CA Ashish Karundia has conducted a meticulous study into the weaknesses and failures of the traditional concept of a permanent establishment. He argues, with reference to a multitude of domestic and international judgements, that the PE concept has failed in reaching the objective of legitimate taxation of income that is attributable to an enterprise of the non-resident enterprise
Permanent Establishment (PE) is a key facet of international taxation and the same constitutes a crucial threshold for the assignment of taxing rights in respect of the business income to a jurisdiction where enterprises operate in more than one country. The concept of permanent establishment has witnessed a sea change since its introduction and hence, the need to address the newer issues. The said concept is designed to ensure that business activities do not get taxed by any state unless significant economic bonds are created between the enterprise and the state.
The present write-up is aimed at addressing some of the weaknesses and failures of the traditional concept of the permanent establishment in reaching the objective of the legitimate taxation of the income that is attributable to an enterprise by the non-resident enterprise in cases where the core business activity of the permanent establishment is regularly performed in the source state. It analyses recent judicial decisions, both Indian and international, that exhibit a common feature, viz., the problem is universal and the world is yet to reach a consensus.
A. Taxation in digital economy
The advent of technology has transformed the way the business is conducted from brick and mortar to digital shops. As a result, enterprises are nowadays running their business digitally which gives them an additional benefit of worldwide presence. The extensive use of internet also leads to shrinking of global market place. Tax authorities try to tax such e-commerce enterprises by determining their permanent establishment status.
In the year 1999, The Organisation for Economic Cooperation and Development (OECD) constituted a Technical Advisory Group (TAG) to examine 28 categories of e-commerce taxation transactions and issue a comprehensive report on the same. The interpretation of the OECD for each of these transactions, more or less, followed its earlier commentary with the objective of providing more clarity on each of these transactions. India had also set up a High Powered Committee (HPC) to examine tricky taxation issues arising from characterization of certain licensing payments. The HPC Report analyzed all categories of payments discussed in the TAG Report. However, it did not agree with the TAG’s recommendations with respect to characterization of payments made for use of software. The HPC did not address complex issues on creation of a permanent establishment in a virtual world.
The general definition of permanent establishment in the first part of Article 5 (1) postulates the existence of a fixed place of business whereas the second part of Article 5(1) postulates that the business is carried out in India through such fixed place. (1) Thus, existence of a place of business is the main pre-requisite to constitute a permanent establishment in the source State. But what would constitute a place of business was neither defined in OECD Model Tax Convention nor was any light thrown in this respect in the 1963 commentary. However, some guidance was given on “place of business” in the 1977 commentary, to mean a facility such as premises or, in certain instances, machinery or equipment.(2)
The place of business needs to be tangible in nature, i.e., having a physical location(3) , though the definition of permanent establishment contained in the OECD Model Tax Convention did not expressly state the requirement of tangible object to have a place of business.(4) The said requirement was expressly mentioned for the first time in the 2003 commentary.(5) The commentary explained that a distinction needs to be made between a computer equipment which may be set up at a location so as to constitute a permanent establishment under certain circumstances, and the data and software which is used by, or stored on, that equipment.(6) The commentary gives the following example:“An Internet web site is a combination of software and electronic data does not in itself constitute tangible property and therefore, does not have a location that can constitute a ‘place of business’ as there is no facility such as premises or, in certain instances, machinery or equipment.(7) The enterprise does not have a physical presence at server’s location since the web site is not tangible and thus, the enterprise cannot be considered to have acquired a place of business by virtue of that hosting arrangement.”(8)
The commentary further states that the person who operates the server is different from the enterprise carrying out business through a website hosted on such server.(9)
Let us see jurisprudence wherein the issue of intangibles is discussed.
In the case of Western Union Financial Services(10) , the taxpayer was a tax resident of United States which entered into agency agreements with persons(11) in India in respect of its money transfer business. The taxpayer installed software in the premises of the agents which gave access to those agents to the mainframe computers in United States for matching of the control numbers. The revenue authorities argued that the taxpayer has a permanent establishment in the form of premises cum software. The Income Tax Appellate Tribunal, Delhi held that mere use of the software from the premises of the agents cannot lead to the decision that the premises-cum-software will be the permanent establishment of taxpayer in India.
In a Swedish case(12) , X and its parent company Y, were part of a group providing a range of technical and other solutions. The group proposed establishment of a data center in Sweden. In the proposed arrangement, X was to acquire a server to be located in leased premises at certain place in Sweden. The said server was planned to include certain type of software provided and owned by Y. Further, neither X nor Y were to have any employees in Sweden and all the monitoring was to be performed by personnel in country. In these facts, the Swedish Supreme Administrative Court held that a possession of intellectual property [software] does not imply that there is a place of business in Sweden and the fact that Y’s customers can take advantage of the software does not alter this position.
