Indian decision on the constitution of a permanent establishment under India-US tax treaty

The High Court (HC) of India delivered its decision on 5 February 2014 in the case of CIT v. eFunds IT Solution Inc. and eFunds Corporation (ITA 735&736/Del/2011) on the constitution of a subsidiary permanent establishment (PE) and ruled that a PE cannot be determined primarily on the basis that there is a close association between the parent and the subsidiary in performing core functions, assets required by the subsidiary in performing services were provided by the parent free of charge and the subsidiary had no capacity to assume business risks. The High Court held that whether or not a PE exists will have to be determined as per article 5 of the India - United States Income Tax Treaty (1989) (the Treaty) and on merits, taking into consideration the facts and conduct of the parties.
The Taxpayers (i.e. eFunds Corporation and eFunds IT Solution Inc.) are companies incorporated in and are tax residents of the US. The Taxpayers had entered into contracts with their clients for provision of Information Technology-enabled (IT-enabled) services. The contracts were further subcontracted by the Taxpayers to their India group company, i.e. eFunds International India Private Limited (eFunds India) and for which, eFunds India was remunerated at arm's length.
During the audit proceedings, the tax authorities held that eFunds India is a PE of the Taxpayers as per article 5 of the Treaty. Further, the tax authorities observed that the analysis of the Functions performed, Assets used and Risks assumed (FAR) by the Taxpayers as well as eFunds India made it clear that eFunds India did not have adequate capability for assuming significant risks to carry out business activities in India (i.e. the software and the databases needed for providing IT-enabled services was provided by the Taxpayers free of charge) and the sales team of the Taxpayers undertook marketing efforts for eFund India. Based on the same, the tax authorities concluded that the entire activities for the Taxpayers were carried out by the PE in India and the PE has not been remunerated on an arm's length basis. The Taxpayers appealed before the HC.
The High Court overturned the decision of the tax authorities and held that the Taxpayers did not have a subsidiary PE in India (by way of fixed place of business or service PE or agency PE). Accordingly, no further income could be attributed and assessed in the hands of the Taxpayers. The High Court further explained the following:

• Mutual Agreement Procedure (MAP): The Taxpayers had requested for a MAP wherein the competent authority of the US and India decided on the apportionment method for attributing profits arising to the Taxpayers and eFunds India. On the same, the High Court held that the MAP, although relevant, cannot be the primary basis to decide whether or not eFunds India was a PE. The same had to be determined on merits and on the basis of facts of the case.
• Fixed place of business: The tax authorities had primarily relied on the close association between eFunds India and the Taxpayers and applied the FAR criteria to determine whether or not the Taxpayers had a fixed place PE. This was not a proper and appropriate test to determine a fixed place PE. The tax authorities did not explain whether the premises of eFunds India was at the disposal, legally or otherwise, of the Taxpayers. Further, the "right to use test" or "disposal test" had not been applied nor was there any finding to the said aspect. In the absence of any such finding, article 5(1) of the Treaty cannot be applied. The fact that eFund India was carrying out core activities of the Taxpayers or did not bear significant business risk or was reimbursed of major costs was irrelevant in deciding fixed place PE. Further, the Taxpayers' 10K Report (i.e. annual report) filed before the Securities Exchange Commission states that 40% of the employees of the entire group were in India, i.e. were employees of eFunds India and that fact will not make eFunds India a subsidiary PE or a fixed place PE of the Taxpayers.
• Agency PE: The High Court ruled out existence of agency PE in view of the finding that transactions among parties were carried out at arm's length and due to absence of any allegation that the transactions were not in ordinary course of business.
• Service PE: The High Court held that the employees of eFunds India cannot be regarded as "employees or other personnel" of the Taxpayers. Also, the employees of the Taxpayers that were seconded to eFunds India were functioning under the control and direction of eFunds India. Further, the tax authorities could not explain the nature and role of the services so purported to be carried on by seconded employees for the business of the Taxpayers.
• Preparatory activities: The High Court held that, merely because the activities of eFunds India do not fall within the negative or exclusion list of activities set out in article 5(3) of the Treaty, a PE cannot be presumed to be established under article 5(1) or article 5(2). Both the articles of the Treaty will have to be read and applied independently.
• Attribution of profits: It re-iterated that 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 eFunds India, nothing further would be attributable to the Taxpayers. However, if the transfer pricing computation does not adequately reflect the functions performed and risk assumed by eFunds India, then there is need to attribute profits for those functions or risks which have not been considered. For the same, the High Court relied on the Supreme Court decision in the case of Morgan Stanley 292 ITR 416 and OECD Model Commentary on article 7.