12 July 2017 EY Tax Alert Bangalore Tribunal rules on constitution of service PE for services rendered virtually as well as physically 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 This Tax Alert summarizes a recent ruling, dated 21 June 2017, of the Bangalore Income Tax Appellate Tribunal (Tribunal) [1] on the issue of taxability of the consideration received by the Taxpayer for rendering of managerial and consultancy services to an Indian company under the India-UAE Double Taxation Avoidance Agreement (DTAA). The Taxpayer contended that the income was in the nature of fees for technical services (FTS) and, in the absence of an FTS provision under the DTAA, the said income should be classified under the Other Income Article of the DTAA, as per which it cannot be taxed in India in the absence of a permanent establishment (PE). Considering the peculiar facts of the case, the Tribunal held that it is not a case of rendering any services but mere sharing of specialist knowledge, skill etc., thereby qualifying as royalty income under the Indian Tax Laws (ITL), as well as the DTAA and, thus, liable to source taxation in India. [1] [TS-256-ITAT-2017(BANG)]
Notwithstanding its conclusion on the characterization of income as royalty, the Tribunal analyzed the constitution of a service PE, assuming that the income was FTS in nature, and not royalty income. The Tribunal ruled that the literal interpretation of the service PE provision under the DTAA does not require physical presence of the employees in India, as the services can be easily provided remotely (via emails, phone, video conferencing etc.). The only prerequisite is that the services should be rendered through the employees and such services should continue beyond the 9- month threshold. The Tribunal, therefore, held that since the threshold of the service duration remotely, as well as physically, was satisfied in the present case, the Taxpayer created a service PE in India, irrespective of the fact that physical presence of its employees in India was only for 25 days during the given year. Background As per the DTAA, a service PE is constituted if an enterprise of one country furnishes services (including consultancy services) in the other country through its employees or other personnel for a period of more than nine months within any 12-month period (service PE). Furthermore, Article 12 of the DTAA allows restricted rights of taxation to the source state on royalty income (at the rate or 10%). Royalty has been defined under Article 12(3) to mean any payment of any kind as a consideration for the use of, or the right to use, industrial, commercial or scientific equipment, or for information concerning industrial, commercial or scientific experience. However, the DTAA does not separately deal with taxation of income in the nature of FTS. As per Article 22 (Other Income Article), any income not dealt with expressly under any specific Articles of the DTAA shall be taxable only in the country of residence. However, where such income is effectively connected to a taxpayer s PE in the source state, it shall be taxed in the PE state as per Article 7 (Business Income Article) of the DTAA. Facts The Taxpayer, a company incorporated in the UAE, was engaged in the business of providing regional service activities for the benefit of its group entities in India, the Middle East and Africa. During the tax years under consideration [2], the Taxpayer entered into a regional headquarter service agreement with its group entity in India (ICo) to provide managerial and consultancy services. These services were rendered either by the Taxpayer s employees visiting India or remotely from outside India through email, phone calls, video conferencing etc. The Taxpayer claimed income from these services to be in the nature of FTS and, in the absence of an FTS Article under the DTAA, such income would fall under the Other Income Article of the DTAA [3] and would be taxable in India only if there exists a PE in India. The Taxpayer further claimed that it does not have any PE in India (including a service PE) since the stay of its employees was only for 25 days in total during the given year and did not cross the 9-month threshold. The Tax Authority contended that the income was taxable in India as royalty under the ITL, as well as the DTAA. This view was upheld by the Dispute Resolution Panel (DRP). Aggrieved, the Taxpayer filed an appeal before the Tribunal. Tax Authority s contentions The income should be regarded as royalty under the DTAA due to the scope of the Taxpayer s activities, as also the terms of the agreement, such as obligation of ICo to maintain secrecy of information provided to it by the Taxpayer, access to/permit to use the specialized knowledge, skill and expertise of the Taxpayer. Reliance was placed on judicial precedents where Courts have upheld that know-how could be imparted through documentation, discussion of technical problems etc. Alternatively, even if the services rendered by the Taxpayer were considered to be FTS in nature, in the absence of a specific FTS provision in the DTAA, the same would be taxable in India under the domestic laws. Even under the DTAA, FTS forming part of business activities would be taxable in India as business income, as the Taxpayer creates a service PE in India under the DTAA. [2] Tax year 2009-10 and 2010-11 [3] Relied on the Tribunal ruling in the Taxpayer s own case (for a different year) - [(2017) 184 TTJ 351] and the ruling of the coordinate bench in the case of IBM India P. Ltd v. DDIT (Intl.Taxation) [IT (IT)A Nos. 489 to 498/Bang/2013 dated 24 January 2014].
