Direct Tax Alert

Delhi Tax Tribunal rejects the concept of Virtual Service PE and emphasises on physical presence of employees in the Source state for the constitution of Service PE

BACKGROUND

One of the significant concepts in the international tax arena is that of a Permanent Establishment (PE) through which source countries can tax profits earned by non-resident entities from the business activities carried out by the non-resident in the source country. As per Article 5 of the Double Taxation Avoidance Agreement (DTAA) entered by India with other countries, a foreign enterprise would be considered to have a PE in India if it has a fixed place of business in India or carries out a business in India through Construction PE or Agency PE. Further, certain DTAAs also provide for a ‘Service PE’ which is established if (i) the non-resident provides services for a period longer than the prescribed threshold for instance 90 days (ii) the said services are provided in the source country through the employees or other personnel of the non-resident. Traditionally, a Service PE requires the physical presence of employees of the non-resident in the source country. However, with the advent of the digital economy, this understanding is being challenged as jurisdictions have started doing away with this requirement. For instance, Saudi Arabia, Israel and Kuwait have passed internal guidelines that suggest a non-resident would have a Service PE if it provides services, including consulting services, through employees or other personnel who are offshore and not physically present in the Source State.  

In this regard, recently the Delhi Tax Tribunal1 examined whether the condition of the physical presence of employees or other personnel of a foreign enterprise in India is necessary to constitute a Service PE as per Article 5(6)2 of India-Singapore DTAA or it will get attracted even if the services are provided remotely. We, at BDO in India, have summarised the ruling of the Delhi Tax Tribunal and provided our comments on the impact of this decision.