In the case of Right Florist(13) , the taxpayer availed online advertisement services from Google Ireland Ltd. and Yahoo US for which payments were made without withholding tax. Google Ireland Ltd. and Yahoo US were having presence in India only in the form of website. The Income Tax Appellate Tribunal, Kolkata held that a website does not constitute a ‘permanent establishment’ unless the servers on which websites are hosted are also located in the same jurisdiction and since the servers of Google and Yahoo are not located in India, there is no fixed place permanent establishment in India. The Tribunal held that the interpretation of the expression ‘permanent establishment’, even in the context of tax treaties, does not, normally extend to websites unless the servers on which websites are hosted are also located in the same jurisdiction. The Tribunal explained that the underlying principle is this: while website per se, which is a combination of software and electronic data, does not constitute a tangible property as it cannot have a location which constitutes place of business, a web server, on which the web site is stored and through which it is accessible, is a piece of equipment having a physical location and such location may thus constitute a ‘fixed place of business’ of the enterprise that operates that server. A search engine, which has only its presence through its website, cannot therefore be a permanent establishment unless its web servers are also located in the same jurisdiction.
In the case of Webbase Enterprises Limited(14) , a Hong Kong based company was involved in sale of contact lenses and cosmetics in Sweden through internet. The taxpayer purchased services of third party i.e. Fortus International AB, which handles sourcing, personnel resources, storage etc. All products were purchased from Fortus’s storage. Fortus’s representative was granted power of attorney to represent the taxpayer in Sweden. The taxpayer did not maintain any of its own personnel or storage units in Sweden and it solely focused on the marketing and development of products, which was done from Hong Kong. The taxpayer though registered itself for tax purposes in Sweden stating that they conducted business in Sweden, a matter which they later in trial maintained was an error, insisting that the case should be tried on factual matters instead of an error of registration. The Gothenburg Court of Appeal noted that; the consumers enter into agreement with the taxpayer directly through the websites and payment is made straight to the taxpayer, taxpayer has no personnel in Sweden and is depended on Fortus for sales as the products they sell are bought from Fortus’s storage and Fortus conducts all delivery and accounting, taxpayer has no physical access to the internet servers and they do not dispose of the Fortus’s space. The Gothenburg Court of Appeal held that even though the taxpayer’s business activity, sales of lenses and cosmetic through the internet, is made possible through Fortus, taxpayer has no permanent establishment in Fortus’s space.
In a Danish case(15) , an international gambling company that offered various kinds of online games via internet proposed to apply for gaming license from Gambling Authority in Denmark following the liberalization of the Danish gaming market. The Company did not intend to establish an office in Denmark and instead planned to run the game itself through a Danish website from a server that is physically located outside Denmark. The Danish Tax Board confirmed that the gaming company does not have a permanent establishment in Denmark and thus, not subject to limited tax liability.
In a Finnish case(16) , a Swedish company was engaged in the electronic sale and leasing pictures primarily to advertising agencies in the Nordic countries through its website. The pictures could either be downloaded or delivered to the customer on CD-ROM directly from Sweden. The payment was made electronically. The company neither had any office/warehouse in Finland nor was the server located in Finland. The company had two representatives from Finland who worked from home and were responsible to market the company’s websites and maintain business links there. The website of the company was considered not to create Swedish company’s permanent establishment in Finland by Finnish Central Board of Taxation.
The Polish Ministry of Finance(17) was seized of a situation wherein a German company was trading in goods with Polish group companies and the orders were carried out through a website hosted by a server located in Germany. The German company was not having any staff or office in Poland. In this fact situation, the Ministry of Finance held that permanent establishment is not created because all the activities were carried on through a website hosted on a server located outside Poland.
Similarly, the Israeli Taxation Authority(18) denied permanent establishment of a foreign company functioning in Israel through website (operated by local unrelated individuals). The Taxation Authority noted as a fact that the server of the website was located outside Israel.
A different view was taken by the Spanish Court in the case of Dell Products, Ireland(19) . In this case, the taxpayer sold goods in Spain through a website whose server was located outside Spain though dedicated to the Spanish market. The Spanish affiliate (Dell Spain) employed people to translate the website, review the contents and administered the site. The Spanish Central Economic-Administrative Court observed that Dell Products, Ireland had tax nexus with Spain as the activities performed in Spain were economically significant (i.e., trading, selling and delivering) and thus a ‘virtual permanent establishment’ exists in Spain despite the fact that it had no physical contact with Spain.
