Synopsis
·
Interpretation of DTAAs
·
Concept of a PE
and tax incidence thereon
·
PE situation
arising out of deputation of employees
·
Installation PE
·
Service PE
·
Dependent agent
·
Conclusion
Interpretation
of DTAAs:
Double taxation avoidance agreements (“DTAAs”) are designed to promote mutual
trade and investment between the countries that have entered into such
agreements. They aim at ensuring that the same income is not taxed in both
countries, in the hands of the same entity. The DTAA provides that a particular
source of income can be taxed by Country A or by Country B, where Country A and
B have entered into the DTAA. Or the DTAA can provide for sharing of the income
for the purpose of tax levy between the two countries. India has entered into
DTAAs with most of her trading partners. But for a proper interpretation of
DTAAs it is also essential to understand the very concept of the DTAA and its
applicability versus the domestic laws in each country.
DTAA Models:
One immediate object of DTAAs is to promote bilateral
trade by the avoidance of double taxation of income. Over the years, several
model tax treaties have been formulated by various governments/multilateral
agencies. The three well-known models are the OECD Model, the UN Model and the
US Model.
The UN Model is largely based on the OECD Model, the
main difference being that the OECD Model gives importance to the right of the
resident state (country where the tax payer is a tax resident) to tax the
income. On the other hand, the UN Model gives importance to the source state
(country from where the income is derived) to tax the income. The US Model has
been published by the US Treasury Department.
Most of the DTAAs entered into by India with the
developed countries of the world are largely based on the UN Model but those
with OECD countries follow a mixture of OECD and UN
models. Thus, it is also important to
keep abreast of the commentaries that are issued from time to time as regards
treaty interpretation.
Overriding nature of DTAAs:
Under a DTAA, the Contracting States mutually undertake
to respect and apply the DTAA provisions. This is one of the fundamental
principles of law of DTAAs. Yet, it is essential to bear in mind that DTAAs may
not always override domestic laws. The practice differs from country to
country. It is important to understand what is the status of the DTAA under the
domestic law and what is its relationship with the domestic law.
There are two approaches to this. Under the first
approach, the countries treat both the International Law and the domestic law
as part of the same legal system and give International Law1
precedence over domestic law. Under the second approach, both the DTAAs and
domestic laws are treated as separate legal systems and in case of a conflict;
it is the domestic law, which is given priority by the domestic courts.
In the United Kingdom (“UK”), DTAAs form part of the UK law only to the extent to which
they have been given effect through an act of Parliament. In Germany,
international agreements have to be made effective through implementing
legislation. In France, certain agreements can only form part of the domestic
law, if legislation is specifically enacted adopting them into the domestic
system. In the United States (“US”),
DTAAs have equal status with domestic laws, but in practice the latter
abrogates the earlier.
In India, section 90(2) of the Income-tax Act, 1961 (“Act”) clearly provides that:
“Where the Central Government has
entered into an agreement with the Government of any country, outside India
under sub-section (1) for granting relief of tax, or as the case may be,
avoidance of double taxation, then, in relation to the assessee to whom such
agreement applies, the provisions of this Act shall apply to the extent they are more beneficial to that
assessee”
In other words, there is clarity under Indian tax laws,
that the provisions of the Act will apply only if they are more beneficial;
else if a taxpayer is covered by the DTAA, it is the provisions of the DTAA
that shall apply.
Concept
of a PE:
The issue of taxable presence and Permanent
Establishment (“PE”) is among the
foundation stones of international taxation. All the three Model Conventions
use the concept of a PE as the main instrument to establish taxing jurisdiction
over a foreigner’s business activities.
To illustrate: If Company X which is a tax resident of
Country A carries on operations in Country B, then Country B can tax the
business profits of such company only to the extent they are attributed to a PE
in Country B. In such a scenario, Country A, depending upon the provisions of
DTAA entered into with Country B, will grant Company X either a tax exemption
or a tax credit with respect to the income earned in Country B.
Under Article 52, paragraph 1, of the OECD
Model Convention, a PE is defined as a fixed place of business through which
the business of an enterprise is wholly or partly carried on. Under Article 7,
paragraph 1, of the OECD Model Convention, a foreign taxpayer will be subject
to income tax, if it carries on its business through a PE in the other Country.
