BUSINESS CONNECTION, PERMANENT ESTABLISHMENT, TAX TREATIES: KEY CONSIDERATIONS
INTRODUCTION
In the course of entering a country for conducting business, a foremost consideration is the potential tax implication. Corporations are generally averse to pay in multiple jurisdictions. As a consequence, tax planning governs entry strategies. The taxability of any entity in India depends on its residential status. A resident taxpayer is subject to tax in India with respect to its global income. A company incorporated in India is a tax resident in India. Moreover, in the case of any other company, if the control and management of such a company occurs entirely in India during a fiscal year, the company is considered to be a tax resident in India, for that year. Once a company is tax resident, it is subject to tax in India on its global income.
For companies who do not have a presence, but may potentially have some kind of activity, the notion of business connection assumes significance. As stated above, an important criterion to make income chargeable to tax is that of the residence of the payee. Most foreign companies are considered non-resident in India by virtue of the fact that their management centers are based outside India. However, a foreign company may have activities in India, without being a resident.
This bulletin examines the concept of business connection as provided under the Income Tax Act, 1961 (“Act”), and its implications for foreign companies along with the relevance of tax treaties and permanent establishments.
1. What is a business connection?
The principle of a business connection attempts to charge to income tax any income derived by virtue of the activities carried on by a person in India and based on the nature of the presence. Under Section 9(1)(i) of the Act, the following income is deemed to accrue or arise in India:
“…all income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situated in India.”
The explanation to this section provides that in the case of a business where all operations are not in India, the income of the business deemed to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried on in India. The idea is that if any person has a certain level of direct or indirect activity in India, then the income derived from such activity should be subject to income tax in India. This does not mean that a person who is engaged in trade with India necessarily carries out an activity in India. It is quite possible to sell goods to a person in India where the transfer of title occurs outside the territorial jurisdiction of the country. In contrast, a foreign company working on a turnkey project involving construction, assembly or similar activities may have a business connection in India as these activities tantamount to a real presence of the foreign entity in India.
Similarly, a foreign company may have a relationship with an Indian entity through which it carries out its activities in India. In such a case, the relationship and transaction(s) is examined to ascertain whether, as a result of the relationship, and not merely based on a sole or series of transactions, the foreign company
derives income where the relationship and the transaction between the foreign company and the Indian entity is other than at an arm’s-length or as between principal and principal. The notion of “between principal and principal” is distinct from commercial agency where a foreign company may have an agent who promotes sales of its goods for a commission. If an agent acts in the normal course of his business as an independent agent and receives a reasonable income from his agency activities on the sales made by the foreign company in India, then this will not create a business connection between the foreign company and the agent.
The basic idea for any foreign company to bear in mind is whether the course of business between itself and an Indian entity leads to a presumption that the latter is not acting independently in the normal course of its business. For instance, in the event an Indian entity does not make the usual profit normally derived from the transaction and, instead, the foreign company has a pecuniary benefit from the low level of profit made by the Indian entity, then there maybe a case for the establishment of a business connection.
If the income of any foreign company is derived from a business connection, then it will be liable to pay tax on “such part of the income as is reasonably attributable to the operations carried out in India.” Presently, foreign companies are taxed at the rate of 42% after permissible deductions.
2. Business Connection and tax treaties
The above provides an overview of the liability to Indian income tax of a foreign company. At the same time it is worthwhile to examine the effect that tax treaties have on the analysis of the taxation of income in India. Usually, when a foreign company establishes a joint venture in India, it receives various types of income from the joint-venture company which often fall within the following categories:
- Royalties: income from the licensing of know-how;
- Technical Service Fees: income from the provision of technical services;
- Dividends: income from the dividends received from the JVC; and
- Business Profits: income from the sale of machines and components.
Naturally, the tax authorities – both in India and in the home country of a foreign entity – will want a slice of the pie, and will be keen to tax the income. From the perspective of the Indian tax authorities the income generation comes from activities in India, and, if the transaction is between two Indian companies, tax would be payable in India. Similarly, the home country of the foreign company would like to see tax revenues because the recipient of the income is a resident in its jurisdiction. Assuming that the tax authorities of the two countries levied tax, and in the absence of agreements between governments for avoidance of double taxation, international business and trade will be in jeopardy because entrepreneurs will end up paying significant profits as tax in both the relevant jurisdictions. As a consequence, many countries enter into bilateral agreements for the avoidance of double taxation and to decide who gets to share what in the tax pie.
