In general, as regards tax treaties entered into by India, the provisions
relating to taxation of business profits (Article 7 of the tax treaty) provide
that in computing the profits of a PE, there shall be allowed as deduction,
expenses which are incurred for the purposes of the business of the PE, whether
incurred in India or elsewhere.
In 1976, Indian legislature realized the need of placing some checks and balances for deductibility of PE expenses that are not incurred in India. Section 44C was introduced in the Income tax Act, 1961 (‘the Act’) for this purpose. Central Board of Direct Taxes (CBDT) issued circular no. 202 in July 1976 wherein it explained the intent behind the provision. The circular stated that it is extremely difficult to scrutinize and verify claims in respect of head office expenses, particularly in the absence of account books of the head office which are kept outside India. It added that foreign companies operating through branches in India sometimes try to reduce the incidence of tax in India by inflating their claims in respect of head office expenses. It was with a view to getting over these difficulties section 44C was introduced.
Section 44C defines head office expenses and lays down limit to which such expenses can be claimed as deduction from PE profits. It covers all executive and general administration expenses including rent, rates, taxes, insurance, salary, travelling etc. incurred outside India. The definition in the Act is inclusive and the tax treaties do not provide any definition. Usually, the executive and general administrative expenses include expenses that are related to the overall management of the enterprise and in addition to the specifics in the inclusive definition it can encompass depreciation, expenses related to office equipment, expenses on periodic meetings, training and skill enhancement, market research and analysis, expenses on standard operating procedures, marketing costs for the overall enterprise etc.
The limit of deduction is restricted to five percent of adjusted total income even if the expenses actually incurred and attributable to the PE are higher.
2. Issues surrounding deductibility of head office expenses
This provision has been a subject matter of litigation on various counts. The key issues that arise are as under:
• Whether the particular expense incurred falls within the mischief of the section
• Whether the section applies if whole of the business operations are in India
• Whether the non-discrimination clause of the tax treaty can override this provision
The scope of the present article is primarily restricted to the last issue. To set the context, the first issue involves a determination as to whether at all an expense is constrained by the provision of section 44C. The expense necessary for functionality of PE can be categorized in three, namely (a) expenses that PE itself incurs in India (b) expenses that the foreign company incurs at head office level exclusively for the Indian PE and (c) expenses that the foreign company incurs at head office level generally for its business which also benefits the PE being a part of the legal entity. As regards expenses of first category, the same are clearly not affected by Section 44C since the very definition of ‘head office expenses’ specifies that these are expenses incurred outside India. As regards second category, it was held in CIT vs Emirates Commercial Bank Ltd. 262 ITR 55 (Bom) that the provisions of section 44C cover only those expenses which are common for various locations and require apportionment and do not affect the expenses exclusively incurred for Indian PE. Meaning thereby that section 44C applies only to the last category stated above. Without dealing with the correctness of this decision, the discussion in the article below is confined to the expenses falling in last category (i.e. common for various locations) which section 44C intends to regulate and restrict.
3. Interplay with tax treaties
General: As noted above, Article 7 of the tax treaties generally provides that all expenses including executive and general administrative expenses incurred for the purpose of PE should be considered for determining PE profits.
The text of Article 7(3) [old] as per OECD Model Tax Convention of 2010 (‘OECD MC’) is as under:
Scope: The phrase ‘for the purposes of the permanent establishment’ is wide enough to cover expenses which are not exclusively for the purpose of PE but which common for the enterprise and benefit PE as well. This is also supported by the language of latter part of the clause wherein the situs of incurrence of expenses has been made irrelevant i.e. the expense need not have been incurred in the state of PE itself. The proposition that the expense need not be exclusively for the PE also finds support from international case law on the subject. In a German Supreme Court ruling, [costs] have been held to be attributable to the PE ‘if, and to the extent that, the expenses were sparked off by some special supplies or services by the head office for the benefit of the branch or if, and to the extent that, the supplies or services made available by head office and giving rise to the costs were furnished in the interest of the overall enterprise and this in the interest of the PE as well (Professor Klaus Vogel On Double Taxation Conventions, 3rd Ed, Kluwer, 1997, p. 450).