Article 5, paragraph 2, includes a branch to be a PE.
Thus, if an Indian company sets up business operations in Japan through a
branch, then Japan, has the right to tax that portion of the profits of the
Indian company that are attributed to the PE in Japan. A subsidiary, in general
does not constitute a PE. However, if such subsidiary is regarded as a
dependent agent of the parent company it would give rise to the existence of a
PE in the other country.
This presentation paper does not purport to deal with
the tax incidence in case of a branch or a subsidiary. It concentrates on those
circumstances where deputation of employees by an Indian company to a foreign
country could result in the existence of a PE of the Indian company in the
foreign country. In such a scenario, the profits of the Indian company would be
taxed in the foreign country to the extent to which they are attributed to such
PE.
PE arising out of deputation of employees:
It is quite difficult to imagine that mere deputation of
employees, without actually having a branch in the other country, or a wholly
dependent subsidiary can result in the existence of a PE. But this could well
happen.
In this context
it is essential to carefully examine the following issues:
·
Installation PE
·
Service PE
·
Dependent agent
As per Article 5, paragraph 3 of the OECD Model Convention:
“A
building site or construction or installation project constitutes a Permanent
Establishment only if it lasts for more than twelve months”
This clause has as its basis the “duration test”. Thus,
if the twelve month period for a building site, or construction or installation
project, is exceeded a PE is deemed to exist from the beginning of the project.
While the duration test applies to each project, if several contracts are
inextricably interlinked, both geographically and commercially, the duration
could be aggregated and a PE could be regarded as being in existence in a
foreign country, even if each such project is based on different contractual
agreements.
Case study 1
Company A is a Bangalore based software company. It has
recently bagged an award to carry out the development and installation of
customized software for a major bank in the Netherlands (Dutch Bank). Besides
installation it will also carry out certain ancillary activities in Netherlands
such as onsite testing of the software. The intellectual property in the
software will also vest with the Dutch Bank. Will this result in the creation
of an “installation PE” of Company A in the
Netherlands?
Let us examine the provisions of the DTAA entered into
between India and the Netherlands. Article 5 (3) provides as follows:
“A building site or
construction, installation or assembly project constitutes a permanent
establishment only where such site or project continues for a period of more
than six months.”
Earlier the view was that installation projects could
only be those relating to roads, bridges, canals and so on. But, tax
authorities world over have kept pace with changing times. Installation of
customized software is more than likely to fall within the provisions of
Article 5(3) and if such installation project is carried on at the client’s
site for a period of more than six months, viz: at the premise of Dutch Bank in
the Netherlands, Company A will have a PE in the Netherlands.
Netherlands will have the right to tax that portion of
the profits of Company A that can be attributed to such PE in the Netherlands.
In other words, the onsite profits of Company A to the extent to which they are
attributed to such PE will be subject to tax in the Netherlands.
The OECD Model Convention does not contain a service PE
clause. Nonetheless, a few DTAAs entered into by India with other countries do
incorporate this provision. By virtue of the existence of such a clause, if
services are rendered through employees in the other country for a period more
than the prescribed number of days a PE could be constituted.
For this purpose multiple counting of days is to be
avoided. For example, if Mr. A and Mr. B are rendering services concurrently
for the same period of 30 days for a particular project in Country C, the
number of days which will be considered is 30 days and not 60 days. Moreover,
for all practical purposes, if an employee has visited Country C, not for the
purpose of rendering services, these days should not be taken into
consideration in calculating the prescribed period.
Case study 2
Company B is a Hyderabad based company, which provides
non-technical services to clients abroad. Two of its employees, Mr. X and Mr. Y
will be deputed to Singapore to work for a period of 100 days during the year
2003. Consequently, will a “Service PE” of Company B exist in Singapore?
Let us examine the provisions of the DTAA entered into
between India and Singapore. Article
5(6) provides as follows:
“An enterprise shall be deemed to have a Permanent
Establishment in a Contracting State, if it furnishes services, other than
services referred to in paragraphs 43 and 54 of this
Article and technical services as defined in Article 12, within a Contracting
State through employees or other personnel, but only if:
a) Activities
of that nature continue within that Contracting State for a period or periods
aggregating to more than 90 days in any fiscal year; or
b) Activities
are performed for a related enterprise (within the meaning of Article 9 of this
Agreement) for a period or periods aggregating to more than 30 days in any
fiscal year
Thus, as the services rendered
by Company B, in Singapore are not in
the nature of technical services5 and the services are rendered
through its employees for a period aggregating to more than 90 days in a fiscal
year, Company B will have a PE in Singapore.
