e-Funds IT Solutions/ e-Funds Corp vs. DIT (Delhi High Court)

Entire law on taxability of Permanent Establishment under DTAA, impact of Mutual Agreement Procedure (MAP) and computation of profits attributable to PE explained

eFunds Corporation, USA and eFunds IT Solutions Group Inc, USA entered into contracts with their clients for providing certain IT enabled services. The same contract was either assigned or sub-contracted to eFunds India for execution. The AO, CIT(A) & Tribunal (42 SOT 165) held that from the Function performed, Assets used and Risks assumed (FAR analysis) by assessee and eFunds India, it was clear that eFunds India was not having requisite software and database needed for providing IT enabled services independently and that they were made available by the assessee to eFunds India free of any charges. It was also held that eFunds India did not bear any significant risk as the ultimate responsibility lay with the assessee. It was also noted that the sales team of the assessee undertook marketing efforts for its affiliates including eFunds India. It was accordingly held that the entire activities of the assessee in India were carried out by eFunds India Ltd (an agent) and said agent had not been remunerated on arm’s length price basis, it was to be held that the assessee had a Permanent Establishment (“PE”) in India in respect of back office operation and software development services being carried out by its subsidiary. It was also held that the assessee’s income was liable to tax in India in respect of operations performed by subsidiary company on its behalf. On appeal by the assessee to the High Court HELD allowing the appeal:

(i) Re Whether a subsidiary can be a Permanent Establishment: While under Article 5(6), a holding or a subsidiary company by themselves would not become PE of each other, a subsidiary can become a PE of the holding company if it satisfies the requirements of Article 5. Accordingly, any premises belonging to the subsidiary that is at the disposal of the parent (the “right-to-use test”) and that constitutes a fixed place of business (the “location test” and the “duration test”) through which the parent carries on its own business (the “business activity test”), gives rise to a PE of the parent under Art. 5(1). In addition under Art. 5(5) of the OECD Model, a subsidiary constitutes an agency PE of its parent if the subsidiary has the authority to conclude contracts in the name of its parent and habitually exercises this authority, unless these activities are limited to those referred to in Art. 5(4) or unless the subsidiary does not act in the ordinary course of its business as an independent agent within the meaning of Art. 5(6);

(ii) Re Location or fixed place PE under Article 5(1) and (2) of DTAA: The word “permanent” refers to some degree of permanency and not a mere transitory nature of the business in the other State. The expression “fixed place of business” refers not only to physical location in the form of immovable property or premises but in certain instances can mean machinery and equipment. The word “fixed” refers to a distinct place with some or certain degree of permanence. The carrying on of “business” should be “through” the fixed place of business. The fixed location test may be in form of a legal right or can be inferred from the facts when the foreign establishment and its employees are allowed right to use the place of business belonging to a subsidiary, a third party. The term “through” postulates that the taxpayer should have the power or liberty to control the place and hence the right to determine the conditions according to its needs;

(iii) Re What constitutes a “Service PE” under Article 5(2)(l) of the DTAA: Article 5(2)(l) and (k) defines what can be called service PE. Sub-clause (l) requires furnishing of services within the second contracting State by a foreign enterprise through its employees or other personnel. But a PE is created only if activities of that nature continue for a period or periods aggregating more than 90 days in 12 months period or under clause (ii) services are performed within that State for a related enterprise as defined in Article 9 paragraph 1. For application of clause (ii) no time period stipulation is postulated. Sub-clause (l) would apply only if the foreign enterprise or the two assessees had performed services in India through their employees or personnel, i.e., personnel engaged or appointed by the foreign assessee. The employees and other personnel must be of the non-resident assessee to create a service PE. Any other interpretation or treating employees of the Indian entity, i.e., e-Fund India as “other personnel” of the foreign assessee would lead to incongruities and irrational result, for every subsidiary which engages an employee, would always become a PE of the controlling foreign company. This would be contrary to the overriding mandate of Article 5 paragraph 6;

(iv) Re Impact of Article 5(3) and its over-riding effect and consequences: Article 5 (3) contains a list of negative activities which are deemed not to create PE. First and foremost, Article 5(1)/(2) should be applicable but then if the activities fall within parameters of paragraph 3, PE is not created for imposing tax in the second state. It does not follow that if activities are not covered in the negative or exclusions set out in paragraph 3, a PE is established or deemed to be established under paragraphs 1 or 2 of Article 5;

(v) Re What is “Agency PE” under Article 5(4) and (5) of DTAA: A dependent agency is one which is bound to follow instructions and is personally dependent on the enterprise he represents. Such dependency must not be isolated or once in a while transaction but should be of comprehensive nature. The “dependency test” requires examination and answer whether the business interest of the principal and the agency have merged. When there is evidence of merging of interest, then power to instruct the agent exceeds a certain level. In such cases the Principal regularly participates in the process of settling current business problems or exercises discretionary power in the said respects. The OECD Commentary does not accept dependency based on financial support, supply of patents etc. as itself creating agency PE. Interdependence must exist in both legal and economic respects but the independence is the main criteria;

(vi) Re Relevance of Mutual Agreement Procedure: The MAP procedure and agreement is no doubt relevant but cannot be determinative or the primary basis to decide whether the assessee had PE in India. Whether or not PE exists is a matter of law and fact and there has to be determination of the said issue on merits. A decision on merits will normally be “persuasively” conclusive for subsequent or other assessment years, unless there are good and sufficient reasons to take a contrary or divergent view. However, a concession on point of law, is not binding for other assessment years or a different assessee. It is always open to the competent authorities of the two countries to enter into an agreement for avoidance of double taxation and bring a litigation/dispute to an end.

(vii) Re Facts: On facts, there is no material to hold that the two assessees had a fixed place of business in India through which the business of the enterprise was wholly or partly carried on. It has not been stated that the premises of e-Fund India were at the disposal, legally or otherwise, of the two assessees. The “right to use test” or “disposal test” has not been or applied nor is there any finding to the said aspect. In the absence of any such finding Article 5(1) cannot be applied. The fact that e-Fund India provides various services to the assessee and was dependent for its earning upon the two assessees is not the relevant test to determine and decide location PE. The fact that the subsidiary company was carrying on core activities as performed by the foreign assessee does not create a fixed place PE. The allegation that e-Fund India did not bear sufficient risk is irrelevant when deciding whether location PE exists. The other circumstances such as reimbursement of costs etc were also irrelevant;

(viii) Re Computation, apportionment or accumulation of income/profit: Article 7(5) states that the profits attributed to the PE in Article 7(1)(a) shall only include profits derived from assets and activities of the PE. The determination should be by the same method from year to year unless there are good and sufficient reasons. Only the assets and activities of the PE i.e. “e-Fund India” can be taken into consideration for attribution of profits to the two assessees, if it is assumed that e-Fund India was PE of the assessee. The activities, which were not undertaken by e-Fund India and the assets of the two assesses outside India, cannot be taken into account or attributed for earning/income of the two assessees. This is subject to the limited force of attraction principle, which in the present case is not applicable. The method of apportionment has to be fair, rational and logical. If the transfer pricing analysis includes and takes into account risk taking functions of the PE enterprise, nothing further would be attributable to the foreign or non-resident enterprise. However, if the transfer pricing computation does not adequately reflect the functions performed and risk assumed by the Indian enterprise, there is need to attribute profits for those functions or risks which have not been considered. Data placed by the taxpayer which is examined and considered in transfer pricing analysis is, therefore, of importance and has to be examined in each case (Morgan Stanley 292 ITR 416 (SC) & commentaries by OECD, Klaus Vogel, Phillip Baker & Arvid A. Skaar referred)