However, for the purpose of deductibility of the expenses from the PE income, there must be established a business connection between the expenses and the PE. Further, as per OECD MC Commentary, the deductibility does not depend on the actual remittance / reimbursement of the expenses by the PE.
Hence the expense governed by section 44C can find shelter under this article subject however to establishing the fact of its actual incurrence and its connection to the business of the PE. It is believed that since the expenses are general and for overall enterprise, a direct benefit of the PE is not a prerequisite for the deductibility and the test rather is the connection between the expense and the business of the PE. Needless to add that the base amount which is to be apportioned to different parts of the enterprise using some allocation key should not include the expenses which are exclusive for either the head office or some other PE.
Role of domestic legislation: As the tax treaty is not a complete code for determination of the quantum of taxable profits, the provisions of domestic legislation come into play for arriving at the same.
OECD MC Commentary on Old Article 7 provides (at para 30 of the Commentary) in this regard as under:
Hence, the provisions of domestic law regarding computation of income come into play for computation of income in general. Thus the provisions of say Section 40A, Section 43B etc would apply equally for computing a PE income (see contra however State Bank of Mauritius vs DCIT 149 TTJ 708 (ITAT Mumbai) which with due respect requires reconsideration).
Treaty override: As quoted above, Article 7(3) of the OECD MC mandates allowance of expenses (by using expression “shall be allowed”) irrespective of the place of its incurrence. This element in the Article thus operates as a non-discriminatory code whereby a discriminatory treatment for expenses depending on place of their incurrence is negated. The non-discrimination rule embodied in Article 7 is however limited in scope i.e. it operates only for a PE and that too only against a discriminatory treatment based on the place of incurrence of the expense. Hence, this article cannot be interpreted in a manner to avoid applicability of general computation provisions of domestic law or even any other discriminatory treatment that PE may receive.
Another Article specifically dealing with non-discrimination in general also finds place in modern treaties. Article 24(3) OECD MC in this regard reads as under:
The language of this Article is more generally couched. This Article can prevent any kind of discrimination which PE taxation may face in a contracting country. For example if the domestic law prevents deduction of marketing expenses totally or limits the same, irrespective of the place of incurrence, then one would need to fall back on an Article similar to 24(3) of OECD MC.
In the context of limitation imposed by Section 44C, since the same is founded on place of incurrence of expense, the provisions of Article 7(3) are enough and there is no necessity of resorting to Article 24. Thus, when the tax treaty contains provisions similar to Article 7(3) above, the same would prevent the operation of Section 44C and head office expenses would be allowed in full, provided of course that, the fact of their incurrence and business connection with PE are established. This proposition has been accepted in ITO vs Degremont International (1985) 11 ITD 564 (Jaipur ITAT) and State Bank of Mauritius (2012) 149 TTJ 708 (ITAT Mumbai).
Specific cases: Indian tax treaties with some countries are however worded differently from OECD MC in this regard. For example India US tax treaty in its Article 7(3) provides as under:
At a first glance, one may feel that the underlined phrase is clarificatory of the position highlighted in para 30 of OECD MC Commentary (supra) and would not militate against non-discriminatory mandate preceding it. The contrary has however been commented by US authorities in the technical explanation issued specifically for India US tax treaty. The extract of the technical explanation reads as under:
Hence, by subjecting the PE expenses to the domestic law limitations, India US tax treaty yields before the limitation imposed by Section 44C.
Thus, the India US tax treaty while on one hand mandates deductibility of PE expenses irrespective of place of its incurrence, on the other hand it subjects them to Section 44C which limits expenses incurred abroad. The only way to reconcile this is that while the limitation imposed under section 44C will operate, there cannot be absolute denial to deductibility of overseas expenses. To ensure that section 44C is not subsequently amended to deny such expenses in totality, protocol to the India US treaty specifically freezes the limitation of domestic law to what prevailed at the time of entering into the treaty.
Further, as there is a specific admission of domestic law limitation in Article 7(3) the general provisions of Article 26 of the said tax treaty (pertaining to non-discrimination) cannot be of any help. This is supported by para 4 of the Commentary on Article 24 of OECD MC which (relevant extract) reads as under:
This proposition has not been followed in Metchem Canada Inc. vs DCIT (2006) 99 TTJ 702 (ITAT Mumbai) and in the light of discussion above, the decision respectfully requires reconsideration.
