Mumbai Tribunal rules on DAPE in case of marketing and distribution activities carried out by an Indian branch for group companies

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1 4 July mber 2012 EY Tax Alert Mumbai Tribunal rules on DAPE in case of marketing and distribution activities carried out by an Indian branch for group companies Executive summary 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 Ernst & Young advisor. This Tax Alert summarizes a recent ruling of the Mumbai Income Tax Appellate Tribunal (Tribunal) [1] in the case of Varian India Pvt. Ltd. (VIPL), a US company having an Indian branch (Taxpayer). The Taxpayer is engaged primarily in marketing and distribution of products manufactured by its group entities worldwide. The group entities were resident in countries such as Australia and Italy. On facts, the Tribunal held that distribution and representation activities of the Taxpayer like liaison, marketing and promotion of products of its group entities do not create a permanent establishment (PE) in India for any of the group entities. Since the Taxpayer represents many group entities, its activities cannot be said to be devoted, wholly or almost wholly, on behalf of one particular enterprise. Furthermore, its transactions with its group entities have been determined to be at arm s length. Hence, it cannot be considered as a dependent agent of any of the enterprises it represents. In the absence of a PE, the force of attraction rule under the India-US Double Taxation Avoidance Agreement (US DTAA), India-Australia Double Taxation Avoidance Agreement (Australia DTAA), and the India-Italy Double Taxation Avoidance Agreement (Italy DTAA) cannot be applied. [1] TS-292-ITAT-2013

2 Background and facts VIPL is a company incorporated in the US and is a wholly owned subsidiary of Varian Inc., USA. The Taxpayer is the only Indian branch of VIPL and is primarily engaged in the distribution of products manufactured by the Varian Group of Companies (VGCs) worldwide. The structure has been schematically depicted below: The structure: Varian Inc, USA VIPL, USA Varian, Italy Varian, Australia Varian, Netherlands Varian, Swiss Outside India (Group Companies) India Branch Distribution and representation arrangement India The Taxpayer has a Distribution and Representation Agreement (DRA) with five of the VGCs. Under this agreement, the Taxpayer is engaged in two types of sales activities. The first being direct sales in which the Taxpayer directly imports products from the VGCs and sells them to Indian customers on a principal-to-principal basis. The second is indent sale activity where the products are directly sold by the VGCs to the Indian customers but the Taxpayer carries out pre-sale activities like liaisoning, marketing and other incidental post-sale support activities for which it is entitled to commission. Income from both these activities has been offered to tax in India by the the Taxpayer.

3 The Tax Authority has, however, assessed an additional 10% of the profit margin of three of the VGCs (Australia, US and Italy) as additional income of the Taxpayer on the basis that the Taxpayer constitutes a dependent agency PE (DAPE) of these VGCs. Accordingly, it attributed the 10% profit of the VGCs by invoking the force of attraction rule under the relevant DTAAs ( US DTAA, Australia DTAA and Italy DTAA). The Taxpayer contended that the whole arrangement under the indent sales mechanism was promotion and sales support services of the various products of the VGCs and it was not acting as a dependent agent for any of them. Furthermore, the transaction between entities was at arm s length and this was affirmed by the Transfer Pricing Officer (TPO). Therefore, no PE arises in India in the instant case and, accordingly, the question of attribution of additional profits to a DAPE does not arise. The First Appellate Authority upheld the Tax Authority s view. It was held that VIPL, through the Taxpayer, is acting as a dependent agent of the VGCs and all the conditions given in the relevant articles of the respective DTAAs stand fulfilled. On application of the domestic provisions of the Indian Tax Laws (ITL) for attributing the profits, it confirmed the rate of 10% on operating profit made by the Tax Authority. Aggrieved, the Taxpayer appealed before the Tribunal. Tribunal ruling On DAPE In order to treat an agent as a PE within the meaning of Articles 5(4) and 5(5) of the US DTAA, it is vital that such an agent should fit into the description of dependent agent and has to perform at least one of the activities mentioned in Article 5(4). Otherwise, it cannot be held that the agent constitutes a PE of the foreign enterprise. Covered activities for a dependent agent Under Article 5(4) of the US DTAA, a person is said to be dependent agent only when one of the following three conditions is satisfied: He has and is habitually exercising an authority in India to conclude contracts on behalf of the US enterprise. He has no such authority but habitually maintains stock of goods in India from which he regularly delivers goods on behalf of the US foreign enterprise and carries out some additional activities in India contributing to the sale of goods. He habitually secures orders in India, wholly or almost wholly, for the US enterprise. The language in the Australia DTAA and the Italy DTAA is similarly worded. Additionally, these DTAAs also include the activity of manufacturing or processing goods belonging to the foreign enterprise. In the present fact pattern, the Taxpayer does not book the indent sale and corresponding purchase in its books of account because it is not a part of any legal contract with the VGC s Indian customers. It does not take any title or own any risk of loss in relation to such products and it also does not raise any invoice on the Indian customers or collect funds from them. Therefore, the test of covered activities for a DAPE fails for the following reasons: Indent sale orders booked are not binding on the VGCs as they may accept or reject the orders completely at their own discretion. From the DRA, it is clear that the Taxpayer has no authority and also cannot negotiate or conclude contracts on behalf of the VGCs. It, further, does not have any power or authority to act for or bind or commit a supplier for any of the activities carried out in India. For its support activities, the Taxpayer is only entitled to a certain percentage as commission on sales made directly by the VGCs from Indian customers. The Taxpayer mainly facilitates the process of sale. The title of the goods supplied by the VGCs is directly passed on to the Indian customers and the

