EY Tax Alert. India s positions on the 2017 Update to the OECD Model Convention and Commentary. Executive summary

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1 28 November 2017 EY Tax Alert India s positions on the 2017 Update to the OECD Model Convention and Commentary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor. Executive summary On 21 November 2017, the Organisation for Economic Co-operation and Development (OECD) approved the contents of the 2017 Update to the OECD Model Tax Convention (MC) and Commentary 2014 (the OECD Model). The 2017 Update, which was previously approved by the Committee on Fiscal Affairs on 28 September 2017, will be incorporated in a revised version of the OECD Model that will be published in the next few months [1]. The 2017 Update largely contains changes which were agreed as part of the Base Erosion and Profit Shifting (BEPS) project and the follow-up work thereon. In addition, it incorporates certain other changes that were released for public comments on 11 July 2017 and have been finalized now. Like the previous updates, the 2017 Update contains various positions of the OECD and non-oecd member countries, including those of India. India was granted the Observer Status in July 2006 and continues to have a working relationship with the OECD [2]. [1] Source [2] India is on the Governing Board of the OECD s Development Centre and it also participates as an observer in some OECD committees and various working groups. The OECD Council, at the ministerial level, adopted a resolution on 16 May 2007 to strengthen the cooperation with India, amongst some other South Asian countries, through a program of enhanced engagement. While enhanced engagement is distinct from accession to the OECD, it has the potential, in the future, to lead to membership. (Source:

2 The inclusion of the positions of non-member countries (NMCs) has been done with an intent to give them the flexibility, like member countries, to identify the areas where they are unable to agree with the text of an Article of the OECD MC or with an interpretation given in the Commentary. In this way, the NMCs could be expected to associate themselves with the development of the OECD Model. Accordingly, the positions of the NMCs reflect their views on the text of the OECD MC and the Commentary thereon. Positions of NMCs (including India) were made part of the OECD Model for the first time in 2008 [3] and the same are updated with each update to the OECD Model. India s positions to the 2017 Update are mainly on Article 5 on permanent establishment (PE), Mutual Agreement Procedure (MAP) and on certain other miscellaneous provisions such as the tie-breaker rule for nonindividuals, tax treaty eligibility for transparent entities etc. This Tax Alert highlights the key changes to India s positions in the 2017 Update. India s reservations on the 2017 Update to the OECD MC and Commentary Article 5- PE Deemed PE due to significant economic presence The OECD s BEPS Action 1 Final Report examining the tax challenges of digital economy identifies, amongst others, a new nexus test in the form of significant economic presence as an additional option for determination of taxable presence in a state [4]. This is, however, not a specific recommendation in the Final Report and the work on Action 1 is still in progress with the OECD, the final outcome of which is expected in Furthermore, as per the Commentary, a website which is a combination of software and electronic data, does not create a PE since the enterprise does not have a physical presence at a location that can constitute a place of business. In the 2014 OECD MC, India had reserved a position that a website can create a PE in certain circumstances or by virtue of hosting a website on a server at a particular location. India has made the following positions in the 2017 Update: (A) Right to deem a PE of a foreign enterprise in India if it has significant economic presence in India, as discussed in BEPS Action 1 (Digital Economy). (B) A website may constitute a PE where it leads to significant economic presence of the foreign enterprise in India [5]. (C) Depending on facts, a foreign enterprise can be considered to have acquired a place of business through a website on any equipment, if opening the website on that equipment includes downloading of automated software, such as cookies, which use that equipment to collect data from that equipment, process it in any manner or share it with the enterprise. Positions on BEPS amended Article 5(5) and 5(6) Agency PE [6] Non-inclusion of the term routinely in Dependent Agent PE clause The 2017 Update expands the scope of Agency PE to cover a person who habitually plays the principal role in conclusion of contracts that are routinely concluded without material modification by the enterprise. India has reserved a right on non-inclusion of the term routinely. In other words, Agency PE can be created even if contracts are concluded without material modification by the enterprise on a non-routine basis. Person working exclusively for a foreign enterprise cannot be considered as independent, irrespective of its close relationship with the enterprise The 2017 Commentary provides that if a person acts exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related, that person shall not be considered to be an independent agent. India has reserved a right on non-inclusion of the term to which it is closely related. Thus, according to India, if a person acts exclusively or almost exclusively on behalf of one or more enterprises, such person may not qualify as an independent agent, irrespective of whether such person is closely related to the enterprise or not. [5] The current position deviates from India s previous position to the 2014 OECD MC stating that a website can create a PE in certain circumstances. The circumstances were not explained previously. India has modified its position considering the developments in BEPS Action 1. [3] Refer EY Tax Alert dated 22 July 2008 titled 2008 update to the OECD Model Tax Convention- India s position on the Articles of the Model Convention/Commentary [4] Refer EY Global Alert dated 23 October 2015 titled OECD releases final report on the tax challenges of the digital economy under Action 1 [6] 2017 changes to Article 5(5) and 5(6) of the OECD MC are based on the final report on BEPS Action 7. Refer Global Tax Alert dated 19 October 2015 titled OECD releases final report on preventing the artificial avoidance of permanent establishment status under Action 7.

