Permanent Establishment: Understanding its Nuances from Leading Judicial Decisions

Permanent Establishment in India

During the past couple of years, it has been observed that foreign companies are engaging Indian entities for outsourcing their backend operations like accounting, human resources, software services, etc. in India. In such circumstances, Indian tax authorities are worried about the fact whether by undertaking such arrangements, the foreign companies are avoiding the tax implications that may be triggered in India.

Thus, whenever a foreign company plans to outsource its operations to India or undertake any business activities in India, either by setting up a subsidiary or by entering into a contract with a third-party entity, there is a risk that such subsidiary or entity may be construed as a PE of the foreign company in India. Let us understand what the meaning of PE is.

The term PE is defined under Section 92F of the Income Tax Act, 1961 (‘the Act’)², which states that PE includes a fixed place of business through which the business of the enterprise is wholly or partly carried on. The concept of PE is elaborated in the Double Taxation Avoidance Agreements (‘DTAA’) entered into by India with various countries. Broadly speaking, the PE can be of the following types:

• Fixed Place PE – A place of business of the foreign company where it has a certain level of permanency and right to use it for the purposes of its business.
• Service PE – Furnishing of services by a foreign enterprise through its employees or other personnel, if the activities of that nature continue for a period of generally more than 183 days in any 12-month period. However, the time period may vary from treaty to treaty.
• Agency PE – If an agent habitually concludes contracts or habitually plays the principal role leading to the conclusion of contracts routinely concluded without material modification by the foreign company. In certain cases, an Agency PE may also arise where the agent maintains a stock of goods or merchandise in the Source state from which goods or merchandise are regularly delivered on behalf of that enterprise.

The concept of PE is of considerable importance in the field of international taxation as business profits of a foreign enterprise cannot be taxed by a Source State (the country in which the said income is earned) unless it proves the existence of a PE in that State. The comparable term to PE under the Indian Income-tax Act, 1961 (‘ITA’) is “business connection”,³ which prescribes conditions under which a foreign company shall be considered as conducting business in India.

Further, even if it is established that a foreign company has a business connection in India, its business profits shall be taxed in India, only if it has a PE in India as per the respective DTAA. Thus, the concept of business connection is wider than PE. If it is established that the foreign company has a PE in India, then the profits attributable to such PE are liable to tax in India.

As the PE of a foreign company in India gives the Source State the right to tax, it is an important Article under the DTAA, majorly for the developing countries. Let us understand the conditions under which an entity may be considered as a PE in India.

For any enterprise to be considered as a PE, the following tests are to be analyzed and, if the same are fulfilled, it is said that the foreign company has a PE in India:

• Location and Permanency Test
• Disposal Test
• Business Activity Test

Thus, it can be understood that if any foreign company has a place of business in India, which has some level of permanency and is available at the disposal of the foreign company from where it can conduct its business activities, such place can be considered as a PE of the foreign company in India. While analyzing PE, especially a Fixed Place PE, it has been held by the courts that any place available at the disposal of the foreign company for conducting its business activities shall be considered as a PE in India. The duration for which such place was permanently available at the disposal of the foreign company may not be relevant, if, in substance, the place was available to conduct the business activities. The Article 5(1), i.e. Fixed Place PE does not make reference to any minimum period for which a PE should be in existence in the source States. Generally, as per the UN and OECD commentaries, a Fixed Place PE is not considered to be in existence where the place of business is maintained for a period of less than six months.

The Formula One Judgement

The landmark judgement passed by the Hon’ble Supreme Court in the case of Formula One⁴ has highlighted that, irrespective of the duration of the place of business available to the foreign company, it can constitute a Fixed Place PE in India if all the other factors are fulfilled. In the said case, the assessee being a UK based company had granted the right to host and promote Formula F-1 Race at a motor racing circuit owned by Jaypee Sports, an Indian Company.

The assessee had full access to the circuit and it could dictate as to who was authorized to access it. Further, although the circuit belonged to Jaypee Sports during the said period, organizing any other event at the circuit was not permitted. Thus, based on the facts of the case, the courts observed that the assessee has a place to conduct its business activities in India that was at its disposal with a certain level of permanency. Hence, it was held that the said circuit constituted a PE of the assessee in India, irrespective of the duration of such permanency of the place of business.

