12 September EY Tax Alert. Delhi HC rules on permanent establishment and profit attribution

Transcription

1 12 September 2011 EY Tax Alert Delhi HC rules on permanent establishment and profit attribution

2 Executive summary This Tax Alert summarizes two recent rulings of the Delhi High Court (Delhi HC) in the cases of Rolls Royce Plc (RRPLC) [ITA No. 493/2008] and Rolls Royce Singapore Ltd. (RRSL) [ITA No. 1278/2010] [1] on the issue of whether the foreign enterprises, based on the facts, constituted a permanent establishment (PE) in terms of Article 5 under India s Double Taxation Avoidance Agreements (DTAAs) with the UK (UK DTAA) and Singapore (Singapore DTAA), respectively, and also with respect to the amount of profit attributable to such a PE. The Delhi HC, in the case of RRPLC, relied on the decision of the Delhi Income Tax Appellate Tribunal (ITAT) and upheld that a PE exists on account of the activities carried out by its whollyowned subsidiary in India. In the case of RRSL, the Delhi HC, in view of the additional evidence furnished, referred the matter back to the Tax Authority to readjudicate on whether RRSL s relationship with its Indian representative constituted a Dependent Agent (DA) PE for RRSL. Furthermore, the Delhi HC held that, in the absence of a transfer pricing (TP) analysis that considered the functions performed and the risks assumed by the foreign enterprise for determining the arm s length nature of the remuneration paid to the DA, the payment to the DA cannot extinguish the tax liability of RRSL. [1] Source: delhihighcourt.nic.in RRPLC Background and facts RRPLC, a tax resident of the UK, is engaged in the business of supplying aero-engines and spare parts to Indian customers. Rolls Royce Indian Limited (RRIL) is a company incorporated under the laws of the UK, having offices in India which render liaison services to RRPLC. In the course of assessment, the Tax Authority held that RRPLC had a business connection in India under the provisions of the Indian Tax Laws (ITL) as a result of marketing and supply of equipment to Indian customers carried out through RRIL. Furthermore, RRPLC also constituted a PE under Article 5 of the UK DTAA. The First Appellate Authority accepted the Tax Authority s contention and held that profits attributable to the extent of 75% of the profits arising from Indian sales would be taxable in India as attributable to the PE. Aggrieved, RRPLC appealed before the ITAT. The ITAT, after providing a detailed analysis, held that RRPLC constituted a business connection under the ITL as well as a PE in terms of the UK DTAA. As regards attribution of profits, the ITAT allocated 50% of the profits towards manufacturing activities and 15% towards R&D activities and held that the same were not taxable in India as they were carried out outside India. However, the ITAT reduced the profit allocated to marketing activities carried out in India from 75% to 35% and held that the same was taxable in India [2]. Subsequently, RRPLC filed a petition seeking rectification of the above order and stating that only net profit (after reducing expenses with respect to R&D activities) should be subject to tax in India. The ITAT rejected this and observed that no part of the R&D activity was carried out in India and, consequently, expenses in relation to such activities should not be reduced while computing the profits attributable to the PE in India. Therefore, all expenses incurred by RRPLC for marketing activities should be reduced while determining the proportionate global profits taxable in India [3]. Delhi HC s ruling Reliance was placed on the ITAT decision which held that RRIL maintained a permanent office in India to undertake various activities and, therefore, constituted a business connection under the provisions of the ITL. This conclusion was not merely based on the agreement entered into between RRPLC and RRIL but also on the consideration and analysis of various documents which were found during the course of survey carried out by the Tax Authority. [2] Kindly refer EY Tax Alert dated 4 December 2007 for further details. [3] Kindly refer EY Tax Alert dated 17 February 2009 for further details. 2 EY Tax Alert

