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Delhi HC delivers an important pronouncement on permanent establishment

In a significant decision delivered recently, the Hon’ble High Court of Delhi (“Hon’ble HC”) has shot down the case of the Income Tax Department (“ITD”) wherein the ITD had alleged three kinds of permanent establishments (“PE”). In Progress Rail Locomotive Inc.[1] (“Assessee”), the ITD intended to target the Assessee by putting it in all three conceivable PE silos i.e., Fixed Place PE, Service PE and dependent agent PE (“DAPE”) and used it as reasons to reopen the case. The Hon’ble HC rejected the contentions of the ITD by holding them to be prima facie unsustainable.

ITD’s contentions

The Assessee is a US-based company engaged in the manufacturing and supply of equipment to rail customers globally, including the Indian Railways. The Assessee has a wholly owned subsidiary called Progress Rail Innovations Private Limited[2] (“PRIPL”).

The ITD contended that PRIPL’s premises in India were at the Assessee’s disposal, and were  also used by its personnel visiting India for discussions with its customers like the Indian Railways. The ITD relied on the “Marketing and Engineering Services Agreement” between the Assessee and PRIPL to contend that the latter was engaged in providing support for marketing, warehousing, inventory management and transportation, etc., to the Assessee. Some employees of PRIPL reported to the employees of Assessee located outside India. The ITD alleged PRIPL to be a virtual projection of the Assessee in India and hence, should be regarded as its PE in India. The ITD extensively relied on the statements obtained from the employees of PRIPL, their emails etc to further buttress its arguments.

The ITD also alleged that the employees of the Assessee visited India to oversee PRIPL‘s operations and devise future business strategies. Thus, it was contended that the Assessee was furnishing services in India through its employees to PRIPL. The ITD relied upon Article 5(2)(l)(ii) of India USA DTAA and pointed out that where a foreign entity provided services through its personnel in another country for a related enterprise, even a single visit by such people could establish a Service PE since the India-USA DTAA does not stipulate a minimum time-period, unlike other DTAAs.

With respect to creation of a DAPE in India, the ITD alleged that PRIPL was authorised to take decisions on behalf of the Assessee w.r.t sales in India to its customers like the Indian Railways, submission of tenders, follow-ups for POs, tracking of delivery, payments, other communications, etc. The ITD argued that PRIPL had the authority to conclude contracts and hence, was acting as a dependent agent of the Assessee in India. A rubber stamp belonging to the Assessee was also found in the office of PRIPL during a survey. The ITD also contended that PRIPL secured orders for the Assessee and hence, constituted DAPE even as per Article 5(4)(c) of India USA DTAA.

Arguments put forward by the Assessee

The Assessee relied upon Article 5(1) of India USA DTAA, which states that PE means a fixed place of business through which the business of an enterprise is wholly or partly carried on. The Assessee argued that it received only back office and technical support services from PRIPL, which have already been examined by the transfer pricing officer (“TPO”) in case of PRIPL who did not hold PRIPL to be a PE of the Assessee. The Assessee also relied on the OECD commentary[3] as per which a decisive criterion for the constitution of a PE was to ascertain if such an activity was an essential and significant part of the activity of the enterprise as a whole. The Assessee also pointed out that the ITD, in its reasons for reopening the case, nowhere held that it had the exclusive possession of any particular part of PRIPL’s premises. The Assessee and PRIPL supplied different types of products to Indian Railways and the Assessee directly sold all its products. The Assessee also relied on Article 5(6) of India USA DTAA, which states that a PE cannot be assumed merely on the basis that an entity was controlled by the other entity situated in another country.

On issue of Service PE, the Assessee argued that as per Article 5(2)(l)(ii) of the DTAA, relied upon by the ITD, services need to be rendered by a foreign entity in India in favour of a related enterprise, whereas it was not the case of the ITD itself that Assessee rendered services to PRIPL within India.

In respect of creation of DAPE, the Assessee argued that as per Article 5(4)(a) of India USA DTAA, a DAPE can arise in India only if an agent exercised the authority to conclude contracts on behalf of the foreign entity in India and it habitually exercised such authority. The Assessee, relying on the OECD Commentary, argued that such an authority being granted to PRIPL should have been to conclude contracts pertaining to business operations of foreign entity and not merely contracts to engage employees or for internal operations, etc of PRIPL, and since such an authority was absent, it will not lead to the establishment of a DAPE of the Assessee in India.  

