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The Income-tax Department recently treated damages payable under an arbitral award as “windfall gains” and subjected this amount to income-tax at the rate of 42%. The damages were treated as windfall gains under the India-Switzerland Double Taxation Avoidance Agreement (DTAA). Indeed, this was perhaps the first time in the world that an arbitral award of damages was sought to be taxable as “windfall gains” falling in the same genre as winnings from lotteries or horse races!
A foreign arbitral award was made on November 17, 2014, and the challenge to the award under section 48 of the Arbitration and Conciliation Act, 1996 was dismissed by the Delhi High Court and was also unsuccessfully challenged before the Supreme Court. The amount was deposited in the Delhi High Court and was to be remitted to the successful party in Europe.
In a surprising turn of events, the Income-tax Department took the stand that the arbitral award that granted compensation of USD 45.73 million for breach of contract had resulted in a “windfall gain”, and was accordingly taxable in India under Article 22(3) of the DTAA which reads as follows:-
“Notwithstanding the provisions of paragraph 1, if a resident of a Contracting State derives income from sources within the other Contracting State in the form of lotteries, crossword puzzles, races including horse races, card games and other games of any sort or gambling or betting of any form or nature whatsoever, such income may be taxed in that other Contracting State.”
As the foreign decree-holder did not have a Permanent Establishment (PE) in India, it could not be taxed as business income under the DTAA. Therefore, the further ingenious idea was to tax it as “income from other sources”. However, under the India-Switzerland DTAA, “income from other sources” is taxable only in the State in which the recipient of the income is resident. Therefore, even if the award for compensation was “income from other sources”, it could be taxed only in Switzerland which was the domicile or residence of the Swiss company i.e. the decree-holder. Now, to get over this limitation, the Income-tax Department went one step further and treated this award as akin to income from lotteries, horse races, card game and so on. In a sworn affidavit before the Delhi High Court, the Department claimed that the award was to be treated as a “windfall gain” because it was received due to an unforeseen event over which the recipient had no control!
Mercifully, this stand of the Department was rejected by the Delhi High Court in a short order passed by Justice Rajiv Shakdher. The provisions of section 2(24)(ix) of the Income-tax Act, 1961 are identical to the provisions of Article 22(3). If an international arbitral award is a windfall gain under the DTAA, all domestic awards will equally be taxable as income from “windfall gains” under the domestic law as well. This will be contrary to well-settled decisions of the Supreme Court which clearly demarcated cases where compensation was to be treated either as a revenue receipt or as a capital receipt. But it is unlikely that any
tax authority anywhere in the world has taken the view that an arbitral award is a windfall gain in the nature of a lottery or as winnings from horse races and so on.
Such an absurd interpretation seriously dents the image of India in the commercial world. And what is worse is that there is no accountability or any responsibility fastened on the officer who took such a plea in the first place.
The author is a Senior Advocate practicing in the Supreme Court.
Members of the Nani Palkivala Arbitration Arbitration Centre (NPAC) will be writing a weekly column for Bar & Bench analyzing the latest developments on the law of arbitration.