Supreme Court Explains Law on What Constitutes ‘Permanent Establishment’ Under DTAA and Its Taxability
Double taxation is the levy of tax by two or more countries on the same income, asset or financial transaction. This double liability is mitigated in many ways, one of them being a tax treaty between the countries in question. A tax treaty between two or more countries to avoid taxing the same income twice is known as Double Taxation Avoidance Agreement (DTAA). When a tax-payer resides in one country and earns income in another country, he is covered under DTAA, if those two countries have one in place.
The Apex Court in the case of Director of Income Tax – II (Appellant) vs M/s Samsung Heavy Industries Co Ltd (respondent) revisited the question of taxability of income attributable to a “permanent establishment” set up in a fixed place in India, arising from the ‘Agreement for avoidance of double taxation of income and the prevention of fiscal evasion’ with the Republic of Korea (DTAA).
Facts of the Case
- On 28.02.2006, the Oil and Natural Gas Company (ONGC) awarded a “turnkey” contract to a consortium comprising of the Respondent/Assessee, i.e. Samsung Heavy Industries Co. Ltd. (incorporated in South Korea) and Larsen & Toubro Limited, a contract for carrying out surveys, design, engineering, procurement, fabrication, installation and modification at existing facilities, and start-up and commissioning of entire facilities covered under the ‘Vasai East Development Project’
- On 24.05.2006, the Assessee set up a Project Office in Mumbai, India, which was to act as “a communication channel” between the Assessee and ONGC in respect of the Project. Pre-engineering, survey, engineering, procurement and fabrication activities initially took place abroad in 2006.
- Commencing from November, 2007, these platforms were then brought outside Mumbai to be installed at the Vasai East Development Project.
- With regard to AY 2007-2008, the Assessee filed a Return of Income showing nil profit in relation to the activities carried out by it in India.
Order of Assessing Officer (AO)
- A draft Assessment Order was passed by the AO.
- This Draft Order went into the terms of the agreement in great detail, and concluded that the Project in question is a single indivisible “turnkey” project, whereby ONGC was to take over a project that is completed only in India.
- Resultantly, profits arising from the successful commissioning of the Project would also arise only in India.
- The AO held that, it is evident that the work relating to fabrication and procurement of material was very much a part of the contract for execution of work assigned by ONGC.
- The work was wholly executed by PE in India and it would be absurd to suggest that PE in India was not associated with the designing or fabrication of materials.
- The Draft Order then went on to attribute 25% of the revenues allegedly earned outside India as being the income of the Assessee eligible to tax.
Order by Dispute Resolution Panel (DRP)
The Dispute Resolution Panel, by its order, after considering objections to the Draft Order by the Assessee, held that:
- The AO had given a specific finding that the assessee had a project office in India, when it was given the contract.
- The assessee had not contested the existence of the Project office in India but it has only contested that the project was used merely for preparatory and auxiliary activities.
- This submission of the assessee did not hold merit because if it wanted to perform only preparatory and auxiliary activities then it could have opened a liaison office.
- The opening of a project office clearly shows that the assessee was doing something more than what would have been done through liaison office.
- Considering the nature of activities undertaken in India it is clear that PE existed in the case of assessee.
- The agreement was a “turnkey” project which could not be split up, as a result of which the entire profit earned from the Project would be earned within India.
- Basing itself on data obtained from the database “Capital Line”, DRP picked up four similar projects executed by companies outside India, and found the average profit margin to be 24.7%, which, would therefore justify the figure of 25% arrived at in the Draft Order.
- DRP dismissed the Assessee’s objections and the Draft Order was made final by the AO.
- The Assessee then filed an appeal against the Assessment Order before the Income Tax Appellate Tribunal (ITAT).
Appeal to ITAT
- The ITAT confirmed the decisions of the AO and the DRP that the contract was indivisible.
- According to the ITAT, the way the terms of the contract were described and the way the work on contract is to proceed clearly show that all the activities of contract will be the role of Mumbai project office as the same has to work as a channel between Assessee Company and ONGC.
