- A fixed base PE is only created where the foreign entity has a location with a degree of permanence, at its disposal, through which it conducts its business;
- Employees who are de jure and de facto employed by the Indian subsidiary cannot be considered ‘other personnel’ of the foreign enterprise for service PE purposes;
- An agency PE is created only if the agent is bound to follow instructions and is personally dependent on the enterprise it represents;
- MAP procedure and agreement are relevant, but cannot be primary basis for determination of a PE.
In a landmark decision, the High Court of Delhi (“High Court”), in e-Funds Corporation v. DIT1 has exhaustively laid down first principles in relation to the determination of a Permanent Establishment (“PE”). While these principles have been internationally accepted by the Organization for Economic Co-operation and Development (“OECD”) and the like and reiterated by several benches of the Income Tax Appellate Tribunal (“Tribunal”), this is one of the first High Court rulings where determination of a PE has been dealt with in a clear and comprehensive manner.
E-Funds Corporation (“E-Funds US”) is a company incorporated in the United States of America (“US”) and part of a group which is engaged in the business of electronic payments, ATM management service, decision support & risk management and similar professional service. The group structure as relevant to the ruling is provided below:
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E-Funds US and its group company, e-Funds IT Solutions Group Inc. (“E-Funds IT US”) entered into contracts with their clients for the provision of Information Technology (“IT”) enabled services. These contracts were either assigned or sub-contracted to e-Funds International India Private Limited (“E-Funds India”) for execution. The Assessing Officer (“AO”), relying upon the Functions, Assets and Risks Analysis (“FAR Analysis”) performed in relation to E-Funds US and E-Funds India, observed that:
- E-Funds US allowed E-Funds India to use its technology and infrastructure for provision of IT enabled services for free;
- E-Funds US undertook even marketing activities for the E-Funds India and the latter did not bear any significant risks in the overall services;
In light of this, the AO concluded that:
- E-Funds India was an agent of E-Funds US and E-Funds IT US that was not remunerated at arm’s length and thus, that E-Funds India constituted a PE of E-Funds US and E-Funds IT US in India.
- The AO ruled that a part of the income of E-Funds India was to be taxed in India as income attributable to E-Funds US and E-Funds IT US.
This view was upheld by the Commissioner of Income Tax (Appeals) (“CIT(A)”) and the Tribunal on appeal. Aggrieved by the ruling, E-Funds preferred an appeal before the High Court.
A number of questions were raised in the course of the proceedings and some of the key questions contained the judgment of the High Court are provided below.
RULING OF THE COURT
The High Court, after hearing all contentions put forth by the parties, arrived at the following conclusions:
Subsidiary as PE: The High Court has relied on Article 5(6) of the Double Taxation Avoidance Agreement between India and the US (“India-US DTAA”) to uphold the internationally accepted rule that a subsidiary or parent company of the foreign company carrying on business in the source State does not by itself create a PE in the source State. However, the Court held that a PE would be created if the entity in the source State fulfills the criteria for a PE prescribed in Article 5 of the India-US DTAA.
Determination of PE: The following are some of the key observations made by the High Court:
- The High Court observed that a fixed base PE is constituted only when three tests are satisfied:
- The physical test:
- The foreign entity should have a physical premise in India at its disposal. Such physical place includes not just immovable property but also in certain instances, machinery, equipment etc.
- The location/duration test:
There must be a degree of permanence or the physical presence in India must be of an enduring nature and not temporary.
- The functionality/business activity test:
The foreign enterprise must conduct its own business through such fixed base or premise. The High Court concluded that the functionality test implies that the foreign entity should have the right to use the fixed place and control it as per its liberty for the conduct of its business, whether such right to use is legalized in the form of documentation or inferred from the facts.2
- In the present case, since neither E-Funds US nor E-Funds IT US had a physical premise in India at its disposal or control over use of E-Funds India’s premises for its business, the High Court arrived at the conclusion that no fixed base PE was created. While holding so, the High Court also held that relying solely on the FAR Analysis without analyzing the aforementioned three tests is not an appropriate means to determining existence of a fixed base PE.
- There is a controversy as to whether as to whether the criteria provided in Article 5(1) need to be satisfied for the creation of specific PEs provide in Article 5(2) such as a building/construction site/assembly project PE. Although the High Court did not provide an affirmative view on the specific issue, the High Court expressed its support to the global view that the criteria provided under Article 5(1) need to be satisfied for any sort of fixed place PE and that the items in Article 5(2) are merely examples.3 However, the High Court has dealt with service PE separately and has made an observation that Article 5(2)(k) also provides for a type of service PE.
- The Tribunal had taken the view that E-funds US and E-funds IT US created a service PE in India. The High Court upheld the view that as long as employees are de facto and de jure employees of the subsidiary in the source State, they cannot be held to constitute ‘other personnel’ of the foreign entity. However, with respect to employee deputation, the High Court, relying on the Supreme Court’s view in Morgan Stanley4, held that where no service PE can be created by employees performing stewardship activities, the nature and functions performed by the employees along with the nature of their control and supervision by each entity need to be examined in respect of furnishing of other services.