Even if Mr. X and Mr. Y are not deputed to Singapore,
but Company B, sub-contracts the work to Mr. T, then and the activities of
Mr. T6 are subject to detailed instructions and comprehensive
control of Company B, then if Mr. T renders service in Singapore for a period
of more than 90 days during 2003, Company B will have a service PE in
Singapore.
Dependent agent
Article 5, paragraph 5 of the OECD Model Convention states as
follows:
“Notwithstanding
the provisions of paragraph 1 and 2, where a person other than an agent of an
independent status to whom paragraph 6 applies is acting on behalf of an
enterprise and has, and habitually exercises, in a contracting state an
authority to conclude contracts in the name of the enterprise, that enterprise
shall be deemed to have a Permanent Establishment in that state in respect of
any activities which that person undertakes for the enterprise, unless the
activities of such person are limited to those mentioned in paragraph 4 which,
if exercised through a fixed place of business, would not make this fixed place
of business a Permanent Establishment under the provisions of this paragraph.”
Thus,
to qualify as an agency PE, either (a) an agent or persons dependent on the
enterprise or (b) an independent agent who is not acting in the ordinary course
of his business must:
a) Act on behalf of
the enterprise;
b) Must have the
authority to conclude contracts in the name of the enterprise; and
c) Must exercise
this authority on a habitual or ongoing (Not isolated) basis.
These
contracts should relate to the core operations or essential and significant
(not ancillary) business activities of the enterprise.
The issue of whether or not a dependent agency PE is
created arises in situations where third parties act on behalf of the company
in another country. Employees generally are regarded as dependent agents,
unless it can be proved that such an employee is an independent agent.
For a dependent agency PE to exist in the other country,
it is essential that a dependent agent must have acted on behalf of the
enterprise and the act of such agent should be binding on the enterprise. It is
vital that the dependent agent has the authority to actually conclude binding
contracts in the name of the enterprise. Mere solicitation of business or
negotiation of a contract, where the enterprise has the right to reject the
negotiations entered into by the agent does not result in an agency PE.
However, in this context, it is also
essential to look at the interpretation of this term by
tax authorities in the other country. For example, in Denmark, PE issues could
arise if the agent does not disclose to the customer that the agent is not
entitled to sign any contracts. It is also essential that the dependent agent
exercises the authority to conclude such contracts “habitually”. It should be
exercised repeatedly and not just on an odd occasion.
In certain circumstances, even a subsidiary of a company
in another country could be regarded as a dependent agent. Thus the profits of
the company to the extent to which they can be attributed to such subsidiary
can be subject to tax in the other country.
Case study 3:
This case study deals with a decision by the Italian
court (Italian Corte Suprema di Cassazione) in the case of Ministry of Finance
vs Philip Morris dated March 7, 2002.
The court gave two rulings, one in relation to direct
taxes and the other in relation to VAT. In these rulings, the court has laid
down five principles for determining PE.
These rulings have the effect of widening the PE
concept, especially in relation to multinational group structures, which may
have within its fold a hidden PE entity.
Philip Morris GmbH (“PMG Co”), a German resident company,
had entered into distribution agreements with the Italian state monopoly (“AAMS”) for the sale of cigarettes in
Italy. Under the agreements, the PMG Co could appoint a representative in Italy
to visit warehouses and sales outlets and accordingly it appointed Intertaba
Spa (“IS Co”).
Under the agreement between PMG Co and AAMS, IS Co was
not allowed to perform any marketing or sales activities. IS Co received a fee
for its activities as a representative of PMG Co. It also rendered similar
services to other foreign companies selling cigarettes in Italy.
PMG Co was assessed to direct taxes as well as VAT, by
the Italian tax administration on the contention that IS Co constituted a PE of
the PMG Co due to its role in the negotiations between PMG Co and AAMS. All the
profits from the sale of cigarettes to Italy were attributed to this PE.