- The Mumbai project office of the assessee would play a vital role in the execution of entire contract and if assessee wants to contend otherwise, the onus is on assessee and not on the revenue.
- ITAT found that there was a lack of material to ascertain as to what extent activities of the business were carried on by the Assessee through the Mumbai Project Office, and therefore it was considered just and proper to set aside the attribution of 25% of gross revenue earned outside India, which was attributed as income earned from the Mumbai project office.
- The matter was sent back to the AO to ascertain profits attributable to the Mumbai project office after examining the necessary facts.
Appeal to High Court (HC)
- An appeal from the ITAT was filed in the HC by the Assessee. High Court concerned itself with the question as to whether can it be said that the Agreement permitted the India Taxing Authority to arbitrarily fix a part of the revenue to the permanent establishment of the appellant in India?
- The HC held that the question as to whether the Project Office opened at Mumbai cannot be said to be a “permanent establishment” within the meaning of Article 5 of the DTAA would be of no consequence.
- HC then held that there was no finding that 25% of the gross revenue of the Assessee outside India was attributable to the business carried out by the Project Office of the Assessee.
- According to the HC, neither the AO nor the ITAT made any effort to bring on record any evidence to justify this figure.
- This being the position, the appeal of the Assessee was allowed
- HC set aside the judgment and order under appeal as well as the assessment order insofar as the same relates to imposition of tax liability on the 25% of the receipt upon the appellant in the circumstances mentioned above
- HC observed that the questions of law formulated, while admitting the appeal, have not, in fact, arisen on the facts and circumstances of the case, but the real question was, whether the tax liability could be fastened without establishing that the same is attributable to the permanent establishment of the enterprise situate in India and the same, was answered in the negative and in favour of the appellant.
Appeal to Supreme Court (SC)
Observations of the SC pertaining to Article 5 – Permanent Establishment of the DTAA
- For the purposes 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.
- The term “permanent establishment” shall include— (a) a place of management; (b) a branch; (c) an office; (d) a factory; (e) a workshop; and (f) a mine, an oil or gas well, a quarry or any other place of extraction of natural resources
- The term “permanent establishment” encompasses a building site, a construction, assembly or installation project or supervisory activities in connection therewith, but only where such site, project or activities continue for a period of more than 9 months.
- The term “permanent establishment” shall be deemed not to include:-
- the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise;
- the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;
- the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise
- the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or for collecting information, for the enterprise;
- the maintenance of a fixed place of business solely for the purpose of advertising, the supply of information, scientific research or any other activity, if it has a preparatory or auxiliary character in the trade or business of the enterprise;
- the maintenance of a fixed place if business solely for any combination of activities mentioned above, provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character
Observations of the SC pertaining to Article 7 – Business Profits of the DTAA
- 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 that permanent establishment.
- Where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, the profits in each Contracting State shall be attributed to that permanent establishment as if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.
Reference to Judgment by the SC in the case of Morgan Stanley & Co. Inc
- In Morgan Stanley & Co. Inc. (supra), the DTAA (1990) between India and USA was construed. The facts in that case made it clear that the Morgan Stanley Group was one of the world’s largest diversifying financial services companies.
- Morgan Stanley and Company, which is a part of the Morgan Stanley Group, is an investment bank engaged in the business of providing financial advisory services, corporate lending and securities underwriting.
- One of the group companies namely, Morgan Stanley Advantages Services Pvt. Ltd. (MSAS) entered into an agreement for providing certain support services to Morgan Stanley and Company.
- MSAS, being an Indian Company, was set up to support the main office functions in equity and fixed income research, account reconciliation and providing IT enabled services such as back office operation, data processing and support centre to Morgan Stanley and Company.
- SC tackled the question as to whether a “fixed place” permanent establishment existed on the facts of that case under Article 5 of the India-US treaty – which was similar to Article 5 of the present DTAA.
