Delhi Tribunal rules technical assistance constituted Service PE and related fees were effectively connected business profits

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1 1 April 2014 EY Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date Delhi Tribunal rules technical assistance constituted Service PE and related fees were effectively connected business profits Executive summary This Tax Alert summarizes a recent ruling of the Delhi Income Tax Appellate Tribunal (Tribunal) in the case of JC Bamford Excavators Ltd. 1 (Taxpayer) on the tax implications arising from a grant to use intellectual property rights (IPRs) and the provision of services of personnel by the Taxpayer to a wholly-owned Indian subsidiary, under the India-UK Double Taxation Avoidance Agreement (Treaty), as well as the Indian Tax Laws (ITL). The Tribunal held that consideration for the grant of use of IPRs was taxable as royalty income in India. It also held that activities of inspection and testing by employees of the Taxpayer were undertaken to ensure that the quality of the licensed products adhered to the specifications/global standards, which was in the interest of the Taxpayer. Such activities would amount to stewardship activities and would not give rise to a permanent establishment (PE) in India. However, technical assistance which was rendered to the Indian subsidiary by employees of the Taxpayer resulted in a Service PE and fees for such technical services were effectively connected with the Service PE. Accordingly, such fees were taxable as business profits under the Treaty. Detailed discussion Background The Taxpayer, a tax resident company of the UK, was engaged in the business of manufacture, assembly, research, design and sale of material-handling equipment. The Taxpayer entered into a Technology Transfer Agreement (TTA) with its whollyowned subsidiary in India (ICo).

2 As per the terms of the TTA, the Taxpayer was required to perform the following activities for consideration: Grant license to manufacture, assemble, use and sell the licensed products and, for that purpose, permit ICo to use knowhow, trademark, inventions and any confidential information (IPRs) belonging to the Taxpayer. Deliver technical documents containing the IPRs and give reasonable engineering skills to enable the licensed products to be manufactured as per the quality standards. Conduct random testing and inspection of licensed products manufactured by ICo to ascertain if they meet the quality standards. For this purpose, employees of the Taxpayer occasionally visited the premises of ICo. Provide technical assistance to ICo s personnel in relation to the manufacture or assembly of the licensed products through its (Taxpayer s) technical consultants. For the technical assistance as stated under the TTA, the Taxpayer and ICo entered into an International Personnel Assignment Agreement (IPAA), pursuant to which, the Taxpayer identified and assigned eight employees to work with ICo. The cost of such employees was recovered from ICo. Such personnel occupied key managerial positions and were engaged in managing overall operations of ICo, such as developing marketing strategies, ensuring uninterrupted supply of products, and assistance in manufacturing of licensed products. The Tax Authority contended that the presence of the assigned personnel for more than 90 days constituted a Service PE for the Taxpayer in India in terms of the Treaty. Also, royalty and other payments from ICo were effectively connected with the Service PE and, hence, were considered as business profits under the Treaty. In the absence of books of account of the Taxpayer or any details of expenses, 20% of the revenue can be considered as an estimate of tax admissible expenditure and the remaining net income is subject to the full rate of tax under the ITL. However, the Taxpayer contended that it did not have a PE in India as under the TTA, occasional visits of the Taxpayer s employees for inspection and quality check were an integral part of the royalty. Personnel assigned under the IPAA ceased to be employees of the Taxpayer and became the employees of ICo. Accordingly, the presence of such personnel did not constitute a PE of the Taxpayer in India and the reimbursement of salary of such employees under the IPAA was not taxable in India. Accordingly, the fee received under the TTA was taxable as royalty/fees for technical services (FTS) under Article 13 of the Treaty, as well as ITL. On appeal, the First Appellate Authority upheld the position adopted by the Taxpayer. The Tax Authority then appealed to the Second Appellate Authority i.e., the Tribunal. Tribunal s ruling The Tribunal noted that consideration received by the Taxpayer can be allocated to three income streams as follows: (i) consideration for the supply of IPRs under the TTA; (ii) consideration for services of employees occasionally visiting India for inspection and quality testing (Occasional Visitors) as part of the obligation under the TTA; and (iii) consideration for services of employees loaned to ICo on an assignment basis for providing technical assistance and overall management of ICo (Assignees). The Tribunal addressed the following issues in determining the taxability of the three income streams. PE exposure for the Taxpayer Assignees services in India The following are the pre-conditions for the Taxpayer to trigger a Service PE in India under the Treaty: The actual rendering of services, including managerial services; Such services should be other than those taxable under Article 13 (royalties and FTS); Such services should be rendered within India; Such services should be rendered by the Taxpayer through its employees or other personnel; and The activities should continue for a period or periods aggregating more than 90 days within a 12 month period. 2

