A Stamp of Permanence: High Court Lays Down Litmus Tests for Determination of PE
In a landmark decision, the High Court of Delhi (“High Court”), in e-Funds Corporation v. DIT1 has exhaustively laid down first principles in relation to the determination of a Permanent Establishment (“PE”). While these principles have been internationally accepted by the Organization for Economic Co-operation and Development (“OECD”) and the like and reiterated by several benches of the Income Tax Appellate Tribunal (“Tribunal”), this is one of the first High Court rulings where determination of a PE has been dealt with in a clear and comprehensive manner.
E-Funds Corporation (“E-Funds US”) is a company incorporated in the United States of America (“US”) and part of a group which is engaged in the business of electronic payments, ATM management service, decision support & risk management and similar professional service. The group structure as relevant to the ruling is provided below:
E-Funds US and its group company, e-Funds IT Solutions Group Inc. (“E-Funds IT US”) entered into contracts with their clients for the provision of Information Technology (“IT”) enabled services. These contracts were either assigned or sub-contracted to e-Funds International India Private Limited (“E-Funds India”) for execution. The Assessing Officer (“AO”), relying upon the Functions, Assets and Risks Analysis (“FAR Analysis”) performed in relation to E-Funds US and E-Funds India, observed that:
In light of this, the AO concluded that:
This view was upheld by the Commissioner of Income Tax (Appeals) (“CIT(A)”) and the Tribunal on appeal. Aggrieved by the ruling, E-Funds preferred an appeal before the High Court.
A number of questions were raised in the course of the proceedings and some of the key questions contained the judgment of the High Court are provided below.
Ruling of the COURT
The High Court, after hearing all contentions put forth by the parties, arrived at the following conclusions:
Subsidiary as PE: The High Court has relied on Article 5(6) of the Double Taxation Avoidance Agreement between India and the US (“India-US DTAA”) to uphold the internationally accepted rule that a subsidiary or parent company of the foreign company carrying on business in the source State does not by itself create a PE in the source State. However, the Court held that a PE would be created if the entity in the source State fulfills the criteria for a PE prescribed in Article 5 of the India-US DTAA.
Determination of PE: The following are some of the key observations made by the High Court:
Mutual Agreement Procedure: In the present case, the competent authorities of India and the US had initiated MAP proceedings and had entered into an agreement as to attribution of profits between E-Funds US and E-Funds IT US in case a PE is created. The tax authorities had contended that the PE issue stood determined owing to India and US resorting to the MAP agreement as to attribution of profits under Article 27 of the India-US DTAA. The High Court held that although the MAP procedure and agreement are relevant, they can be in no way the primary basis for determination of a PE. The High Court concluded that MAP proceedings had been initiated on a without prejudice basis and that the existence of a PE is a question of law and that it needs to be determined purely on merits.
Attribution of Profits: Coming to attribution of profits to a PE, the High Court re-iterated the principle laid down in Morgan Stanley5 that where a PE is held to exist, subject to application of the force of attraction rule, only profits in relation to the assets and activities of the PE may be attributed to it and that an arm’s length payment to a subsidiary PE as per FAR Analysis would be sufficient for such attribution.
In a landmark ruling on the subject, the High Court has taken a well-considered view on the concept of a PE and has after a comprehensive analysis of international tax jurisprudence and the global position, prescribed exhaustive criteria that need to be fulfilled for a PE to be constituted in India.
The High Court’s observations on the issue of determination of a fixed base PE may be considered well needed guidance on the issue. Although the Tribunal and the Authority for Advance Rulings on certain occasions have upheld the three tests required under the OECD Model Convention and commentary for the creation of a fixed base PE, since no High Court or the Supreme Court had upheld the same till the present decision, the tax authorities have almost never applied these tests while determining a PE during assessment proceedings. It is pertinent to note that certain rulings, even at Tribunal level, have failed to consider these criteria. For instance, the Delhi bench of the Tribunal in Convergys Customer Management Group Inc. v. ADIT6 had applied a risk based approach based on a FAR analysis for determination of a fixed base PE as opposed to application of these tests. This decision provides much awaited surety on the position and has prescribed the fulfillment of the physical, location/duration and business activity tests as the litmus test for determination of a fixed base PE.
However, although the High Court has taken the view that all location based PEs in Article 5(2) need to fulfill the criteria under Article 5(1), the High Court has dealt with service PE separately and has held that in addition the service PE provision in Article 5(2)(l), Article 5(2)(k) also provides for a type of service PE. This may be indicative of the view adopted by the High Court that supervisory services in relation to a building site/construction or assembly project may on a stand-alone basis be considered a service PE if the time period requirement is satisfied.
On the issue of basic service PEs, the High Court has followed settled law laid out by the Supreme Court on service PE implications arising on deputation on employees. Moreover, the observations of the High Court stating that de facto and de jure employees of an Indian subsidiary cannot be considered ‘other personnel’ of the foreign entity and that supervision and control over the employees is the most important test for determining service PE implications may be helpful in a situation where employees are seconded by a foreign entity to its Indian associated enterprise. Therefore, this may be relied upon to take the view that seconded employees of the foreign entity who take up employment with the Indian entity during their period of secondment and who act under the supervision and control of the Indian entity do not create a service PE in India.
Finally, the High Court’s detailed observations on when an agency PE is created, when the exclusionary list under Article 5(3) becomes applicable, attribution to PEs and the basis of the MAP procedure give much needed clarity on areas which were ambiguous till date owing to lack of clear judicial positioning on the same.
All in all, the judiciary in India continues to give hope in an uncertain tax environment and the decision of the High Court gives much welcomed clarity to several taxpayers who have faced absurd assessment orders containing findings as to existence of a PE. One can only hope that the attitude of the tax authorities in the future towards PE determination would stand influenced by the principles laid down in the decision.
1 ITA No. 735-740, 802, 845, 912-919, 1002, 1200, 1217, 1219 of 2011.
2 DIT v. Morgan Stanley, 292 ITR 416(SC); Commentaries released in relation to the OECD Model Convention and the UN Model Convention ; Skaar, Arvid A., Permanent Establishment: Erosion of a Tax Treaty Principle, 1991, Kluwer Law Publishers; Vogel, Klaus, Klaus Vogel on Double Taxation Conventions, 3rd edition, 2005, Kluwer Law International; Baker, Philip, Double Taxation Conventions: A Manual on the OECD Model Tax Convention on Income and on Capital, 2007, Thomson Sweet & Maxwell.
3 United Nations, Handbook on Selected issues in Administration of Double Tax Treaties for Developing Countries
6  212 Taxman 613 (Delhi).