Indian subsidiary of a foreign company providing back office support operations does not constitute a PE in India

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The Delhi High Court (High Court) in the case of e-Fund Corporation, USA (e-Fund Corp.) and e-Fund IT Solutions Group Inc., USA (e-Fund Inc.) [Collectively referred as taxpayers] held that taxpayers subsidiary in India by itself does not create a fixed place Permanent Establishment (PE) under the India-USA tax treaty. The taxpayers neither had a fixed place of business in India through which business of enterprise was wholly or partly carried on nor had right to use any of the premises belonging to e-Fund International India Private Limited (e-Fund India),

The High Court also observed that merely because the non-resident taxpayer to protect their interest, for ensuring quality and confidentiality has sent its employees to provide stewardship services, will not make the Indian subsidiary or another entity, a PE of the non-resident company even if the employees of the non-resident taxpayer were taken on deputation.

The Indian subsidiary was neither authorised nor habitually exercised authority to conclude contract, etc. Therefore, there was no agency PE of the taxpayer in India. On the issue of profit attribution, the High Court held that the activities, which were not undertaken by e-Fund India and the assets of the taxpayers located outside India, cannot be taken into account or attributed for earning/income of the taxpayers. Since proper income was declared and taxed in the hands of e-Fund India, nothing remains to be attributed or taxed in the hands of the taxpayers.

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Indian subsidiary of a foreign company providing back office support operations does not constitute a PE in India

  1. 1. KPMG FLASH NEWS KPMG IN INDIA Indian subsidiary of a foreign company providing back office support operations does not constitute a PE in India 11 February 2014 Background Recently, the Delhi High Court (High Court) in the case of e-Fund Corporation, USA (e-Fund Corp.) and eFund IT Solutions Group Inc., USA (e-Fund Inc.) 1 [Collectively referred as taxpayers ] held that taxpayers subsidiary in India by itself does not create a fixed place Permanent Establishment (PE) under the IndiaUSA tax treaty (tax treaty). The taxpayers neither had a fixed place of business in India through which business of enterprise was wholly or partly carried on nor had right to use any of the premises belonging to e-Fund International India Private Limited (e-Fund India), The High Court also observed that merely because the non-resident taxpayer to protect their interest, for ensuring quality and confidentiality has sent its employees to provide stewardship services, will not make the Indian subsidiary or another entity, a PE of the non-resident company even if the employees of the non-resident taxpayer were taken on deputation. The Indian subsidiary was neither authorised nor habitually exercised authority to conclude contract, etc. Therefore, there was no agency PE of the taxpayer in India. On the issue of profit attribution, the High Court held that the activities, which were not undertaken by e-Fund India and the assets of the taxpayers located outside India, cannot be taken into account or attributed for earning/income of the taxpayers. Since proper income was declared and taxed in the hands of e-Fund India, nothing remains to be attributed or taxed in the hands of the taxpayers. Facts of the case The taxpayers were residents of USA . e-Fund Corp. was the ultimate holding company of e-Fund India, a company incorporated and resident of India, and also of e-Fund Inc. _________________ 1 DIT v. E Funds Corporation (ITA 738/2011), DIT v. E Funds IT Solutions (ITA No. 736/2011 & 737/2011). © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  2. 2. The taxpayers had four main business lines, namely electronic payments, ATM management service, decision support and risk management and professional services. eFund India had performed back office operations in respect of the first three. This included data entry operations etc. in respect of decision support and risk management. A subsidiary per se does not form a PE The Delhi Bench of the Income-tax Appellate Tribunal (the 2 Tribunal) in the taxpayers own case held that the taxpayers have entered into contracts with their clients for providing certain IT enabled services which were either assigned or sub-contracted to e-Funds India for execution. Therefore, both, eFunds Corporation and e-Funds India came under legal obligation to provide services to clients of eFunds Corporation. Further, based on the Function performed, Assets used and Risks assumed (FAR