4 Taxpayer undertakes neither any risk nor title of the product at any point of time. The orders relating to indent sale are only introduced and liaised by the Taxpayer. The Taxpayer does not secure them. The orders are not binding on the VGCs until accepted by them. The Taxpayer has no authority to accept orders on behalf of any of the VGCs. Also, the Taxpayer does not deal with Varian Inc., USA alone but with multiple group entities. It is also seen that none of the risks like market risk, product liability risk, R&D risk, credit risk, price risk, inventory risk or foreign currency risk is undertaken by the Taxpayer. Thus, the Taxpayer does not assume any kind of risk on behalf of the VGCs. The Taxpayer also does not manufacture or process any other products developed or manufactured by the VGCs. Thus, the Taxpayer only performs administrative support functions and does not perform functions as are envisaged under Article 5(4) of the US DTAA and the corresponding provisions in the Australia DTAA and Italy DTAA. Whether a dependent agent Article 5(5) of the US DTAA lays down the following twin conditions which need to be simultaneously satisfied to result in an agency PE: Firstly, the activities of such an agent are devoted, wholly or almost wholly, on behalf of the enterprise. Secondly, the transactions between the agent and the enterprise are not made under the arm s length conditions. As regards the second condition, the TPO had found that the Taxpayer s transactions have been at arm s length price, which acknowledges the fact that the Taxpayer has been compensated by the VGCs at arm s length price. Even the Tax Authority has not adversely held that compensation in the form of commission is not at arm s length. The second condition is, therefore, also not fulfilled. On subsidiary as PE Merely because VIPL is a 100% subsidiary of Varian Inc., USA, neither VIPL nor the Taxpayer would constitute a PE of Varian Inc., USA in India. This is clear from Article 5(6) of the US DTAA that states that mere existence of a subsidiary does not, by itself, constitute the subsidiary company as a PE of the parent. Hence, the Taxpayer cannot be held to constitute a PE of Varian Inc., USA or any of the other VGCs. The Tribunal also distinguished the decision of the Delhi High Court in the case of Rolls Royce PLC [2] on the basis that the facts of the case were not similar to the present case. On application of force of attraction rule To fall within the ambit of force of attraction rule, the following two basic requirements need to be satisfied: (i) (ii) The foreign enterprise should have a PE in India for the purpose of selling goods and merchandise. The direct sale by the foreign enterprise is the same or similar to the kind of goods or merchandise sold by the PE in India. A review of sales data for two years indicates that the percentage of commission income and sales from the three VCGs appear normal and with regard to Varian Inc., USA, the activities of the Taxpayer, as a proportion of total sales of the group in India, are in the range of 5-7%. Hence, it cannot be said that the Taxpayer is devoted, wholly or almost wholly, on behalf of any one VGC. In this case, the Taxpayer does not constitute a PE of any of the VGCs. Therefore, force of attraction rule will not apply in this case. Accordingly, attribution of 10% profit margin on the basis of global accounts of the VGCs is not valid and, hence, stands deleted. [2] Kindly refer EY Tax alert dated 12 September 2011

5 Comments In a global business environment, MNCs often engage with affiliates. This ruling reaffirms the general principles for determining existence of PE under the agency PE rule. The Tribunal has ruled that merely because one of the foreign group companies has an Indian branch, it cannot be held to be an agent of all the group companies that it represents in India unless the conditions laid down under the agency PE rule are fulfilled. This ruling also clarifies that since the Taxpayer, in carrying out its pre and post-sales support activities had not borne any risks arising from sales of the group companies, it cannot be considered as a DAPE of the group companies. This ruling reinforces the need for MNCs operating in India to review the scope of their Indian operations and the nature of their intercompany relationships and to make an assessment of a potential PE risk.

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