[Pragya Kaushik was a Law Clerk-cum-Research Assistant to Hon’ble Justice Rohinton Fali Nariman in 2019-20 and is a graduate from National Law School of India University, Bangalore]
The determination of Indian tax liability of a foreign enterprise is a deeply contentious topic plaguing the Indian tax law regime. It involves a lot of complicated issues, one of them being the determination of whether a foreign enterprise is conducting its business in India through a permanent establishment (‘PE’), and the resultant Indian tax liability of the enterprise. Many foreign enterprises have been involved in a tussle with the Indian Revenue over this issue since many years. One such dispute was finally settled by the Supreme Court last week, in the case of DIT-II (International Taxation), New Delhi v. Samsung Heavy Industries Co. Ltd. (‘SHI’). The case involved the India-Korea Agreement for Avoidance of Double Taxation and Prevention of Fiscal Evasion (‘DTAA’).
The taxability of the income of a Korean enterprise (or any foreign enterprise, provided that India has a similar DTAA with that foreign country) in India works in the following way. As per article 7(1), DTAA, the business profits of such enterprise would generally be taxable only in Korea, unless the enterprise engages in business through a PE situated in India. In such a case, the profits of enterprise would be taxable in India as well. However, only that portion of the profits which can be attributed to the Indian PE may be taxed in India. For this, the Indian Revenue has to first establish that there is a PE of the enterprise in India. Thus, the issue of taxability of the income attributable to the PE of a foreign enterprise, commences with the inquiry into whether a PE exists in India.
Facts of DIT-II (International Taxation)
ONGC, in 2006 gave a ‘turnkey’ contract to a consortium of Larsen & Toubro Limited (‘L&T’) and SHI, for carrying out certain work with respect to the ‘Vasai East Development Project’ (‘VEDP’). In May 2006, a ‘Project Office’ (‘PO’) was set up by SHI in Mumbai for use as a communication channel between SHI and the ONGC with respect to the VEDP. SHI’s returns of income for assessment year 2007-08 showed nil profit with respect to its activities in India. In the Draft Assessment Order (‘Order’), the Assessing Officer held that the work was wholly executed by the PE of SHI in India. SHI’s objections to this Order were dismissed by the Dispute Resolution Panel, which held that the nature of activities undertaken by SHI in India showed that SHI had a PE in India.
Before the Income Tax Appellate Tribunal (‘ITAT’)
The ITAT referred to certain documents, mainly, SHI’s board resolution for opening the PO and SHI’s application to RBI for opening the PO, to hold that the purpose of the PO was coordination and execution of the entire project. Hence, the ITAT concluded that the PO was SHI’s fixed place PE in India, to carry out the contract wholly or partly, as under article 5(1), DTAA.
SHI had argued before the ITAT that the PO was not involved in any core business activity of SHI and was only an auxiliary office. To prove this, SHI produced the accounts it maintained in India which did not show any VEDP-related expenditure. ITAT dismissed these arguments by observing that the terms in the contract, and the way the work had to be executed, showed that in the execution of the entire contract, the PO had a vital role to play, i.e., to act as a channel between ONGC and SHI.
ITAT also held that it is SHI’s (the assessee) onus to prove that first,the activities undertaken by its Indian PE are auxiliary or preparatory in nature, and hence, that the PE falls under article 5(4), DTAA. ITAT noted that SHI didn’t discharge this onus. ITAT further held that the mode of maintaining accounts alone cannot determine the character of the PE.
The High Court of Uttarakhand allowed SHI’s appeal to a certain extent (which falls outside the scope of this post), but didn’t inquire into the question of taxability of the income attributable to a fixed place PE in India.
Before the Supreme Court
The three-judge bench of the SC looked at article 5 (Permanent Establishment) and article 7 (Business Profits) of the DTAA. Then it referred to the following landmark SC decisions, which involved similar treaty provisions: DIT (International Taxation), Mumbai v. Morgan Stanley & Co. Inc., CIT v. Hyundai Heavy Industries Co. Ltd., Ishikawajma-Harima Heavy Industries Ltd. v. DIT, Mumbai, and Asst. DIT, New Delhi v. E-Funds IT Solution Inc.
