1
CONCEPT OF PERMANENT ESTABLISHMENT AND BUSINESS PROFITS
ICAI
BANGALORE
JUNE 5, 2015
RANI N R
Business Connection
• Business connection is the domestic equivalent of Permanent Establishment with subtle differences.
• Aspect of “business connection” is dealt by Section 9(1)(i) of the Income Tax Act.
• The term ‘business connection” not defined in the statute.
2
Business Connection…
In CIT vs. National Mutual Life Association of Australia [(1993) 1 ITR 350 (Bom)] it was held that the three eminent conditions to constitute a ‘Business Connection’ are:
• There should be a business in India
• There should be a connection between non-resident person or company and that ‘business’ and
• The non-resident has earned an income through such connection.
Business Connection…
• Section 9(1)(i) was amended by the Finance Act 2003. Explanations (2) & (3) were added to define business connection in agency relationships in order to remove doubts regarding the expression ‘business connection’ and to align the provisions of the Income Tax Act with those of DTAA’s
3
Business connection
Business of which all operations are not carried out in India
Only such part of the income as is reasonably attributable to the operations carried out in India, would be deemed to have accrued in India
Business of which operations are confined to purchase of goods in India for export
No income shall be deemed to have accrued in India
Others
Non- resident news agency
No income shall be deemed to have accrued in India
Individual/ firm /company whose operations confined to shooting cinematography
No income shall be deemed to have accrued in India
Permanent Establishment
4
Importance of Permanent Establishment
• Business profits, under Article 7 of the treaty are taxable
only if the non resident has a PE in India
• Concept of PE is used to determine the right of „Source
State‟ to tax business profits of the foreign enterprise
• Existence of PE also enables the Source State to tax
capital gains, dividends, interest and royalties that are
effectively connected/attributable to such PE
PE - Meaning
I T Act DTA
Sec 44DA
Read with
Sec 92F
Sec 9 ( 1) ( i)
Explanat ion 2
Art icle 5
PE includes a fixed
the place of business 1. Extended meaning
of business
connect ion through which the
business of the
enterprise is wholly
or part ly carried on
2. Sim ilar to DAPE
5
PE - Relevance
I T Act DTA
Royalt ies & FTS No PE PE
No PE PE BP/ FTS/
R
1 5 % 4 0 %
R/ FTS BP
u/ s
1 1 5 A ( 1 ) ( A& B)
On Gross
Receipts
As per
FA, 2 0 1 3 , I Sch
Part I I Ent ry No. 2 ( b) ( x )
4 0 %
As per
FA , 2 0 1 3 , I Sch
Part I I
Ent ry No. 2 ( b) ( x)
Concessional rate
On Gross
Receipts
No Tax
On Net receipts
after expenses
On Net receipt s
aft er expenses
Importance of PE ….
The concept of a PE is relevant for determining the
right of a Cont ract ing State ( CS) to tax the profit s
of an enterprise of the other Cont ract ing State.
Under all three MCs, the existence of a PE is the
decisive condit ion for the taxat ion of incom e from
business act ivit ies.
Under Art icle 7 a CS cannot tax the profits of an
enterprise of the other CS unless it carr ies on its
business through a PE situated therein.
6
DTA – Art icle 5
5 ( 1) 5 ( 2) 5 ( 3) 5 ( 4)
Extended
Categories
Fixed
place of
business
Exclusions Dependent
Agent PE
1. Place of Managem ent
2. Branch
3. Office
4. Fact ory
.
6.A m ine, an oil or gas
well, a quarry
7. Warehouse
8.Far m , Plantat ion 9.