analysis) by taxpayers and e-Funds India, it was clear that e-Funds India was not having requisite software and database needed for providing IT enabled services independently; therefore, to that extent they were made available by taxpayers to e-Funds India free of any charges. Also, eFunds India did not bear any significant risk as ultimate responsibility lay with taxpayers. As per the Article 5(6) of the tax treaty, the company, which controls or is controlled and carries on business in the other State by itself, would not constitute PE of the other company. A subsidiary can become a PE of the holding/controlling company or the related company, if it satisfies the requirements of other paragraphs of Article 5, notwithstanding and negating the protection provided under Article 5(6), which recognises legal independence of the two entities for tax purposes. In view of above and further having regard to fact that entire activities of taxpayer in India were carried out by e-Funds India Ltd. (an agent) and said agent had not been remunerated on arm’s length price basis, it was held that taxpayer had Permanent Establishment (PE) in India in respect of back office operation and software development services being carried out by its subsidiary. Accordingly, taxpayer’s income was liable to taxed in India in respect of operations performed by subsidiary company on its behalf. There was no material to hold that the taxpayers (i) had a fixed place of business in India through which business of enterprise was wholly or partly carried on and (ii) had right to use any of the premises belonging to e-Fund India. Accordingly, Article 5(1) of the tax treaty cannot be invoked to constitute a PE in India. Following factors are not the relevant to determine and decide location PE:  e-Fund India provides various services to the taxpayers and was dependent on them for its’ earning  e-Fund India did not bear sufficient risk centre operations plus 16 percent basis or that the basis of margin fixation was not known Business Connection 3 Relying on various decisions , the High Court held that there was a business connection of the taxpayers in India, because the e-Funds India was providing information and details to the taxpayers in USA for the purpose of entering into contracts with third parties and subsequently the said contracts were performed fully or partly by e-Funds India as an assignee or sub-contractee. Looking at the nature of the said transactions and the manner in which contracts were executed and where the taxpayers had assumed and agreed to third party claims and risks; business connection was established. However, it was held that when provisions of tax treaty and provisions of the Act are applicable to the taxpayer, which one of the two is more beneficial or advantageous to the taxpayer should apply. ______________ E Funds Corporation v. ADIT [2010] 42 SOT 165 (Del) CIT v. R.D. Aggarwal and Company [1965] 56 ITR 20 (SC), CIT v. Toshoku Ltd., Guntur and Ors. (1980) 125 ITR 525 (SC), Ishikawajma-Harima Heavy Industries Ltd. v. DIT [2007] 288 ITR 408 (SC) 3 Fixed place PE  e-Fund India was reimbursed the cost of the call High Court’s Ruling 2 Subsidiary constitutes an independent legal entity for the purpose of taxation. Holding or a subsidiary company by themselves would not become PE of each other.  direct or indirect costs, and corporate allocations in software development centre or BPO  assignment or sub-contract to e-Fund India  whether or not any provisions for intangible software was made or had been supplied free of cost Even if the foreign entities have saved and reduced their expenditure by transferring business or back office operations to the Indian subsidiary, it would not by itself create a fixed place or location PE. The fact that the subsidiary company was carrying on core activities as performed by the foreign taxpayer does not create a fixed place PE. If an enterprise enters into contracts, assign or sub-contract works or render services to a third party on behalf of the principal, by itself would not lead to a subsidiary becoming a PE unless the relevant requirements of Article 5 are satisfied. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  3. 