3 Fragmentation cannot be ignored even independent of anti-fragmentation rules In the 2017 Update, a new anti-fragmentation rule has been introduced, which seeks to deny PE exemption of preparatory/auxiliary activities if specific conditions are satisfied. The Commentary [7] clarifies that unless the anti-fragmentation provisions are applicable, the preparatory/auxiliary activity condition is of no relevance in a case where an enterprise maintains several fixed places of business to which other listed PE exemption clauses apply since, in such cases, each place of business has to be viewed separately and in isolation for deciding whether a PE exists. India does not agree with the above interpretation of the OECD Commentary. According to India, even when the anti-fragmentation provision does not apply, an enterprise cannot fragment a cohesive operating business into several small operations in order to argue that each is merely engaged in a preparatory or auxiliary activity. Low-risk distributor may create PE The 2017 Commentary states that a buy-sell distributor (irrespective of whether it is an associated enterprise or not) may not be considered as a Dependent Agent PE since it is neither acting on behalf of a non-resident (NR) enterprise nor is it selling goods that are owned by such NR enterprise. The goods that are sold to the customers are owned by the distributor itself. This conclusion would apply even if the distributor acted as a low-risk distributor. India does not agree with the above interpretation because it considers that distribution of goods owned by an enterprise (by an associated or related enterprise) may create PE, particularly in a case where the risks are not borne by such distributor. Repair work on project subsequent to completion of construction work to be added to original construction period The 2017 Update states that a building site or construction or installation project constitutes a PE only if it lasts more than 12 months. The Commentary clarifies that work that is undertaken on a site after the construction work, pursuant to a guarantee that requires an enterprise to make repairs, would normally not be included in the original construction period. India does not agree with such interpretation. According to India, any work undertaken on a site shortly after the construction work has been completed, including repair works undertaken pursuant to a guarantee, may be taken into account as part of the original construction period. Collection of information on risks not preparatory or auxiliary, in case of insurance company If a fixed place of business is used merely for collecting information for an enterprise, such place may not be treated as PE, provided such activity of information collection qualifies as preparatory or auxiliary for the enterprise. In this regard, the Commentary illustrates this by stating that, if an insurance company that sets up an office solely for the collection of information, such as statistics or for understanding risks in a particular market, such collection of information will be a preparatory activity. India does not agree with the above interpretation. Collection of data for the purpose of determination or quantification of risk by an enterprise in the business of managing risks, such as insurance, is not an activity of preparatory or auxiliary character. Treatment of Value Added Tax (VAT)/ Goods and Services Tax (GST) relevant for determining PE The 2017 Commentary states that treatment under VAT/GST is irrelevant for the purposes of the interpretation and application of the definition of PE. Hence, when evaluating PE, one should not draw any inference from the treatment of a foreign enterprise for VAT/GST purposes, including from the fact that a foreign enterprise has registered for VAT/GST purposes. India does not agree with the above. According to India, treatment under VAT/GST can be a relevant factor for determining PE. Disposal test The 2017 Commentary provides that where an enterprise does not have a right to be present at a location and does not use that location itself, that location cannot be considered as being at the disposal of the enterprise. Furthermore, the 2017 Commentary also introduces an example: when a cross-frontier worker performs most of his work from his home situated in one state rather than from the office made available to him in the other state, his home should not be considered as being at the disposal of the enterprise. However, India does not agree to either of the above clarifications. According to India: a) Even where an enterprise does not have a right to be present at a location and does not use that location itself, such location can, in certain circumstances, be considered as being at the disposal of the enterprise [8]. [7] Para 74 of the 2017 Commentary on Article 5 [8] No specific circumstance has been explained or illustrated in this regard.