Stores
10. Natural Resources
11. Building sit e
12. Service PE
A. Goods or
Merchandise
1. Storage
2. Display
3. Delivery
A. Act ivit ies
not
Lim it ed to
Prelim inary &
4. Maintenance
5. Processing
B. Place of
Business for-
1. Collect ing
inform at ion
Auxiliary
Character
B. Concludes
Cont racts
2. Advert isem ent C. Exclusively
Secures orders
Relevance of Permanent Establishment in International taxation
PERMANENT ESTABLISHMENT
Business
Profits
• Head Office
Business Profits
• PE
Country R Country S
Corporate Tax Corporate Tax
7
Article 5 of the Treaty – Typical structure of a PE article
Permanent Establishment
[Article 5]
Article 5(1) – Fixed Place
PE
Article 5(2) – Specific
inclusions
Article 5(3) – Construct ion
PE
Article 5(4) –
Exclusions from PE
Article 5(5)- Dependent
Agent PE
Article 5(6) – Independent
Agent
Article 5(7) –
Subsidiary company
Basis Rule PE – Article 5(1) ► “For the purpose of this Convention, the term “permanent
establishment” means a fixed place of business through
which the business of an enterprise is wholly or partly carried
on”
► Five Essential ingredients of Basic Rule PE(Fixed place PE)
► There must be a place of the business. (place of business test)
► The place of business must be located at a certain area.(location test)
► The taxpayer must have a certain right to use the place of business
(right to use test)
► The use of the place of business must last for a certain period of
time. (permanence test)
► The activities performed through the place of business must be a
business activity as per treaty or domestic law (business activity
test)
8
Article 5(1) - Basic Rule PE
Location test
Right to use test
Business activity
test
Permanence test
Place of business
test
A PE can be constituted under “Basic Rule” only if all of above conditions are satisfied
“the term ‘permanent establishment’ means a fixed place of business through which the business of an enterprise is wholly or partly carried on”
Test for Basic Rule PE…
• Whether there is place of business ?
• Is such place of business “fixed” ?
• Whether the foreign enterprise carries on its business either wholly or partly through this fixed place of business ?
• Whether the place of business have a certain degree of permanency ? (duration test)
• Whether the place of business is “at disposal” of the foreign enterprise ?
• Whether the activities are “preparatory or auxiliary” ?
9
Basic Rule PE – Place of business test
The term „place of business‟ covers any premises, facilities or installations
used for carrying on the business of the enterprise.
Mere fact that an enterprise has certain amount of space at its disposal which is used for business activit ies is sufficient to constitute a place of business {OECD Commentary(2010)}
Examples:
Cer tain permanently used area in a customs depot (e.g. for the storage of
dutiable goods
Certain pitch in market place used for carrying out the business
A Computer server located in India
Office of 3 meters by 6 meters { Motorola Inc & Others, 95 ITD 269 (Del)}
A hotel room {Renoir consulting Ltd. vs. Dy. DIT (Mum –Trib)}
Basic Rule PE – Power of disposition test
Place should be at disposal of foreign enterprise for business
activities of foreign enterprise
The foreign enterprise should have the ability to exercise some right
or dominion or control
The place may be owned, rented or leased;
Legal right to use need not be the sole determinant; factual use or
exercise of such right will have a greater bearing
Even illegal occupation could constitute a PE
Service provider‟s office is “generally” not at disposal of service
recipient
10
Basic Rule PE – Duration Test No minimum threshold under Indian law
The fixed place of business must have a certain degree of permanence, ie should not
be of purely temporary nature
Availability of a fixed place of business for a reasonable period should result in
compliance with this condition.
An isolated activity should not lead to establishment of a fixed base PE as the
ingredients of regularity, continuity and repetitiveness are essentially missing
Where the activities are of a recurrent nature, each period during which the place is
used needs to be considered in combination with the number of times during which
that place is used (which may extend over a number of years)
A place of business may constitute a Fixed Place PE, even though it exists, in practice,
only for a very short period of time, where the nature of the business is such that it will
only be carried on for that short period of time
OECD Commentary – PE normally have not been considered to exist in situations
where a business had been carried on in a country through a place of business that
was maintained for less than six months
Dutch Company
Netherlands Germany
German Company
Underground pipeline network
Transported crude oil and crude oil products
Operated by remote control
through a computer in Netherlands
Technical functions and business administration were exercised exclusively by personnel located in Netherlands
Independent firms were hired to maintain and repair that part of the pipeline network that was situated in Germany
German Court held PE exist in Germany
•Pipeline was a fixed place of business
•It was firmly connected to German Territory
Dutch company’s nature of business being
• Usage of Pipeline network
• Used for Transportation Services
Employment of Personnel in Germany was not necessary for fixed place of business •Mechanical and Automatic installations are sufficient
11
21
Computer server and fixed place PE
Case Law Principles
Amadeus Global Travel
Distribution s SA vs. DDIT
Computers installed at customer‟s premises amounted to fixed
place PE in India
Galileo International Inc
vs.DCIT
Computers installed at the Indian subscriber‟s (Indian agents‟)
offices gave rise to fixed PE in India
Western Union
Financial services Ind.
vs. ADIT
Computer software per se could not give rise to Fixed PE in
India.
