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India Tax & Regulatory For private circulation only

International Tax Alert

Volume: ITX/2/2014 9 February 2014

Indian entity or its employees providing back office operations did not create PE for offshore entity
Synopsis
The Delhi High Court (Delhi HC) in its judgment dated 5 February 2014 analyzed the provisions of Article 5 dealing with Permanent Establishment (PE) and considering the facts of case held that neither the Indian entity nor its employees who provided back office operations create a PE for the foreign entity in India. The judgment has comprehensively explained situations that could create a PE for a foreign entity in India and has also thrown some light on attribution of profits.

Facts
e-Fund Corporation, USA (e-Fund Corp.) and e-Fund IT Solutions Group Inc., USA (e-Fund Inc.) (collectively referred to as taxpayer/s) were incorporated under the laws of the USA and were tax residents of the USA. e-Fund International India Private Ltd., India (e-Fund India) was a company incorporated in India and a resident of India. e-Fund Inc. and e-Fund India were wholly owned indirect subsidiaries of e-Fund Corp. The taxpayers had four main business lines, namely (a) Electronic Payments; (b) ATM Management Service; (c) Decision support and risk management; and (d) Professional Services. e-Fund India had performed back office operations in respect of the first three. This included data entry operations etc. in respect of Decision Support and risk management. e-Fund India was remunerated for the services rendered to the taxpayers. The international transactions between the taxpayers and e-Fund India and the income of e-Fund India were made the subject matter of arms length pricing by the tax authorities.

The Mutual Agreement Procedure (MAP) under Article 27 of the India-US tax treaty was resorted to in the case of e-Fund Corp. for the AY 2003- 04 and in the case of e-Fund Inc. for the AYs 2003-04 and 2004-05. These AYs are not under consideration by the present HC decision.

As per the terms of the MAP, the Competent Authorities agreed on a basis for attributing income in relation to Indian operations. The letter issued by the Competent Authorities stated that the said basis would not be binding on subsequent years. The taxpayer intimated the tax authorities that they did not agree on technical merits that they had a PE in India but had agreed to accept the mutual settlement.

Considering the facts of the case, on the main issue of PE, the Assessing Officer (AO) came to the conclusion that the taxpayers had a PE in India, which was confirmed by the Commissioner of Income-tax (Appeals) [CIT(A)] as well as by the Tribunal. On other issues, the Tribunal held that re-opening of assessment was valid in law; MAP proceedings had an important bearing on the PE issue and had to be given effect on priority wherever required. However, the Tribunal did not adopt the method adopted by the AO or as agreed under MAP for attributing the profit to the Indian PE of the taxpayers.

Significant issues
Whether the taxpayers have a PE in India under Article 5(1) (fixed place PE), 5(2)(l) (service PE) and 5(4) (agency PE) of the India-US tax treaty? Whether the taxpayers have a business connection in India in terms of provisions of the Income Tax Act (ITA)? Whether any income of e-Fund India can be attributed and assessed in the hands of the taxpayers? If yes, whether the Tribunal was correct in adopting a method for determining attribution of profits different than as agreed under MAP for some of the AYs?

High Court Judgement

Permanent Establishment in India:

Fixed place PE Neither in the assessment order nor in the appellate order including the order of the Tribunal, there is any material and relevant discussion to hold that the taxpayers had a fixed place of business in India through which business of enterprise was wholly or partly carried on. None of the authorities including the Tribunal have held that the taxpayers had right to use any of the premises belonging to e-Fund India. The right to use test or disposal test had not been applied nor was there any observation or finding to that effect. In the absence of any such finding, it cannot be said that the taxpayers had a fixed place of business in India as contemplated in Article 5(1) of the India-US tax treaty. Paragraph 3 of Article 5 sets out a negative list or excludes activities performed through a fixed place in India or USA by a foreign enterprise/assessee, from application of paragraphs 1 and 2 to Article 5. It does not follow that if activities are not covered in the negative or exclusions set out in paragraph 3, a PE is established or deemed to be established under paragraphs 1 or 2 of Article 5.

The submissions of the Revenue that the taxpayers were a joint venture or in partnership with e-Fund India as the business of the assessee and the Indian subsidiary were interlinked and closely connected, were out of the context.