4 b) With respect to the example of home/office employee, India is of the view that the home of the employee can be considered as being at the disposal of the enterprise. On permanence test and Short Duration PE MAP As per the Commentary, a PE is deemed to exist only if there is certain degree of permanence in the source country. In general practice, this is satisfied if the place of business is maintained for a period of six months. An exception to this condition is a case where business activities are carried on exclusively in a country. In such case, even if the business exists for a shorter durationdue to the nature of the business activity-its connection with that country is stronger. This exception is illustrated in the following two circumstances: 1) An individual, resident in State R, contracts with the producer of a documentary to provide catering services at the remote village at State S where such documentary is proposed to be shot for a fourmonth period. The individual will provide such services from his parents home which is located at the village. In such case, the Commentary states that the time requirement for a PE is met since the restaurant is operated during the whole existence of that particular business. 2) However, a company, resident of State R, operating various catering facilities in State R, may also operate a cafeteria in State S during a fourmonth production of a documentary. In that case, the company s business, which is permanently carried on in State R, is only temporarily carried on in State S. Hence, it could not be considered that the time requirement for a PE is met. India disagrees with the OECD s view in scenario 2. According to India, operation of catering facilities in scenario 2 also meets the time requirement for constituting a PE. Mandatory binding arbitration Article 25 of the OECD MC on MAP contains provisions in relation to mandatory binding arbitration. India has consistently made it clear that it is not in favor of adopting mandatory binding arbitration. It is for the same reason that India opted out of the mandatory binding arbitration provisions of the Mulitlateral Instrument. In line with the same view, India has reserved its right to not include the mandatory arbitration Article in its tax treaties. MAP access in transfer pricing (TP) cases in the absence of Article 9(2) in the tax treaty India has been of the view that it is not obliged to provide corresponding adjustment or MAP access in TP cases under tax treaties which do not have Article 9(2) of the OECD MC. This was reflected in India s position to the Commentary on Article 25. One of the minimum standards under BEPS Action 14 requires countries to grant MAP access in TP cases [9]. To enable countries to meet this minimum standard, the MLI provisions provide an option to countries to include Article 9(2) in their tax treaties. Countries were, however, allowed to opt out of this requirement if they agreed to: a) Provide corresponding adjustment or MAP access in TP cases despite the absence of Article 9(2) in the tax treaty; or b) Include a provision in the tax treaty limiting the time during which it would make adjustment to transfer prices or income allocated to a PE. As part of the MLI, India had agreed to include Article 9(2) of the OECD MC in is tax treaties. Recently, the Indian tax administration clarified India s position to provide MAP access in TP cases even under the tax treaties which, presently, do not have Article 9(2) [10]. In line with the above, India has deleted its reservation on Article 25 of the Commentary in the 2017 Update. Right of competent authorities to bilaterally resolve difficulties or doubts concerning interpretation or application of the tax treaty Article 25(3) of the OECD MC authorizes competent authorities of the countries to suo moto resolve doubts or difficulties which may arise in interpretation or application of the tax treaty, by way of mutual agreement. The 2017 Commentary has inserted an additional para to the Commentary of Article 25 to clarify that, pursuant to the authority granted by the OECD MC, competent authorities may enter into a mutual agreement to agree on the meaning of the words which are undefined in the relevant tax treaty. Furthermore, they may also clarify the meaning of a defined term to resolve any doubts or difficulties that may arise in the interpretation of such defined terms. India does not agree with the above Commentary and it is of the view that an undefined term in the tax treaty will have the same meaning as it has under the laws of the state which applies the tax treaty and, hence, cannot be a subject matter of MAP. MAP access to be allowed only where it is certain that there will be taxation in conflict with the tax treaty, and not probable The Commentary on Article 25 clarifies that MAP under the tax treaty can be initiated as soon as it is probable that the action of the Tax Authority will result in taxation which is not in accordance with the tax treaty, without waiting till the time where tax is actually charged on him or notified to him. [9] Refer EY Global Alert dated 8 October 2015 titled OECD releases final report on improving the effectiveness of dispute resolution mechanisms under Action 14. [10] Refer Press Release by the Central Board of Direct Tax (CBDT) dated 27 November 2017