Intangible asset, such as an internet website are not fixed
place of business.
ITO vs. Right Florists
(P) Ltd.
“PE” does not normally extend to websites unless the servers
on which websites are hosted are also located in the same
jurisdiction
Website per se, which is a combination of software and
electronic data does not itself constitute a tangible property as
it cannot have a location which constitute a place of business
Article 5(2) – Specific Inclusions Specific Inclusions – OECD MC
► A place of management
► A branch
► An office
► A factory
► A workshop
► A mine, an oil & gas well, a quarry or any other place of extraction of natural resources
Additional inclusions - Indian Treaties
► Warehouse in relation to person providing storage facilities for others – Treaties with Singapore, USA, Mauritius, Netherlands etc
► A store or premises used as a sales outlet – Treaties with USA, Netherlands, Germany etc
Whether inclusions in 5(2) independent of 5(1) ?
12
A place of
management
Branch
Office
An
Office
A
Factory
A
Workshop
A
mine
AN OIL OR
GAS WELL
Article 5(3) – Construction PE Article 5 (3) - Building and Construction PE – Building site or construction or installation project constitutes a PE only if it lasts
more than twelve months • Building site: not only construction of buildings but also construction of roads,
bridges or canals etc, and renovation thereto 12 Month Period – OECD Model – Twelve month test applies to each individual site or project – A building site should be regarded as a single unit, even if it is based on several
contracts Duration – Site exists from date on which work begins, including any preparatory work – It continues to exist until work is completed or permanently abandoned. Should
not be regarded as ceasing to exist if work is temporarily discontinued UN Model – Six months test applies to each individual site or project
13
Type of Projects
Would include:
– Construction of buildings
– Roads, bridges, canals
– Renovation (involving more than mere decorating) of
buildings, roads, bridges, etc
– Laying of pipelines and excavating and dredging
– Installation of new plant and equipment
– Planning and supervision of the above (UN Model –
only supervision)
OEDC MC and UN MC – Difference in Approach towards PE
OECD MC UN MC
1. Under Construction PE, assembly
and supervisory activities are not
covered
1. Assembly and supervisory
activities are specifically provided
for.
2. Threshold for construction PE is
12 months
2. Threshold for construction PE is 6
months
3. Does not provide for “Service PE”
clause
3. Provides for “Service PE” clause
4. Maintenance of stock for delivery
does not create “Agency PE”
4. Maintenance of stock for regular
delivery, even without authority to
conclude contracts, triggers
“Agency PE” – Stock Agent
14
ARTICLE 5(3): Construction PE
Building Site
• Building Site
Construction Site
• Construction of Buildings
• Sewerage systems
• Bridges and canals
Installation Project
. Excavating, dredging and laying of pipelines
Project lasts for
more than 12 months
Constitutes PE
Planning & Supervision carried on by builder incusive falls within Construction PE.
If a person carries on only planning and supervision without construction then it does not constitute construction PE
6 months in case of UN Model
Temporary Breaks
Any temporary discontinuance of the work due to any factors such as seasonal interruptions of any other barriers such as labour shortage, material shortage should be disregarded while computing the project duration.
Ending Date
The date when the foreign enterprise either completes/abandons the work completely should be considered as its ending date.
Starting Date
The date when a foreign enterprise commences its first activity (including preparatory work should be considered as the start date.
15
• OECD MC clarifies 12 months threshold to be applied in respect of each individual site or project.{Stand alone approach}
• Project site to be treated as single unit even if it is a result of multiple contracts if those multiple contracts form a commercially and geographically coherent whole. {Aggregate approach}
• Stand alone approach or Aggregate approach needs to be applied on a case to case basis depending on the fact pattern of each case.
• Period spent by a sub-contractor working on the site must be considered for the purpose of deciding the threshold period.
• Contract split over different years: Conclusion would largely depend on the language used in the respective Treaty. For eg: India – Germany DTAA: “project or activity continues for a period exceeding six months” – in this case period of six months should be considered for each fiscal year independently.
16
India- US DTAA : “ project or activities continue for a period of more than 120 days in any twelve month period”
in this case the continuous period of 120 days should be considered over a period of twelve months even if it spreads over two fiscal years.
Accordingly in the case of US, a PE could exist in both the fiscal years. In the protocol to the treaty it is mentioned that where the time period of 120 days extends to over two taxable years, a PE would not exist in the year in which a site, project, etc. continues for less than 30 days.