Any treaty which is worded similar to India US treaty is likely to receive similar interpretation (please see Abu-Dhabi Commercial Bank Ltd. vs JCIT (2007) 18 SOT 170 (ITAT Mumbai) based on India UAE tax treaty – though the reasoning of the decision with due respect is not correct).
4. Conclusion
While the computation of taxable income of PE is an exclusive domain of domestic law, the limitation imposed by Section 44C can be negated by the non-discriminatory mandate of Article 7(3) without having recourse to specific non-discrimination Article of the relevant tax treaty. However where the Article 7(3) itself subjects it to the limitations of domestic law (as in the case of India US or India UAE treaties) the deduction has to be curtailed in accordance with section 44C and reference to specific non-discrimination Article of the relevant tax treaty is unlikely to be of any help.
In 1976, Indian legislature realized the need of placing some checks and balances for deductibility of PE expenses that are not incurred in India. Section 44C was introduced in the Income tax Act, 1961 (‘the Act’) for this purpose. Central Board of Direct Taxes (CBDT) issued circular no. 202 in July 1976 wherein it explained the intent behind the provision. The circular stated that it is extremely difficult to scrutinize and verify claims in respect of head office expenses, particularly in the absence of account books of the head office which are kept outside India. It added that foreign companies operating through branches in India sometimes try to reduce the incidence of tax in India by inflating their claims in respect of head office expenses. It was with a view to getting over these difficulties section 44C was introduced.
Section 44C defines head office expenses and lays down limit to which such expenses can be claimed as deduction from PE profits. It covers all executive and general administration expenses including rent, rates, taxes, insurance, salary, travelling etc. incurred outside India. The definition in the Act is inclusive and the tax treaties do not provide any definition. Usually, the executive and general administrative expenses include expenses that are related to the overall management of the enterprise and in addition to the specifics in the inclusive definition it can encompass depreciation, expenses related to office equipment, expenses on periodic meetings, training and skill enhancement, market research and analysis, expenses on standard operating procedures, marketing costs for the overall enterprise etc.
The limit of deduction is restricted to five percent of adjusted total income even if the expenses actually incurred and attributable to the PE are higher.
2. Issues surrounding deductibility of head office expenses
This provision has been a subject matter of litigation on various counts. The key issues that arise are as under:
• Whether the particular expense incurred falls within the mischief of the section
• Whether the section applies if whole of the business operations are in India
• Whether the non-discrimination clause of the tax treaty can override this provision
The scope of the present article is primarily restricted to the last issue. To set the context, the first issue involves a determination as to whether at all an expense is constrained by the provision of section 44C. The expense necessary for functionality of PE can be categorized in three, namely (a) expenses that PE itself incurs in India (b) expenses that the foreign company incurs at head office level exclusively for the Indian PE and (c) expenses that the foreign company incurs at head office level generally for its business which also benefits the PE being a part of the legal entity. As regards expenses of first category, the same are clearly not affected by Section 44C since the very definition of ‘head office expenses’ specifies that these are expenses incurred outside India. As regards second category, it was held in CIT vs Emirates Commercial Bank Ltd. 262 ITR 55 (Bom) that the provisions of section 44C cover only those expenses which are common for various locations and require apportionment and do not affect the expenses exclusively incurred for Indian PE. Meaning thereby that section 44C applies only to the last category stated above. Without dealing with the correctness of this decision, the discussion in the article below is confined to the expenses falling in last category (i.e. common for various locations) which section 44C intends to regulate and restrict.
3. Interplay with tax treaties
General: As noted above, Article 7 of the tax treaties generally provides that all expenses including executive and general administrative expenses incurred for the purpose of PE should be considered for determining PE profits.