Since the employees of e-Fund India are not to be counted and treated as employees of the assessees; e-Fund India being a separate entity and taxable assessee and the employees being de jure and de facto employed with e-Fund India, the High Court held that no service PE was created in the present case.
- The High Court observed that Article 5(3) provides for an exclusionary list by which if activities are covered under Article 5(3), a PE under Articles 5(1) or (2) cannot be constituted. The High Court laid down in categorical terms that Article 5(3) does not operate in such a manner that a fixed base PE would necessarily be created if the activities do not fall within the ambit of Article 5(3).
- The Tribunal had also taken the view that E-Funds and E-Funds IT US had created a dependent agent PE in India. The High Court ruled that an agency PE is created in a situation where a representative of the foreign entity acts on its behalf in the source State, is bound to follow instructions and is personally dependent on the enterprise it represents. Based on the view taken by Arvid Skaar is in his writings, the High Court concluded that the dependency of an agent is generally proven by the fact that business interest of the principal and the agent have merged. Since the OECD Model Convention does not accept dependency based on financial support, supply of patents etc., interdependence at both a legal and economic level must exist for a person to be a dependent agent. Further, one of the conditions prescribed under the provision such as habitual conclusion of contracts, securing of orders etc. on behalf of the foreign entity needs to be satisfied.
In the present case, since e-Funds India was not authorized to habitually conclude contracts on behalf of e-Funds or e-Funds IT, the High Court held that a dependent agent PE was not constituted.
Mutual Agreement Procedure: In the present case, the competent authorities of India and the US had initiated MAP proceedings and had entered into an agreement as to attribution of profits between E-Funds US and E-Funds IT US in case a PE is created. The tax authorities had contended that the PE issue stood determined owing to India and US resorting to the MAP agreement as to attribution of profits under Article 27 of the India-US DTAA. The High Court held that although the MAP procedure and agreement are relevant, they can be in no way the primary basis for determination of a PE. The High Court concluded that MAP proceedings had been initiated on a without prejudice basis and that the existence of a PE is a question of law and that it needs to be determined purely on merits.
Attribution of Profits: Coming to attribution of profits to a PE, the High Court re-iterated the principle laid down in Morgan Stanley5 that where a PE is held to exist, subject to application of the force of attraction rule, only profits in relation to the assets and activities of the PE may be attributed to it and that an arm’s length payment to a subsidiary PE as per FAR Analysis would be sufficient for such attribution.
In a landmark ruling on the subject, the High Court has taken a well-considered view on the concept of a PE and has after a comprehensive analysis of international tax jurisprudence and the global position, prescribed exhaustive criteria that need to be fulfilled for a PE to be constituted in India.
The High Court’s observations on the issue of determination of a fixed base PE may be considered well needed guidance on the issue. Although the Tribunal and the Authority for Advance Rulings on certain occasions have upheld the three tests required under the OECD Model Convention and commentary for the creation of a fixed base PE, since no High Court or the Supreme Court had upheld the same till the present decision, the tax authorities have almost never applied these tests while determining a PE during assessment proceedings. It is pertinent to note that certain rulings, even at Tribunal level, have failed to consider these criteria. For instance, the Delhi bench of the Tribunal in Convergys Customer Management Group Inc. v. ADIT6 had applied a risk based approach based on a FAR analysis for determination of a fixed base PE as opposed to application of these tests. This decision provides much awaited surety on the position and has prescribed the fulfillment of the physical, location/duration and business activity tests as the litmus test for determination of a fixed base PE.
However, although the High Court has taken the view that all location based PEs in Article 5(2) need to fulfill the criteria under Article 5(1), the High Court has dealt with service PE separately and has held that in addition the service PE provision in Article 5(2)(l), Article 5(2)(k) also provides for a type of service PE. This may be indicative of the view adopted by the High Court that supervisory services in relation to a building site/construction or assembly project may on a stand-alone basis be considered a service PE if the time period requirement is satisfied.
On the issue of basic service PEs, the High Court has followed settled law laid out by the Supreme Court on service PE implications arising on deputation on employees. Moreover, the observations of the High Court stating that de facto and de jure employees of an Indian subsidiary cannot be considered ‘other personnel’ of the foreign entity and that supervision and control over the employees is the most important test for determining service PE implications may be helpful in a situation where employees are seconded by a foreign entity to its Indian associated enterprise. Therefore, this may be relied upon to take the view that seconded employees of the foreign entity who take up employment with the Indian entity during their period of secondment and who act under the supervision and control of the Indian entity do not create a service PE in India.
Finally, the High Court’s detailed observations on when an agency PE is created, when the exclusionary list under Article 5(3) becomes applicable, attribution to PEs and the basis of the MAP procedure give much needed clarity on areas which were ambiguous till date owing to lack of clear judicial positioning on the same.
All in all, the judiciary in India continues to give hope in an uncertain tax environment and the decision of the High Court gives much welcomed clarity to several taxpayers who have faced absurd assessment orders containing findings as to existence of a PE. One can only hope that the attitude of the tax authorities in the future towards PE determination would stand influenced by the principles laid down in the decision.