Different parties – same Project
• Where different parties are involved in the execution of different but connected parts of the same project under a single umbrella contract, PE is to be looked at for each of the foreign entity and if the activities of the respective entities exceed the threshold limit as per the respective treaty then only PE exist for that foreign entity.
• Aggregation approach cannot be applied
17
33
Case laws – Construction PE
Case Law Principles
DIT vs. Paper Products Ltd.
{(2002) 257 ITR 1 (Del)}
Control over project not necessary. The project belonged to
Indian Company and German Company gave technical
supervision support. The duration of supervisory services is
the only relevant criteria . The Tribunal held that German
Company had a construction supervisory PE in India though
the German Company was not the owner of the project.
It is not necessary that the provider of supervisory services
must have control over the site as per India –Germany DTAA.
CIT vs. Vishakhapatnam Port
Trust {144 ITR 146 AP)
Mere supervision is not the same thing as installation, the
assessee could not be said to have PE in India.
Motorola Inc. [95 ITD 269
(Del Spl. Bench)]
Six months “threshold” should be considered for each taxable
year and there is no PE if the presence in a taxable year is
less than six months
Service PE
A service PE comes into being when an enterprise is –
Furnishing services,
Through its employees or
Other Personnel,
In the same or the connected project
For a period or periods aggregating more than 6 months
Service PE
Furnishing Services of any kind including Consultancy constitutes Service PE
Other than those services referred under Article dealing with Royalties & Fees for technical services
This clause goes beyond the ‘fixed base’ concept
This extension of taxation by the state of source is of particular significance in connection with making personnel available and with providing technical assistance
18
Service PE
• Most treaties specify a period of 90 days to constitute a Service PE
(UAE has a specified period of 9 months);
• Special clause for “Associated Enterprises” in some treaties
where lower time threshold necessary to constitute Service PE eg
USA (1 day), UK(30 days), Singapore (30 days);
• The concept specifically excludes services covered by Fees for
Technical Services (FTS)/ Fees for Included Services (FIS) Article
India’s approach towards PE ► Combination of OECD and UN Model with emphasis on source based
taxation consistent with the object and rationale of the UN MC
► Approach not uniform, differs form treaty to treaty:
► “Service PE” clause is found in treaties with USA, UK, Singapore etc but
not in treaties with Mauritius, Germany, Netherlands etc
► Threshold for “Service PE” for services to related enterprises is 30 days
for treaties with UK, Singapore etc; for USA even 1 day will trigger
“Service PE” risk
► Treaties with Australia, Germany, Singapore and UK contain “securing
orders” clause and Associated Enterprise clause in their Agency PE
definition, which is missing in Treaties with Netherlands, Mauritius etc.
19
• Man days vs. Solar days
Whether each employee/other personnel’s stay in the source State should be counted separately (ie; man days) or:
Whether each day of presence of such employees/ personnel on a collective basis should be treated as the presence of the non- resident service provided in the source country (ie; solar days)
“Solar days“ principle for counting of the days to find out
the existence of PE appears to be a better view.
{based on logical reading of UN model treaty, OECD commentary and also Indian judicial precedents}
• Working days vs. Holidays vs. Leave period OECD commentary provides a view that only ‘working days’ to be included in counting the days of presence of the foreign enterprise in the source state. No guidance found in UN commentary
20
• Interpretation of term “Month”
Certain treaties, the threshold limits are to be calculated in relation to months (India – UAE treaty).
General Clauses Act, 1897 defines the term ‘month’ as ‘month shall mean a month reckoned according to the British calendar”
No guidance is found in the Model commentaries in this context as well as domestic tax law.
• Interpretation of term “Same or connected projects”
The entire period for which the non-resident service provider renders services in India would need to be considered/aggregated for the purpose of calculation of the Service PE threshold.
OECD Commentary gives a detailed guidance regarding the indicative factors for the phrase “same or connected projects”
UN Commentary does not provide any guidance in this regard.
21
Service PE vs Domestic Tax Law
• Fees for Technical Services (‘FTS’) – if there is no business connection as per Section 9(1)(vii)
• Business profits if there is a business connection as per Section 9(1)(i)
• If there is no PE (fixed base) of non-resident exists under the Act, FTS would be taxable on gross basis as per the applicable rates of tax.
