Direct Tax Alert

BACKGROUND

In an evolving digital and globally integrated economy, issues surrounding the taxation of cross-border services, the scope of Permanent Establishment (PE), and the relevance of physical presence have gained unprecedented significance. As businesses increasingly deliver services through virtual platforms, tax authorities often find themselves navigating the tension between traditional treaty principles and modern business realities to establish a PE in a country.

Certain Double Taxation Avoidance Agreements (DTAAs) provide for a ‘Service PE’ which is established if the non-resident provides services for a period longer than the prescribed threshold. Traditionally, a Service PE requires the physical presence of employees of the non-resident in the source country. However, with the advent of the digital economy, this understanding is being challenged by the tax authorities.
In the past, the Delhi Tax Tribunal¹ had an occasion to analyse whether the condition of the physical presence of employees or other personnel of a foreign enterprise in India is necessary to constitute a Service PE as per Article 5(6) of India-Singapore DTAA, or it will get attracted even if the services are provided remotely. To read our detailed alert, please click here. The tax authorities challenged the Tribunal order before the Delhi High Court. Recently, the Hon’ble Delhi High Court², has passed its ruling on the said matter. We, at BDO India, have summarised the Delhi High Court ruling and provided our comments on the impact of the decision hereunder:

FACTS OF THE CASE

The taxpayer, a non-resident company engaged in the business of legal advisory services, rendered services remotely from outside India and through two of its employees who visited India for rendering such services. During FY 2019-20, employees of the taxpayer stayed in India for a total period of 120 days, which included their 36-day vacation period, 35 days involving business development activities and 5 common days when the stay of both employees coincided.  Therefore, the total number of days on which services were furnished in India remains 44 days. The taxpayer filed its tax return for Fiscal Year (FY) 2019-20 and for FY 2020-21, declaring “nil” income. The tax officer made an addition to the income on the grounds that the taxpayer constituted “service PE” in terms of Article 5(6) of the India- Singapore DTAA. During FY 2020-21, none of the employees of the taxpayer visited India to render legal advisory services; rather, the same were rendered from outside India. The tax officer, therefore, alleged that the taxpayer constituted a virtual service PE in India since it had rendered advisory services to Indian clients from outside India.
The Dispute Resolution Panel (DRP) upheld the tax officer’s order. The taxpayer then filed an appeal before the Delhi Tax Tribunal, which ruled in its favour. Aggrieved by this decision, the tax authorities approached the Hon’ble Delhi High Court.

DELHI HIGH COURT RULING

The Hon’ble Delhi High Court, while affirming the Delhi Tax Tribunal’s ruling that the taxpayer did not constitute a service PE and virtual service PE in India, made the following observations:

Constitution of the service PE in India

• Article 5(6) of the DTAA provides that an enterprise shall be deemed to have a permanent establishment in the contracting state through its employees or other personnel only if the activities within the contracting state continue for a period aggregating to 90 days in a FY.

• In support of its case that the two employees worked for 44 days each, the taxpayer has furnished time-stamp sheets of the employees, which depict the days on which the said two employees worked for the Indian clients, and also the details of bills made out to the clients in India and the amounts received thereof.

• The taxpayer also furnished a declaration that these employees did not work on client projects during their vacation period. This indicates that if the vacation days are excluded from the total 120 days for which the employees of the taxpayer were present in India, the number of days would come to 84 days, which is less than the 90-day threshold provided under Article 5(6)(a) of the DTAA for the constitution of a service PE in India.

• The Delhi Tax Tribunal has rightfully held that business development days as well as common days also need to be excluded while computing the threshold of service PE since no services were provided by the employees to customers in India during the time spent on business development. Further, affirmed that the computation for the number of days for the determination of service PE should not be based on man-days by aggregating the common days spent by more than one individual in India.

• Actual services have been furnished only for 44 days out of the total duration of 120 days of their stay in India. Only the days on which actual services were rendered by the employees of the taxpayer need to be considered while computing the threshold limit of 90 days for service PE determination.

Constitution of Virtual Service PE in India

• Article 5(6)(a) of the DTAA expressly provides that a PE of an enterprise shall be deemed to have been established in the contracting state if it furnishes services “within” the contracting state “through employees or other personnel”.

