BACKGROUND

In order to avoid double taxation in a cross-border transaction, income may be taxed either on the basis of Source Rule¹ or Residence Rule². This Rule is generally contained in Double Taxation Avoidance Agreements (DTAA or Tax Treaty or Treaties). Unless the income (such as royalty, fees for technical services, etc) is specifically taxed, income of a Foreign Company can be taxed only if it has a Permanent Establishment (PE) or business connection in India. Where a Foreign Company has a PE in India, only the income that is attributable to such PE is taxable in India.
A situation may arise that the Foreign Company would have incurred a loss at global level even though at PE level it has positive income. In such cases, a question may arise about attribution of profits to the PE in India and its taxability. Recently, the Full Bench of Hon’ble Delhi High Court³ had an opportunity to determine whether losses at the entity level would be relevant to determining the taxability of the PE in India, which may be earning profits.

We, at BDO in India, have summarised this ruling and provided our comments on the impact of this decision hereunder:
         
FACTS OF THE CASE

• The taxpayer, a foreign company incorporated in the United Arab Emirates (UAE) had a PE in India.  The taxpayer filed a petition with the Delhi High Court with regard to the applicability of Article 7(1) of the India-UAE DTAA if the taxpayer had incurred losses at global level in the relevant Fiscal Year (FY).

• The taxpayer relied upon the decision of the Delhi Tax Tribunal in case of Nokia Solutions & Networks OY⁴ and argued that in case the enterprise at an entity level had suffered a loss in the relevant FY, no profit or income attribution would be warranted insofar as the PE is concerned.

• The Division Bench of the Delhi High Court doubted the correctness of the view expressed in the case of Nokia Solutions & Networks OY (supra).

• Consequently, a full Bench of the Delhi High Court was constituted to determine whether the findings of the Delhi Tax Tribunal in the case of Nokia Solutions & Networks OY were correct or not.

DELHI HC RULING

The full bench of the Hon’ble Delhi High Court, while overturning the decision of Nokia Solutions & Networks OY, held that PE is an independent taxable entity and global income of the entity is not relevant for profit attribution. In this regard, Hon’ble Delhi High Court made the following observations:

Re. Meaning of ‘PE’ under DTAA and as per judicial precents

• Article 5 while defining the expression “PE” brings within its ambit a varied nature of establishments and which need not necessarily be those which have a separate legal persona. The nature of establishments which are included within the meaning of the phrase “PE” range from a place of management to a mine or a building site and thus not being confined to a juridical entity as is ordinarily understood in law.

• Reliance was placed on the decision of the Supreme Court in the case of Morgan Stanley & Co. Inc.⁵and Delhi Court in the case of International Management Group (UK) Limited⁶ wherein it was held that the profits of the PE are to be determined on the basis of what an independent enterprise under similar circumstances might be expected to derive on its own i.e. for the purpose of taxation, PE is to be viewed as distinct and separate.

• The PE principle enables the assignment of tax to the country which constitutes the source. It creates a functional relationship and connection between the principal entity and the place of business whose activities give rise to income or profit. It is this fictional creation of an independent economic centre in a Contracting State which informs the allocation of taxing rights.

• Once the DTAA confers an independent identity upon the PE, it would be wholly erroneous to answer the question of taxability basis either the activities or profitability of the parent or the entity which seeds and sustains the PE.

• Reliance is placed on the Hon’ble Supreme Court decision in Morgan Stanley⁷ wherein it was observed that a distinction is liable to be drawn between a PE with respect to income earned in the Contracting State where it is domiciled or deemed to exist and the global enterprise of which it may be a part.

Re. Concept of ‘PE’ under various Double Taxation Commentaries

• Klaus Vogel on Double Taxation explains the PE concept as constituting the threshold and the "essential demarcation line" in the source State which sanctions the imposition of a tax in a fiscal jurisdiction other than the State of residence.

• As per Commentary on Article 7 of Organisation for Economic Co-operation and Development (OECD) Model, the imperatives of viewing the PE as a separate and independent centre for the purposes of fiscal treatment and taxation is necessitated for reasons of attribution and recognition of income generated by it independently.

• Further, reliance is placed on United Nations Model Double Taxation Commentary which states that the is based upon the undertaking of economic activity in a particular State irrespective of the residence of an enterprise and the same being understood to be in the nature of a conglomerate or an entity which may have many arms or independent functional units situate in various fiscal jurisdictions. 

Re. PE to be viewed as independent centre of Revenue

• Article 7 of the DTAA postulates that the profits of an enterprise shall be taxable only in that State. It, therefore, as a matter of first principle, restricts the taxation of profits of an enterprise only to and in the State of which it may be a resident. However, it then proceeds to expand the scope of taxability by taking into consideration the activities that may be undertaken by such an enterprise in the other Contracting State through a PE situated therein. This is further explained by Article 7(1) prescribing that if the enterprise were carrying on business through a PE situated in the other Contracting State, its profits would become liable to be taxed in the other State, restricted however, to the extent that those profits are attributable to that PE.