• Deputation/Secondment arrangements Essential to determine who is the real or economic employer of the deputed/seconded employees. Different/contradictory views by the judicial authorities based on different combination of facts/ arrangements.
22
Morgan Stanley & Co., - 292 ITR 416 (SC)
Morgan Stanley & Co., Inc – Investment Bank
Sent Stewards to ensure high standards of the quality of the services are met to
Morgan Stanley Advantage Services - India
Held, that stewardship activities did not create PE. The presence was not to carry on significant activity of business
but ensuring that standards are maintained
Deputed certain employees on request of Morgan Stanley India to work for
Morgan Stanley India
PE is created since - Morgan Stanley Inc would be responsible for the work of deputed employees Employees continue to be on the payroll of Morgan Stanley Inc Employees continue to have lien on their employment with Morgan Stanley Inc
44
Case laws – Service PE Case Law Principles
Ram Prashad vs.
CIT{(1972)86 ITR 122
(SC)}
Distinction between „servant‟ and „agent‟.
Servant acts under direct control and
supervision of his master, an agent is not
subject to direct control and supervision of the
principal in exercise of his work though he is
bound to exercise authority based on the
instructions of the principal
Cliffod Chance vs.
DCIT {(2002) 82 ITD
106 and Maharashtra
State Electrcity Board
{(2004) 90 ITD 793}
For the purpose of service PE threshold,
counting should be as per solar days (ie; after
sunrise and before sunset)
23
45
Case laws – Service PE Case Law Principles
IDS Software Solutions
(India) P. Ltd. {(Bang)
(2009) 122 TTJ 410
Reimbursement of salary cost not taxable as Fees for
Technical service. The seconded employee was held to
be under control and supervision of Board of Directors
of Indian company and hence Indian company was the
economic employer of the seconded employee
AT & S India Private
Limited {(AAR) (2006) 287
ITR 421
Secondment was subservient to a foreign collaboration
agreement. Hence reimbursement of salary cost of
seconded employee is in the nature of FTS. Since the
payment was taxable as FTS existence of business
presence was not discussed.
Verizon Data Services
Private Limited
{(AAR)(2011) 337 ITR 192}
Indian company cannot be considered as economic
employer of the seconded employee as they continue to
remain in the payroll of the Foreign Company. Also the
power to terminate their employment remains with the
Foreign Company. Held that the services were in the
nature of FTS and existence of PE was not dwelled
upon.
46
Case laws – Service PE Case Law Principles
Centrica India Offshore
Private Limited {(AAR)
(2012) 348 ITR 45}
Seconded employees did not have any right to
claim salary from Centrica India. Also the
seconded employee were on the payroll of
overseas entity and had a lien on their jobs in
overseas entity. Held that the services are not in
the nature of FTS and since the conditions of
Service PE clause were fulfilled, the overseas
entity had a Service PE in India under the relevant
tax treaty.
Target Corporation
India Private Limited
(2012)
Relying upon the AAR decision in the case of
Centrica India , the AAR held that the right to
terminate employment is a „sure test‟ for
determining employer-employee relationship.
The right to terminate secondment is separate
from the right to terminate an employment. It was
held that salary recharge would be taxable.
However AAR has not commented on the
characterisation of such payments ie; whether
they would be business income or FTS.
24
Article 5(4) – Exclusions from PE • OECD: A PE will not include:
Use of facilities solely for storage, display or delivery of goods
Maintenance of stock of goods solely for storage, display or delivery
Maintenance of stock of goods solely for purpose of processing by another
enterprise
Maintenance of fixed place of business solely for purpose of purchasing goods, or
collecting information
Maintenance of fixed place of business solely for purpose of carrying on any
activity of a preparatory or auxiliary character
…solely for combination of any of the above
Goods or Merchandise
of the Enterprise
“SOLE PURPOSES”
Use of Facilities solely for the
purpose of Storage, display
or delivery
Maintenance for the purpose of
storage, display or delivery
Maintenance for the purpose of processing by
another enterprise Maintenance of a
fixed place of business solely for
the purpose of Purchasing or of
collecting information
Maintenance of a fixed place of
business solely for the purpose of any
preparatory or auxiliary activity
Maintenance of fixed place of
business for any combination of these activities
which are preparatory or
auxiliary
Article 5(4) Excluded Activities
PE not formed Due to
insignificant economic activity
UN model does not recognise “delivery”
25
Article 5(5) - Dependent Agent PE (DAPE)
Conditions to be satisfied (cumulative conditions)
Should be a „Person‟
Agent other than an agent of independent status as per Article 5(6)
Acting on behalf of an enterprise
Has an authority to conclude contracts in a Contracting State
Habitually exercising such authority in a Contracting State
In name of enterprise
Not auxiliary activities
Satisfaction of all the above conditions is necessary
Notwithstanding Art 5(1) & 5(2)
A Person not being an independent
agent
Acts on behalf of an enterprise
Habitually exercises in the contracting
state
An authority to conclude contracts in the name of the
enterprise
Such enterprise is deemed to have a PE
in that State
Unless the activities of such a person are
those specified in Art 5(4)
Which if exercised as per Art 5(4) through
a fixed place of business would not
constitute PE
Article 5(5) terms such a person as a
DEPENDENT AGENT
A person’s commercial activities for an enterprise are subject to detailed instruction or comprehensive control by the enterprise, the person is regarded as dependent.