3 The Tribunal held that based on the facts, the arrangement and the terms of agreement, the following factors supported the view that the Assignees continued to be the employees of the Taxpayer: Assignment of employees to ICo was pursuant to the license of IPRs to ICo, for which the Taxpayer committed to provide technical assistance to ICo from time to time at ICo s request and subject to the availability of specialists or engineers. The IPAA was not an independent contract in itself but simply formalized the terms of supply of Assignees to ICo. No employment contract between ICo and the Assignees/appointment letter/terms and conditions of assignment were placed on record before the Tribunal. Assignees retained lien on their employment with the Taxpayer such that, after completion of three years, the Assignees would resume employment with the Taxpayer at a level no less favorable than that which they left prior to the deputation. Agreements clearly mentioned that the Assignees would be subject to the rules and regulations of ICo but would not be considered as employees of ICo. The Taxpayer had full responsibility to remunerate the Assignees. Recovery of cost from ICo is nothing but consideration for supply of the Assignees. The Assignees have no legal recourse to ICo for any grievances or disciplinary actions. Such matters were directed to the Group Human Resources Manager or Group Director. There is no material on record to show that the Assignees terminated their employment with the Taxpayer and were re-employed with ICo. It is quite natural that persons assigned to ICo for consideration will work under the direction of ICo and could not have worked for the benefit of the Taxpayer. Furthermore, factors like designation within ICo, visiting cards/statutory tax forms are not decisive and it is the substance of the transaction which is relevant. In view of the above factors and the Supreme Court s (SC) decision in the case of Morgan Stanley, 2 it was concluded that the Assignees remained employees of the Taxpayer during the period of assignment. With respect to the nature of services rendered, the Assignees were responsible for ensuring customer satisfaction, developing marketing strategies, and technical assistance. The Assignees were managing the overall operations of ICo and, hence, rendered managerial services to ICo. There is no dispute that the services were rendered in India and the duration of stay of the assigned employees in India was more than 90 days within the 12 month period. Since all the conditions as mandated by the Treaty were satisfied, the presence of the Assignees created a Service PE for the Taxpayer in India. Service integral to the royalty arrangement under the TTA Occasional Visitors undertook activities in India in terms of the obligations integral to the TTA. Activities of Occasional Visitors i.e., testing and inspections were carried out to ensure that the licensed products adhered to the global standards of quality. Such activities were required by and in the interest of the Taxpayer and it amounted to stewardship activities which cannot be considered for constituting a PE in India. Reliance in this regard was placed on the SC decision in the case of Morgan Stanley (supra). Taxability under Article 7 on business profits vis-à-vis Article 13 on royalty and FTS Consideration for granting the IPRs in relation to the technical knowhow, patent rights and confidential information for the manufacture and sale of licensed products falls within the scope of royalties as defined under the Treaty, as well as the ITL. Consideration received for the provision of services of personnel was for the application/enjoyment of IPRs and it qualified as FTS under the Treaty, as well as the ITL. Effectively connected with PE In terms of the Treaty, where a right or property or contract for which the royalty or FTS is paid is effectively connected with a PE through which the beneficial owner of the income carries on business in the source state, (i.e., India in the present case), then such royalty/fts would be taxed as business profits under Article 7 and Article 13 on royalty and FTS would cease to apply. 3

4 For applicability of Article 7, effective connection should exist between the PE on the one hand and right, property or contract on the other, and not royalties or FTS flowing from such right, property or contract. The words effectively connected are akin to really connected. In the context of royalties, it is in the nature of something more than the mere possession of the property or right by the PE but equal to or a little less than the legal ownership of such property or right. But, in no case, remote connection between the PE and property or right can be categorized as effectively connected. It is of significance to note that an effective connection is required to be seen between the PE and the contract from which such fees resulted and not such FTS per se. The mere fact that such fee is effectively connected with the PE is not sufficient to bring the amount within the purview of business profits. Taxation of income streams For the various income streams, it was concluded: The royalty income from IPRs cannot be said to be effectively connected with the Service PE and the same would be taxable as a royalty on a gross basis under the Treaty, as well as the ITL. The Service PE, in the form of Assignees as part of the TTA, had no role in granting, creating or making available the IPRs to ICo. In fact, the assignment of personnel took place after the grant of IPRs. As the consideration for the Occasional Visitors was embedded along with the consideration for IPRs, splitting the two would be an academic exercise. The Service PE is represented by the Assignees assigned to ICo. Thus, the contract, by virtue of which the Assignees were sent to India, is effectively connected with the Service PE and FTS arising out of such contract would be taxable as business profits under Article 7 of the Treaty. Since the details of expenses were not available, the matter was remitted to the Tax Authority for fresh determination of the amount of income in terms of Article 7 of the Treaty. Implications Business arrangements with affiliates across jurisdictions involving technical collaboration for use of IPRs and assignment of employees for related assistance are not uncommon in multinational enterprises. However, such arrangements often raise peculiar tax issues under the applicable Double Taxation Avoidance Agreements, as well as the ITL. This ruling deals with the issues of royalty taxation as well as Service PE exposure on assignment of personnel to an entity in India. It provides guidance on the factors which are relevant for determining whether services are rendered as employees of the foreign enterprise or whether the assignees have become employees of the Indian entity. On this aspect, apart from relying on principles laid down by the SC in the case of Morgan Stanley (supra), the Tribunal acknowledged the substance over form approach based on actual conduct and the arrangement. It is also noted that, where assignment of employees is incidental to a technology transfer agreement, it indicates that the foreign enterprise is rendering services through its employees. Furthermore, activities like quality control undertaken for ensuring global standards of the licensed products, for the benefit of the parent company, are regarded as stewardship activities not giving rise to a Service PE. This ruling also addresses the interpretation and application of the term effectively connected which has not been defined under the ITLA and the Double Taxation Avoidance Agreements. Endnotes 1. [TS-161-ITAT-2014(DEL)]. 2. [292 ITR 416]. 4

5 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP (India), Mumbai Sudhir Kapadia Ernst & Young LLP (India), Hyderabad Jayesh Sanghvi Ernst & Young LLP (United Kingdom), Indian Tax Desk, London Nachiket Deo Ernst & Young Solutions LLP, Indian Tax Desk, Singapore Gagan Malik Ernst & Young LLP, Indian Tax Desk, New York Tejas Mody

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