Relying on the aforementioned decisions, the SC held that a ‘fixed place’ PE (as under Article 5(1)) of a foreign enterprise in India, exists only when the establishment is one through which the business of the enterprise is wholly or partly carried on. However, if an enterprise simply maintains a fixed place of business in India, which is auxiliary or preparatory in nature in the business or trade of the enterprise, then it’s not a PE as per Article 5(4)(e). SC held that the profits of the foreign enterprise will be taxable in India only when the enterprise does its core business through an India PE. Further, only those profits which are attributable to the PE can be taxed in India.
The SC also relied on the Board Resolution of SHI for opening the PO which stated:
“…1.) That the Company hereby open one project office in Mumbai, India for coordination and execution of Vasai East Development Project…
2.) That the Company hereby does make and constitute Mr. Sangsoon Park… as the Company’s true and lawful representative with full power and authority for the purpose of establishing a project office and coordinating and executing delivery of documents in connection with construction of offshore platform modification of existing facilities for ONGC above…” (emphasis added)
The SC noted that the ITAT’s conclusion, that the PO was established for the core activity of coordination and execution of the entire project, was based only on the first paragraph of the Board Resolution, and thus, was set aside as perverse. Instead, the SC noted, that as per the second paragraph, the purpose of the PO was to coordinate and execute delivery of only certain documents.
The ITAT’s finding that the accounts of the Mumbai PO were not enough to determine the character of PE was also set aside as perverse. Further, the ITAT’s finding that the onus lay on SHI, as the assesse, to show that the Mumbai PO is a PE, was set aside as being contrary to the Assistant Director of Income Tax v. E-Funds decision.
The SC noted that the ITAT had ignored a particular argument of SHI: that there were only two people working in the PO, and both weren’t qualified to carry out any core activity of SHI. Hence, the SC held that the PO is not a fixed place PE of SHI, under Article 5(1), DTAA; the PO would instead be covered by Article 5(4)(e), DTAA, because the PO was meant to be a liaison office between ONGC and SHI, and thus, was an auxiliary office.
Analysis and Conclusion
Articles 5(1), (2) and (3) of the DTAA list out the conditions in which a Korean enterprise can be said to have an Indian PE, while article 5(4) contains a list of deemed exceptions to PEs. Article 5(1) defines a fixed place PE, according to which, a Korean enterprise is said to have a fixed place PE in India if it has a fixed place of business in India through which the business of the enterprise is wholly or partly carried on. However, as article 5(4)(e) states, such fixed place of business will not be considered as a PE if it has a preparatory or auxiliary character in the trade or business of the enterprise.
The fixed place of business in the present case, was the Mumbai PO. For levying taxes, the Indian Revenue had to first establish that this PO was a fixed place PE of SHI. Only then the questions of attributability of profits of the enterprise to the PE, and taxability of such profits under Indian laws, could arise. As noted by the SC, this had been clarified in the E-Funds decision, where it held that “…The burden of proving the fact that a foreign assessee has a PE in India and must, therefore, suffer tax from the business generated from such PE is initially on the Revenue…”.
The determination of the existence of a PE of a foreign enterprise in India is a deeply factual enquiry; and a finding as to the existence of a PE cannot be arrived at on a mere prima facie satisfaction. The ITAT here largely relied on certain documents, like SHI’s Board Resolution for opening the PO, SHI’s application to RBI for opening the PO, and the RBI’s approval for the same. In the Board resolution also, the ITAT focused on the first paragraph alone. All these gave a prima facie impression that the PO was opened for coordination and execution of the entire project, and was thus involved in the core business activity of SHI. However, the SC delved deeper, and looked at various other factors which the ITAT had ignored or dismissed. The SC focused on the second paragraph of the Board Resolution (which clarified that the PO was established for coordinating and executing delivery of certain documents, and not the entire project), the fact that the accounts of the PO showed no expenditure incurred in relation to execution of the contract, and that the only two people employed in the PO were not qualified to carry out any core activity of SHI. Thus, the SC concluded that the PO isn’t a fixed place PE of SHI in India, as per article 5(1) read with article 5(4)(e), DTAA.
This decision spells a wave of relief for the taxpayers and constitutes a firm reiteration of first, the necessity of a deep, factual enquiry into the determination of existence of the PE of a foreign enterprise in India, in accordance with the provisions of the relevant DTAAs, and second,the fact that the initial burden lies on the Indian Revenue, and not the assessee, to prove that there is a PE of the foreign enterprise in India, before moving further to determine the Indian tax liability of that enterprise.
– Pragya Kaushik