Further, the Assessee relied on analysis undertaken by the renowned author Skaar who, in his commentary[4], propagated the theory that the parent company having a say in the top management of its subsidiary would not, by itself, imply that the subsidiary is a PE, unless both entities are alter egos and undertake joint business activities.

Observations of the Hon’ble HC

The Hon’ble HC referred to Vishakapatnam Port Trust,[5] which introduced theconcept of virtual projection and held that a Fixed Place PE needs to be of an enduring and permanent nature. The Hon’ble HC observed that since PRPL’s premises was neither taken over in its entirety or in part by the Assessee to conduct business activities, it would not be construed as its virtual projection in India. Further, the Hon’ble HC held that as per the Hon’ble Supreme Court in Formula One World Championship[6], a foreign entity should have the right to use and exercise control over such physical place to constitute a PE even in the absence of formal legal rights whereas the ITD has failed to show exclusive or significant control by the Assessee on the business premises of PRIPL to support its case.

The Hon’ble HC referred to Article 5(1) of the India USA DTAA and cited rulings of the Hon’ble Supreme Court in Morgan Stanley & Co. Inc.[7], E-Funds IT Solutions Inc.[8], National Petroleum Construction Co.[9], Samsung Heavy Industries Company Limited[10]and UAE Exchange Centre[11] According to the aforesaid rulings, back-office operations or support services such as market research, data processing, serving as a communication channel or liaison office, etc., do not constitute as Fixed Place PE as they do not form part of primary business activity of a foreign entity in India. These activities have a preparatory or auxiliary character and are covered as exception under Article 5(3)(d) or Article 5(3)(e) of the DTAA. These provisions specifically exclude activities like collecting information or supply of information or other activities of a preparatory or auxiliary character from the ambit of Fixed Place PE.  

The Hon’ble HC took cognizance of the activities performed by PRIPL such as routing communication between the Assessee and the Indian Railways, gathering information, studying market trends, etc. It held that these activities are covered within Article 5(3)(d) and partly by Article 5(3)(e) of India USA DTAA.

The Hon’ble HC also held that the administrative control and all human resource related functions of employees of PRIPL were still in its own hands. Mere reporting or placing of representatives by a parent company on the board of directors of its subsidiary would hardly lead to the constitution of a PE in India. The Hon’ble HC reiterated the analysis undertaken by Skaar in his commentary[12], relied on by the Assessee, which stated that having a say in the top management would not, by itself, imply that the subsidiary is a PE. The Hon’ble HC also accepted the Assessee’s argument that as per Article 5(6) of India USA DTAA, merely because  control is exercised by one entity over another entity situated in another country, it cannot be assumed that a PE is formed.

On the issue of Service PE, the Hon’ble HC held that the ITD could not even remotely establish that the Assessee had rendered any service to PRIPL. It was incumbent on ITD to establish that the Assessee’s employees discharged functions related to PRIPL’s business. It held that mere visits by the Assessee’s personnel or managerial oversight by them of PRIPL or exchange of information between them as a parent and subsidiary would not lead to the establishment of a Service PE, unless the Assessee performed services for PRIPL. The Hon’ble HC also identified that in the reasons for reopening, the ITD had in fact taken a stand that PRIPL performed services for the Assessee leading to the constitution of a DAPE.

With respect to creation of a DAPE, the Hon’ble HC held that the ITD had failed to establish its case even on a prima facie basis. Neither in the notice or in the reasons for reopening the ITD has alleged that PRIPL had the authority to conclude contracts for the Assessee. Even the material collected by the ITD did not suggest such view. It had not been disputed by the ITD itself that the Assessee and PRIPL had independent dealings with the Indian Railways. The Hon’ble HC held that discovery of the Assessee’s rubber stamp in the premises of PRIPL does not imply that PRIPL had the authority to affix that seal on any document. With reference to Article 5(4)(c) of the India USA DTAA, the Hon’ble HC observed that the ITD failed to establish that: a) PRIPL secured orders for the Assessee in India; b) it habitually performed any such activity; and c) PRIPL was concerned wholly or almost wholly with any such activity. Therefore, the Hon’ble HC held that a DAPE shall also not arise in India.  

