Conference on International Taxation and FEMA Coimbatore Branch of SIRC of ICAI

1. Conference on International Taxation and FEMA Coimbatore Branch of SIRC of ICAI 8th and 9th Feb 2013 Permanent Establishment & Business Profits

2. Snap shot of this presentation • Residence and Source Based taxation • Permanent establishment • - Relevance of PE taxation • - Basic Rule PE / Fixed Base PE • - Examples of PE (Positive definitions of PE) • - Constructions / Installation PE • - Exceptions to PE (Negative definitions of PE) • - Agency PE • - Service PE • - Force of Attraction • PE in E- commerce Scenario • - Internet website • - Use of server – hosting arrangement • - Use of server – Own server • - Internet service provider

3. Snap shot of this presentation (contd…) • Business Profits • Relevance of PE in Business Profits • Force of Attraction • Allocation of profits to PE • Business Connection • Attribution and Indian Tax laws

4. Need for DTA • The problem with the Classical system of taxation is that Double Tax is built-in in the system. By the very nature of the Classical system of taxation; moment, there is a cross border income; two or more countries will claim the right to tax the same. • It is also understood that if double tax is allowed, either the international trade will not take place, or it will go under ground. In other words, there will be more smuggling & black money. Ultimately, the Governments will lose their tax revenues in more ways than one. • Hence most Governments have entered into Double Tax Avoidance Agreements (DTAs).

5. Country of Residence (COR) tax capability • Country of Residence (COR) has an inherent jurisdiction to tax its resident’s global income. • This need not/ cannot be stated in the treaty. • A Government acquires its taxing jurisdiction by its domestic legislation. • DTA neither grants/vests/nor allots such jurisdiction. • Therefore, the DTA does not grants this taxing right.

6. Permanent establishment’s(PE’s) effects on COR & Country of Source (COS) COR • A person resident in a country will be fully taxed on his Global income of all kinds in the COR. • Category of income is not important at all. • When we are considering the income of a person in his COR, the question of PE just does not arise at all. • Liability arises purely because he is resident of the country. No further reason is required for the Government to tax him

7. COS • A Government cannot tax a non-resident. • However if a non-resident businessman has presence in the host country (COS) beyond a critical line (thresh hold), then he can be liable to income-tax. • For Business Profits that critical line is permanent establishment.

8. PERMANENT ESTABLISHMENT • Relevance of Permanent Establishment in International taxation Country R Country S Corporate Tax Corporate Tax

9. Article 5(1) of the OECD model DTA Basic Rule PE For the purposes of this convention, the term “Permanent Establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on.

10. PERMANENT ESTABLISHMENT This was originally propounded in the German Pipeline decision (1996)

11. Operated by remote control through a computer in Netherlands Dutch Company German Company Transported crude oil and crude oil products Netherlands Germany Technical functions and business administration were exercised exclusively by personnel located in Netherlands Underground pipeline network Independent firms were hired to maintain and repair that part of the pipeline network that was situated in Germany

12. Article 5(2) of the OECD model tax treaty gives examples of PE and includes especially…

13. A place of management Branch Office An Office A Factory A Workshop A mine AN OIL OR GAS WELL

14. Planning & Supervision carried on by builder incusive falls within Construction PE. ARTICLE 5(3): Construction PE If a person carries on only planning and supervision without construction then it does not constitute construction PE Project lasts for more than 12 months 6 months in case of UN Model Constitutes PE

15. Service PE Service PE • Furnishing Services of any kind including Consultancy constitutes Service PE • Other than those services referred under Article dealing with Royalties & Fees for technical services • This clause goes beyond the ‘fixed base’ concept • This extension of taxation by the state of source is of particular significance in connection with making personnel available and with providing technical assistance • A service PE comes into being when an enterprise is – • Furnishing services, • Through its employees or • Other Personnel, • In the same or the connected project • For a period or periods aggregating more than 6 months

16. Morgan Stanley & Co., - 292 ITR 416 (SC) Morgan Stanley & Co., Inc – Investment Bank Sent Stewards to ensure high standards of the quality of the services are met to Morgan Stanley Advantage Services - India Deputed certain employees on request of Morgan Stanley India to work for Morgan Stanley India PE is created since - Morgan Stanley Inc would be responsible for the work of deputed employees Employees continue to be on the payroll of Morgan Stanley Inc Employees continue to have lien on their employment with Morgan Stanley Inc Held, that stewardship activities did not create PE. The presence was not to carry on significant activity of business but ensuring that standards are maintained

