1

CONCEPT OF PERMANENT ESTABLISHMENT AND BUSINESS PROFITS

ICAI

BANGALORE

JUNE 5, 2015

RANI N R

gananth.co@gmail.com

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.

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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

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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

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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.

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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

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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)

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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” ?

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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

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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

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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) ?

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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

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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

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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.

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• 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.

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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

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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

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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.

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• 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

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• 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.

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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.

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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

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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)

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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.

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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.

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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”

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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

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• 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

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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

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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

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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.

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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

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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

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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.”

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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

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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

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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)

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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

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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