15 May 2013 Global Tax Alert India s Delhi Tribunal rules on permanent establishment, profit attribution and royalty taxation Executive summary This Tax Alert summarizes a recent ruling of the Delhi Income Tax Appellate Tribunal (Tribunal) in the case of Convergys Customer Management Group Inc. (Taxpayer). 1 The Tribunal was required to rule on issues such as whether the Taxpayer constituted a permanent establishment (PE) in India under the India US income tax treaty (treaty), appropriate methodology for attributing profits to such PE, taxability of software payments and link charges as royalties under the the treaty and the obligation to pay advance tax under such circumstances. The Tribunal found that the Taxpayer s employees frequently visited the premises of its Indian subsidiary (IndCo) and some of its seconded employees worked in key positions such as Country Head, Managing Director, etc., of IndCo. Hence, the Tribunal held that, as such employees have a fixed place at their disposal and IndCo was practically the projection of the Taxpayer s business in India, the Taxpayer had a fixed place PE in India. Furthermore, 15% of residual profits arrived at after reducing profits of IndCo was held to be a reasonable profit attribution to the PE. The Taxpayer was obliged to pay advance tax on such additionally attributed income. Payments to reimburse the Taxpayer for software and link charges were held as not meeting the requirement of royalties under the treaty and, therefore, not taxable in the hands of the Taxpayer.
Background The Taxpayer, a tax resident of the US, provides information technology (IT) enabled customer management services by utilizing its advanced information system capabilities, human resource management skills and industry experience. The Taxpayer has a subsidiary in India, IndCo, which provides IT-enabled call centre/back office support services to the Taxpayer on a principal-toprincipal basis. The Taxpayer contended that to service its customers, services were required to be procured from IndCo on a principal-to-principal basis and that the Taxpayer s business was not carried out in India. Furthermore, the substantial risks of procurement of services such as market, price, R&D, service liability risks, etc., vested with the Taxpayer. Furthermore, as the customers were outside India, such risks resided outside India. The Taxpayer also argued that the procurement of services was akin to purchasing goods/merchandise and, accordingly, the benefit of the PE exclusion, i.e., preparatory or auxiliary function should be available. The Taxpayer had availed a packaged enterprise application known as PeopleSoft License (Software). The group companies, including IndCo, used the Software. Out of the total amount incurred by the Taxpayer, a proportion of the license cost/maintenance cost for the Software was allocated by the Taxpayer to IndCo which was, subsequently, reimbursed by IndCo. The link charges pertain to leased lines (undersea cables) that allow a dedicated capacity for a private, secure communication link from India to the US, which enabled IndCo to communicate with its customers. The Taxpayer, in the first instance, made payment for such link charges to telecom service providers in the US and, thereafter, cross-charged the portion of the cost incurred by it in connection with the India-half link to IndCo. The Tax Authority alleged that the Taxpayer, in its activities in India through its employees and subsidiary, satisfied the requirement of a fixed place, services and also a Dependant Agent PE (DAPE) in India. For the purposes of attributing profits, the Tax Authority recomputed the taxable income by allocating global revenue in proportion to the number of employees. Furthermore, payments for software license and link charges were taxed as royalty income under the Indian Tax Laws (ITL), as well as the treaty. On appeal, the First Appellate Authority i.e., CIT(A) agreed with the Tax Authority that a fixed place PE existed as the premises of IndCo were at the Taxpayer s disposal and the business of the Taxpayer was carried on from such premises. Furthermore, the First Appellate Authority held that management of the risk related to delivery of services was carried out in India by the Taxpayer through its employees visiting India/seconded employees. It also held that entrepreneurial services were performed by the Taxpayer through its employees who supervised, directed and controlled the operations of IndCo. On attribution of profits, the First Appellate Authority held that no further profits can be attributed to the Taxpayer s PE to the extent that the transfer pricing (TP) study of IndCo captures the functions, assets and risks. However, further profit was required to be attributed on account of: (a) Certain assets being deployed in India; and (b) Entrepreneurial services to manage risk related to the service delivery being performed in India. While the First Appellate Authority upheld the Tax Authority s action that the software payment was a royalty, following the ruling of the Karnataka High Court in Samsung Electronics Co. Ltd. [203 Taxman 477], 2 it agreed with the Taxpayer that payments for link charges do not constitute royalty payments under the treaty. Both the Taxpayer and the Tax Authority appealed before the Second Appellate Authority i.e., the Tribunal. Tribunal s ruling On the existence of a PE Considering the entirety of facts, the view espoused by the First Appellate Authority on fixed place PE needs to be upheld for the following reasons: The Taxpayer s employees frequently visited the premises of IndCo to provide supervision, 2 Global Tax Alert