FACTS OF THE CASE
  • Taxpayer, a resident of Singapore is engaged in providing legal advisory services to several international clients including in India.
  • For the relevant years under consideration i.e. Fiscal Year (FY) 2019-20 and 2020-21, the taxpayer had entered into legal advisory contracts with the Indian clients. In FY 2019-20, part of the advisory services was rendered remotely outside India and there were situations when employees of the taxpayer travelled to India for a total period of 120 days which included their vacation period (36 days), days involving business development activities (35 days) and rendering of services to Indian clients. Further, common days (5 days) were excluded from the total number of days after which the total days for which the services were furnished in India remains to be 44 days. In FY 2020-21, the services were rendered remotely from outside India and no employees visited India for provision of services.
  • The taxpayer filed its return for Fiscal year (FY) 2019-20 and 2020-21 declaring Nil income and claiming credit of Tax Deducted at Source (TDS). Later, the taxpayer’s case was selected for scrutiny and notices were issued and served upon the taxpayer.
  • The taxpayer was issued a show cause notice as to why the receipts from rendering services to Indian clients be not taxed in India on account of the constitution of Service PE in India.
  • The Taxpayer filed submissions before the tax officer which were found untenable by the tax officer. Aggrieved, the taxpayer filed an objection with the Dispute Resolution Panel (DRP) which directed the tax officer to reconsider the submissions made by the taxpayer before passing the final assessment order. Tax officer passed a final assessment order holding that taxpayers constituted service PE in India based on the physical presence of employees in India and also virtual service PE. It observed that in terms of Article 5(6) of the India-Singapore DTAA what is important is the aggregate duration of provision of services by the non-resident within India and Singapore and the duration of the physical presence of the employees in India is not material.
  • Aggrieved, the taxpayer filed an appeal before the Delhi Tax Tribunal.
DELHI TAX TRIBUNAL RULING
The Delhi Tax Tribunal made the following observations while ruling in favour of the taxpayer:
  • As per Article 5(6) of the India-Singapore DTAA, the following conditions need to be cumulatively satisfied for the constitution of a service PE in India:
    • Employees or other personnel of the taxpayer should be present in India;
    • There should be furnishing of services within India through employees or other personnel of such taxpayers; and
    • Furnishing services should continue for a period exceeding 90 days in an FY or 30 days in an FY when such services are rendered to related enterprises.
  • As per Article 7 of the India-Singapore DTAA, the profits of the taxpayer (not falling within the purview of any other Article dealing with a specific item of income i.e. Fees for technical service) can be taxed in India only if the business is carried out through a PE situated in India. It is an undisputed fact that for relevant years under consideration, the taxpayer had no office/fixed place of business in India in the relevant FY and is governed by the beneficial provisions of the India-Singapore DTAA.
  • Thus, applying the provisions of Article 5(6)(a) of the India-Singapore DTAA to the present case, in order to constitute a service PE, the actual performance of service in India is essential and accordingly only when services are rendered by employees within India with their physical presence during the FY shall be taken into account for computing threshold limit for the creation of service PE of a taxpayer in India. The Supreme Court in the case of E-Funds IT Solutions Inc.3 held that the requirement of service PE is that services must be furnished “within India”.  
  • It is an undisputed fact that for FY 2019-20, services have been furnished by taxpayers only for 44 days. This excludes the vacation period for which reliance is placed on the Mumbai Tax Tribunal ruling in the case of Linklaters LLP4. Further, to arrive at the threshold, business development days as well as common days comprising 35 and 5 days respectively are also to be excluded as no services were provided to customers in India on business development days and computation of the threshold should not be based on man-days by aggregating common days spent by more than one individual.  Accordingly, the taxpayer does not constitute service PE in India as per India-Singapore DTAA.
  • So far as FY 2020-21 is concerned, physical rendition of services in India beyond the threshold period is a prerequisite for the creation of service PE and as none of the employees of the taxpayer were physically present in India, the taxpayer does not constitute service PE in India as per India-Singapore DTAA.
  • With respect to tax authorities’ contention that the taxpayer constituted virtual service PE in India for both FYs, the findings of the tax authorities are not based on correct appreciation of facts and understandings of law enshrined in Article 5(6)(a) of the India-Singapore DTAA. For this purpose, the reliance placed by tax authorities:
    • on Bangalore Tax Tribunal ruling in the case of ABB FZ LLC5 is misplaced as the facts of ABB FZ LLC and the present case are different. In ABB FZ LLC, the main issue pertains to the taxability of fees for technical service (FTS) in India when India-UAE DTAA does not contain an Article for taxation of FTS.
    • on OECD Interim Report (2018) which focuses on the concept of virtual service PE wherein the requirement of physical presence is no longer relevant for the application of service PE. However, this view has been officially endorsed in Saudi Arabia only but not in India. The taxpayer does not constitute virtual service PE in India as no provision regarding the establishment of virtual service PE is mentioned under India-Singapore DTAA. Hence, the present service PE provision requiring physical rendition of service in India should only be applied. This view is supported by the OECD Interim Report 2018 itself since it mentions that in the absence of any amendments to the DTAA provisions, the measures suggested in the report can be challenged by the taxpayers before the courts.     
BDO IN INDIA COMMENTS

This is a welcome ruling for the taxpayer as it brings clarity and certainty on service PE concept. The ruling has touched upon several concepts paramount being the rejection of tax authorities view on ‘virtual service PE’ based on OECD Interim Report. Apart from this, the ruling has also clarified that vacation days, business development visits and common days are to be excluded for the purposes of duration test for determining whether the taxpayer had a PE in India. It is pertinent to note that Virtual PE is an ongoing question and not restricted to COVID-19 pandemic.  In this era of digital age, more and more businesses are looking at remote service rendering and is therefore critical. This ruling is likely to be tested in higher courts and therefore taxpayers should factor potential litigation on this aspect before different tax authorities. Hence it is important that adequate professional advice is taken and necessary contemporaneous documentation is maintained.

1 Clifford Chance PTE Ltd Vs ACIT SA No. 437/Del/2023 (Delhi Tax Tribunal)
2 As per Article 5(6) of the India-Singapore DTAA, where any enterprise provides services in any contracting state through its employees or other personnel for a period aggregating more than 90 days in any FY, it shall constitute to have a Service PE in such state.
3 ADIT, New Delhi vs M/s E-Funds IT Solution Inc. Civil Appeal No. 6082 of 2015 (Supreme Court)
4 Linklaters LLP vs. DDIT 106 taxmann.com 195 (Mumbai Tax Tribunal)
5 ABB FZ LLC 83 taxmann.com 86 (Bangalore Tax Tribunal)