• The words “within a Contracting State” and “through employees or other personnel” contemplate rendition of services in India by the employees of the non-resident enterprise, while mandating a fixed nexus, physical footprint within India. The term “within” has a certain territorial connotation, and in the absence of personnel physically performing services in India, there can be no furnishing of services “within‟ India.

• The concept of a virtual service PE does not find mention anywhere in the DTAA.

• The tax authorities may potentially be justified in raising concerns regarding the taxability of foreign entities in the increasingly open global virtual economy and the diminishing requirement of physical presence of non-resident employees to furnish services. However, taxability of entities in such instances remains subject to the applicable provisions of law- both treaty and domestic.

• The DTAA has been drafted and executed after numerous rounds of bilateral deliberations and negotiations at the highest level and must be interpreted strictly. If something is conspicuous by its absence, the presumption is that it has been deliberately done so. It is not for courts to read in concepts which are not expressly provided for by the treaty.

• Further, it is necessary to note that the comments made by India as recorded in the OECD Model Convention, and also the concept of Significant Economic Presence (SEP) brought about in the domestic tax jurisdiction through the Finance Act, 2018, do reflect a deliberate policy to capture digital or virtual economic participation outside the traditional permanent establishment framework.

• Certain jurisdictions may have moved away from the requirement of physical presence of employees to constitute a service PE. However, the same has not been administratively recognised by India, and in the absence of any changes made to the treaty provisions of the DTAA, such developments do not alter the interpretive constraints imposed by the wording of the DTAA.

• Until Article 5(6) of the DTAA is renegotiated or supplemented, the existing treaty framework does not extend to virtual or digital services provided from abroad.

Judicial precedents regarding constitution of Virtual Service PE

• Reliance placed by tax authorities on the Bangalore Bench’s decision in the case of ABB FZ LLC³ is misplaced due to distinguishable facts. In ABB FZ LLC, the main issue pertains to the taxability of fees for technical service (FTS) in India when the India-UAE DTAA does not contain an article for taxation of FTS.

• Further, reliance placed by the tax authorities on the Madras High Court’s decision in the case of Verizon Communications Singapore Pte. Ltd⁴. is misplaced since in Verizon, the issue of PE was neither raised nor argued before the Court.

• Furthermore, the Hon’ble Supreme Court’s decision in the case of Hyatt International Southwest Asia Ltd.⁵ which held that the relevant test is the continuity of business presence in the aggregate and not the stay/duration of any particular individual is also distinguishable on facts, as there is no argument raised with respect to the stay of any one particular individual in India; rather it is the aggregate time of stay of employees of the taxpayer that has been taken into consideration to examine whether the threshold for Service PE mandated by the DTAA has been reached.

• Reliance placed by the tax authorities in the South African Tax Court at Johannesburg in AB LLC and BD Holdings LLC⁶ wherein the tax authorities contended that “double counting‟ of days is permitted while computing the threshold for permanent establishment used this foreign case to argue that "double counting" of days is permitted (aggregating presence across overlapping periods) and part-performance constitutes PE is rejected because the US-South Africa treaty used a "183 days in any 12-month period" rolling test whereas the India-Singapore DTAA uses a fiscal year threshold (90 days).

• Further, the Spanish Supreme Court’s decision in the case of Dell⁷ is also rejected since it established a Fixed Place PE and Dependent Agent PE based on the substantial use of a subsidiary's premises, which is not relevant as the current case is strictly about Service PE based on the duration of services rendered by employees, which involves a completely different legal test.

BDO INDIA COMMENTS

With the advent of digitisation, companies often provide services without the physical presence of employees in the recipient country. It may be pertinent to note that certain countries (like Saudi Arabia, Israel and Kuwait) have acknowledged the digital presence and have held that even if services are performed entirely offshore, it would constitute a service PE. While the OECD Interim Report, 2018 refers to a minority view expressed by some countries that the requirement of physical presence is no longer relevant for the constitution of service PE as services can be rendered from remote locations as well, it also provides that in the absence of any amendments to the tax treaty provisions themselves, these measures run the risk of being challenged by taxpayers before Courts.

This ruling affirms that the tax authorities cannot tax virtual presence in the absence of specific provisions in the tax treaty. It reinforces the principle that India cannot tax foreign businesses unilaterally when a DTAA exists, and also provides guidance for computing the stay days threshold.