealed the soundness of legal rationale for a distinction in pre-award and post-award interest. Moreover, the earlier cases did not consider the existing statutory/discretionary test, which is essential to interest taxation. This test clicks perfectly into this void like the missing puzzle piece finally clicking into place, resolving the longstanding contradictions on post-award interest taxation.

However, the application of this approach comes with a caveat. While the Indian arbitration regime provides for statutory post-award and discretionary pre-award interest, this may not be the case in other jurisdictions. The seat of arbitration determines the applicable arbitration law. Therefore, in a scenario where the seat is in a foreign jurisdiction such as England, where post-award interest is also discretionary, both pre-award and post-award interest ought to be treated similarly as compensation under 'business profits'. In both the Siemens and Glencore International cases, the seat of arbitration is India, with post-award interest being statutory and hence, separately taxed as discussed. Hence, every judgment would have to consider whether the post-award interest exists statutorily in the regime or not.