The text of Article 7(3) [old] as per OECD Model Tax Convention of 2010 (‘OECD MC’) is as under:
“In determining the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the permanent establishment, including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere.” (emphasis supplied)
Scope: The phrase ‘for the purposes of the permanent establishment’ is wide enough to cover expenses which are not exclusively for the purpose of PE but which common for the enterprise and benefit PE as well. This is also supported by the language of latter part of the clause wherein the situs of incurrence of expenses has been made irrelevant i.e. the expense need not have been incurred in the state of PE itself. The proposition that the expense need not be exclusively for the PE also finds support from international case law on the subject. In a German Supreme Court ruling, [costs] have been held to be attributable to the PE ‘if, and to the extent that, the expenses were sparked off by some special supplies or services by the head office for the benefit of the branch or if, and to the extent that, the supplies or services made available by head office and giving rise to the costs were furnished in the interest of the overall enterprise and this in the interest of the PE as well (Professor Klaus Vogel On Double Taxation Conventions, 3rd Ed, Kluwer, 1997, p. 450).
However, for the purpose of deductibility of the expenses from the PE income, there must be established a business connection between the expenses and the PE. Further, as per OECD MC Commentary, the deductibility does not depend on the actual remittance / reimbursement of the expenses by the PE.
Hence the expense governed by section 44C can find shelter under this article subject however to establishing the fact of its actual incurrence and its connection to the business of the PE. It is believed that since the expenses are general and for overall enterprise, a direct benefit of the PE is not a prerequisite for the deductibility and the test rather is the connection between the expense and the business of the PE. Needless to add that the base amount which is to be apportioned to different parts of the enterprise using some allocation key should not include the expenses which are exclusive for either the head office or some other PE.
Role of domestic legislation: As the tax treaty is not a complete code for determination of the quantum of taxable profits, the provisions of domestic legislation come into play for arriving at the same.
OECD MC Commentary on Old Article 7 provides (at para 30 of the Commentary) in this regard as under:
“…paragraph 3 only determines which expenses should be attributed to the permanent establishment for purposes of determining the profits attributable to that permanent establishment. It does not deal with the issue of whether those expenses, once attributed, are deductible when computing the taxable income of the permanent establishment since the conditions for the deductibility of expenses are a matter to be determined by domestic law, subject to the rules of Article 24 on Non-discrimination (in particular, paragraphs 3 and 4 of that Article)” (emphasis supplied).
Hence, the provisions of domestic law regarding computation of income come into play for computation of income in general. Thus the provisions of say Section 40A, Section 43B etc would apply equally for computing a PE income (see contra however State Bank of Mauritius vs DCIT 149 TTJ 708 (ITAT Mumbai) which with due respect requires reconsideration).
Treaty override: As quoted above, Article 7(3) of the OECD MC mandates allowance of expenses (by using expression “shall be allowed”) irrespective of the place of its incurrence. This element in the Article thus operates as a non-discriminatory code whereby a discriminatory treatment for expenses depending on place of their incurrence is negated. The non-discrimination rule embodied in Article 7 is however limited in scope i.e. it operates only for a PE and that too only against a discriminatory treatment based on the place of incurrence of the expense. Hence, this article cannot be interpreted in a manner to avoid applicability of general computation provisions of domestic law or even any other discriminatory treatment that PE may receive.
Another Article specifically dealing with non-discrimination in general also finds place in modern treaties. Article 24(3) OECD MC in this regard reads as under:
“3. The taxation on a permanent establishment which an enterprise of a Contracting State has in the other Contracting State shall not be less favorably levied in that other State than the taxation levied on enterprises of that other State carrying on the same activities. This provision shall not be construed as obliging a Contracting State to grant to residents of the other Contracting State any personal allowances, reliefs and reductions for taxation purposes on account of civil status or family responsibilities which it grants to its own residents.”
The language of this Article is more generally couched. This Article can prevent any kind of discrimination which PE taxation may face in a contracting country. For example if the domestic law prevents deduction of marketing expenses totally or limits the same, irrespective of the place of incurrence, then one would need to fall back on an Article similar to 24(3) of OECD MC.
In the context of limitation imposed by Section 44C, since the same is founded on place of incurrence of expense, the provisions of Article 7(3) are enough and there is no necessity of resorting to Article 24. Thus, when the tax treaty contains provisions similar to Article 7(3) above, the same would prevent the operation of Section 44C and head office expenses would be allowed in full, provided of course that, the fact of their incurrence and business connection with PE are established. This proposition has been accepted in ITO vs Degremont International (1985) 11 ITD 564 (Jaipur ITAT) and State Bank of Mauritius (2012) 149 TTJ 708 (ITAT Mumbai).