The following factors were considered to be not relevant in determining a fixed place PE: (a) Close association between e-Fund India and the taxpayers (b) Various services being provided by e-Fund India to the taxpayers and its dependence upon them for its earning (c) e-Fund India not bearing sufficient risk (d) Assignment or sub-contract of contracts to e-Fund India (e) e-Fund India being reimbursed on a certain cost-plus basis (f) Direct or indirect costs and corporate allocations in software development centre or BPO

(g) Intangible software being provided to e-Fund India free of cost (h) Saving / reduction in cost by transferring business or back office operations to the Indian subsidiary (i) (j) The manner and mode of the payment of royalty or associated transactions e-Fund India carrying on core activities as performed by the taxpayers

The judgment contains an observation suggesting that certain other entities of e-funds group may have a PE in India if it is found that they have a place of management in India. This observation was made with specific reference to the fact that employees of certain offshore entities reported to an employee in India. This, not being the subject matter of the present appeal, was not discussed further. Agency PE

Conditions of Articles 5(4) of the India-USA tax treaty were not satisfied as e-Fund India was not authorized and did not habitually exercise authority to conclude contract or was maintaining stock or merchandise from which it delivered goods or merchandise on behalf of the taxpayers or secured orders on behalf of the taxpayers.

Conditions of Article 5(5) of the India-USA tax treaty were not satisfied as there was no allegation or considered finding that the transactions were not in ordinary course of business and the assessment order did not state or mention how and why the transactions between the taxpayers and e-Fund India were not at arms length.

Further, the following factors were considered to be not relevant in determining Agency PE: (a) (b) 40% of the employees of the entire group were in India i.e. were employees of e-Fund India Provision of any software, intangible data etc. irrespective of the same being provided free of cost or otherwise (c) Basis of reimbursement of certain expenses to e-Fund India

Service PE The employees and other personnel must be of the non-resident assessee to create a service PE. Any other interpretation or treating employees of the Indian entity, i.e. e-Fund India as other personnel of the foreign assessee would lead to incongruities and irrational result, for every subsidiary which engages an employee, would always become a PE of the controlling foreign company.

The nature and functions performed by the employees seconded by the foreign enterprise/assessee to the Indian enterprise/subsidiary and who exercised control and supervised them, are critical factors in determining whether a Service PE exists on not. When and if the said employees had provided stewardship function, no PE exists even if the employees of the non-resident assessee were taken on deputation.

Employees of e-Fund India were not to be counted and treated as employees of the taxpayers as e-Fund India was a separate entity and taxable assessee. Based on facts, two employees deputed to e-Fund India did not create the Service PE as the entire salary cost was borne by e-Fund India and they were working under control and supervision of e-Fund India.

Subsidiary PE A holding or a subsidiary company by themselves would not become PE of each other. In view of Article 5(6) of India-USA tax treaty, the taxpayers and Indian Subsidiary (e-Fund India) did not become PE of each other in the respective countries just because they controlled or were being controlled by another company.

Business Connection in India Business connection did exist, not because the taxpayers were associated enterprise or had a subsidiary in India, but because the e-Funds India was providing information and details to the taxpayers in the USA for the purpose of entering into contracts with third parties subsequently the said contracts were performed fully or partly by e-Funds India as an assignee or sub-contractee. Looking at the nature of the said transactions and the manner in which contracts were executed and where the taxpayers had assumed and agreed to third party claims and risks, business connection was established. What was attributable and taxable as business connection was not adjudicated and decided by the High Court. This was because both the tax authorities and the taxpayer had proceeded that in terms of Section 90(2) of the Act, provisions of the India-USA tax treaty were more beneficial to the taxpayer.

MAP The MAP procedure and agreement, is no doubt relevant but cannot be determinative or the primary basis to decide whether the assessee had PE in India. Whether or not PE exists is a matter of law and fact, and there has to be determination of the said issue on merits.

Profit attribution In the MAP proceedings once a formula was adopted, it should be consistently followed. But if the said formula was irrational and inappropriate; it could be corrected in other and subsequent years.

Comments
The Delhi HC held that no income of the e-Funds India could be attributed and assessed in the hands of the taxpayers as the taxpayers did not have a PE in India.

This is a landmark decision in the area of International Taxation. The Delhi HC in its judgment has referred to OECD and UN commentaries as well as views expressed by eminent international authors while arriving at the conclusion that the taxpayers in the instant case did not have a PE in India. This judgment provides the much needed relief to the international business community who has set up back office operations in India.

Way Forward
Taxpayers should review their existing arrangement / contracts with Indian entities to assess whether or not there exists a PE in India or not. Where employees are seconded to India ascertain under whose control and supervision are these employees working and who is bearing the costs of such employees. Assess whether place of management of any of the offshore entities can be said to exist in India. If a PE exists in India, ascertain a reasonable and logical basis for ascertaining the profits that are attributable to the Indian PE.

Source: E Funds Corporation The Delhi HC judgement dated 5 February 2014

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