3 The ITAT also held that RRIL s presence in India constituted a PE for RRPLC for the following reasons: RRIL s premises constituted a fixed place of business through which some business activities were carried out and such place was also at the disposal of RRPLC. Activities carried out through the fixed place were not in the nature of preparatory or auxiliary but constituted a core business activity of marketing, negotiating and selling of the equipment. orders and worked exclusively for RRPLC. of RRPLC visited India frequently and the premises of RRIL were being occupied and used during such visits. With respect to deductibility of expenses on account of the R&D activities carried out outside India, the ITAT had appropriately dealt with this matter and, hence, the question of setting off such expenses against profits from marketing activities did not arise. Furthermore, after taking into consideration all the relevant aspects, the ITAT had provided a detailed discussion while holding that RRIL constituted a PE of RRPLC in India. While undertaking critical analysis of the various documents, the ITAT had also considered the objections filed by RRPLC. The ITAT had duly considered and answered all such objections. Therefore, there was no requirement to remand the matter back to the ITAT for re-adjudication. Thus, the order of the ITAT was upheld in its entirety. RRSL Background and facts RRSL, a tax resident of Singapore, is engaged in the business of supply of spare parts for oil field equipment and rendering repairs/overhauling services of certain equipment. RRSL, in its tax return, had offered the service fee income on cash/receipt basis as fees for technical services. Furthermore, income earned with respect to supply of equipment was not offered to tax in India for the reason that there existed no PE in India in terms of Article 5 of the Singapore DTAA. The Tax Authority was of the view that RRSL was contractually obligated to supply spare parts as well as furnish repair/overhauling services to Indian customers to whom equipment was supplied by other group companies of RRSL. RRSL had established a complete set-up of facilities for providing such services to Indian customers. Therefore, RRSL had a business connection in India as well as a PE in terms of Article 5 of the Singapore DTAA. As the supplies and services were intricately and inextricably linked with each other, the same were taxable in India. Furthermore, RRSL had obtained the services of ANR Associates (ANR) in India which was engaged in receiving/soliciting orders and as ANR was wholly and exclusively working for RRSL, it constituted a DA of RRSL. Consequently, RRSL constituted a DAPE in India. The First Appellate Authority accepted the Tax Authority s order. Aggrieved, RRSL appealed before the ITAT and argued that ANR was an independent entity providing similar services to other clients and RRSL was not its sole customer. Furthermore, ANR did not have the power to negotiate and conclude contracts on behalf of RRSL and the transactions carried out were on a principal-toprincipal basis. Consequently, ANR should be treated as a person working in an independent capacity and, therefore, should not constitute a DA in India. Alternatively, even if ANR is treated as a DA of RRSL, the payment of USD 40,000 per annum that was paid, being an arm s length price, no further income was attributable in India in the hands of RRSL for the reason that ANR was already liable to tax in India. The ITAT, after considering the arguments of RRSL and the Tax Authority held that RRSL constituted a fixed place PE in terms of Article 5(1)/(2) of the Singapore DTAA. Furthermore, the ITAT, after considering the various documents on record, summarized the activities carried out by ANR in the following terms: ANR maintained premises in India to carry out its obligation as an agent of RRSL. business on behalf of RRSL at its premises in India. and also in maintaining customer relationships with existing/potential customers. presentations and demonstrations to ensure that customers were aware of RRSL s products. 3 EY Tax Alert

4 The ITAT observed that RRSL had complete control and supervision over the activities carried out by ANR. ANR was the sole agent of RRSL and, economically, it was almost wholly dependent on RRSL. Furthermore, ANR was not authorized to promote products of competitors. The method of remunerating ANR was changed from a variable basis (5% of the invoice value) to a fixed one (USD 40,000). The ITAT observed that this sort of remuneration fixation was usually not done between two independent parties in any uncontrolled transaction. Considering these aspects, the ITAT ruled that ANR constituted a DA of RRSL. As regards adequacy of attribution in India, the ITAT observed that the methodology adopted in remunerating ANR suggested that RRSL was controlling it and, therefore, the payment was held not to be at arm s length. Subsequently, the ITAT held that the remuneration at the rate of 10% should meet the arm s length criteria. Aggrieved by the ITAT s order, RRSL appealed before the Delhi HC with respect to existence or otherwise of a PE in India on account of the activities of ANR and the subsequent income attribution in India. RRSL s arguments ANR was an agent of independent status as it was an existing entity. Also, prior to entering into an agreement, ANR had its own infrastructure etc., and, therefore, should be treated as an agent of independent status. Accordingly, ANR should not constitute a DA in India. One of the reasons considered while evaluating whether or not ANR constituted a DA was that the agent was prohibited from marketing products of competitors. This aspect, per se, was not conclusive to suggest that the agent was not of independent status. Furthermore, the ITAT rejected the contention that ANR was also engaged in providing similar services to various customers for the reason that sufficient evidence was not provided as regards the client base of ANR and the amount of commission earned therefrom. Reference was drawn to the tax returns of certain years filed by ANR to suggest that it was rendering similar services to other customers as well and, therefore, was acting in an independent capacity and, consequently, should not constitute a DA in India. Alternatively, even if it is considered that ANR constituted a PE in India, no further profits shall be attributed to the DA on account of the arm s length remuneration paid. Reliance was placed on the Supreme Court (SC) decision in the case of Morgan Stanley and Co. Inc. [4] which had held that, when the transaction is at arm s length, nothing further can be attributed to the PE provided that the transfer price to the associated enterprise (that also constitutes a PE) takes into account all the risk-taking functions of the multinational enterprise. Similar observations were made by the Bombay HC in the case of Set Satellite (Singapore) Pte. Ltd. [5]. [4] [292 ITR 416] [5] [307 ITR 205] Delhi HC s ruling Existence or otherwise of a PE RRSL s argument that the ITAT had not considered the aspect that ANR was not wholly or almost wholly dependent and whether any control/supervision was exercised, was inappropriate for the reason that the ITAT had passed a well-reasoned order after considering the ambit of activities carried out by ANR. Reliance was placed on the tax returns of ANR to suggest that it had been rendering services to other customers as well from which it had been earning commission and the commission earned from RRSL was not its only source of income. The question whether ANR had income from other customers as well and the extent of such income was relevant to decide whether ANR could be treated as an agent of independent status. Since the Tax Authority did not look into this aspect and the ITAT also disposed of the issue deciding against RRSL on wrong premises, the matter was remanded back to the Tax Authority for readjudication. The Tax Authority would decide the question of applicability of the DA clause under the Singapore DTAA as to whether ANR was providing services to customers other than RRSL as well and had substantial income from those other customers and whether ANR was wholly or almost wholly working on behalf of RRSL. RRSL was permitted to file all relevant evidence before the Tax Authority to enable it to come to an appropriate conclusion. However, the onus 4 EY Tax Alert

