Direct Tax Alert

BACKGROUND

The concept of Permanent Establishment (PE) is critical in determining a country’s right to tax the business profits of a foreign enterprise. Under the tax treaties, the source state may tax such profits only if the foreign enterprise has a PE in that country. The definition and scope of PE are set out in Article 5 of the relevant tax treaties, which covers various types of PE such as Fixed place PE, Agency PE, Service PE, etc. A typical business set up of multinational enterprises (MNEs) having offices/ presence in different countries prefers to have standard infrastructure. To ensure uniformity across its different locations, MNEs generally have a Standard Operating Procedure (SOP) in place. In terms of the SOP, designated employees generally visit different locations to oversee its implementation and operations.
Recently, the Hon’ble Supreme Court (SC)¹ had an occasion to analyse whether operational control and oversight of Indian operations would constitute a foreign entity’s PE in India. We, at BDO India, have summarised this ruling and provided our comments on the impact of this decision hereunder:

FACTS OF THE CASE

The taxpayer, incorporated and tax resident of the United Arab Emirates (UAE), is engaged in rendering consultancy services in the hotel sector. It entered into two Strategic Oversight Services Agreements (SOSAs) with Asian Hotels Limited, India (AHL), having a tenure of 20 years. In terms of SOSA, the taxpayer agreed to provide strategic planning services and “know-how” to ensure that the hotels operated by AHL in India were developed and operated as efficient and high-quality international full-service hotels. The taxpayer treated the amount received towards the provision of these services as not taxable in India on the following counts:

• India-UAE Double Tax Avoidance Agreement (DTAA) does not have an Article on Fees for Technical Services.

• The amount received is business income and in the absence of PE in India, the same is not taxable in India in terms of Article 5(1) of India-UAE DTAA.

However, the tax officer opined that the taxpayer had a PE in India in terms of Article 5(1) of the India-UAE DTAA and accordingly, taxed the income from these hotel-related services.

On appeal, the DRP as well as the Delhi Tax Tribunal upheld the tax officer’s view. On further appeal, the larger bench of the Hon’ble Delhi High Court held that the taxpayer had a PE in India in the form of a fixed place of business.

Aggrieved, the taxpayer preferred an appeal before the Hon’ble SC. The Hon’ble SC, while affirming the Hon’ble Delhi High Court’s ruling, made the following observations:

SUPREME COURT RULING

Disposal Test

• Article 5(1) of the India–UAE DTAA defines a PE as “a fixed place of business through which the business of an enterprise is wholly or partly carried on”. This is consistent with the definition provided in section 92F(iii-a)² of the IT Act.
• Reliance was placed on the SC ruling in Formula One³, wherein it was observed that for PE to exist, two essential conditions must be satisfied:
  • The place must be “at the disposal” of the enterprise, and
  • The business of the enterprise must be carried on through that place.

• The period of SOSA of 20 years, coupled with the taxpayer’s continuous and functional presence, satisfied the tests of stability, productivity and dependence.
• The test is not whether a formal right of use was granted, but whether, in substance, the premises were at the disposal of the enterprise and were used for conducting its core business functions. The SC expressly held that exclusive possession is not essential – temporary or shared use of space is sufficient, provided business is carried on through that space.
• The Organisation for Economic Co-operation and Development (OECD) does not rigidly define the disposal test but provides illustrative examples. There is no straightjacket formula applicable to all cases. Typically, trading operations require a continuously used fixed place, whereas service-oriented businesses may not.
• Determining whether a fixed place PE exists must involve a fact-specific inquiry, including the enterprise’s right of disposal over the premises, the degree of control and supervision exercised, and the presence of ownership, management, or operational authority.

