ABC Private Limited Note on the Tax Implications of Joint Development Agreement

1 1.1 Facts ABC Group (the group) is a UK-based diversified financial services group. The groups businesses include private equity, property investment and finance, corporate structure finance and asset management and securities trading. ABC group has combined gross assets exceeding $3 billion with a net worth of approximately $1bn. The group proposes to set-up an Indian Company to invest in real estate projects in India. For the purposes of the above investment by the Indian Company, the group desires to understand the key tax implications of undertaking real estate projects in India under a Joint Development Agreement (JDA) with the Indian joint venture partners. The real estate projects would be compliant with the conditions laid out under Press Note 2 (2005 series) relating to FDI in townships, housing, built-up infrastructure and construction-development projects. Objective 2.1 Based on the above facts, the purpose of this note is to analyze the following: Concept of Association of Persons (AOP) and judicial precedents ; Tax implications under the Income Tax Act, 1961 (the Act) for the AOP and its members; and Factors to be taken into consideration while entering into a JDA to mitigate the AOP exposure.

1.2

1.3

3 3.1

Concept of AOP Section 4 of the Act states that where any Act of the Central Legislature enacts that income -tax shall be charged for any year at any rate or rates, tax as that rate or those rates shall be charged for that year in accordance with, and subject to the provisions of, this Act in respect of the total income of the previous year of every person.

3.2

The term "person" as defined in section 2(31) of the Act includes, Individual, a Hindu undivided family, a company, a firm, an association of person or a body of individuals, whether incorporated or not, a local authority, and every artificial juridical person, not falling within any of the preceding sub-clauses.

Discussion Draft

Explanation:- For the purposes of this clause, an association of persons or a body of individuals or a local authority or an artificial juridical person shall be deemed to be a person, whether or not such person or body or authority or juridical person was formed or established or incorporated with the object of deriving income, profits or gains; 3.3 Thus, the Act contains a concept of an artificial person being liable to tax viz. AOP. An unincorporated group of persons could be regarded as an AOP to which the specific provisions relating to taxation would apply with the consequence that each member of the AOP would not be separately subject to tax on its own respective capacity for its share of income in the AOP. Attention is brought to the ruling in the case Income Tax Officer vs Atchaiah [218 ITR 239 (SC)] where the Supreme Court has held as under: Sec.4 extracted herein above says that income-tax shall be charged on the total income "of every person" and the expression "person" is defined in cl. (31) of s. 2. The definition merely says that expression "person" includes inter alia a firm and an AOP or a BOI whether incorporated or not. There are no words in the present Act which empower the ITO or give him an option to tax either the AOP or its members individually or for that matter to tax the firm or its partners individually . If it is the income of the AOP in law, AOP alone has to be taxed; the members of the AOP cannot be taxed individually in respect of the income of the AOPs. Consideration of the interest of revenue has no place in this scheme Thus, once an AOP comes into being, it is mandatory for it to be assessed as such and the Income Tax Officer has no option to assess the members instead, on their respective shares. 3.4 The term AOP has not been defined under the Act and therefore has to be understood in its plain and ordinary meaning and in the light of the principles laid down by various judicial rulings. The judicial rulings lay down the following principles determining whether any agreement can be construed as forming an AOP are as under. Indira Bal Krishna [39 ITR 546 (SC)] In this case, co-widows of a Hindu governed by the Mitakshara law inherited his estate which consisted of immovable properties, shares etc. The question was whether the widows could be assessed in the status of an association of persons in regard to the income derived from the properties inherited by them. The Supreme Court observed that: The word "associate" means "to join in common purpose, or to join in an action" . Therefore, "association of persons", as used in section 3 of the Indian Income-tax Act, means an association in which two or more persons join in a common purpose or

3.5

Discussion Draft

common action, and as the words occur in a section which imposes a tax on income, the association must be one the object of which is to produce income, profits or gains. That co-widows succeeded as co-heirs to the estate of their deceased husband and took as joint tenants with rights of survivorship and equal beneficial enjoyment; they were entitled as between themselves to an equal share of the income. Though they took as joint tenants, no one of them had a right to enforce an absolute partition of the estate against the others so as to destroy their right of survivorship. But they were entitled to obtain a partition of separate portions of the property so that each might enjoy her equal share of the income accruing there from That, as there was no finding that the three widows had combined in a joint enterprise to produce income, and as they had done no act which had helped to produce the income, it could not be held that they had the status of an association of persons within the meaning of section 3 of the Indian Income-tax Act. Thus, in the instant case, the mere fact that the income was received in respect of joint property/assets was not sufficient to constitute an AOP. What is relevant is whether there was any joint enterprise which led to the production of income. 3.6 Van Oord Acz BV, in re [248 ITR 399 (AAR)] This is a landmark ruling which brings out the true interpretation of AOP in the context of collaboration agreements. The applicant entered into a joint venture with an Indian company to undertake a construction contract in India. The relationship of the parties was that of an unincorporated association formed for the purposes of collaborating in respect of the contract. Each of the parties expressly agreed that it is not their intention through the joint venture to carry on a business in common with the other parties with a view to make profit and that it is their intention to utilize the jointly for better co operation of their relationships with the employer and the division of the work and the gross income arising under the contract. Further, each party agreed to bear its own losses and retain all profits arising from the performance of its requisite work. Both the parties specifically agreed that nothing in the agreement shall be deemed to give rise to a partnership between the parties or to any contract for services between the parties and each of the parties shall undertake to use all reasonable endeavors not to do any act or thing which would cause such a relationship to arise. The applicant opened an office near the project site for the purpose of executing his part of the contract and obtained the permission from the Reserve Bank of India (RBI) for the purpose of opening such office. The applicant even made independent arrangements for the execution of his part of the contract.