A person acting for only one principal would appear to be a dependant agent. IRC v/s London Produce Co [1968] 2 ALL ER 1975 and Case 23/93 (1003) 93 ATC 288
Dependant Agent
26
• Powers do not need to extend to actual signing of the contracts
• Authorised to negotiate all elements and details of a contract that binds the contract
Concluding Contracts
• Art 5(5) deems existence of PE even without existence of fixed place of business
• This ensures as an anti avoidance measure to appoint agents and in order to avoid PE status
Fixed place of business
Exercise the authority to conclude contracts in the name
Person said to have authority to conclude contracts if, he/she:
► Has sufficient authority to bind foreign enterprise and decide final terms
► Can act independently, without control from the principal
► Is authorized to negotiate all elements and details of a contract
► Agency PE would be constituted where approval of contract by foreign enterprise is a mere formality
OECD Position
► Agent is required to conclude contracts relating to operations which constitute business proper of the enterprise
► Participation / attendance in mere negotiations of contracts not sufficient to trigger DAPE
Signature
• No signature but negotiation of all elements and details of the contract in a way binding on the enterprise
27
Article 5 (6) - Agent of Independent Status
► A person is regarded as an agent of independent status if he is legally and
economically independent of the foreign principal
► Ordinarily an independent agent does not constitute a PE if he acts in the ordinary
course of his business while acting for his principal
Key terms
► Legal independence - Agent is not subject to significant control/ instruction by
principal with respect to manner in which work is carried out
► Economic independence - Agent bears “entrepreneurial risk” associated with his
business operations
► Ordinary course - As commonly understood by relevant industry
Independent Agent – Tests
Yes
Agent
Are activities wholly, or almost wholly, on behalf of principal?
No
Yes
Yes
Independent Agent
No
Dependent Agent
Is he acting ordinary course of his business?
Is he legally & economically
independent
► Not subject to high degree of control
(like employer/ employee relationship)
► Not subject to detailed instructions and
control in respect of conduct of business
► Conduct business according to own view,
expertise and method
► Will the agent continue its business if
principal terminates the service agreement
► Agent bears the risk of loss from its own
activities
No
28
Independent Agent • A PE will NOT include:
► Carrying on of business in the other contracting state through:
► a broker,
► general commission agent, or
► any other agent
of an INDEPENDENT status acting in the ordinary course of their
business – legal and economic independence
Independent Status of an
agent determined by
Legal Independence
Economical Independence
The Principal has no control over, or
power to interfere in, the day-to-day
business of the agent
Agent conducts its own exclusive
business wherein It bears the
entrepreneurial risk of the business
29
Criteria for Dependence
Nature of Relationship Between Agent and Principal
Agent has NO entrepreneurial Risk
Agent is subject to detailed instructions or to
comprehensive control
Agent is DEPENDENT
Article 5 (7) - Subsidiary Company
► Enterprise under the same control need not be a PE
► Subsidiary company may constitute PE if it satisfies any
of the conditions for creating a PE
► Parent Company may constitute a PE under Article 5(1)
or Article 5 (2) in a State where it has a place of business
other than the subsidiary company.
30
ARTICLE 5(7)
Holding Company
Subsidiary Company
Existence of Holding and Subsidiary Relationship
does not make each other PE of the other in
the respective states
A subsidiary can be PE of its parent if
It is not an independent agent of its parent AND
Habitually exercises
authority to conclude
contracts in the name of its
parent company
Business Profits and Attribution of Profits to
Permanent Establishment
31
Why Attribution?...