3. Further, as the taxpayers did not have any branch office or factory or workshop in India, and merely because they had a subsidiary in India, that by itself did not create a fixed place of business/location PE within the meaning of Article 5(2)(b) to (k) of the tax treaty. The High Court relied on the Supreme Court’s decision in 4 case of Morgan Stanley where it was observed that back office operations by the Indian subsidiary to the parent to support the main office functions do not satisfy the second requirement of Article 5(1) of the tax treaty, i.e., carrying on of business in India through such fixed place. The Indian subsidiary was in fact merely supporting the front operations of the principal company and therefore there was no fixed place PE. PE due to ‘Place of Management’ President of e-Fund India had provided management support services in U.K. and Australia, while certain personnel of South-east Asia region had provided marketing support services to e-Fund India as well as eFund group entities overseas. Accordingly employees of said entities reported to the President who in turn was reporting to e-Fund Corp. Aforesaid factual position prima facie indicates that the said activities may have resulted in a PE under Article 5(2)(a) under the heading ‘Place of Management’ but the said provision has not been invoked. The High Court held that extent and timing of applicability of the ‘Place of Management’ principle in such cases, require findings of facts at the first instance and cannot be made matters to be decided for the first time in an appeal before the High Court under section 260A of the Act. Article 5(3) and consequences its over-riding effect and Article 5(3) is a non-obstante provision which overrides Article 5(1) and 5(2) of the tax treaty. While analysing whether taxpayer has PE, first and foremost, Article 5(1)/(2) should be applicable but then if the activities fall under the Article 5(3), PE cannot be created for imposing tax in the second state. The Tribunal was not correct in applying Article 5(3) that all activities performed and undertaken by the Indian subsidiary and their employees would create a PE in India because the activities of e-funds India were not preparatory or auxiliary in character i.e. the activities are not satisfying the conditions of Article 5(3). Article 5(3) is not a positive provision but a negative list. The said Article does not create a PE but has a negative connotation and activities specified when carried on do not create a PE. ______________ 4 Service PE Employees of E-Fund India were their employees, i.e. employees of an Indian entity and not employees of the taxpayers. The employees of e-fund India did not become other personnel of the taxpayers, once and if the said persons were defacto and dejure employed by the Indian entity/enterprise. The words ‘employees and other personnel’ under the Article 5 of the tax treaty have to be read along with the words ‘through’ and ‘furnishing of services’ by the foreign enterprise within India. Thus, the employees and other personnel must be of non-resident to create a Service PE. The High Court relied on the Supreme Court decision in the case of Morgan Stanley and held that merely because the non-resident taxpayer to protect their interest, for ensuring quality and confidentiality has sent its employees to provide stewardship services, will not make the Indian subsidiary or another entity, a PE of the non-resident company even if the employees of the non-resident taxpayer were taken on deputation. Agency PE Subsidiary by itself cannot be considered to be a dependent agent PE of the Principal. However, a subsidiary may become dependent or an independent PE agent provided the tests as specified Article 5(4) and (5) are satisfied. It was not the case of tax department that e-Fund India was authorised and habitually exercised authority to conclude contract or was maintaining stock or merchandise from which it delivered goods or merchandise on behalf of the taxpayer or secured orders on behalf of the taxpayer. Therefore, the conditions and requirements of Article 5(4)(a) to (c) are not satisfied. The fact that e-Fund India had provided necessary inputs to e-Fund Corp or e-Fund Inc. to enable them to enter into contracts which were assigned to e-Fund India will not make e-Fund India a PE of the taxpayer. As per Article 5(5), an agent is not considered to be an independent agent if his activities are wholly or mostly wholly on behalf of foreign enterprise and the transactions between the two are not made under arm‘s length conditions. The twin conditions have to be satisfied to deny an agent, the character of an independent agent. The transactions between the taxpayers and e-Fund India were at arm‘s length and were taxed on arm‘s length principle and therefore, requirements of Article 5(5) are not satisfied. Consequently, there was no Agency PE of the taxpayer in India. DIT v. Morgan Stanley and Co. Inc. [2007] 292 ITR 416 (SC) © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  4. 