5 India did not have any reservation on this view of the Commentary so far. However, India has now observed that it does not agree with such interpretation and is of the view that MAP can be invoked only in cases where it is certain, and not probable, that the action of the Tax Authority will result in taxation which is not in accordance with the tax treaty. Notifying cases where MAP access may be denied for transactions considered abusive under the domestic laws The Commentary notes that many countries deny MAP access in cases where the transaction in relation to which MAP access is made is considered abusive as per the domestic laws. The OECD is of the view that in the absence of a specific exclusion, MAP access cannot be denied. However, it gives an option to countries to deny MAP access in cases involving serious violation of domestic laws, provided that such countries disclose all the circumstances in which they would deny MAP access. India has observed that it does not agree with the OECD view that all such circumstances in which MAP access may be denied are to be listed and made clear by the contracting state. India is of the view that Article 25 is worded in a manner that it provides countries the right to deny MAP access in certain circumstances [11]. India positions on other Articles Tie-breaker rule for persons other than Individuals Under the 2014 OECD MC, dual resident persons other than individuals (dual resident entity or DRE ) are treated as treaty resident of the state in which its place of effective management or POEM is situated. The Commentary also explained that POEM, for this purpose, means the place where key managerial and commercial decisions that are necessary for the conduct of the entity s business as a whole are, in substance, made. India had reserved its right to include a provision in its tax treaties providing that dual residency would be resolved under MAP in cases where the POEM of the entity cannot be determined. India had also observed that it did not agree with the OECD s interpretation of POEM as the place where key management and commercial decisions are taken and had indicated that POEM can be considered to be situated in a place where the main and substantial activity of the entity takes place. The 2017 Update has amended the tie-breaker rule in case of DREs and provides that treaty residence for DREs will be resolved through MAP between countries, having regard to its POEM, the place of incorporation and any other relevant factors. It also provides that in the absence of any agreement between the countries, DRE will not be entitled to any relief or exemption under the tax treaty, except as may be agreed under MAP. [11] 2017 Update does not specify the circumstances in which tax treaty Since the 2017 Update has amended the tie-breaker rule for DREs from POEM to MAP, India has deleted the above positions. Eligibility of transparent entities to avail tax treaty benefits Article 1 of the OECD MC defines persons who are covered by a tax treaty. It provides that the tax treaty applies to persons who are residents of one or both the contracting states. In order to ensure that tax treaty benefits are granted to transparent entities, a new para has been inserted in Article 1 of the OECD MC to provide that income derived by or through a transparent entity will be considered as income of a resident to the extent such income is treated, for the purpose of taxation, by that contracting state as the income of a resident of that contracting state. India has reserved its right of not including such a provision in its tax treaties. Furthermore, the 2017 Commentary on Article 1 has been updated to clarify the meaning of the phrase income derived by or through a transparent entity to include income of a transparent entity of a third state, provided such entity is considered transparent as per the domestic laws of one of the states and income of that entity is attributed to a resident of such state. India has observed that it does not agree with the OECD view of extending the applicability of the tax treaty to income earned by an entity of a third state. Derivative benefit test A new Article 29 has been added in the 2017 Update to incorporate the minimum standard agreed to as part of the work on BEPS Action 6. Article 29 incorporates the Principal Purpose Test (PPT), as well as the Simplified Limitation of Benefits (SLOB) rule envisaged under BEPS Action 6 [12]. Article 29, amongst others, provides that tax treaty benefits will be allowed only to persons who satisfy the definition of qualified person or who satisfy other objective tests of the SLOB Article. One of the objective tests under the SLOB Article is grant of