Navigating the Intricacies of Service Permanent Establishment: A Summary of Key Legal Disputes

 The global business landscape has transformed dramatically. With the rise of digitalization and e-commerce, companies can now operate and provide services across borders without a traditional physical presence. This evolution has created a significant challenge for tax authorities worldwide: how to tax the profits generated by foreign enterprises in their jurisdiction. The long-established international tax rule is that a source state can only tax the business profits of a foreign enterprise if it has a Permanent Establishment (PE) there.

 

While there are several types of PE (like a fixed place of business or a construction site), this article focuses on the complexities and legal disputes surrounding the "Service PE." A Service PE is triggered when a company furnishes services in another country through its employees or other personnel for a period exceeding a threshold defined in the relevant tax treaty.

 

The Foundation: What is a Service PE?

 

Most of India's Double Taxation Avoidance Agreements (DTAAs) are based on either the OECD or UN Model Conventions. The UN Model Convention contains a specific clause (Article 5(3)(b)) stating that a Service PE is created if services are furnished through employees or personnel for more than 183 days within any 12-month period.

 

Indian treaties often have a Service PE clause, particularly when the definition of "Fees for Technical Services" (FTS) is narrow (e.g., requiring a "make available" clause, as in treaties with the US, UK, etc.). However, the application of this seemingly simple rule—checking if employees spent more than 'X' days—has been the subject of numerous legal disputes.

 

Key Legal Disputes and Judicial Interpretations

 

1. The Critical Requirement of Physical Presence

A fundamental question is whether services must be rendered within the source state. The language in treaties ("activities… continue within a Contracting State") strongly implies a requirement for physical presence.

• The Dispute: Can services provided remotely from outside India (e.g., via video conferencing) to clients in India create a Service PE?
• The Judicial View: Indian courts have consistently held that physical presence is necessary. The Delhi ITAT in Clifford Chance PTE Ltd (2024) explicitly negated the concept of a "virtual PE," stating that in the absence of treaty amendments, only physical presence counts. This view is supported by the OECD Commentary.
• India's Stance: It is important to note that India has officially expressed a reservation to this OECD Commentary, arguing that physical presence should not be a prerequisite, indicating a potential area for future conflict.

2. The "Other Personnel" Conundrum

The treaty language covers services provided through "employees or other personnel." The scope of "other personnel" is crucial.

• The Dispute: Does this include personnel from a third-party contractor or only the foreign enterprise's own staff?
• The Judicial View: The term "other personnel" expands the scope to include individuals who are not formal employees but are under the control, supervision, and instruction of the foreign enterprise. However, the key is dependency. In E-Funds IT Solutions Inc, the court held that employees of an Indian subsidiary could not be considered "personnel" of the foreign parent because their de jure (legal) and de facto (actual) employer was the Indian entity.

3. Calculating the Threshold: Man-Days vs. Solar Days

Perhaps the most common practical dispute is how to calculate the number of days spent in the source state.

• The Dispute: If 10 employees work in India for 20 days each in the same period, does that count as 10 "solar days" (i.e., 20 calendar days on which work was performed) or 200 "man-days" (10 employees x 20 days)?
• The Judicial View: The judiciary has consistently rejected the tax authorities' "man-days" approach. Precedents like Worley Parsons Services, Valentine Maritime, and Clifford Chance firmly establish that the threshold is based on "solar days." In this example, only 20 days would be counted towards the threshold.

4. What Counts as a "Day"? Workdays vs. Holidays

The calculation isn't just about who is present; it's also about what they are doing.

• The Dispute: Should weekends, national holidays, and vacation days spent in the country be included in the day count?
• The Judicial View: Tribunals have ruled that days on which no services are actually rendered should be excluded. The Mumbai ITAT in Linklaters LLP held that holidays must be excluded. The Delhi ITAT in Clifford Chance followed this principle, excluding periods spent on vacation from the threshold calculation.

5. Aggregation: What Activities Can Be Combined?

Treaties often require aggregating time spent on activities "of that nature" or "for the same or connected project."

• The Dispute: Can a company aggregate time spent by different employees on completely different projects for different clients to cross the threshold?
• The Judicial View: It depends on the specific treaty language. Many Indian treaties (following the newer UN Model) allow aggregation of all service activities. However, treaties with countries like Korea, China, and the UAE specify aggregation only for "the same or connected project." Therefore, dissimilar or unconnected projects cannot be combined under these treaties.

6. The Interplay with Fees for Technical Services (FTS)

A single payment for services can potentially be taxed under two different articles of a tax treaty.

• The Dispute: If a payment qualifies as FTS and the service period also triggers a Service PE, how is it taxed?
• The Resolution: The judiciary applies the principle that specific provisions override general ones.
• If the services are FTS but the duration does not exceed the Service PE threshold, the income is taxable as FTS (usually a gross basis with a capped tax rate).
• If the duration does exceed the threshold, a Service PE is constituted, and the income is taxable as business profits (allowing for deduction of expenses, potentially resulting in a higher tax liability if the profit margin is high).
• Some treaties (e.g., with the US, UK) explicitly exclude income taxable as FTS from the scope of Service PE, avoiding this clash altogether.

7. Excluded Activities: What Doesn't Count as "Furnishing Services"?

Not every activity performed by an employee in the source state counts towards the Service PE threshold.

• The Dispute: Do activities like supervision, stewardship, or business development constitute "furnishing of services"?
• The Judicial View: The Supreme Court in Morgan Stanley held that stewardship activities (oversight of an investee company) do not constitute a service provided to that company. Similarly, the Delhi ITAT in Clifford Chance held that days spent on business development (marketing, pitching for new clients) should be excluded because there is no "flow of services" to a customer during those activities.

 

Conclusion: A Settled Landscape with Future Challenges

The Indian judiciary has provided substantial clarity on most traditional disputes surrounding Service PE. The principles of physical presence, solar days, exclusion of holidays, and the narrow definition of "furnishing services" are now well-established.

However, challenges persist. The concept of a "Virtual Service PE," which India supports, remains contested and unresolved due to the current language of existing treaties. As business models continue to evolve towards greater digitalization and remote work, this tension between physical presence and economic presence will only intensify.

For multinational corporations, careful planning and deliberation are essential. Understanding the specific language of each relevant tax treaty, meticulously tracking the physical presence and activities of personnel, and being aware of these judicial precedents are crucial to navigating the intricate world of Service PE and avoiding unexpected tax liabilities. The future will depend on whether international tax treaties are amended to keep pace with the modern digital economy.