Section 90 of the Act empowers the Central Government to enter into agreements with foreign countries for granting relief in respect of double taxation. Section 90(2) provides that where a treaty exists, the provisions of the Act “shall apply to the extent they are more beneficial to that assessee.” India is a signatory to tax treaties with various countries. Therefore, if the home country of the foreign company has signed a tax treaty with India it is crucial to examine how that will impact the internal Indian legislation.
It is not possible to generalize, but most tax treaties signed by India are based on either the United Nations or the OECD model. Each agreement is negotiated bilaterally and even small changes in the model treaties can lead to significant changes in tax liability. The objective of this bulletin is not to examine the provisions of any one treaty in-depth, but to highlight some important points.
2.1 Permanent Establishment (“PE”)
When examining the liability to tax under the domestic legislation and also under a treaty, it is important to identify the nature of the income as different rates apply. For the purpose of taxation of a foreign company’s income arising in India, the Act differentiates between income from dividends, royalties and technical service fees, and adds the notion of “business connection” to cover other types of profits. Under the tax treaties, generally, income from dividends, royalties and technical service fees is also specifically treated. The notion of PE overrules “business connection.” This is a crucial consideration which cannot be over-emphasized, and the specific definition of PE assumes significance in each treaty. The general principle found in most treaties is that (a) if a foreign company receives income by way of interest, royalties or fees for technical services then such income is subject to taxation in India;1 and (b) if a foreign company has a PE in India, then the profits attributable to that PE will be taxable in India at the prescribed rates.
Further, in many treaties, if a foreign company has a PE in India, even income derived from royalties, technical fees or dividends, if it is attributable to the PE, may be taxed as income of that PE. Often foreign entities do not want their income from India to be taxed in India, as income attributable to a PE. It is, therefore, necessary to examine the definition of PE in the relevant treaty. Frequently, the definition includes:2
“…a fixed place of business through which the business of the enterprise is wholly or partly carried on, including a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well and likewise encompasses a building site, a construction, assembly or installation project or supervisory activities in connection therewith, but only where such site, project or activities continue for a period or periods of more than six months; or the furnishing of services, including consultancy services, by an enterprise through employees or other personnel engaged by the enterprise for such purpose, but only where activities of that nature continue (for the same or a connected project) within the country for a period or periods aggregating to more than six months within any twelve month period.”
The term PE was recognized in CIT v. Visakhapatnam Port Trust as requiring the following: “In our opinion, the words “permanent establishment” postulate the existence of a substantial element of an enduring or permanent nature of a foreign enterprise in another country which can be attributed to a fixed place of business in that country. It should be of such a nature that it would amount to a virtual projection of the foreign enterprise of one country into the soil of another country.3”
Often the presence of foreign companies’ employees leads to creation of a PE, and the entities sometimes create technical service companies for the provision of these services. It is also possible that the investing entity and the service company may be situated in different countries from the parent. While structuring, the main consideration is where one finally wants the dividend income of the investment company to end – for instance, reinvestment, dividends to shareholders – and the tax consequences thereof.
As the terms of tax treaties with India vary from country to country, while structuring a project many companies try to take the benefit of the treaties of various countries depending upon how a treaty deals a particular income. Therefore, if a foreign company is located in Country X and Country Y has a favorable tax treaty with India for, say, withholding taxes on royalties, the foreign company may wish to set up a special purpose vehicle in Country Y which will then invest in the joint venture.
CONCLUSION
While treaty shopping is not an unusual exercise, the Indian (and even global) tax authorities are increasingly sensitive to this and have started questioning structures formed for avoiding the payment of tax and sans any real commercial purpose. Tax authorities aim to examine the commercial reality of any transaction which is also apparent in tax treaties since they generally contain a provision that any artificial transfer of profits from an enterprise in one country to an enterprise in another country, will be adjusted and taxes levied, as if on an arm’s-length transaction. India has a system of advance tax rulings which is very useful to determine the Indian tax incidence of any transaction and reduces the protracted, litigious process with the tax authorities. Where doubts emerge about the potential tax liability and conflicting views cannot be reconciled, it is prudent for enterprises to consider seeking this advance ruling.
1 The rates vary between types of income and also between country to country and are generally on the gross amounts.
2 Extract from the United Nations model.
3 144 FIR 146 (AP).