The US and Indian competent authorities are famously at loggerheads over the principles to be applied in transfer-pricing double tax cases. Some of the important issues involved are:
- the appropriate mark-up on costs for services;
- when and how to reward location savings; and
- whether marketing intangibles exist.
Virtually all of these double tax cases involve a US parent company, its Indian subsidiary and a transfer pricing adjustment made by the Indian Revenue Service. In recent months, the two competent authorities have been in discussions to establish mutually agreeable principles for resolving the disputes.
However, transfer pricing is not the only issue on the table. Many current competent authority cases involve the Indian Revenue Service's assertion that a US parent has a permanent establishment in India and that substantial profits should be attributed to that permanent establishment. Undoubtedly, the US competent authority is seeking to establish principles for resolving permanent establishment cases as well, and was recently given a boost by the Delhi High Court's taxpayer-favourable decision in the e-Funds case (TS-63-HC-2014 (DEL)).
This update discusses the constructive permanent establishment principles laid down by the e-Funds court. However, Indian permanent establishment risk remains high, and this update suggests some concrete steps for mitigating that risk.
The US parent (e-Funds Corp) and its indirect US subsidiary (e-Funds, Inc) conducted an electronic payments business and engaged their Indian affiliate (e-Funds India) to perform back-office and data-entry services. In a comprehensive and articulate analysis, the court drew on the holding of the Indian Supreme Court in the Morgan Stanley case and addressed all three kinds of potential permanent establishments – fixed place of business, services and agency – and resolved them in a manner consistent with international norms. The court found that neither of the US companies (together, the 'assessees') had a permanent establishment in India under the terms of the US-India Treaty. The court laid out principles for making that determination.
The court found that the mere existence of an Indian subsidiary does not create an Indian permanent establishment of a US parent. Conversely, the fact that an Indian subsidiary exists does not preclude a finding that the US parent has a permanent establishment.
The court also held that a US parent will have a fixed place of business permanent establishment (under Article 5(1) of the treaty) only if the US parent has the right to use a location in India (eg, an Indian subsidiary's facilities) and in fact carries out activities at that location on a regular basis:
"None of the authorities including the tribunal have held that the two assessee[s] had right to use any of the premises belonging to e-Fund India… In the absence of any such finding Article 5(1) cannot be invoked and applied."
The mere existence of a contract for services between the US parent and the Indian subsidiary does not create a fixed place of business permanent establishment of the US parent. In addition, the US parent's access to an Indian location on the Article 5(2) list (eg, place of management, branch, office or factory) does not necessarily create a permanent establishment. The requirements of Article 5(1) must first be satisfied.
The court also found that the following factors are not relevant to a fixed place of business permanent establishment analysis:
- "The fact that e-Fund India provides various services to the assessee and was dependent for its earnings upon the two assessees is not the relevant test to determine and decide location PE."
- "The fact that e-Fund India did not bear sufficient risk is irrelevant when deciding whether location PE exists."
- "The fact that e-Fund India was reimbursed the cost of the call centre operations plus 16%... is not relevant for determining location or fixed place PE."
- "Neither provision of any software, intangible data, etc. whether free of cost or otherwise, makes e-Funds India an agency or fixed place PE of the two foreign assessees."
- The "existence of [a] PE does not depend upon transfer of assignment or sub-contracting work/services to India, with an intent and purpose to save costs and to increase profitability of the assessee resident abroad".
- The "contention and finding recorded that e-Fund India had provided necessary input or information to e-Fund Corp or e-Fund Inc. to enable them to enter into contracts which were sub-contracted or assigned to e-Fund India, will not make e-Fund India a permanent establishment of the assessee".
- A services permanent establishment (Article 5(2)(l)) exists if the US parent's "employees or other personnel" only perform services in India. The employees of the Indian subsidiary are not automatically the US parent's "other personnel".
- Where the US parent seconded employees to the Indian subsidiary, no permanent establishment exists if the employees' activities are stewardship in nature: "merely because the non-resident assessee[s] to protect their interest, for ensuring quality and confidentiality has sent its employees to provide stewardship services, will not make the Indian subsidiary or another entity, a PE of the non-resident company."
The court also indicated – although it was not necessary to its opinion because of the particular facts of the case – that no permanent establishment exists if the seconded employees are controlled by and engaged in activities that are the business of the subsidiary, and not the US parent.
If the Indian activities of an enterprise are limited to the 'preparatory or auxiliary' activities described in Article 5(3), there is no permanent establishment, even if the permanent establishment requirements of Article 5(1) and (2) have been met: "Paragraph 3… does not create a PE but has a negative connotation and activities specified when carried on do not create a PE."
The US-Indian Treaty includes two agency permanent establishment provisions:
- Article 5(4) (based on the Organisation for Economic Cooperation and Development (OECD) model) is the typical dependent agent permanent establishment provision, which the court found not to exist in the e-Funds case:
- "It is not the case of the Revenue that e-Funds India was authorized and habitually exercised authority to 'conclude' contract."
- A dependent agent permanent establishment is not created merely because a US parent assigns or sub-contracts services to its Indian subsidiary.