17. PE not formed Due to insignificant economic activity Article 5(4) Excluded Activities UN model does not recognise “delivery”

19. Illustration 1 3 Year Contract Polrail Information Technology and communication services Singco. Singapore Poland Employee of Singco visits Polrail frequently Most of the work is done at Singco’s facilities in India To present and discuss the results of work done to date. To gather and analyse further technical data and other information, To formulate with the Polrail’s management the strategy for subsequent work. Each visit never lasts for more than a week All visits in a 12 month period certainly do not exceed 3 months. Employee was assigned whichever office facilities happened to be available in Polrail’s Warsaw building IS PE CREATED BY SINGCO IN POLAND?

20. Dependant Agent A person’s commercial activities for an enterprise are subject to detailed instruction or comprehensive control by the enterprise, the person is regarded as dependent. A person acting for only one principal would appear to be a dependant agent. IRC v/s London Produce Co [1968] 2 ALL ER 1975 and Case 23/93 (1003) 93 ATC 288

22. INDEPENDENT AGENT ARTICLE 5(6)

23. The Principal has no control over, or power to interfere in, the day-to-day business of the agent Agent conducts its own exclusive business wherein It bears the entrepreneurial risk of the business

24. Criteria for Dependence Nature of Relationship Between Agent and Principal Agent has NO entrepreneurial Risk Agent is subject to detailed instructions or to comprehensive control Agent is DEPENDENT

25. ARTICLE 5(7) Existence of Holding and Subsidiary Relationship does not make each other PE of the other in the respective states

26. Impact of e-commerce In the increasing interactive commercial use of the Internet in recent years, the location of a PE as a geographical point is more challenging Is human intervention required before a PE can exist? Does the use of the internet create a PE abroad for an enterprise?

27. E- Commerce - PE • PE by definition needs – • A fixed place of business; or • A dependent agent working in the Country of Source E- Commerce by its very structure needs neither fixed base nor human intervention Can the concept of PE be applied to E-Commerce?

28. Internet constitutes PE? Internet Website Hence no PE created

29. Internet constitutes PE? Use of Server – hosting arrangement

30. Internet constitutes PE? Use of Server – Own Server

31. Internet constitutes PE? Internet Service Providers

32. HOW TO DETERMINE PE? Does the Basic Rule in Arts. 5(1) and 5(2 )apply? 1 Does the building / construction/ installation project rule in Art 5(3) apply? 2 NO YES YES 3 Do the Exceptions in Art 5(4) Apply? YES PE EXISTS 6 NO NO YES Is the business conducted through agents who are legally and economically independent or by a non – agent subsidiary? Is the business conducted through Dependant agent? 4 5 NO 7 NO PE NO YES

33. Illustration 2 • He participates in the trade fair under following circumstances: • Has a non-exclusive annual licence to occupy a specific area. The licence can be varied, suspended or revoked at any time. • Entry into Canada is temporary for immigration purposes for limited purpose of attending fair • Canadian customers cannot order or return his products. He has no telephone in Canada • His goods are not stored in Canada (apart from inventory in his van and booth. • Significant proportion of his total business profits each year is earned at the trade fair. Canada Pacific Business Development Trade Fair Mr. Bush resident of Los Angeles, California, USA. He carries on a small part-time, but lucrative business selling knives, gloves and handy utensils from a trailer and collapsible booth – transports to 2 markets in California for a period of 2-3 weeks per year. For 15 years He has towed his trailer and booth to the Trade fair Sells goods for over a 3-week period At the end of each trade fair tows back to USA Returns to Canada only in the next Trade fair Does Mr.Bush have a PE in Canada?

34. BUSINESS PROFITS Residence State Source State Business Activity ENTERPRISE Article 7(1): Source State may only tax if Business Activity constitutes a PE Article 5: Definition of Permanent Establishment Article 7: Income Attribution

35. Relevance of PE for Business Profits • Permanent Establishment is a Litmus test that is used in all the treaties to determine whether the business income is subject to tax in the Country of Source • Concept of PE is totally irrelevant in considering the assessee’s tax liability in COR. It assumes importance only while considering the tax liability in the host country (COS). • There is considerable scope for PE profits to be “massaged” by the manipulation of charges for goods and services supplied between the entity’s head office and its PE.