Tribunal s ruling At the outset, the Tribunal dismissed the Taxpayer s appeal concluding that the Taxpayer was not entitled to treaty benefits, as the Taxpayer failed to provide any evidence showing that it was wholly managed and controlled in the UAE and is a tax entity in the UAE so as to qualify as a resident of the UAE under the DTAA. Also, the Tax Residency Certificate furnished by the Taxpayer was not in relation to the tax years under consideration and pertained to a year later in time. Nevertheless, the Tribunal ruled on merits, as under: Taxability as FTS The Tribunal agreed with the Taxpayer that where income qualifies as FTS, in the absence of a specific provision under the DTAA, same would fall under the Other Income Article. Furthermore, such other income would be taxable in India as per the DTAA only where the Taxpayer has a PE in India. The physical presence of employees in India was only for the purposes of providing access for using the information pertaining to industrial, commercial or scientific experience belonging to the Taxpayer and to help ICo commercially exploit the same. Also, the information provided by the Taxpayer was acquired through its expertise, experience and knowledge based on its association with the group. Moreover, such information was not available in the public domain and could not be acquired on its own effort. Performing specialized services for a party is different from transferring of specialized knowledge or skill. The Taxpayer provided information pertaining to industrial, commercial or scientific experience and also permitted ICo to use such confidential information. Accordingly, consideration for grant of such use was royalty. Service PE Without prejudice to the above conclusion, the Tribunal analyzed the existence of a service PE, had the services been FTS in nature: The Tribunal, thereafter, analyzed the service PE trigger and acknowledged that the issue of PE would become relevant only where the income is not considered as royalty, but as FTS. Characterization of income as royalty Based on the below observations, the Tribunal ruled that the Taxpayer had not rendered any services to ICo, per se, but merely provided access to or shared its specialized knowledge, skill and expertise with ICo. Hence, the consideration received from ICo was taxable as royalty under the ITL, as well as the DTAA. The Taxpayer had merely provided access to specialized knowledge, skill, expertise and had not done anything more for actually rendering the services. There was no evidence of actual rendering of services by the Taxpayer. This was further supported by the following elements: o A case of contract for services involves a greater level of expenditure to perform the contractual obligations, which couldn t be established by the Taxpayer. o The nature of activities as encompassed by the scope and ambit of the agreement is such that, apparently, it was impossible to render such activities or services through phone calls or merely with the help of three persons sent only for 25 days to India. Under the DTAA, a service PE is said to exist if: i) An enterprise furnishes services, including consultancy services, in the other contracting state. ii) The said services were furnished through the employees or other personnel in the other contracting state. iii) Such activities continued for the same project or a connected project for a period or periods aggregating more than nine months within any 12- month period. Undisputedly, the Taxpayer was providing consultancy services in India through its employees, thereby satisfying the first two conditions. In respect of the third condition, considering that the services can easily be provided remotely [4] without physical presence, the 9-month threshold applies to rendering of services on the same or a connected project and does not contemplate stay of employees in India for nine months. A literal interpretation of the service PE provision under the DTAA also suggests the same. Though, during the tax year under consideration, the Taxpayer rendered these services only for three months, it continued to render the services in the subsequent tax year. Hence, the threshold of nine months within any 12-month period stands satisfied. [4] Through virtual modes like email, internet, video conferencing etc.
The Tribunal also noted that satisfaction of the fixed PE condition under Article 5(1) is not a prerequisite for trigger of PEs listed under Article 5(2), including the service PE provision [5]. Accordingly, the Taxpayer constituted a service PE in India under the DTAA. [5] Referred to various Supreme Court rulings wherein it was held that an inclusive provision enlarges the scope of the original provision and Article 5(2) is an inclusive provision which denotes extension of the base PE rule defined under Article 5(2). Comments The Tribunal took note of the terms of the service agreement, such as specific clause for maintaining secrecy of IPR and scope of services, which indicated that information concerning technical, industrial, commercial or scientific knowledge, experience or skill was provided. The Tribunal also noted that information so provided was acquired by the Taxpayer through its expertise, experience and knowledge and affiliation with the group, which was not available in the public domain. Considering these features, coupled with the fact that the actual presence of employees was insufficient to actually render the services, the Tribunal concluded that the arrangement was that of royalty, as against service agreement as contended by the Taxpayer. Additionally, the Tribunal had adopted a broad and unconventional approach in interpreting service PE which triggers source taxation, linked to rendering of services physically in India. The Tribunal regarded the 9-month threshold of service PE as met in India even when the presence of the employees in India for rendering these services was only for 25 days, while the overall service contract crossed the threshold of nine months. Taxpayers covered by a similar fact pattern may need to evaluate the impact of this ruling on their business arrangements.
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