The Courts have thus, taken a consistent view (except Dell Product, Ireland) that only tangible objects can qualify as place of business. Does it mean that entities having economic presence without any physical presence in the source state will not trigger permanent establishment? A perusal of the history leading to the emergence of the concept of permanent establishment shows that it has to be understood in the light of second industrial revolution characterized by relatively immobile production factors and doctrine of economic allegiance propounded by the four Economists consisting of Professor Gijsbert Bruins, Professor Luigi Einaudi, Professor Edwin Seligman and Professor Sir Josiah Stamp. The intention was thus, to give fair share to each State according to their contribution.
The existing definition of permanent establishment is insufficient to meet the technological advances. How to read an active act in light of technological advances was addressed by Francis Bennion(20) in his book titled, ‘Statutory Interpretation’, where he said that one may refer to ‘doctrine of updating construction’ while interpreting an ‘ongoing Act’ (always speaking). The said doctrine suggests that in construing an ‘ongoing Act’, the interpreter is to presume that Parliament intended the Act to be applied at any future time in such a way as to give effect to the true original intention and thus, the interpreter is to make allowances for any relevant changes that have occurred, since the Act’s passing, in law, social conditions, technology, the meaning of words, and other matters. In other words, an enactment of former days is thus, to be read today in light of dynamic processing received over the years, with such modification of the current meaning of its language as will now give effect to the original legislative intention. The said doctrine is applied by Supreme Court of India in the case of S.J. Choudhary(21) and Podar Cement(22) .
The author is of the view that DTAA is, by its very nature, an ‘ongoing Act’ and thus, doctrine of updating construction can be applied to the ‘concept of permanent establishment’. Accordingly, there is a possibility that e-commerce companies may create a ‘Permanent Establishment‘ in India, even though such companies do not have any physical presence in India, by applying the doctrine of updating construction. The said interpretation would also help in achieving the intention of giving adequate share to the State from where the revenue is actually generated and there would be no need to introduce the Virtual PE concept or a similar concept in the DTAA. This will also do away with the difficulties such as amendment of DTAA’s by various countries, prospective applicability of the newly introduced concept, etc., associated with the introduction of Virtual PE or similar concept.
The United States Supreme Court in the case of Burger King Corporation observed that it is an inescapable fact of modern commercial life that a substantial amount of business is transacted solely by mail and wire communications across state lines’, thus obviating the need for physical presence within a State in which business is conducted. The Madras High Court in the case of Verizon Communications(24) observed that in a virtual world, the physical presence of an entity has today become an insignificant one. It was also observed that technological development brought in by the use of and role of digital information, goods etc., and the foreign enterprise does not need physical presence at all in a country for carrying on business.
The Action 1: Addressing the Tax Challenges of the Digital Economy final report issued by OECD on 5th October, 2015 under the G20 Base Erosion and Profit Shifting Project did not recommend any of the options namely (i) a new nexus in the form of a significant economic presence, (ii) a withholding tax on certain types of digital transactions, and (iii) an equalization levy, at this stage, as it is of the belief that the measures developed in the Base Erosion and Profit Shifting (BEPS) Project will have a substantial impact on BEPS issues identified in the digital economy and that such measure will mitigate some aspects of the broader tax challenges and result in effective levying of consumption taxes in the market country. The report, however, gave a free hand to Countries by stating that Countries could, however, introduce any of these three options in their domestic laws as additional safeguards against BEPS, provided they respect existing treaty obligations, or in their bilateral tax treaties. The author does not share the recommendation of OECD to bring some changes under the domestic laws with a condition to respect the existing treaty obligation because in event of conflict between the domestic law and treaty, the treaty generally(25) prevails and accordingly, the countries would not be benefitted.
B. Business restructuring
The increased cut throat competition to provide quality services to clients at a low cost or the urge to maximize profits has forced Multi-National Companies to set up a subsidiary in low cost jurisdiction and a major portion of their work is outsourced to such subsidiary. The existence of a subsidiary company does not, by itself, constitute that subsidiary company a permanent establishment of its parent company on the principle that, for the purpose of taxation, a subsidiary company constitutes an independent legal entity. Further, even the fact that the trade or business carried on by the subsidiary company is managed by the parent company does not constitute the subsidiary company a permanent establishment of the parent company.(26) This section deliberates on the issues concerning the conversion of full-fledged manufacturers into contract or toll manufacturers as well as conversion of full-fledged distributors into commissionaires.