36. Relevance of PE for business Profits IT Act DTA Royalties & FTS No PE PE No PE PE BP/FTS/ R/IPS R/FTS/IPS BP 10% u/s 115A(1)(BB) On Gross Receipts 40% As per FA, 2012, I Sch Part II Entry No. 2(b)(ix) On Net receipts after expenses 40% As per FA Act, 2012, I Sch Part II Entry No. 2(b)(ix) On Net receipts after expenses Concessional rate On Gross Receipts No Tax

37. Business profits – Treaty Provisions

38. Attribution of profits to Permanent establishment – Article 7(1) R – Resident Country; S- Source Country

40. Attribution of profits to PE – Article 7(1) • Article 7 (1) merely provides that profits attributable to PE may be taxed in “S” country. • Provisions of section 9(1)(i) is also worded on similar lines. It states, if in case part of business is carried out in India and balance outside India, then the profits attributable to operations carried out in India is deemed to accrue or arise in India. • Note: law does not prescribe any method to attribute profits to PE

41. Attribution of Profits - Conditions • Existence of PE must for attribution • Business is carried on through such PE • Preparatory activities do not trigger attribution • Only profits attributable to such PE is taxable in the source country ALLOCATION OF PROFITS TO A PE Where Company R has a PE in Country S, Country S is normally entitled to tax the profits derived from its jurisdiction and will also normally have first claim to tax those profits. If Company R’s Country of Residence taxes worldwide income of its residents it would typically give relief to Company R for the tax it pays to Country S by way of the foreign tax credit System

42. Decision regarding taxation of profits attributable to PE in COS

43. Taxation of profits of PE in the country of residence • Country of residence has right to tax its residents irrespective of the country in which the income arises • The language of Article 7(1) should not be interpreted to mean that the state of residence gives up its right to tax – contrary to SRM case • Whenever profits attributable to PE are taxed ONLY in the COS and not in the COR, it would be made clear by a language which categorically says so. • Eg: DTAA between India with Bulgaria, Hungary, Czechoslovakia, Poland.

44. In Bombay Burmah Trading Corp vs. ACIT 82 ITD 531 (Mumbai Tribunal) held that profits attributable to PE in Tanzania were subject to tax in India in terms of Article 7 of DTA. Excerpt of DTAA between India and Tanzania ARTICLE 7 - Business profits - 1. The profits of an enterprise of a Contracting State shall be taxable only in that Contracting State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other Contracting State but only so much of them as is attributable to that permanent establishment.

45. ATTRIBUTION OF PROFIT – ARTICLE 7(1)

46. Force Of Attraction A Inc. (US Co.) $ 200 USA $ 100 Direct sale of Garments India Import of Garments Branch in India Sale of Imported garments Various Customers Profits of India Branch = Profit earned through own sales + Profit earned by A Inc. from direct sales to customers

47. Distinct and separate enterprise approachArticle 7(2)-Arms Length Pricing • where an enterprise of a Country R carries on business in Country S through a PE situated in Country S, there shall in each Country be attributed to that PE the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise with which it is a PE.

48. Issues arising on application of Article 7 (2) • Can profit be earned from transaction with self? • When Capital asset is converted into stock-in-trade, law treats it as a transfer and is subject to Capital Gains tax • Associated Enterprise as per definition u/s 92A mean a person (includes PE of such person) …..intending thereby that even a PE is to be treated as separate enterprise. • Income Tax law itself, in above cases accepts the concept of taxing profits from transaction with self.

49. Issues – Article7(2) • CBDT Circular no. 649 dtd 31/03/1993 • When PE remits FTS to the HO, fee would be taxable in the hands of HO. Therefore, PE is required to deduct tax. • CBDT Circular no. 740 dtd 17/04/1996 • Indian banking branch of Non-Resident company makes interest payment to its HO or branch situated in any other country, it is required to deduct tax at source u/s 195. • The above 2 circulars admit the concept that one can make profit by trading with self.

50. Issues arising on application of Article 7 (2) • Challenges while adopting Separate Entity Approach… • A head office transfers goods to a PE and • PE sells the goods to a customer. • Is the income recognized by the head office • (i) upon transfer of the goods to the PE – as if the PE were a subsidiary company of a foreign parent or • (ii) upon sale to the client, because the entity as a whole only realizes the income upon sale to the separate legal entity (the client) and not upon the internal transfer?