5 would be on RRSL to prove that ANR had been rendering services and earning commission from other customers and, accordingly, it could be said if ANR was not acting wholly or almost wholly on behalf of RRSL. Attribution of profits Earlier, the remuneration was payable at the rate of 5% of the invoice value which, however, was changed to a fixed fee basis. The ITAT had observed that this sort of remuneration fixation was usually not done between two independent parties in any uncontrolled transaction. The remuneration payable, therefore, seemed to be in the nature of transaction controlled by RRSL and, consequently, could not be considered to be made on an arm s length basis. Moreover, RRSL had not furnished any instance of transaction entered into between two independent parties in an uncontrolled manner in support of its contention that remuneration of lump sum amount of USD 40,000 was determined at arm s length. From the above, it was clear that RRSL could dictate the terms of payment by altering the same and reducing it to USD 40,000 per annum from 5% of invoice value when it was found that, on the basis of 5%, the total commission payable could be much higher. This clearly led to the inference that RRSL was in a position to dictate terms. However, no issue would arise in case an arm s length price was paid by RRSL to ANR for the activities carried out in India through its PE viz., ANR. Also, if the said price i.e., USD 40,000 per annum had already been taxed in India in the hands of ANR, then, there would be no requirement to tax RRSL. However, from the facts, it appeared that no TP study was carried out by RRSL. Thus, in the absence of any TP analysis, it cannot be said that such commission could fit the description of reasonable profits within the meaning of Article 7(2) of the Singapore DTAA. Consequently, the SC decision in the case of Morgan Stanley (supra) and the Bombay HC decision in Set Satellite (supra) would not be applicable in the present case. FAR study formally takes into consideration the functions performed, assets used and the risks assumed. Thus, to find out whether a DA is remunerative at arm s length, it is necessary to take into account all the risk-taking functions of the multinational enterprise. If all the risk-taking functions of the enterprise have not been taken into account, there would be a need to attribute further profits to the DAPE for those functions/risks of the DA that have not been considered. In the absence of such an exercise and any material on record on these aspects, RRSL was not in a position to establish that the remuneration paid to ANR was equal to the arm s length price. The SC decision in the case of Morgan Stanley (supra) had referred to the functions performed and risks assumed by the enterprise as distinguished from the functions performed and the risks assumed by the agent which may constitute a DAPE. Comments This ruling reinforces the need for multinational companies 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. This risk would need to be specifically evaluated in light of the facts that a number of India s DTAAs provide for a fairly low threshold for existence of a PE and the possibility that the Tax Authority could attempt to attribute profits to a PE in the absence of adequate documentation to apply arm s length principles for attribution. This ruling also highlights the importance of a robust TP analysis that considers the functions performed and the risks of the foreign enterprise for remunerating a DA to avoid additional profit attribution to a DAPE. 5 EY Tax Alert

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