- According to the SC, the second requirement of Article 5(1) of DTAA was not satisfied with regards to back office functions.
- MSAS in India would be engaged in supporting the front office functions of MSCo in fixed income and equity research and in providing IT enabled services such as data processing support centre and technical services as also reconciliation of accounts.
- In order to decide whether a PE stood constituted one has to undertake functional and factual analysis of each of the activities to be undertaken by an establishment.
- From that point of view, SC was in agreement with the ruling of AAR that in the present case Article 5(1) was not applicable as MSAS would be performing in India only back office operations. Therefore to the extent of the above back office function the second part of Article 5(1) was not attracted.
- Another aspect which was discussed was the exclusion of PE under Article 5(3).
- Under Article 5(3)(e) activities which were auxiliary in character and which were carried out at a fixed place of business would not constitute a PE.
- SC was of the view that the abovementioned back office functions proposed to be performed by MSAS in India fell under Article 5(3)(e) of DTAA. Therefore, in the present case MSAS would not constitute a fixed place PE under Article 5(1) of DTAA as regards its back office operations.
- SC then went on to hold that activities performed by stewards who were deployed by the American Company to work in India as employees of the Indian company were so employed merely to protect the American companies’ interests in a competitive world, by ensuring quality and confidentiality of services performed in India.
- It was therefore found that so far as stewardship was concerned, this activity would fall within Article 5(2)(l) of the US-India treaty, and therefore would be outside the term “permanent establishment” as defined.
- On the deputation of certain employees of the American Company to work as employees of the Indian Company, it was found, however, that the American Company was rendering services through its employees to the Indian Company, as a result of which a “service” permanent establishment would stand established on this count.
Reference to Judgment by the SC in the case of Hyundai Heavy Industries Co. Ltd
- The facts in Hyundai Heavy Industries Co. Ltd. (supra) made it clear that the turnkey contract entered into between Hyundai Heavy Industries Co. Ltd. and ONGC was divisible into two parts
- SC foundon reading Article 7 of the CADT, that the said Article was based on OECD Model Convention.
- Para (1) of Article 7 stated the general rule that business profits of an enterprise of one contracting State may not be taxed by the other contracting State unless the enterprise carries on its business in the other contracting State through its PE.
- The said Para (1) further laid down that only so much of the profits attributable to the PE were taxable.
- Para (2) of Article 7 laid down that the attributable profit can be determined by the apportionment of the total profits of the assessee to its various parts or on the basis of an assumption that the PE is a distinct and separate enterprise having its own profits and distinct from GE.
Observations considering the present case on whether the profits that accrued to the Korean GE for the Korean operations were taxable in India or not
- Applying the above test to the facts of the present case, SC found that profits earned by the Korean GE on supplies of fabricated platforms cannot be made attributable to its Indian PE as the installation PE came into existence only after the transaction stood materialised.
- The installation PE emerged only after the contract with ONGC stood concluded.
- It emerged only after the fabricated platform was delivered in Korea to the agents of ONGC.
- Therefore, the profits on such supplies of fabricated platforms cannot be said to be attributable to the PE.
- In terms of Para (1) of Article 7, the profits to be taxed in the source country were not the real profits but hypothetical profits which the PE would have earned if it was wholly independent of the GE.
- Therefore, even if we assume that the supplies were necessary for the purposes of installation activity of the PE in India and even if we assume that the supplies were an integral part, still no part of profits on such supplies can be attributed to the independent PE unless it is established by the Department that the supplies were not at arm’s length price.
- No such taxability can arise in the present case as the sales were directly billed to the Indian customer (ONGC).
- No such taxability can also arise as there was no allegation made by the Department that the price at which billing was done for the supplies included any element for services rendered by the PE.
- Therefore SC was of the view that the profits that accrued to the Korean GE for the Korean operations were not taxable in India.
Reference to Judgment by the SC in the case of E-Funds IT Solution Inc
- SC concerned itself with the India-US Double Taxation Avoidance Agreement with similar provisions.