• Residence Country – generally taxation of global profits
• Right of source country to tax profits of foreign enterprise operating
in its jurisdiction – when Permanent Establishment („PE‟) exists i.e.
Source Based Taxation
- Only those profits which are attributable to PE in the source
country
Attribution of business profits of foreign enterprises- Governing Provisions
Under Income Tax Act and Rules („Domestic Law‟):
– Section 9(1)(i) of the Act read with Rule10
Under Tax Treaty:
– Article 7 of Tax Treaties
32
Attribution of profits under the Income Tax Act
Section 9(1)(i) of the Act:
“The following incomes shall be deemed to accrue or arise in India:-
all income accruing or arising, whether directly or indirectly, through
or from any business connection in India, or through or from any
property in India, or through or from any asset or source of income
in India, or through the transfer of a capital asset situated in India.”
Explanation 1(a) to section 9(1)(i) of the Act:
“In the case of a business of which all the operations are not carried
out in India, the income of the business deemed under this clause to
accrue or arise in India shall be only such part of the income as is
reasonably attributable to the operations carried out in India”
Attribution of profits under the Income Tax Act
• Rule 10 of the Income-tax Rules:
In any case in which the Assessing Officer is of opinion that the actual amount of the income accruing or arising to any non-resident person whether directly or indirectly, through or from any business connection in India …………………………………… cannot be definitely ascertained, the amount of such income for the purposes of assessment to income-tax may be calculated :
(i) at such percentage of the turnover so accruing or arising as the
Assessing Officer may consider to be reasonable, or (ii) on any amount which bears the same proportion to the total profits and
gains of the business of such person (such profits and gains being computed in accordance with the provisions of the Act), as the receipts so accruing or arising bear to the total receipts of the business, or
(iii) in such other manner as the Assessing Officer may deem suitable.”
33
Rule 10(i) - Presumptive Method
- Income computed at such percentage of the turnover as the AO may consider reasonable
- Ad hoc profits are estimated as attributable to the operations in India Rule 10(ii) - Proportionate Method
- Profits computed in ratio of India receipts to total receipts of the business - Proportionate profits based on worldwide income is attributed to the
operations in India - Difficult method as worldwide income of the enterprise is to be computed
under the Act before applying proportionate method - In case of different businesses, relevant business income needs to be
considered
Rule 10(iii) - Discretionary Method - Such method as is deemed fit by tax authorities – AO may devise any
mechanism on facts and circumstances of the case.
Methods prescribed under Rule 10
• CBDT Circular No. 23 dated 23 July 1969 – Now
withdrawn
Non-Resident selling goods from outside India to Indian customers on
principal-to-principal basis through Agents in India
– If the agent‟s commission fully represents the value of the profit
attributable to his service; it should prima facie extinguish the
assessment.
– This principle is now well established including by Supreme Court
in the case of Morgan Stanley
34
Indian scenario: Some key judicial precedents (1/2) Ad hoc Attribution – A few instances
• Taxability of trading profits where sale is concluded in India
- 10% of supply – Annamalis Timber 41 ITR 781 (Madras HC)
• Taxability of offshore supplies where PE played some role
- 20% of global profits – NETWORKS, OY : 96 TTJ 1 (Delhi ITAT, SB)
• Taxability of offshore supplies where PE was involved in marketing
activities
- 35% - marketing , 50% manufacturing, 15% R&D of Global profits.