Further, theHon’ble HC observed that the variety of functions performed by PRIPL for the Assessee, as detailed above, already stood covered in its transfer pricing study. Therefore, once the TPO accepted the remuneration of PRIPL to be at arm’s length, no further attribution can take place and the question of a PE would become redundant as was also held in Honda Motor Company Limited[13].

With these observations, the Hon’ble HC quashed the reassessment proceedings[14] initiated against the Assessee.

Our thoughts

This is an extremely important precedent that may have far reaching implications. The decision very lucidly explains the characteristics and circumstances that could lead to the establishment of a PE. It also frowns upon the unnecessary aggression shown by the ITD to contend the constitution of a PE at each and every situation of a foreign company getting orders from Indian customers. It explains the exceptional circumstances wherein a foreign company could be held to have established a PE and at the same time, rebukes the ITD for contending a Fixed Place PE merely because a few employees were found at the premises of the Indian subsidiary.

It also explains the salient features of establishing a Service PE or a DAPE. The ruling highlights that it is absolutely necessary for the foreign company to be rendering services to the Indian related party for it to have established a Service PE. Further, the Indian subsidiary should actually be seen to have acted at the behest of the foreign parent to be regarded as a DAPE.

It must be noted that the ITD has been extremely aggressive in its dealings with multi-national entities and does not avoid a single instance of alleging that they have established a PE in India. Often, the ITD is seen invoking all the pertinent aspects of having a PE without too much of thought or evidence. As a consequence, the taxpayer is forced to defend its position in each and every situation, notwithstanding that no evidence has been put forth to substantiate its claim by the ITD. This leads to an unnecessary and prolonged litigation between the taxpayer and the ITD. While in most circumstances the taxpayer is able to get justice from the judiciary, it gives a bad name to the ITD and also impacts India’s ranking in ease of doing business parameter. It is high time that the Ministry of Finance and the Central Board of Direct Taxes prepare certain standard operating procedures that should be adhered to, while initiating allegations against the taxpayers. Similarly, a mechanism should be devised to reward tax officers who are able to generate additional revenues for the government and penalise those who initiate unwarranted litigation.

This decision should go a long way in restoring faith of the taxpayer community in the tax administration and the judiciary, in addition to providing valuable guidance for planning of their tax affairs in India.

[1] Progress Rail Locomotive Inc. (formerly Electro Motive Diesel Inc.) Vs. Deputy Commissioner of Income Tax (International Taxation), Circle  – Noida & Ors.

[2] Formerly known as EMD Locomotive Technology Pvt. Ltd

[3] Double Taxation Conventions, A Manual on the OECD Model Tax Convention on Income And On Capital, Philip Baker Q.C, Thomson Reuters, (2009)

[4] Permanent Establishment, Erosion of a Tax Treaty Principle authored by Arvid Aage Skaar.

[5] Commissioner of Income Tax, Andhra Pradesh vs. Vishakapatnam Port Trust 1983 SCC Online AP 287

[6] Formula One World Championship vs. Commissioner of Income Tax (2017) 15 SCC 602

[7] Director of Income Tax (International Taxation) vs. Morgan Stanley & Co. Inc. (2007) 7 SCC 1

[8] Assistant Director of Income Tax-1 vs. E-Funds IT Solutions Inc. (2018) 13 SCC 294

[9] National Petroleum Construction Co. vs. Director of Income (International Taxation) (2016) SCC Online Del 571s

[10] Director of Income Tax-II (International Taxation) vs. Samsung Heavy Industries Company Limited (2020) 7 SCC 347

[11] Union of India vs. UAE Exchange Centre (2020) 9 SCC 329

[12] Permanent Establishment, Erosion of a Tax Treaty Principle authored by Arvid Aage Skaar.

[13] Honda Motor Company Limited, Japan vs. Assistant Director of Income Tax, Noida & Ors. (2018) 6 SCC 70

[14] under Section 148 of Income Tax Act