• Article 7(1) of the DTAA envisages the profits of a PE being liable to be independently taxed notwithstanding that PE being a constituent of a larger enterprise which may be domiciled in the other Contracting State.

• Article 7(1) thus in clear and unequivocal terms constructs a dichotomy between the profits that may be earned by an enterprise on a global scale and those which are attributable to a PE situated in the Contracting State. This becomes evident from Article 7(2), which stipulates that where an enterprise carries on business through a PE in the other Contracting State, profits would be liable to be attributed to that PE as if it were a distinct and separate enterprise engaged in similar activities and independent of the enterprise of which it may be a part.

• Article 7(2) uses the phrase “dealing wholly independently with the enterprise of which it is a permanent establishment”. Article 7(2) thus clearly bids us to view the PE as a distinct and separate entity engaged in undertaking business activity in its own right in a Contracting State. It would consequently and on a fundamental plane be incorrect to fuse the incomes generated by an enterprise as a whole with the income that may be earned by a PE in one of the Contracting States.

• It would be incorrect to interpret Article 7 as requiring us to ignore the income that may be generated pursuant to activities undertaken by a PE in one of the Contracting States and making the exercise of attribution dependent upon the profits or the income that the enterprise may otherwise earn at an entity level. In fact, Article 7(1) itself excludes the profits of an enterprise from being subjected to tax till such time as such an entity carries on no business in the other Contracting State through a PE.

• Consequently, even though a PE may be merely a part of the larger entity, the profits generated from its activities undertaken in the other State becomes subject to taxation. Article 7(1) further requires us to undertake an exercise of identifying the extent of profits as are attributable to the PE. It is to that extent alone that the profits of the enterprise ultimately come to be taxed.

• OECD Commentary also explains that the taxation right of the source State is dependent upon the existence of a PE.

• As per Section 5 of the IT Act, global income of a resident is subject to taxation. For non-residents, it is the principles of income accruing or arising which are decreed to govern. It is these broadly accepted and well-recognised principles which imbue the DTAA as well.

• The profits of an enterprise do not become subject to taxation unless it is found that it functions in the other Contracting State through a PE. Article 7 further postulates that it is only such income which is attributable to the PE which would be subjected to tax in the source State. As is pertinently noted in the OECD and UN Commentaries, it would be wholly incorrect to find taxation based on the overall activities or profitability of an enterprise. The source State is ultimately concerned with the income or profit which arises or accrues within its territorial boundaries and the activities undertaken therein. As those commentaries pertinently observe, the profits attributable to a PE are not liable to be ignored on the basis of the performance of the entity as a whole. This position is also affirmed by the Hon’ble Supreme Court in Morgan Stanley (supra) and Ishikawajama⁸.

• If the contentions of the taxpayer were to be accepted, the tax officer would be recognised to have the power to tax even in a situation where although the entity be profitable, the PE may have incurred a loss. Applying the same logic, in a converse situation, the Contracting State would be countenanced to have the right to tax only if the taxpayer at a global level were found to have earned profit. That is clearly not the import of Article 7 of the DTAA. Therefore, the argument of global income or profit being relevant, or determinative is totally unmerited and misconceived.

• Further, Article 7 does not expand its gaze or reach to the overall operations or profitability of a transnational enterprise. It is concerned solely with the profits or income attributable to the PE. The taxability of income earned by a PE existing in a Contracting State is not even remotely linked or coupled to the overall operations of the enterprise of which it may be a part. The argument of worldwide income is thus rendered wholly untenable.

• The activities of a PE are liable to be independently evaluated and ascertained in light of the plain language in which Article 7 stands couched. The fact that a PE is conceived to be an independent taxable entity cannot possibly be doubted or questioned.

• The Decision of the Special Bench in Motorola Inc⁹. which was relied in Nokia Solutions has clearly been misconstrued and it, in any case, cannot be viewed to be an authority for the proposition which was canvassed on behalf of the taxpayer. Article 7 cannot possibly be viewed as restricting the right of the source State to allocate or attribute income to the PE based on the global income or loss that may have been earned or incurred by a cross-border entity.

BDO IN INDIA COMMENTS

The Full Bench of Delhi HC has affirmed that PE should be treated as a separate and independent entity, which is in line with the meaning provided by the commentaries and the DTAA.
With regard to the attribution of profits to a PE, the Delhi HC has overturned the findings laid down in the decisions of Nokia Solutions and Motorola Inc. and held that reliance on the global income for the attribution of profits to the PE may not depict a correct picture of the actual business activity that may be carried out by the PE in the source country. Further, if the global income is considered for profit attribution and an entity is incurring losses at a global level, it may lead to tax erosion and non-taxation in the source country.