a. Contract manufacturing
In case of Roche Vitamins(27) , a Swiss tax resident awarded contract for manufacture and product packing to its Spanish subsidiary at a remuneration of cost plus 3.3% mark up. Additionally, it also appointed its Spanish subsidiary as its agent for promoting the products and interests of the parent. The Supreme Court of Spain held that the Spanish subsidiary constituted a fixed place of business of Roche Vitamins and thus, a fixed place permanent establishment is constituted. Similar views were also expressed by the Spanish Central Economic-Administrative Court in the case of Dell Products(28) wherein it agreed with the tax administration that Dell Products had a fixed place permanent establishment in Spain through its Spanish subsidiary as essential part of the business functions was carried on using the facilities, premises and personnel of the Spanish subsidiary and thus, the activity of the parent company should be considered as being carried on through a fixed place of business in Spain. The Spanish Central Economic-Administrative Court followed the Dell ruling and gave a similar view in case of Honda(29) as well.
In the case of Borox, the Spanish subsidiary(30) signed two separate contracts with its UK parent; one for warehousing, provision of services(31) and another one for sales promotion. The tax authorities presumed that there was a fixed place of business of the parent at the premises of the subsidiary and, therefore, there was a permanent establishment in Spain. The Spanish National High Court(32) and Spanish Supreme Court(33) considered the existence of an ‘established, permanent and complete business structure’ as a type of a fixed place of business and concurred with the view of the lower authorities.
In a German case, a Swiss company entered into a contract manufacturing agreement with a German company wherein the German company manufactured flavouring sauces with its own personnel pursuant to the recipes and upon instructions of the Swiss company. The Swiss company also rented space from the German company and established production facility there. The said production facility was rented to the German company. The German Court of First Instance Baden-Wurttemberg held the contract manufacturing facility in the rented premise amounted to fixed place of business though denied the existence of Swiss company’s fixed place permanent establishment as it was German company who was conducting business at such place and not the Swiss company.(34) In a case with identical facts, the German Court of First Instance Baden-Wurttemberg(35) came to the conclusion that the Swiss company maintained a permanent establishment in Germany. The facts that the personnel of the German manufacturer followed the instructions of the Swiss principal and that the German manufacturer was allowed to use the premises belonging to the Swiss principal for no consideration were cited in support of the decision.
The author is of the view that outsourcing of manufacturing activities to subsidiary or independent contract manufacturer would not automatically result in creation of, fixed place of business of the parent company in the form of premises of the related entity/independent contractor or permanent establishment. However, where practically all the facilities, services, personnel, premises etc. are available to the parent company, the parent company can be said to have a permanent establishment.
b. Commissionaire arrangements
One of the instances where agent of dependent status triggers Agency PE is where such agent has the authority to conclude contract. The conclusion of contract involves a number of activities such as solicitations, marketing, liaisoning, negotiations, etc. Further, such authority needs to be exercised in the name of the enterprise.
Under Common law, contract entered between an agent and a customer is always binding on the principal whether the contract is concluded in its own name or in the name of principal. In other words, common law treats the contract apparently made between the agent and the third party as the one made between the principal and the third party through the medium of the agent whether or not the principal is disclosed to the third party. In contrast, under the Civil law, term ‘agency’ describes the relationship between a principal and a person which acts on account of that principal i.e. to conclude contracts binding on him. However, to conclude a contract binding on the principal, the agent needs to disclose the principal to the third party in the process of contracting failing which the concluded contract doesn’t bind the principal. The Civil law thus, distinguishes between the direct representation and indirect representation.
Direct representation is where the agent enters into the contract with the customer ‘in the name of the principal’ whereas indirect representation is where the agent enters into the contract with the customer ‘in its own name’ as against ‘in the name of the principal’. The contracts entered into under direct representation are only binding on the principal and not those entered under indirect representation, which is binding on the agents.
Civil law thus, distinguishes contracts made in the name of the principal (direct representation), which bind the principal, and contracts made in the name of the agent (indirect representation, as), which do not, whereas no such distinction exist in Common law.
The commissionaire agreement is a leading example of indirect representation. Commissionaire agreement may be defined as an arrangement through which a person sells products in a given State in its own name but on behalf of a foreign enterprise who is the owner of the products. Accordingly, the ‘commissionaire arrangement’ as a concept does not exist in common law countries (e.g. India, UK) but only in civil law countries (e.g. France, Norway etc.). As the contracts entered under commissionaire arrangements (indirect representation) are not binding on the principal, some Courts have taken a view that the same do not gives rise to Agency PE of the principal as the contract is concluded in the name of the agent and not the enterprise. The same has resulted in restructuring of business i.e. conversion of distributors into commissionaires.
