Direct Tax Alert

BACKGROUND

Generally, business receipts (with some exceptions) of a Foreign Company are taxable in India only if the Foreign Company has a Permanent Establishment (PE) or Business Connection in India. The term PE is defined in the Double Tax Avoidance Agreement (DTAA). The most common forms of PE are Fixed Place PE, Service PE and Dependent Agent PE. Most of the time, a foreign company sets up a subsidiary in India for various commercial reasons. While most of the DTAAs provide that mere controlling of a company would not result in a foreign company having a PE, considering the closeness between both the holding and subsidiary company, a question may arise as to whether there will be a fixed place PE or agency PE or service PE. In this regard, recently, the Delhi High Court¹ had an opportunity to examine whether a wholly owned subsidiary can constitute a PE in terms of Article 5 of the India-USA DTAA.

We, at BDO in India, have summarised this ruling and provided our comments on the impact of this decision hereunder: 

FACTS OF THE CASE

• The taxpayer, a foreign company registered in the United States of America, is engaged in the manufacturing of rolling stock, infrastructure solutions and providing solutions and technologies to rail customers across the globe. The taxpayer is also engaged in supplying equipment directly to the Indian Railways and to Diesel Locomotive Works (DLW), Varanasi. These supplies are effected by way of imports which are made directly to the Indian Railways against Bills of Entries.

• The taxpayer had a registered office in Delhi and had been allotted a Permanent Account Number (PAN). Since no income accrued or arose in India, it did not file a tax return in India.

• The taxpayer has a wholly owned subsidiary in India (ICO) which has a manufacturing unit in Noida and an office in Varanasi. In Fiscal Year (FY) 2021-22, the Noida plant was shut down and the manufacturing facility was shifted to Hubli in Karnataka.

• ICO is engaged in the provision of support services to taxpayers on which it is remunerated on a cost-plus basis. ICO provides back-office support and technical support services like monitoring the Indian market for upcoming tenders and participating in tender meetings to provide technical support and coordination with regard to the locomotives and spare parts/ components etc. directly purchased by Indian Railways from the taxpayer.

• Basis the survey conducted at the premise of ICO on 6 March 2019, it was alleged that the Noida office was liable to be viewed as a Fixed Place PE/ Service PE/ Dependent Agent PE (DAPE) and therefore income attributable to the PE was liable to be taxed under the IT Act. On the basis of the survey report, the tax officer proposed to reopen the taxpayer’s assessment under section 147/148 of the IT Act.

• Aggrieved, the taxpayer, filed a writ petition to quash the notices issued without jurisdiction.

• The Delhi High Court (Delhi HC) granted a stay on the proceedings pursuant to section 148 of the IT Act until disposal of the writ petition. However, Delhi HC reopened the hearing in order to apprise the taxpayer of some of the issues emanating from the jurisdiction of the tax officer.

DELHI HC RULING

The Delhi High Court, while quashing the reassessment proceedings and holding that the taxpayer doesn’t have a PE in India, made the following observations:

Re. Jurisdiction of respondent 1

• Notification dated 3 November 2014 broadly distributes the territorial areas amongst the Commissioners of Income-tax. The distribution is made on an area/regional basis. However, the very same Notification proceeds to empower the Commissioners, Assistant Commissioner and Joint Commissioner of Income-tax to further delegate their powers of assessment to officers’ subordinate to them.

• Undisputedly insofar as respondent 1 is concerned, it could have derived authority to assess the taxpayer or to subject it to proceedings under the IT Act, only if it had come to conclude that the taxpayer had a PE within the jurisdiction of respondent 1.

• The decision of respondent 1 on the issue of PE emerges as being not only the central point of contestation but also of significant import since the very foundation of the reassessment action rests on the correctness of the view as taken by respondent 1.

Re. Service PE

• Article 5(2)(l)² of the India-USA DTAA enumerates the conditions which if found to exist would lead to the creation of a Service PE. A Service PE would come into existence when a foreign enterprise performs or provides services to a related enterprise in the other State through employees or other personnel.

• In order to constitute a service PE, the employees of the taxpayer visiting India should discharge functions in connection with the business of the Indian entity. The tax authorities have not placed any material to indicate that the taxpayer is rendering services in favour of the wholly-owned Indian subsidiary.

• The visit of employees of the taxpayer, their interaction with employees of the ICo, and discussion on subjects of mutual concern or interest is not the rendering of a service. Such forays are principally concerned with sharing of best practices, experiences and problem-solving. It cannot possibly be understood to constitute the rendering of a service.

• The periodic visits of employees of the taxpayer to India were at best liable to be recognised as an extension of the right of the holding company to oversee India operations and exercise broad managerial oversight. These are, as some authors have chosen to describe, “normal management contributions”

Re. Fixed Place PE

• In the reasons set out for initiating action under Sections 147/148 of the IT Act, the tax authorities failed to establish that any part of the Noida or Varanasi premises was set apart or exclusively placed in and under the control of the taxpayer for use of its business activities.

• The concept of virtual projection is concerned with a functional integration between the two units, which would mean an establishment which has been virtually used for all purposes to carry out the paramount business activity of the taxpayer. None of these factors are either alluded to or appear to have been borne in consideration before arriving at the conclusion that the ICo constituted a Fixed Place PE.  

• No evidence is submitted by the tax authorities to satisfy the PE tests of stability, productivity and dependence as observed by the Hon’ble Supreme Court in Formula One World Championship Limited and the “at the disposal of” test.