- Article 5(5) (based on the UN Model Treaty) states that an otherwise independent agent can become a permanent establishment if the agent's activities are both "wholly or mostly wholly on behalf of foreign enterprise and the transactions between the two are not made under arm's length conditions". The e-Funds court found no such relationship to exist because there was no dispute that the transactions were made under arm's-length conditions.
Although the Delhi High Court gave e-Funds a resounding win, the outcome would likely have been different if the court had found some of the following facts, which were either not substantiated by the assessing officer or found not to be present in the e-Funds case:
- The US parent's employees made regular use of the Indian subsidiary's facilities.
- The US parent's non-seconded employees and other personnel performed services in India, either for the US parent or for the Indian subsidiary.
- Employees seconded from the US parent to the Indian subsidiary performed non-stewardship activities and were under the control of or compensated by the US parent.
- Employees of the Indian subsidiary managed operations outside of India (eg, in the United Kingdom), which might have supported a place of management permanent establishment assertion.
- The Indian subsidiary had and habitually exercised authority to enter into contracts on behalf of the US parent.
- The Indian subsidiary acted wholly or mostly on behalf of the US parent, and inter-company transactions were not priced at arm's length.
The court's wide-ranging opinion summarised numerous other fact scenarios that might have led to a permanent establishment determination. Thus, permanent establishment determinations in India remain highly fact intensive and subjective.
In addition, the court's opinion left doubts about some key questions:
- When, under Article 5(5), will the activities of an agent for a foreign enterprise be treated as "devoted wholly or almost wholly on behalf of that enterprise"?
- What standards and whose views are applied in determining whether the transactions are priced at arm's length?
- What quantum of non-stewardship activities of employees seconded from the US parent to the Indian subsidiary is sufficient to create a permanent establishment, and how is the pertinent control test evaluated?
The e-Funds decision thus highlights the need for continued diligence on the permanent establishment front. In that regard, the following practices could be helpful in mitigating permanent establishment risk in India and elsewhere.
Know local law
The e-Funds court found that the US parent would have been taxable under local law, but that the US treaty trumped the local law. Where a US treaty is not available, local law will provide the rule and be determinative.
Set up and maintain consistent corporate governance
From board resolutions to invoicing, all documentation should be consistent with the chosen form for the local presence. The separate legal status of the local entity must be established and preserved. The entity must be functionally independent and adequately capitalised. Its documented and observed assets and risks must be consistent with the chosen structure. In addition, personnel should be made aware of the chosen structure, and operate within that framework. Furthermore, it is important to decide whether employees should receive regular training on the permanent establishment risk, and how that training should be provided to avoid simple mistakes.
Get transfer pricing right
This is a good practice in itself, but also helps to mitigate permanent establishment risk. Under the special terms of Article 5(5) of the US-Indian Treaty, getting the transfer pricing right will ensure that there is no independent agency permanent establishment. Article 5(5) may reflect that non-arm's-length transfer pricing, if significant, calls into question whether the subsidiary has the substance (ie, wherewithal) to fund its own operation. From a practical standpoint, getting the transfer pricing wrong makes a permanent establishment assertion more likely as an alternate assessment for achieving the total local income that the tax authority believes is appropriate. Getting the transfer pricing right, on the other hand, may limit the damage if a (services) permanent establishment is found to exist. In the Morgan Stanley case, the Indian Supreme Court concluded that arm's-length transfer pricing may fully compensate both the Indian subsidiary and any agency permanent establishment that it creates for the foreign parent.
Avoid creating a fixed place of business
In the e-Funds case, the US parent had no fixed place of business in India. However, it is easy to create a fixed place if there is an office set aside at the subsidiary for use by foreign visitors or if the foreign company regularly rents hotel or apartment rooms on a long-term basis. It is essential for the foreign party to avoid taking actions, intentionally or unintentionally, that could be found to create a fixed place of operations within India.
Decide whether a permanent establishment is unavoidable
If the local operation is highly integrated with one or more US or other foreign operations, is a permanent establishment avoidable? If not, it may be preferable simply to admit a permanent establishment exists and report it accordingly. This ensures that the taxpayer will have good books and records to demonstrate the income attributable to the permanent establishment. In addition, a permanent establishment filing should help to mitigate the local penalties for non-filing (eg, loss of deductions, penalties, interest and confrontational posture with tax authority), and may reduce the tax authority's incentive to make transfer pricing assessments on the local subsidiary.
The e-Funds case is undoubtedly a step in the right direction for Indian permanent establishment risk. The court referred to and relied on relevant OECD and UN commentary, as well as secondary sources, and reached the right conclusions. However, it is only one court. The Indian Revenue Service is likely to continue searching for permanent establishment issues, and those issues are likely to remain a major sticking point in the US-India competent authority relationship.
For further information on this topic please contact Patricia Lewis, J Clark Armitage or Peter A Barnes at Caplin & Drysdale, Chartered by telephone (+1 202 862 5000), fax (+1 202 429 3301) or email (firstname.lastname@example.org, email@example.com or firstname.lastname@example.org). The Caplin & Drysdale website can be accessed at www.caplindrysdale.com.