In Societe Zimmer Limited(36) , the case concerned a UK company which was engaged in the business of selling orthopedic products. Until 1995 the distribution and marketing of the products in France were conducted by Zimmer SAS, a wholly owned French subsidiary of Zimmer Limited. In 1995 Zimmer SAS sold its assets to its parent company, but continued to distribute the parent’s products as a commissionaire of the parent. Under the commissionaire arrangement, Zimmer SAS could accept orders, make offers, negotiate prices and terms of payment, grant discounts, and conclude contracts with both new and existing clients without the prior approval of its UK parent, Zimmer Limited. The Supreme Administrative Court of France denied the existence of Agency PE as the commissionaire acts in its own name and thus, couldn’t bind its principal. The Court also held that the position would not alter even if (1) all the cost and commercial risks in respect of the products sold by the commissionaire is borne by UK parent, (2) only the products of UK parent was sold, (3) commissionaire was controlled by the UK parent, and (4) all the terms of contracts between the commissionaire and the customers were pre-determined by the UK parent.
In Dell Products(37) , the case concerned a tax resident of Ireland whose products were sold by Dell AS, Norway under the commissionaire arrangement. The arrangement showed that relationship between principal and commissionaire was regulated by Norwegian Commission Act of 1916. Dell AS sold products after entering into agreements with customers in its own name but the taxpayer was not legally bound by agreements which Dell AS entered with its customers. In these facts, the Supreme Court of Norway held that Dell AS could not result in creation of Agency PE as Dell AS had no legal authority to enter into contracts with customers in name of the taxpayer and, therefore, Dell AS could not bind the taxpayer legally.
In the Italian case of Boston Scientific International BV (BSI BV)(38) , a company resident in the Netherlands, held 99% of the shares in an Italian company, Boston Scientific SpA (BS SpA) which acted as its distributor of medical equipment in Italy. BS SpA sold only products on behalf of BSI BV, and did so, on a commissionaire basis: it contracted with its Italian customers, but orders were sent to BSI BV and were fulfilled directly by BSI BV from its warehouse. BSI BV acquired the medical products from other companies in the Boston group. BS SpA was subject to certain restrictions applicable to members of the Boston group, for example with respect to sponsorship. It also entered into contracts itself in respect of factorship and insurance. The Supreme Court of Italy affirmed the decision of the Regional Tax Court of Milan and held that it was correct in holding that the Dutch company did not have a Agency PE as the Italian company entered into contracts in its own name and for its own benefit and not in the name of its Dutch parent.
The author is of the view that Agency PE on account of authority to conclude contract in the name of enterprise will get created whether or not the principal is disclosed to the customer as the principal would still be economically bound by the contract signed by the agent and such interpretation appears more logical. The intention of the drafters was to get Agency PE triggered where the principal was bound by the acts of the agent and not in whose name the contract is signed. The literal interpretation i.e. reading ‘in the name of’ would mean that Agency PE would never get triggered under Civil law where the agreements are entered under ‘indirect representation’ and such an interpretation would lead to unintended results and may lead to tax evasion.
The Action 7: Preventing the Artificial Avoidance of Permanent Establishment Status, final report issued by OECD on 5th October, 2015 under the G20 BEPS Project called for a review of definition of Agency PE and states that under the amended provisions the permanent establishment status will no longer be circumvented via the use of commissionaire or similar structures. The proposal made by the OECD will definitely bring an end to such tax avoidance strategies, however, the author feels that the proposal made will bring clarity for future and will not address the current situation. Does it mean that the States should allow Multi-National Companies to continue with their tax avoidance strategies till the time the proposal made is implemented??
*CA Ashish Karundia is a practicing chartered accountant and is the author of ‘Law & Practice Relating to Permanent Establishment’, a comprehensive commentary on permanent establishment. He can be reached at firstname.lastname@example.org. The author is thankful to Ananya Jain for all the support provided in preparation of this document.
Resolution Number 00/2107/2007 dated 15th March, 2012 (Central Economic-Administrative Court, Spain). The Court also found that the Irish parent has agency permanent establishment in the form of Spanish subsidiary
3K 54/93 dated 7th November, 1996 (Court of First Instance, Baden-Wurttemberg- Germany). The only major difference was that the place of business was not rented, but was let to the German manufacturer without any consideration. The appeal against the said decision was rejected in IB 26/97 dated 7th July, 1997 (Supreme Court, Germany)