Degree of control and nature of functions performed

• The SOSA demonstrated that the taxpayer exercised pervasive and enforceable control over the hotel’s strategic, operational, and financial dimensions. Specifically, the SOSA vested the taxpayer with powers to:
  • Appoint and supervise the general manager and other key personnel,
  • Implement human resource and procurement policies,
  • Control pricing, branding, and marketing strategies,
  • Manage operational bank accounts,
  • Assign personnel to the hotel without requiring the owner’s consent.
• These rights went well beyond mere consultancy and indicated that the taxpayer was an active participant in the core operational activities of the hotel.
• The actual role of the taxpayer was not just advisory in nature but extended to various other administrative roles.
• From the nature of functions carried out by the taxpayer, it could not be said that they were performing merely “auxiliary” functions. The functions performed by the taxpayer, through its staff operating from the hotel premises, were not just limited to setting up a pattern of activities for the hotel but were core and essential functions which clearly established its control over the day-to-day operations of the hotel. Moreover, they were to be continuously performed over a period of 20 years, under an agreement that included revenue sharing. Therefore, the hotel premises clearly satisfied the criteria required to be classified as a “fixed place of business” or a PE.
• Reliance placed by the taxpayer on the SC’s ruling in the case of E-Funds⁴ was misplaced and was distinguishable by facts. In E-funds, the Indian subsidiary merely provided back-office support and was compensated on an arm’s length basis, with no involvement in core business functions. In contrast, in the present case, the hotel itself was the distinct situs of the taxpayer’s primary business operations, carried out under its direct supervision and aligned with its commercial interests.
• The taxpayer’s further submission that daily operations were handled by Hyatt India Pvt Ltd., a separate legal entity, did not decisively support its case. Legal form does not override economic substance in determining PE status.
• Accordingly, the Hon’ble Delhi High Court was correct in concluding that the taxpayer’s role was not confined to high-level decision making but extended to substantive operational control and implementation. The taxpayer’s ability to enforce compliance, oversee operations, and derive profit-linked fees from the hotel’s earnings demonstrated a clear and continuous commercial nexus and control with the hotel’s core functions. This nexus satisfied the conditions necessary for the constitution of a Fixed Place PE under Article 5(1) of India–UAE DTAA.

Employee Presence

• The taxpayer’s executives and employees made frequent visits to India to oversee operations and implement the SOSA.

• The travel logs and job functions of the employees established continuous and coordinated engagement, even though no single individual exceeded the 9-month stay threshold. Under Article 5(2)(i) of India-UAE DTAA, the relevant consideration is the continuity of business presence in aggregate and not the length of stay of each individual employee.

• Once it is found that there is continuity in the business operations, the intermittent presence or return of a particular employee becomes immaterial and insignificant in determining the existence of a PE.

Profit Attribution

• Article 7 of the India-UAE DTAA governing the taxation of business profits provides that only so much of the profits as is attributable to the PE may be taxed in the source state.

• The larger bench of the Hon’ble Delhi High Court in Hyatt International Southwest Asia Ltd⁵, held that profit attribution to a PE in India is permissible even if the overall foreign enterprise has incurred losses. This reinforces the principle that taxability is based on business presence and not the global profitability of the enterprise.

Hon’ble SC affirmed the findings of the Hon’ble High Court that the taxpayer had a fixed place PE in India within the meaning of Article 5(1) of India-UAE DTAA and the income received under the SOSA was attributable to such PE and therefore, taxable in India.

BDO INDIA COMMENTS

The SC has reaffirmed that for the purpose of the disposal test, exclusive possession is not essential, and even temporary or shared use of space is sufficient if business is carried on through that space. Further, one needs to examine the overall facts to determine whether the place is at the disposal of the foreign entity or not.

This ruling broadens the interpretation of PE and confirms that substantive control over the Indian operations constitutes PE even in the absence of an exclusive physical office in India. The risk of PE creation cannot be avoided merely because the duration of employees' stay in India does not exceed the threshold prescribed in the relevant DTAA. Therefore, PE exposure cannot be ruled out if the services are performed offshore. What is relevant is the continuity of business presence in aggregate and not the length of stay of each individual employee, and the nature of services performed. The ruling, therefore, reinforces the substance over form principle in international tax law interpretation. Further, corporate tax liability shall arise even where the foreign principal incurs losses, provided there are profits attributable to the Indian PE.

Foreign entities having services, licensing, or management agreements should take cognisance of this ruling and proactively reassess their contractual and operational frameworks. Particular attention should be given to situations where employees of the foreign entity share premises with employees of Indian group entities, even in the absence of formally allocated space, since such arrangements may trigger potential PE risks.