4. Mutual Agreement Procedure Mutual Agreement Procedure (MAP) procedure as envisaged under Article 27 of the tax treaty was resorted to for the earlier years. As per the communication by US treasury department, they did not agree that taxpayers had a PE in India but they had agreed to mutual agreement to divide income to avoid double taxation. The tax department contended that taxpayer has a PE as India and USA had resorted to MAP as envisaged under Article 27 of the tax treaty. The High Court held that the MAP procedure and agreement is relevant but cannot be the primary basis to decide whether the taxpayer had PE in India. Whether or not PE exists is a matter of law and fact, and there has to be determination of the said issue on merits. This is a welcome ruling of the Delhi High Court where it has been held that having subsidiary in India itself does not create a PE in India. A subsidiary can become a PE of the holding/controlling company or the related company, if it satisfies the requirements Article 5 of the tax treaty. Further merely because the non-resident taxpayer to protect their interest, for ensuring quality and confidentiality has sent its employees to provide stewardship services, will not make the Indian subsidiary or another entity, a PE of the non-resident company even if the employees of the non-resident taxpayer were taken on deputation. This decision will be helpful to the foreign companies which are having their back office operations in India. Attribution of profits The activities, which were not undertaken by e-Fund India and the assets of the taxpayers outside India, cannot be taken into account or attributed for earning/income of the taxpayers. The taxpayers activities though broadly divided into four heads were interconnected and not independent. Method of apportionment has to be fair, rational and logical. Assets and net income criteria applied must collate and refer to the assets which have contributed to the earning of the net income. In the MAP proceedings a formula was adopted and it should be consistently followed but if the said formula was irrational and inappropriate, it could be corrected in subsequent years. The anomaly while computing the proportion of net income attributable to Indian PE was that the net income of the group less income of e-Fund India was attributed to the group assets including assets of e-fund India. The Tribunal was correct in rectifying this anomaly. In view of the income declared and taxed in the hands of e-Fund India, nothing remains to be attributed or taxed in the hands of the taxpayers. Our comments Taxability of foreign companies having subsidiaries for back office support operations in India has been a subject matter of debate before the courts. The Supreme Court in the case of Morgan Stanley dealt with this issue and held that back office functions performed by the Indian company were preparatory and auxiliary in nature and therefore it would not constitute a fixed place PE. It was also held that there was no Agency PE. Further stewardship activities were also not held as a service PE. However, since foreign company had deputed his employees to Indian company and retained control over their terms and employment, the Supreme Court held that there was service PE of a foreign company in India. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  5. 5. www.kpmg.com/in Ahmedabad Commerce House V, 9th Floor, 902 & 903, Near Vodafone House, Corporate Road, Prahlad Nagar, Ahmedabad – 380 051 Tel: +91 79 4040 2200 Fax: +91 79 4040 2244 Bangalore Maruthi Info-Tech Centre 11-12/1, Inner Ring Road Koramangala, Bangalore 560 071 Tel: +91 80 3980 6000 Fax: +91 80 3980 6999 Chandigarh SCO 22-23 (Ist Floor) Sector 8C, Madhya Marg Chandigarh 160 009 Tel: +91 172 393 5777/781 Fax: +91 172 393 5780 Chennai No.10, Mahatma Gandhi Road Nungambakkam Chennai 600 034 Tel: +91 44 3914 5000 Fax: +91 44 3914 5999 Delhi Building No.10, 8th Floor DLF Cyber City, Phase II Gurgaon, Haryana 122 002 Tel: +91 124 307 4000 Fax: +91 124 254 9101 Hyderabad 8-2-618/2 Reliance Humsafar, 4th Floor Road No.11, Banjara Hills Hyderabad 500 034 Tel: +91 40 3046 5000 Fax: +91 40 3046 5299 Kochi 4/F, Palal Towers M. G. Road, Ravipuram, Kochi 682 016 Tel: +91 484 302 7000 Fax: +91 484 302 7001 Kolkata Unit No. 603 – 604, 6th Floor, Tower – 1, Godrej Waterside, Sector – V, Salt Lake, Kolkata – 700091 Tel: +91 33 44034000 Fax: +91 33 44034199 Mumbai Lodha Excelus, Apollo Mills N. M. Joshi Marg Mahalaxmi, Mumbai 400 011 Tel: +91 22 3989 6000 Fax: +91 22 3983 6000 Pune 703, Godrej Castlemaine Bund Garden Pune 411 001 Tel: +91 20 3050 4000 Fax: +91 20 3050 4010 The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. ©2014 2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The KPMG name, logo and “cutting through complexity“ are registered trademarks of KPMG International Cooperative (“KPMG International”), a Swiss entity. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

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