Discussion Draft

The AAR ruled that: having regard to the agreement the applicant could not be treated as a partnership which can only be created by an agreement. Nor could it be treated as an association of persons. In order to constitute an association of persons there will have to be a common purpose or common action and the object of the association must be to produce income jointly. It is not enough that the persons receive the income jointly. In the instant case, each of the two parties had agreed to bear its own loss or retain its own profit separately. Both had agreed to execute the job together for better cooperation in their relationship with the Chennai Port Trust. The association with the Indian company was not with the object of earning income but for co-ordination in executing the contract. The applicant and the Indian company could not be treated as an association of persons for the purposes of levy of income-tax. Thus, in the instant case, where the parties entered into an agreement to facilitate smooth execution of the contract; where the respective rights and obligations of the parties were specifically defined and the agreement stated the intention not to form a partnership or any other association, it was held that there is no AOP. 3.7 Some of the other relevant rulings on AOP are as follows Estate of A. Mohamed Rowther [49 ITR 39 HC (Chennai)]

The words "association" indicates plainly the voluntary combination for a common endeavour and not a mere legal status resulting from operation of law. Co-owners, coheirs or co-legatees do not constitute such association in respect of the income of the joint or common asset by reason only of their jural relationship. But, if they unite themselves with the objective of earning income, they constitute an association of persons for assessment purposes and they cannot take advantage of their legal position to resist assessment on that basis. The essential criterion that attracts the label of "association of persons" in the income-tax department is the unity of the income-making purpose rather than the unity of title in the income-yielding asset. G Murugesan & Brothers vs CIT Madras [88 ITR 432 (SC)]

.There is no formula of universal application as to what facts, how many of them and of what nature, are necessary to come to a conclusion that there is an association of persons within the meaning of section 3; it must depend on the particular facts and circumstances of each case as to whether the conclusion can be drawn or not" For forming an "association of persons", the members of the association must join together for the purpose of producing an income. An "association of persons" can be formed only when two or more individuals voluntarily combine together for a certain purpose. Hence volition on the part of the members of the association is an essential ingredient..

Discussion Draft

In the case of receiving dividends from shares, where there is no question of any management, it is difficult to draw an inference that two or more shareholders function as an "association of persons" from the mere fact that they jointly own one or more shares, and jointly receive the dividends declared. Those circumstances do not by themselves go to show that they acted as an "association of persons". 3.8 Based on the plain and ordinary meaning and the judicial precedents as enumerated above, the summary of the principles for the determination of an AOP can be laid down as under: The parties should come together for a common purpose or common action There should be a sharing in the common pool of income or profits arising out of common or joint activity. There should be definite acts of management on the part of the members, as a result of which the income is earned from the properties/project/activity. Mere receipt of income jointly is not enough to constitute an AOP. The co-owners to the property cannot be deemed to form an AOP if the shares of the co-owners are definite and ascertainable.

3.9

An explanation has been inserted in section 2(31) (reproduced in para 4.2 above) by the Finance Act 2002 with effect from the Assessment Year 2002-03 which provides that an AOP shall be deemed to be a person, whether or not such person or body or authority or juridical person was formed or established or incorporated with the object of deriving income, profits or gains. In our view, the aforesaid amendment is merely to clarify that associations not having object of profit, will still qualify as an AOP. This amendment does not affect the basic requirement of common purpose / action to qualify as an AOP.

AOP - Tax implications Implications in the hands of an AOP 4.1 The taxation of an AOP under the Act is governed by specific set of provisions contained in section 167B of the Act which deals with charge of tax in the hands of an AOP where the shares of the members in AOP are determinate or indeterminate.