- SC held that Section 90 of The Income Tax Act does not speak of the concept of a PE. This is a creation only of the DTAA.
- By virtue of Article 7(1) of the DTAA, the business income of companies which are incorporated in the US will be taxable only in the US, unless it is found that they were PEs in India, in which event their business income, to the extent to which it is attributable to such PEs, would be taxable in India.
- Article 5 of the DTAA provides for three distinct types of PEs – fixed place of business PE under Articles 5(1) and 5(2)(a) to 5(2)(k); service PE under Article 5(2)(l) and agency PE under Article 5(4).
- Specific and detailed criteria are set out in the aforesaid provisions in order to fulfil the conditions of these PEs existing in India.
- The burden of proving the fact that a foreign assessee has a PE in India and must, therefore, suffer tax from the business generated from such PE is initially on the Revenue.
- Dealing with ‘support services’ rendered by an Indian Company to American Companies, it was held that the outsourcing of such services to India would not amount to a fixed place permanent establishment under Article 5 of the aforesaid treaty.
Observations considering the present case on whether the office set up in Mumbai is a permanent establishment or not
- A reading of the aforesaid judgments makes it clear that when it comes to “fixed place” permanent establishments under double taxation avoidance treaties, the condition precedent for applicability of Article 5(1) of the double taxation treaty and the ascertainment of a “permanent establishment” is that it should be an establishment “through which the business of an enterprise” is wholly or partly carried on.
- Further, the profits of the foreign enterprise are taxable only where the said enterprise carries on its core business through a permanent establishment.
- The maintenance of a fixed place of business which is of auxiliary character in the trade or business of the enterprise would not be considered to be a permanent establishment under Article 5.
- Also, it is only so much of the profits of the enterprise that may be taxed in the other State as is attributable to that permanent establishment.
- A reading of the Board Resolution would show that the Project Office was established to coordinate and execute “delivery documents in connection with construction of offshore platform modification of existing facilities for ONGC”.
- The finding, that the Mumbai office was not a mere liaison office, but was involved in the core activity of execution of the project itself was therefore clearly unreasonable.
- When it was pointed out that the accounts of the Mumbai office showed that no expenditure relating to the execution of the contract was incurred, the ITAT rejected the argument, stating that the accounts were in the hands of the Assessee. The mere mode of maintaining accounts alone cannot determine the character of permanent establishment. This was another perverse finding which was set aside.
- Finding that the onus is on the Assessee and not on the Tax Authorities to first show that the project office at Mumbai is a permanent establishment is again in opposition to the judgment in E-Funds IT Solution Inc.
- Though it was pointed out to the ITAT that there were only two persons working in the Mumbai office, neither of whom was qualified to perform any core activity of the Assessee, the ITAT chose to ignore the same.
- It was thus clear that no permanent establishment has been set up within the meaning of Article 5(1) of the DTAA, as the Mumbai Project Office cannot be said to be a fixed place of business through which the core business of the Assessee was wholly or partly carried on.
The Mumbai Project Office, on the facts of the present case, would fall within Article 5(4)(e) of the DTAA, as the office is solely an auxiliary office, meant to act as a liaison office between the Assessee and ONGC. The appeal against the impugned High Court judgment was therefore dismissed.
Formation of a permanent establishment of a foreign company shall depend not only on its existence or even a defined set of parameters but on the commercial arrangement between the two entities as a whole. The activities performed are also of importance. One needs to evaluate whether the company in India is carrying on activities which constitute core activities of the foreign company or is carrying on activities for its own business. The Mumbai Project Office, on the facts of the present case, would fall within Article 5(4)(e) of the DTAA, as the office is solely an auxiliary office, meant to act as a liaison office between the Assessee and ONGC. Since the activities carried on by the liaison office of the non-resident in India was to only carry on such activity of a ‘preparatory’ character, therefore, the same was not a PE in terms of Article 5 of the DTAA.