benefit under the derivative benefit test. In terms of this test, a person who is not a qualified person is entitled to tax treaty benefits if at least more than an agreed proportion of that entity is owned by certain persons entitled to equivalent benefits [13]. India has reserved its right to grant tax treaty benefits under the derivative benefit test to an entity only where it is directly held by the equivalent beneficiary. [12] Refer EY Global Alert dated 20 October 2015 titled OECD releases final report under BEPS Action 6 on preventing treaty abuse. [13] The Commentary on Article 29 accords the benefit under the derivative benefits test, irrespective of whether the entity is owned, directly or indirectly, by the persons entitled to equivalent beneficiaries benefits can be denied

6 Inclusion of recognized pension fund The 2017 Update has amended the definition of a resident to specifically include a recognized pension fund which is also specifically defined to mean an entity or arrangement which is established and treated as a separate person under the taxation laws of a state and: (i) That is established and operated exclusively or almost exclusively to administer or provide retirement benefits and ancillary or incidental benefits to individuals and that is regulated as such by that state or one of its political subdivisions or local authorities; or (ii)that is established and operated exclusively or almost exclusively to invest funds for the benefit of entities or arrangements referred to in (i) above. India has reserved its right to exclude entities covered in (ii) above from the definition of recognized pension fund in its tax treaties. Conclusion The 2017 Update released by the OECD is part of its continuous endeavor to revise and update the OECD MC and Commentary on a contemporaneous basis. The OECD Model forms a basis for conclusion of bilateral tax treaties of many countries. The changes in the 2017 Update are largely BEPS driven and are likely to act as guides to countries which also wish to incorporate BEPS measures in their bilateral tax treaties. India has also expressed its positions on the 2017 Update to the OECD Model in respect of PE, MAP and other Articles. On PE, India continues to reflect a liberal approach in respect of PE determination which is indicated in its positions on Article 5 of the OECD MC. India has expressed positions favoring broad application of Agency PE provisions, disposal test, home office as PE, short duration activity to create a PE and stricter application of specific activity exemption. India is also of the view that treatment of a foreign enterprise for indirect tax purposes is a relevant factor for determining existence of a PE. Interestingly, India has also expressed its intent to deem a PE in digital arrangements based on significant economic presence, including where such presence is due to a website. Incidentally, India had previously introduced in its domestic laws, an equalization levy in respect of certain digital transactions [14]. In respect of MAP, India has reiterated its stand on non-adoption of mandatory binding arbitration. As a welcome move, India has deleted its earlier reservation that MAP access cannot be provided in TP cases in the absence of Article 9(2). Recently, the Indian administration also released a Press Release specifying that MAP access will be provided in TP cases, even in cases where the relevant tax treaty does not have a provision similar to Article 9(2) of the OECD MC. India has also deviated from the OECD Model in certain cases. For instance, on MAP, India has observed that undefined terms in a tax treaty are to be understood as per the law existing in the state applying the tax treaty and cannot be defined by competent authorities under MAP. India has also observed that a MAP application can be made by a taxpayer only in cases where it is certain that the action of the Tax Authorities will result in taxation not in accordance with the tax treaty. India s positions serve as guides to taxpayers on the likely approach of the Indian tax administration, and also as a broad outline of India s tax treaty policy to countries which seek to negotiate a tax treaty with India. Also, a preponderant judicial view [15] in India has been that India s positions on the OECD Model may be relevant only to the extent of interpreting tax treaties which will be entered into by India after making these positions. Countries positions to the OECD MC and Commentary are unilateral positions by the individual countries and the same are not legally binding on the tax administration or taxpayers in respect of a tax treaty interpretation. [14] Refer EY Alert dated 1 March 2016 titled Budget Connect Highlights and impact of Indian Union Budget: Equalisation Levy - Fresh selfcontained code on taxation of Digital Ecommerce transactions [15] Delhi ITAT in GE Energy Parts [ITA No. 671 of 2011); Kolkata ITAT in ITO v Right Florist (P) Ltd. (ITA No of 2011)

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