Permanent Establishment

Article 5(1) of the OECD Model provides “PE” means a “fixed place of business through which the business of an enterprise is wholly or partly carried on.”[1]

The concept of PE authorizes the government of the State to tax the profits of the contracting state provided the profits are attributable to PE established in that state.  International tax treaties through PE help in avoiding double taxation.  The degree of economic penetration justifies the Government in treating a foreign entity in the same manner as domestic entity. Once the PE is established, the residence state either exempts the income, or allows credit of taxes paid by the PE.

Types of Permanent Establishment

1.      Fixed PE

An Indian subsidiary company is categorized as fixed PE of foreign entity as per Article 5(1) of the Income tax treaty between India & foreign entity if the premises belonging to Indian subsidiary is at the disposal of the foreign entity & the business of the foreign entity is carried on wholly or partly through it. This place would be treated as fixed place of business of foreign entity.

2.      Agency PE

An Indian subsidiary company is categorized as Agency PE of foreign entity if foreign entity has appointed this company as an agent in India. Moreover, this agent should be dependent & should have the right to conclude contracts on behalf of the foreign entity. All orders should be secured for the foreign entity. He should also maintain stock of goods from which delivery should be made regularly on behalf of the foreign entity.

3.      Service PE

If the employees of a foreign entity performs services in India exceeding the specified period & the employment agreement is in the name of foreign entity, this proves that, the foreign entity through its employees provides services in India, thus Agency PE is established.

Case Study: Dit v. E Funds IT Solution [2]

Funds Corporation, USA and E-Funds IT Solutions Group Inc., USA entered into contracts with their clients for providing certain IT enabled services, which were assigned to E-Funds India for execution. Based on FAR analysis(functions performed, assets used & risks assumed) Indian tax authorities held that E- funds India was not having required software & database for providing  IT enabled services independently & it also did not bear any significant risk.

Moreover, the entire activities of the US entity were carried out by E-funds, India leading to incidence of PE in India in respect of back office operation & software development services & the PE had not been remunerated on arms’ length price basis & in turn the income was liable to tax in India in respect of operations performed by subsidiary company on its behalf.

The Hon’ble  bench of Delhi High Court , keeping in view the Article 5, Para 6,  of the Indo-US Double Taxation Avoidance Agreement ,stated that, Holding Subsidiary relationship between companies by themselves would not constitute PE of each other. To give rise to PE of the parent company under Article 5(1), premises belonging to the subsidiary should be at the disposal of the parent company (right to use test) & should be a fixed place of business (location test & duration test) through which the parent carries on its own business (business activity test).

The court also referred the Apex Court dictum in DIT (International Taxation) v. Morgan Stanley & Co.[3] in analyzing the interpretation of the text of the Indo-US DTAA to find out the presence or absence of PE in India. The word ‘permanent’ requires some degree of permanency & regularity & not a mere transitory nature of business in the other State.

The expression “fixed place of business” denotes not only physical location, immovable property or premises but in certain cases can mean machinery & equipment also. The business should be carried through the fixed place of business & hence lays down the prerequisite for productive nature of establishment to contribute to the business of the entity.

With respect to service PE as described under Article (5)(2)(1), the Court held that , the essential requirement was furnishing of services within the second contracting state by a foreign enterprise through its employees or other personnel  & such activities continue beyond a stipulated period. It was held that the employees were on the payrolls of the Indian entity & hence were not employees or other personnel of the foreign entity & hence interpretation or treating employees of E- fund India as other personnel of the foreign entity would lead to absurdity making every subsidiary a PE in the Indian context. The services must be performed in relation to activities in India & should not be in relation to the stewardship functions.

With respect to Agency PE as described under Article 5(4) & (5) of Indo-US DTAA, which replaces the fixed place connection with personal connection & highlights dependent agency is one which is bound to follow instructions & is personally dependent on the enterprise he represents & nature of dependency must not be isolated but should be of comprehensive nature & he facilitates the interest of the principal. Hence, it was stated that in accordance with the Article 5(4), subsidiary constitutes an agency PE of its parent if the subsidiary has the authority to conclude contracts in the name of its parent & habitually exercises this authority.

The High Court also stated that the Mutual Agreement Procedure (MAP) under Article 27 of the INDO-US tax treaty is relevant but cannot be determinative or the primary basis to decide whether the tax payer had PE in India which is a matter of law & fact.

Conclusion of the case

Based on the aforesaid understanding & the facts, the High Court held that there is no material to hold that the two US entity had a fixed place of business in India, through which the business of the enterprise was wholly or partly carried on & the premises of the E-fund India were not at the disposal, legally or otherwise to the foreign entity & in the absence of the same, Article 5(1) cannot be applied.  The fact that the subsidiary company was carrying on core activities as performed by the US entity & was not bearing sufficient risk does not create a fixed place PE.

The Court also opined that Article 7(5) of the INDO-US treaty states that the profits attributed to the PE in Article 7(1) (a) shall only include profits derived from assets & activities of the PE, resultantly only the activities & the assets of the PE (E- Funds India) can be taken into consideration for attribution of profits to the US entity, subject to the limited force of attraction principle, which was not applicable in the present case. If the transfer pricing computation does not adequately reflect the functions performed & risk assumed by the Indian enterprise, there is need to attribute profits for those functions or risks which have not been considered as held in Morgan Stanley case (supra).

The judgment of the High Court can be regarded as authoritative precedent in so far as interpreting the text of Article 5 of the Indo-US Tax treaty.

Having analyzed the various connotations of the “Permanent Establishment”, the detailed order of the Court would serve as a useful guide in understanding the facets of Article 5 particularly in the context of the Indo US Tax treaty.

Permanent Establishment Risk

Multiple factors can be seen as playing a role for an enterprise which is seeking to weigh its PE risk. This PE risk could be sometimes intentional or could also be judged as inadvertent. If it is following business strategy of a company, it would be termed as intentional.  On the other hand, inadvertent PE would give scope for amendment to avoid additional tax.

The following situation may create a PE risk for companies operating in foreign countries:

1.     Employed individuals are contributing to the company revenue by their services

2.     Employees are subject to withholding taxes

3.     Employees are working for a fixed term contracts in a foreign country for an extended period, creating a “prolonged worksite” status

4.     Signing contracts within country business & profiting from those contracts

5.     Email address or bank accounts of foreign entity if given

6.     Services of a dependent agent in a foreign country generating revenue