Discussion Draft

4.2

Sub-section 2 of section 167B of ythe Act provides that where the shares of the members of an AOP are determinate and known and the total income of any member of the AOP (excluding his share of income from such AOP) exceeds the maximum amount chargeable to tax in case of that member under the Finance Act of the relevant year, tax shall be charged on the total income of the AOP at the maximum marginal rate of 33.99%. Thus, in the instant case, where any of the member of the AOP is a company or partnership the total income of the AOP will be taxed at the maximum marginal rate of 33.99%

4.3

Further, sub-section 1 of section 167B of the Act provides that where the individual shares of the members of an association of persons or body of Individuals in the whole or in part of the income of the association of persons are indeterminate or unknown, tax shall be charged on the total income of the Association of persons at the maximum marginal rate. The maximum marginal rate as per the Finance Bill 2007 is 33.99%. An AOP is not allowed the deduction for any interest, commission etc paid to members of the AOP under the specific provision of section 40(ba) of the Act. No taxes are applicable on distribution of profits by AOP to its members. Set off and Carry forward of losses Since AOP is considered as a separate tax entity for the purpose of the Act, the provisions of set-off and carry forward of losses under the Act will be independently applicable to the AOP. Accordingly, the members of the AOP will not be able to claim setoff of losses of the AOP against their own taxable income.

4.4

4.5 4.6

Implications in the hands of the members of an AOP 4.7 Section 86 of the Act provides that when the AOP is charged at the maximum marginal rate, the shares of the members in the income of the AOP will not be included in the total income of the member. Therefore the income of the AOP is not taxable in the hands of the individual members of the AOP. Interest, commission etc. paid to a member by an AOP which is not allowed as a deduction under 40(ba) of the Act (as mentioned in para. 4.4 above) is not included in the hands of the individual members as per the provisions of section 67A which provides the method of computing the share of the individual members in the income of the AOP. Minimum Alternate Tax (MAT) Income from the AOP will not be taxable in the hands of the members under section 86 of

4.8

4.9

Discussion Draft

the Act as mentioned above. However, in case of a member being a company, such an income will be included in book profits for the purpose of calculation of the MAT Liability (MAT) under section 115JB of the Act. Explanation to sub-section 2 of section 115JB of the Act provides for the certain specific inclusions and exclusions for the purpose of calculations of book profits. Since income from an AOP is not specifically mentioned in the explanation as excluded from the calculation of book profits, the same will be included in book profits and the company may be required to pay 11.33% (10.3% in case of taxable income below Rs.10 million) of the same as MAT. The above provisions of the MAT under the Act would have most impact in the case where a company is engaged mainly in projects undertaken through a JDA which are considered as AOPs. In such a case, while, for normal tax purpose the share of AOP will be excluded, under the provisions of MAT, such share will form a part of book profits. 5 Tax implications - Comparison Joint Development Parameters Agreement (not an AOP) Entity liable to tax Income Tax Rates Tax on distribution of income Whether income 4 included for MAT purposes 5 Set off inter-se Allowability of 6 interest paid to members 6 6.1 Factors to mitigate AOP exposure From the above understanding about the judicial precedents for the determination of an AOP, the following points should be taken into consideration to mitigate the AOP exposure under the Act while entering into a JDA It should be understood that the following list is merely illustrative and not exhaustive, as the concept of AOP is fact dependent. Not Applicable No separate entity As applicable to the respective members Not Applicable Yes (Share of profit included in normal taxable income Allowed, as not a separate entity

Sr. No. 1 2

Joint Development Agreement (an AOP) Leads to a separate taxable entity 33.99%

Not taxable u/s 86

Yes (Share of profit not included in computing taxable income) Not allowed being separate taxable entities Not allowed as deduction (However, not taxable in the hands of the members)

Discussion Draft

The shares of the parties under the agreement should be determinate and known and should not be indeterminate pending the completion of the contract or for any other reason. The rights and obligation of each of fhe parties should be adequately defined separate and independent of the other party. The rights and obligation of the parties should mainly relate to the execution of their part of the contract .However, it may relate to the execution of the other part of the contract under the other party only to the extent to facilitate the smooth execution of the contract as a whole. If possible, the agreement should be worded as co-ordination and facilitation agreement instead of a JDA.

There should not be sharing of net profits or gains but sharing of gross revenue/ income producing assets between the parties. The parties should have their own purpose of entering into the contract and should not come together for a common purpose or intent. In case of a JDA, the land owner should be interested in the profits from the sale of its property and the developer should be interested in the share in the developed property after construction. Joint management of the project in the form of common bank accounts for the purposes of meeting the expenses for the project and to receive the revenues jointly, joint decision committee to take decisions on the execution of the contract etc should be avoided. Each party should manage its part of the project independent of the other party and should account for its revenues, expenses and profits independently. The sales, if any of the respective ownership under the agreement should be undertaken independently and without recourse to the other party. Apportionment of the common expenses to the respective parties should be avoided as far as possible. The liability for the expenses should be identified at the source and accounted for by the respective parties separately. A clause to the effect that the parties do not intent to form a partnership or any other association and the agreement is entered with the sole purpose of the smooth execution of the project should be incorporated in the agreement.

Discussion Draft