Further, any income attributable to such circuit would be deemed to be taxable in India. This judgement laid down a precedent that if the conditions for establishing a PE are fulfilled, then irrespective of the period of existence of such place of business, it may be construed as a Fixed Place PE in India. The Hon’ble Supreme Court, in the case of Formula One (supra), has indicated that to hold a place of business as a PE, the place should be available at the disposal of the foreign company irrespective of the time period.

The Hyatt International Judgement

In the recent case of Hyatt International (supra), the Hon’ble Supreme Court has placed reliance on the abovementioned judgement of Formula One. The facts of the given case were that Hyatt International had entered into a Strategic Oversight Services Agreements (SOSA) with Asia Hotels Limited (‘AHL’) India, under which it agreed to provide strategic planning services and “know-how”. The main aim of providing such services was to ensure that the hotel was developed and operated as an efficient, high-quality, and an international full-service hotel meeting the global level of standards of Hyatt International.

To undertake and implement the activities mentioned in the SOSA, executives and employees of Hyatt International made frequent and regular visits to India to oversee the hotel operations. Such employees were involved in substantive hotel operations, like recruitment of staff, formulation of policies, and other managerial functions etc. Further, as per the India-UAE DTAA, a Service PE is established if the employees provide services for a period of more than 9 months.

The Delhi HC ruled in favor of the Revenue and concluded that Hyatt International had a PE in India as per the India-UAE DTAA. The decision was appealed before the Supreme Court. Upon considering the facts of the case, the Supreme Court upheld the decision of the Delhi High Court and held that the role of Hyatt International was not merely providing support advisory or auxiliary services to AHL India. Instead, the activities performed were core and essential functions, clearly establishing their control over the day-to-day operations of the hotel.

Further, the agreement included terms for revenue sharing with Hyatt International based on the revenue generated by AHL in India. With respect to the duration of the employees’ stay in India, it was held that though the same was less than the prescribed time of 9 months in the DTAA, in substance, the employees were involved in the major decision-making and revenue-generating activities of the AHL. Thus, it was clearly stated that Hyatt International had a place of business at its disposal wherein business activities were being carried out, thereby resulting in the existence of a Fixed Place PE.

An important factor that is common in both the above cases is that the courts have given importance to the substance over the legal form of the transactions.

If the foreign companies were exercising substantial rights and undertaking/affecting business activities in India, it was held that they had a PE in India, irrespective of technical conditions such as time period, etc. The nature of the activities undertaken were given more importance as opposed to the time period for which the said activities were conducted in India.

This also takes us to certain other questions such as, if a foreign company incorporates a subsidiary in India, outsources its backend activities in India, deputes some of its employees in India, or has a liaison office in India, can it be termed as a PE in India?

Subsidiary as a PE

There have been some instances in the past wherein the revenue has held that an Indian subsidiary of a foreign company may be termed as a PE in India if it is established that the subsidiary is, in substance, nothing but a fixed place for the foreign company through which it is carrying out its business in India.

In the case of Carpi Tech SA v. ADIT⁵ (International Taxation), Chennai, the ITAT Chennai held that since the assessee, a Switzerland-based company, had received a power project from NHPC, in view of fact that all correspondences relating to prospecting of clients, participation in bids, communication with customers, signing of contract documents, execution of the project, and closure of the project etc. were initiated or routed through business address of its subsidiary company in India, it would be considered as a PE in India.

A similar contention was upheld in the case of Huawei Technologies Co. Ltd. v. ACIT, International Taxation⁶ by the ITAT Delhi, wherein a China-based company engaged in the sale of telecom equipment, supplied equipment and handsets to its Indian subsidiary. Since the assessee was conducting its business in India with the active involvement of employees of its Indian subsidiary, who jointly prepared bidding documents, negotiated, and concluded contracts on behalf of the foreign company with its Indian customers, the Indian subsidiary was held to constitute a PE of the foreign company.

While there are cases where a subsidiary has been held to be a PE in India, alternative arguments have also been held by the courts of law.

