"I realise that some of my criticisms may be mistaken; but to refuse to criticize judgements for fear of being mistaken is to abandon criticism altogether... If any of my criticisms are found to be correct, the cause is served; and if any are found to be incorrect the very process of finding out my mistakes must lead to the discovery of the right reasons, or better reasons than I have been able to give, and the cause is served just as well."

-Mr. HM Seervai, Preface to the 1st ed., Constitutional Law of India.

Thursday, October 2, 2008

Supreme Court Judgment

Judgment on Income Tax Assessment Involving Production Sharing Contract (PSC)

(Available at www.judis.nic.in)

Commissioner of Income Tax, Dehradun & Anr. v. Enron Oil & Gas India Ltd.

The Income Tax authority in India sought to tax the respondent firm registered in Cayman Islands which has a Production Sharing Contract with RIL and ONGC, beyond the assessment filed by the company. Respondent filed an assessment which is being disputed by the appellant herein as the A.O. refused to recognize the loss as claimed by the assessee as illusory and not real. The Supreme Court dismissed the Civil Appeal.

Relevant segment of the judgment is given below.

29. To answer this question we were required to understand the subject of a Production Sharing Contract (PSC). The State hires the investor(s) as a contractor(s) for the conduct of work connected with the extraction of minerals. The subsoil belongs to the State. It has a monopoly over the use of the subsoil and the removal from it all natural resources. Under the PSC the State grants to the contractor (investor) exclusive rights to conduct activity of exploration envisaged by the contract. A PSC is a civil-law contract. The contractor (investor) carries out the activities envisaged in the contract (prospecting, search, exploration, extraction etc.) at his own expense and risk. The State does not bear any expenses or risks. If the investor invests in the prospecting and exploration but does not discover any oil, the expended funds is not refundable unless the contract provides otherwise. The State hires the investor as a contractor to perform work for it, but at the expense and risk of the investor. The said work is carried out on a compensated basis, with the State paying the investor not in money, but in terms of a portion of the produced product (oil). This is called as Production Sharing.

30. There are two main systems around the world: royalty/tax systems or production sharing systems. PSCs have become the fiscal system of choice for most countries. Taxes are embedded in the Government share of profit oil. PSC is a complex system. In it, the foreign company provides the capital investment in exploration, drilling and construction of infrastructure. The first proportion of oil extracted is allocated to the company, which uses oil sales to recoup its costs and capital investment. The oil used for this purpose, namely, to recoup capital investment and cost is termed as "cost oil". Once costs have been recovered, the remaining "profit oil" is divided between the State and the company in agreed proportions. The company is taxed on its profit oil. Sometimes, the State participates either itself or through its nominee as a commercial partner in the contract, operating in joint venture with foreign oil companies. In such cases, the State provides its percentage share of capital investment, and directly receives the percentage share of cost oil and profit oil.

31. As stated above, in PSC, the foreign company provides the capital investment and cost and the first proportion of oil extracted is generally allocated to the company which uses oil sales to recoup its costs and capital investment. The oil used for that purpose is termed as "cost oil". Often a company obtains profit not just from the "profit oil", but also from "cost oil". Such profits cannot be ascertained without taking into account translation losses. Moreover, as stated above, taxes are embedded in the profit oil. If these concepts are kept in mind then it cannot be said that "translation losses" under the PSC are illusory losses.

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