• The Noida factory premises and the Varanasi office would clearly not fall under any of the categories which stand specifically enumerated in Article 5(2) and sub-clauses (a) to (k)³ of the India-USA DTAA.

• Further, the taxpayer and the Indian subsidiary were engaged in the manufacture of distinct and divergent categories of products.

• The Noida office undertook manufacturing activity in its own right and supplied products to various arms of the Indian Railways. It is pertinent to note that the tax authorities did not allege that the products being supplied by the taxpayer to DLW or other arms of the Indian Railways were being manufactured in India and through the Indian subsidiary. This factor weighs heavily against the tax authorities.

• Reliance was placed on various judicial pronouncements⁴

Re. Preparatory and auxiliary activities

• Both entities do not appear to have been established with a commonality of general purpose. The expression “preparatory” has been understood to mean work which is undertaken in contemplation of the essential and significant part of the principal activity of an entity. The principal or for that matter the essential activity of the taxpayer is the manufacture and production of goods needed by railroad companies. The principal activity is concerned with the core business activity of the taxpayer. That has clearly not been shown to have been undertaken at the Noida premises.

• The employees of ICo have discharged a dual role in keeping track of supplies made by both the ICo as well as the taxpayer overseeing the timeframes for the supply of goods and articles, as also following up on any rejections or modifications which may have been made by the procurers.

• Following up on purchase orders or gathering information with respect to tenders is work which is clearly of an “auxiliary” or “preparatory” character or concerned with the supply or collection of information. The follow-up functions, though not asserted to have been discharged with sufficient repetition or recurrence, would fall more in the ken of an “auxiliary” function as opposed to a core business function.

• Engagement of Indian personnel in connection with global tenders that were proposed to be submitted or one in which the taxpayer intended to participate would also clearly fall within the ambit of work of an “auxiliary” or “preparatory” character and not be in furtherance of the core activity of the taxpayer.

• Merely because the submission of tenders was aided by a collaborative exercise between the employees of the taxpayer and those of ICo, the same would clearly not meet the test of a complete takeover, a “virtual projection” or for that matter, the ICo being liable to be viewed as an “alter ego”.

• Tracking of letters of credit for shipments, monitoring of upcoming tenders, coordinating with the taxpayer for timely bid submission for tenders in the Indian market, and gathering technical details, these are all services rendered which would fall under the larger umbrella of “preparatory” and “auxiliary” services.

• Further, an employee of the Indian subsidiary reporting to foreign personnel is essentially to ensure compliance with the global best practices of group companies. The performance evaluation of the Indian employees is undertaken by functional heads present in India and is based on feedback received from foreign managers. This too is indicative of administrative control of the employees of the Indian subsidiary resting in the hands of the management situated in India.

• The mere fact that the parent company places representatives on the Board of its wholly owned subsidiary cannot hold that a PE has come into existence.

• The inputs that were received from the Indian design team were not specifically shown to be in respect of products or goods supplied to Indian Railways. Collaboration between the constituents of the independently employed industrial engineers or designers has not been established to be in connection with an India project but pertained to contracts and tenders in Congo and other African nations as well as Bangladesh. Therefore, it cannot be said that income has accrued or arisen in India.

• A collaborative team comprising Indian and foreign employees would not be indicative of the Noida or Varanasi premises having been virtually placed fully at the disposal of the taxpayer.

• A group of companies may well engage in discussions at different levels so as to evolve a marketing strategy or identify a research output with respect to future prospects. That, however, cannot be viewed as being sufficient to hold that the ICo attains the character of a PE. The exchange and collaboration between entities forming part of a larger conglomerate would clearly be intended towards subserving the growth of the group as a whole and could relate to not only operations in India but also to any market in the globe in which the taxpayer may have a footprint.

Re. DAPE

• In order to fall within the scope of Article 5(4)⁵ of the India-USA DTAA, the Indian subsidiary should be conferred with the authority to conclude contracts and it should be habitually engaged in acting in the discharge of that authority.

• The issue of a habitual or recurrent exercise of authority does not arise at all since we have already found that an “authority to conclude contracts” never stood conferred.

• ICo had independent transactions with DLW and other Indian Railway entities. It was thus not a mere arm or an extension of the taxpayer established to secure orders on its behalf and that too “wholly or almost wholly” for it.

• Respondent 1 fails to bear in mind that most of the functions so discharged by the Indian subsidiary were relatable to the agreements which formed part of the transfer pricing study. This, in our considered opinion, would have been sufficient to discharge any presumption of a PE that the said respondent had harboured. This is more so since not only did the Transfer Pricing Officer harbour no doubts in respect of those transactions having been undertaken at arm‘s length, but it also had additionally accepted the assertion of the taxpayer that those were mere back office operations.

BDO IN INDIA COMMENTS

The establishment of PE has always been a vexed issue. In order to have uniformity across all offices, many multinationals have set guidelines. Many a time, a Foreign Company sets up its base (in the form of an India Company) in India on various business considerations. However, tax officers try to consider such a subsidiary to amount to the PE of a foreign taxpayer (or non-resident taxpayer). This has led to litigation with the tax officer. This Ruling will help all such Indian Companies where the tax officer has sought to treat it as PE of the parent entity. Delhi HC has looked into all three aspects – Fixed Place PE, Services PE and DAPE. It is also pertinent to note that the Delhi HC has put reliance on the order passed by the Transfer Pricing Officer.