Specific cases: Indian tax treaties with some countries are however worded differently from OECD MC in this regard. For example India US tax treaty in its Article 7(3) provides as under:
“3. In the determination of the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the business of the permanent establishment, including a reasonable allocation of executive and general administrative expenses, research and development expenses, interest, and other expenses incurred for the purposes of the enterprise as a whole (or the part thereof which includes the permanent establishment), whether incurred in the State in which the permanent establishment is situated or elsewhere, in accordance with the provisions of and subject to the limitations of the taxation laws of that State.” (emphasis supplied)
At a first glance, one may feel that the underlined phrase is clarificatory of the position highlighted in para 30 of OECD MC Commentary (supra) and would not militate against non-discriminatory mandate preceding it. The contrary has however been commented by US authorities in the technical explanation issued specifically for India US tax treaty. The extract of the technical explanation reads as under:
“..The language of this paragraph differs from that in the U.S. Model in one significant respect. Under the U.S. Model deductions are not subject to the limitations of local law which may conflict with the general principle of the paragraph. Paragraph 3 in the Convention provides for such deductions in accordance with the provisions of and subject to the limitations of the taxation laws of the State in which the permanent establishment is situated.
Indian law limits certain deductions of a permanent establishment with respect to head office expenditures. The deduction of amounts characterized as executive and general administration expenditures (not interest) is capped at five percent of the adjusted total income of the permanent establishment. This limitation was included in the Convention because of the difficulties India has had in verifying claimed deductions for head office expenses and because of the desire of the Indians to avoid litigation on this issue. In practice, the Indian taxing authority does not inquire extensively into deductions that do not exceed the five percent cap.
The amount permitted to be deducted is understood by India to be an approximate average of head office executive and general administrative expense incurred by non-Indian companies for the purpose of their permanent establishments in India. However, the rule does not provide absolute certainty that U.S. companies with a permanent establishment in India will be able to deduct from their income subject to Indian tax the entire amount of head office expense incurred for the purpose of the permanent establishment.”
Hence, by subjecting the PE expenses to the domestic law limitations, India US tax treaty yields before the limitation imposed by Section 44C.
Thus, the India US tax treaty while on one hand mandates deductibility of PE expenses irrespective of place of its incurrence, on the other hand it subjects them to Section 44C which limits expenses incurred abroad. The only way to reconcile this is that while the limitation imposed under section 44C will operate, there cannot be absolute denial to deductibility of overseas expenses. To ensure that section 44C is not subsequently amended to deny such expenses in totality, protocol to the India US treaty specifically freezes the limitation of domestic law to what prevailed at the time of entering into the treaty.
Further, as there is a specific admission of domestic law limitation in Article 7(3) the general provisions of Article 26 of the said tax treaty (pertaining to non-discrimination) cannot be of any help. This is supported by para 4 of the Commentary on Article 24 of OECD MC which (relevant extract) reads as under:
“…the provisions of the Article [on Non-discrimination] must be read in the context of the other Articles of the Convention so that measures that are mandated or expressly authorized by the provisions of these Articles cannot be considered to violate the provisions of the Article…”
This proposition has not been followed in Metchem Canada Inc. vs DCIT (2006) 99 TTJ 702 (ITAT Mumbai) and in the light of discussion above, the decision respectfully requires reconsideration.
Any treaty which is worded similar to India US treaty is likely to receive similar interpretation (please see Abu-Dhabi Commercial Bank Ltd. vs JCIT (2007) 18 SOT 170 (ITAT Mumbai) based on India UAE tax treaty – though the reasoning of the decision with due respect is not correct).
4. Conclusion
While the computation of taxable income of PE is an exclusive domain of domestic law, the limitation imposed by Section 44C can be negated by the non-discriminatory mandate of Article 7(3) without having recourse to specific non-discrimination Article of the relevant tax treaty. However where the Article 7(3) itself subjects it to the limitations of domestic law (as in the case of India US or India UAE treaties) the deduction has to be curtailed in accordance with section 44C and reference to specific non-discrimination Article of the relevant tax treaty is unlikely to be of any help.
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