PMG Co won before the second level court that it did not
have a PE in Italy and the case then came up as appeal. The Supreme Court of
Italy laid down five principles for determining whether a PE exists and
remanded the case back to the lower court to compute the tax liability by
applying these principles.
The legal principles established by the Supreme Court are as under:
1. A
company, which is resident in Italy, may take the role of being the permanent
establishment of several foreign companies that belong to the same group and
that pursue the same or a similar
strategy. In such a case – according
to the
Italian Supreme Court, in order to ascertain whether an
activity carried out by a domestic company is auxiliary or preparatory,
reference must be made to the program of the whole group;
2. The monitoring of
a contract is not auxiliary in character;
3. The
participation of representatives or offices of a national structure to a phase
of the conclusion of contracts between a non-resident company and other
resident persons falls within the concept of “authority to conclude contracts
in the name of the enterprise” also in cases where the representatives do not
have any formal negotiation power
4. When
a non-resident company entrusts the management functions to a resident company,
even if it concerns a certain area of operations, this gives rise to the
acquisition of a PE;
5. The
verification of requisites of the PE, including the ones on dependence and
participation in the conclusion of contracts, must be conducted from a
substantial and not from a formal standpoint.
In its observations, the Supreme
Court stressed on the aspect that the IS Co transactions with PMG Co and other
group companies, had been so structured as to avoid IS Co being regarded as a
PE in Italy.
While the determination of existence of a PE in the
source country is a fact driven exercise and no strait-jacket formula can be
evolved for such determination, the Philip Morris ruling has widened the gamut
for such determination.
Conclusion:
Before deputing employees to a foreign country, or
before assigning any activities to be carried on by a third party in a foreign
country, it is essential to examine the possibility of such events creating a
PE in the other country.
PE
as per Article 5 of the OECD Model Convention
1.
For the purpose of this Convention,
the term “Permanent Establishment” means a fixed place of business, through
which the business of an enterprise is wholly or partly carried on
2. The term
“Permanent Establishment” includes especially:
a) a place of management;
b) a branch;
c) an office;
d) a factory;
e) a workshop; and
f) a
mine, an oil or gas well, a quarry or any other place of extraction of natural
resources
3. A
building site or construction or installation project constitutes a Permanent
Establishment only if it lasts for more than twelve months (Installation PE)
4.
Notwithstanding the preceding
provisions of this Article, the term “Permanent Establishment” shall be deemed
not to include:
a) The
use of facilities solely for the purpose of storage, display or delivery of
goods or merchandise belonging to the enterprise;
b) The
maintenance of stock of goods or merchandise belonging to the enterprise solely
for the purpose of storage, display or delivery;
c) The
maintenance of stock of goods or merchandise belonging to the enterprise solely
for the purpose of processing by another enterprise
d) The
maintenance of a fixed place of business solely for the purpose of purchasing
goods or merchandise or collecting information for the enterprise;
e) The
maintenance of a fixed place of business solely for the purpose of carrying on,
for the enterprise, any other activity of a preparatory or auxiliary nature;
f) The
maintenance of a fixed place of business solely for any combination of
activities, mentioned in sub-paragraphs ‘a to e’ provided that the overall
activity of the fixed place of business resulting from this combination is of
preparatory or auxiliary character.
5.
Notwithstanding the provisions of
paragraph 1 and 2, where a person other than an agent of an independent status
to whom paragraph 6 applies is acting on behalf of an enterprise and has, and
habitually exercises, in a contracting state an authority to conclude contracts
in the name of the enterprise, that enterprise shall be deemed to have a
Permanent Establishment in that state in respect of any activities which that
person undertakes for the enterprise, unless the activities of such person are
limited to those mentioned in paragraph 4 which, if exercised through a fixed
place of business, would not make this fixed place of business a
Permanent Establishment under the provisions of this paragraph
6.
An enterprise shall not be deemed
to have Permanent Establishment in a contracting state merely because it
carries on business in that state through a broker, general commission agent or
any other agent of an independent status provided that such persons are acting
in the ordinary course of their business
7.
The fact that a company which is a
resident of a contracting state controls or is controlled by a company which is
a resident of the other contracting state, or which carries on business in that
other state (whether through a Permanent Establishment or otherwise) shall not
of itself constitute either company a Permanent Establishment of the other
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