In the case of Progress Rail Locomotive Inc. v. Deputy Commissioner of Income-tax, International-Taxation, Delhi HC⁷, the assessee, being a US-based company was engaged in the business of manufacturing and sale of locomotives and locomotive parts, supplied equipment directly to Railways and had a subsidiary in India. However, neither email correspondence, communication trails, nor the statement of employees could lead to conclude that the business of the assessee was managed by an Indian subsidiary. Thus, it was held that though the foreign company had a subsidiary in India, it did not result in a PE in India. Similar contentions have been upheld in respect of liaison offices in India, where it has been held that since they assist only in the exchange of information and do not conduct any business activities, they shall not constitute a PE for the foreign company in India.⁸

Outsourcing of Backend Operations in India – Deputation of its Employees in India

In many cases, it is observed that foreign companies outsource their non-core or backend operations to India. The Supreme Court, in the case of Director of Income-tax (International Taxation) v. Morgan Stanley & Co.⁹ analyzed different categories of PE, i.e. Fixed Place PE, Agency PE and Service PE, in quite detail in a similar arrangement where the Indian Company provided backend support services to the foreign company.

As per the facts of the case, the foreign company had outsourced some of its services like information technology support, account reconciliation, research support, etc. to an Indian company related to it. Further, in order to provide some specific services, some personnel of the foreign company were also deputed to the Indian group company and worked under the supervision and control of the Indian company. Herein, the Supreme Court analyzed all three categories of the PE as follows –

• Fixed Place PE – In respect of Fixed Place PE, the Supreme Court observed that the Indian Company would not be considered a PE in India, as it would be performing only back-office operations, which could not be construed as business activities of the multinational enterprise. Further, such activities were of a preparatory or auxiliary character and hence fell under Article 5(3)(e) of the treaty, which excludes such activities from constituting a PE in India.
• Agency PE – It was concluded that no Agency PE existed, as the Indian company did not have the authority to conclude any contracts on behalf of the foreign company.
• Service PE – On the facts of the given case, the services were bifurcated into two activities, namely stewardship activities and work performed by employees on deputation. It was concluded that stewardship activities involved only briefing the Indian staff to ensure that the output met the global standards and that no specific or technical services were provided. Thus, a Service PE was not established due to stewardship services.

Further, in respect of services provided by the employees on deputation, it was observed by the Supreme Court that the deputed employees did not become the employees of the Indian Company. The foreign company remained responsible for their work, and the employees continued to be on its payroll. Hence, a Service PE was held to be established.

Thus, based on the above decisions, it can be understood that the courts have given importance to the nature of activities performed by employees of the foreign company in India and the factors determining who is to be considered as the real employer for the employees.

In another case, Asstt. DIT v. E-Funds IT Solution Inc.¹⁰, employees were deputed to India and worked under the control and supervision of E-funds India, and their remuneration was borne solely by E-funds India. Further, it was observed that as no customers of the foreign company were located in India or had received any services in India, merely because auxiliary operations that facilitated such services were carried out in India, it could not be held that the foreign company was carrying out business activities in India. Accordingly, no Service PE was constituted in India.

However, in Centrica India Offshore (P.) Ltd. v. CIT¹¹, Teradata Operations Inc. v. Dy. CIT¹², courts held that since the right of the seconded employees to receive salaries, other emoluments, and the right of dismissal, etc. vested with the foreign company, such employees were to be considered employees of overseas entities rendering services for their employer in India. In such cases, a Service PE may be held to be established in India.

Conclusion

With the growth and development of the Indian economy and business, many foreign companies are keen to conduct business in India. In such cases, it becomes important to ensure that such transactions do not camouflage their actual nature and that taxes are rightfully received by India.

From the above analysis, it can be understood that the new-age India does not necessarily focus solely on the written laws but goes beyond the words to understand the substance of the transaction undertaken.

Further, if a foreign company has a place of business for a certain period that is under its control and is available at its disposal for carrying out business activities, a PE may be established. For this to happen, it is important that the foreign company is engaged in conducting its business activities in India and not merely carrying on auxiliary or support services. If the services are only in the nature of backend or support services, it may be argued that they do not lead to the constitution of a PE in India.

A similar contention may be made in respect of services provided through its employees in India. If the employees are providing only stewardship services, or if their activities are controlled by the Indian employer, a Service PE may not come into existence.

These are some of the common conclusions that can be drawn on the basis of the abovementioned landmark judgements held in the context of PE in previous years. However, the facts of each case must be analyzed individually, and the decision of whether a foreign company has a PE in India or not will always depend on the specific facts and circumstances of the case.