direction and control over the business operations of IndCo and, accordingly, such employees have a fixed place at their disposal. IndCo is practically the projection of the Taxpayer s business in India and IndCo carries out its business under the control and guidance of the Taxpayer, without assuming any significant risk in relation to such functions. The Taxpayer has also provided certain assets/software on free of cost basis to IndCo. The Taxpayer, however, does not constitute a DAPE in India under the treaty as the prescribed conditions are not satisfied. On attribution of profits The view espoused by the First Appellate Authority that further profit is to be attributed on account of entrepreneurial services to manage risk by the Taxpayer in India is not appropriate since IndCo is remunerated at cost plus irrespective of service delivery. Therefore, this risk resides outside India. Even otherwise, the charge for the seconded employees/ employees visiting India to provide technical services is subsumed in the TP analysis of IndCo. An overall attribution of profits to the PE is a TP issue and no further profits can be attributed once an arm s length price has been determined for IndCo, as the TP analysis subsumes the risk profile of the alleged PE. Thus, there can be further attribution only on account of providing assets and Software free of cost. The correct approach to arrive at the profits attributable to the PE is as under: Step 1: Compute global operating income percentage of a particular line of business as per annual report of the Taxpayer. Step 2: This percentage should be applied to the end customer revenue with regard to contracts/ projects where services are procured from IndCo. The amount arrived at is the operating income from Indian operations. Step 3: Operating income from India operations is to be reduced by the profit before tax of IndCo. This residual profit which represents income of the Taxpayer is to be apportioned to the US and India. Step 4: Profit attributable to the PE should be estimated on residual profits. For the purpose of attribution of residual profits, reliance was placed on two Supreme Court rulings that had dealt on profit attribution to Indian PEs. In the case of Anglo French Textile Co., 3 10% attribution was held reasonable and in Hukum Chand Mills Ltd., 4 15% attribution was held reasonable. The adoption of the higher figure of 15% for attribution of the Taxpayer s PE will meet the ends of justice. On software as royalty A perusal of the definition of royalty under the treaty shows that the payment should be towards use of or the right to use any of the rights therein to be considered as a royalty. Payments for transactions where the rights acquired in relation to the copyright are limited to those necessary to enable the user to operate the program are to be dealt with as commercial/business income and not as royalties. Even though Finance Act, 2012 had widened the scope of the definition of royalty in the ITL, it does not impact the provisions of the treaty in any manner. Considering the judgment of the Delhi High Court in the case of Ericsson AB (ITA No. 504/2007), 5 the purchase of the Software would fall within the category of copyrighted article and not towards acquisition of any copyright in the software and, hence, the consideration will not qualify as a royalty. Even otherwise, the payment is in the nature of reimbursement of expenses and, accordingly, not taxable in the hands of the Taxpayer. On link charges as royalty In the present set of facts, the Taxpayer/IndCo has availed a service from the telecom service providers. They do not have any control or possession over the equipment i.e., the network facilities are under the control of and maintained and operated by the service providers. The Taxpayer has merely procured a service and provided the same to IndCo. No part of the equipment was leased out to IndCo. Even otherwise, the payment is in the nature of reimbursement of expenses and, Global Tax Alert 3
accordingly, not taxable in the hands of the Taxpayer. Therefore, the said payments do not constitute royalties under the provisions of Article 12 of the treaty. On liability to pay advance tax The charging of interest is automatic under the ITL if the Taxpayer has defaulted in payment of advance tax. The income of the Taxpayer was not liable for withholding tax under the ITL. Since the income is being assessed in the hands of PEs which had not filed their returns on the ground that this income was not attributed to an Indian business connection, interest provisions, being mechanical in nature, apply. Impact Having reached the conclusion that a PE of the foreign enterprise exists in India, the Tribunal has adopted a formulary approach for profit attribution to the PE, based on residual profits and has also held that the PE is liable to pay advance tax on this basis. MNCs may need to review the impact of this ruling on their arrangements. The assertion by the Tribunal that link charges provided by telecom operator is a service and should not constitute royalties under the treaty should be helpful for taxpayers having similar arrangements. Endnotes 1. ITA Nos. 1443/Del/2012 & 5243/Del/2011. 2. Kindly refer to EY Tax Alert dated 30 November 2011, titled Karnataka HC ruling characterizes payment for purchase of shrink-wrapped computer program as royalty. 3. [23 ITR 101]. 4. [103 ITR 548]. 5. Kindly refer to EY Tax Alert dated 28 December 2011, titled Delhi HC ruling on business connection and tax treatment of payments for software bundled with hardware. 4 Global Tax Alert
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