Marketing done in India so 35% of global profits atttributable to PE in
India. – Rolls Royce (Delhi HC)
• Taxability of CRS activities where agency PE played marketing activities
- 15% of the total revenues - Galileo International Inc : 114 TTJ 289
(Del. ITAT)
• Taxability of back office operations where PE looks after operations and
marketing activities of overseas affiliates
- Global adjusted profits x India assets/Global assets : eFunds 42 SOT
165 (Delhi ITAT)
Indian scenario: Some key judicial precedents (2/2) Principles of Attribution - Legal Position
• Ahmedbhai Umarbhai & Co (1950) SCR 335
- Profit apportionment on the basis of business activities, manufacturing
profits taxable in the jurisdiction where manufacturing takes place
• Morgan Stanley (292 ITR 416) (SC)
- Profits attribution to PE based on functions assets and risks analysis
• Rolls Royce Singapore Pvt. Ltd (ITA No 1278/2010) dt August 30, 2011
- TP principles should be applied to determine profits attributable to PE
• Hyundai Heavy Industries : 291 ITR 482 (SC)
- Even if supply is considered to be integral part of installation, supply is not
attributable to PE because it is at arm‟s length; Direct billing to customer
represents arm‟s length
35
Enterprise
Residence State Source State
Art 5: Constitution of PE
Framework of OECD Model - Article 7
Article 7(1) - Charging provision
Article 7(2) - Basis of profit attribution
Article 7(3) - Elimination of double taxation
Article 7(4) - Limitation
Article 7(1) - Scope of taxation
Article 7(1): The profits of an enterprise of a Contracting State shall be taxable
only in that State unless the enterprise carries on business in the other
Contracting State through a permanent establishment situated therein. If the
enterprise carries on business as aforesaid, the profits that are attributable to the
permanent establishment in accordance with the provisions of paragraph 2 may
be taxed in that other State.
Key aspects:
• PE test for each source of income
• No guidance on how to interpret the term „profits of an enterprise‟
• Existence of PE must for attribution
• Business should be carried on
- Preparatory activities do not trigger attribution
• Only profits attributable to such PE is taxable in the source country
36
Article 7(2)
For the purposes of this Article and Article [23A] [23B], the profits that are attributable in each Contracting State to the permanent establishment referred to in paragraph 1 are the profits it might be expected to make, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the permanent establishment and through the other parts of the enterprise
Article 7(3)
Where, in accordance with paragraph 2, a Contracting State adjusts the profits that are attributable to a permanent establishment of an enterprise of one of the Contracting States and taxes accordingly profits of the enterprise that have been charged to tax in the other State, the other State shall, to the extent necessary to eliminate double taxation on theses profits, make an appropriate adjustment, the competent authorities of the Contracting states shall if necessary consult each other
37
Article 7(4)
Where profits include items of income which are dealt with
separately in other Articles of this Convention, then the
provisions of those Articles shall not be affected by the
provisions of this Article
Basic construct of India Tax Treaties
Article Key Provisions
Art 7(1)
Basic Rule
• Income Attributable to PE
• Force of Attraction Rule (if any) or Indirect attribution
Art 7(2)
Computation Hypothesis
As if PE is
• a distinct and independent enterprise
• engaged in same or similar activities
• under same or similar conditions
Art 7(3)
Expense Deduction
• Actual Expense incurred, incl. reasonable allocation of General & Admin Overheads
• Whether in source state or in HO state
• Subject to domestic law
• No deduction for HO payment (except reimbursement of actual expenses)
Others (varies from Treaty to Treaty)
• Applying Apportionment method in case of difficulty (reasonable)
• Methodology applied consistently Y-on-Y
• Exception (Purchase activity)
38
Authorized OECD Approach: An outline
Determining the profits
of a PE
Functional / factual analysis
to determine the Activities and
conditions of the PE
Step1: Hypothesising the PE as a distinct and
separate enterprise
Functions performed
Assets used
Risk assumed
Capital and funding
Recognition of dealings
Step 2: determining the profits of the PE
Comparability analysis
Applying transfer pricing
methods to attribute profits
The profits of an enterprise of a Contracting State shall be taxable only in that State
unless the enterprise carries on business in the other Contracting State through a
permanent establishment situated therein. If the enterprise carries on business as
aforesaid, the profits of the enterprise may be taxed in the other State but only so
much of them as is attributable to
(a) that permanent establishment;
(b) sales in that other State of goods or merchandise of the same or similar
kind as those sold through that permanent establishment; or
(c) other business activities carried on in that other State of the same or
similar kind as those effected through that permanent establishment
Force of Attraction Rule – UN MC
‘Force of attraction’ rule not present in OECD Model Convention
It is present in the US Model Convention
39
Example: Attribution of Profit – Force of Attraction
Outside India
PE sells garments manufactured by HO
HO
Customers in India
Customers in India
Direct sale of garments
by HO in India
Sale of pharmaceuticals
in India
Type 1 Force of Attraction
In India
PE
Example: Attribution of Profit – Force of Attraction
Outside India
Negotiation and conclusion of sale of
garments manufactured by HO
HO
Customers in India
Customers in India
Negotiating sale of
pharmaceuticals in India
Conclusion of sale of
pharmaceuticals
Type 2 Force of Attraction
In India
PE
40
Questions