The Death of the 'Offshore Supply' Shield? Why ITAT Delhi Demolished Shanghai Electric's Artificial Contract Splitting

1. The Hook: Why This Case Matters Right Now

For decades, foreign contractors executing large-scale infrastructure projects in India have relied on a classic tax structuring sleight of hand: artificially splitting a single Engineering, Procurement, and Construction (EPC) contract into two. You execute one contract for the "offshore supply" of equipment (where title passes outside India to avoid Indian tax) and a second contract for "onshore services" (supervision and installation, which is offered to tax).

Ever since the Supreme Court’s landmark ruling in Ishikawajima-Harima Heavy Industries, this structure has been the holy grail of tax planning for foreign enterprises. But the Income Tax Appellate Tribunal (ITAT) Delhi’s ruling in Shanghai Electric Group Co. Ltd. v. DCIT (2017) is a stark reminder to the legal fraternity: the Revenue is no longer fooled by mere paperwork. If your offshore supply is inextricably linked to onshore performance guarantees, the ITAT will pierce the veil, collapse the contracts, and attribute a hefty chunk of your global profits to India. For corporate tax lawyers advising foreign multinationals, this judgment is a masterclass in how not to structure a turnkey project.

2. The Facts: Stripped to the Essentials

Shanghai Electric, a Chinese company, was engaged in supplying Boiler, Turbine, and Generator (BTG) equipment to Indian power giants like Reliance, JSW, and Jindal.

The company adopted the classic split-contract model. It filed its Indian tax returns offering only the revenue from onshore supervisory services to tax (opting for the presumptive taxation scheme under Section 44BBB). However, it claimed that the revenue from the offshore supply of the BTG equipment—which constituted a massive 99.75% of the total contract value—was completely outside the Indian tax net. Their reasoning? The sale was concluded outside India, title transferred at a foreign port, and payments were received in foreign currency via wire transfers.

The Assessing Officer (AO), however, read the fine print of the contracts. The AO noted that Shanghai Electric’s obligations did not end when the equipment was loaded onto a ship in China. The company was responsible for the design, manufacturing, erection, testing, and successful commissioning of the plant in India. They were liable for liquidated damages if the plant failed performance guarantee tests on Indian soil. Consequently, the AO treated the arrangement as a composite contract, established the existence of a Permanent Establishment (PE) in India, and attributed 25% of the company's global profits from the offshore supply to this Indian PE.

3. The Arguments: Form vs. Substance

Before the ITAT, the advocates for Shanghai Electric leaned heavily on form. They argued that under the Sale of Goods Act, once the Bill of Lading was handed over and title transferred outside India, the transaction was complete. Relying on Ishikawajima-Harima and Hyundai Heavy Industries, they contended that no income accrued in India. Furthermore, they argued that under Article 7(2) of the India-China Double Taxation Avoidance Agreement (DTAA), attribution of profits to a PE cannot be arbitrary; there must be an economic nexus.

The Revenue, backed by the Dispute Resolution Panel (DRP), argued pure substance. They contended that splitting a turnkey power project into "supply" and "supervision" was a facade for tax avoidance. Relying on the Delhi High Court’s judgment in CIT v. Mitsui Engineering, the Revenue pointed out that the Indian PE was heavily involved in bid preparation, commercial negotiations, site surveys, and warranty obligations. Therefore, the offshore supply was deeply connected to the Indian operations.

4. The Judgment: The Court's Reasoning

The ITAT ruled overwhelmingly in favor of the Revenue on the primary issue of taxability, delivering a crushing blow to the assessee's split-contract theory.

First, the Tribunal held that the contracts were undeniably composite. The true objective of the transaction was not just to sell loose equipment, but to deliver a fully functional power plant. Because the final "Takeover Certificate" was only issued by the Indian buyers after successful performance tests in India, the offshore supply could not be viewed in isolation.

Second, the ITAT made a fascinating (and aggressive) leap in treaty interpretation. Looking at Article 7 of the India-China DTAA, the Tribunal read into it the "force of attraction" rule found in the UN Model Convention. The ITAT held:

"The basic philosophy underlying the force of attraction rule is that when an enterprise sets up a permanent establishment in another country, it brings itself within the fiscal jurisdiction of that another country... profits relating to services rendered by assessee, whether rendered in India or outside India, in respect of Indian projects are taxable in India, and are attributable to the supervisory PE."

Consequently, the ITAT upheld the AO's decision to attribute 25% of the offshore supply profits to the Indian PE, utilizing the company's global profit rate (ranging from 5.53% to 8.57% across various years).

The Silver Lining: The Assessee did win on one procedural ground. Relying on the Delhi High Court in Mitsubishi Corporation, the ITAT deleted the interest levied under Section 234B, noting that since the Indian payers were obligated to deduct TDS under Section 195, the non-resident assessee could not be penalized for failure to pay advance tax.

5. The Critique: A Strategic Blunder by the Defense

Do I agree with the ITAT? On the substance of the composite contract, yes. For too long, tax practitioners have relied on cosmetic contract-splitting while ignoring "cross-fall breach" clauses that legally link the offshore and onshore contracts. The ITAT rightly recognized that you cannot claim a contract is entirely offshore when your engineers are on the ground in India guaranteeing the plant's performance.

However, the ITAT’s jurisprudence on the "force of attraction" rule is highly debatable. Reading UN Model commentaries directly into the India-China DTAA to tax offshore supplies simply because a supervisory PE exists is a dangerous expansion of jurisdiction. It blurs the line between profits attributable to a PE and profits merely associated with the same project.

But the most glaring failure here lies with the assessee's legal strategy regarding quantum. The assessee raised a ground (Ground 6.9) arguing that if profits must be attributed, the AO should use the segmental profit rate of 1.69%, rather than the global profit rate of 8.29%. Yet, during the hearing, the counsel failed to submit any justification or data to support this segmental rate.

This is an unforgivable litigation blunder. By failing to substantiate the 1.69% segmental profit, the advocates essentially handed the AO a blank check. When you are fighting a losing battle on the existence of a PE, your secondary defense—the attribution math—must be bulletproof. The ITAT noted this lack of evidence and summarily dismissed the ground, costing the client crores in avoidable tax liability.

6. The Takeaway for Practitioners

This judgment should be mandatory reading for every corporate lawyer drafting EPC contracts and every tax litigator defending them:

• Drafting matters: You can no longer rely on separate pieces of paper to save you from Indian taxes. If your offshore supply contract contains cross-fall breach provisions, performance guarantees tied to Indian testing, or involves Indian PE personnel in pre-bid negotiations, the taxman will collapse the structure.
• Ring-fence the PE: If you want to protect offshore supply revenues, ensure your Indian PE is strictly confined to onshore supervision. Do not let Indian site offices handle marketing, bid preparation, or warranty claims for the offshore equipment.
• Never abandon the math: If you are arguing against profit attribution, you must present a robust Transfer Pricing (FAR) analysis and audited segmental financials. Pleading a lower profit margin in your grounds of appeal and failing to prove it during arguments is a surefire way to lose your client's money.