INSIGHT: Covid-19 Period—Excludible or Includible in Construction Permanent Establishment

Covid-19 has caused major disruptions to economies and businesses around the entire globe. Apart from inviting various business risks, this disruption is also going to bring forth major issues in the international taxation, more particularly, in determination of a “Permanent Establishment” (PE).

The existence of a PE in a foreign jurisdiction gives a right to that jurisdiction to tax the profits accruing to such PEs. Article 5 of the Model Tax Convention on Income and Capital [Condensed Version of 2017 by OECD] defines the scope of “Permanent Establishment.” A PE can exist in a foreign jurisdiction in various forms [i.e. a branch, a warehouse, a liaison office, activities of a dependent agent (known as ”Agency PE’) or providing certain services for a stipulated period (known as ”Service PE”)] including a construction activity [commonly known as ”Construction PE” or ”Installation PE”].

Amidst the Coronavirus outbreak, amongst many others, construction activities around the globe have reached a standstill, either because of those in power have directed a lockdown in the nation or parties to the construction contract have invoked the force majeure clause and, thus, suspended or terminated the construction or installation activities.

Life seems to be far from normal, as the virus does not appear to go down without a fight. Recommencement is certainly a blurry affair, especially in India, because of the lockdown has been imposed since March 23, 2020, and it shall remain as such at least till May 3, 2020. In such a scenario, a vital question that arises for consideration is “Should the period of suspension of construction activities, caused due to this pandemic, be considered in the stipulated period for the purposes of determining a Construction PE under Article 5?” We have endeavoured to analyse this very concern, especially from India’s perspective.

CONSTRUCTION PE (ARTICLE 5(3) OF MODEL TAX CONVENTION)

Article 5(1) of Model Tax Convention provides that a PE shall include a fixed place of business through which the business of an enterprise is wholly or partly carried on. Article 5(3) states that a building site or construction [viz. the term building site or construction would include construction of building and of roads, bridges or canals, the renovation (more than mere maintenance or redecoration) thereof, laying of pipelines, excavating and dredging] OR Installation Project [viz. putting together or regrouping of prefabricated elements, such as the erection of steel scaffolding or units of production and also, the installation of new equipment in an existing machine]. The building site or construction or installation is collective referred to as the “construction site.” It would constitute a permanent establishment (construction PE) only if it lasts more than 12 months. This is a special sub-set of a fixed place PE with a requirement of 12 months test to constitute a PE. If a construction site does not last for 12 months, construction PE shall not exist.

Also, to constitute a PE, it is necessary that the enterprise is carrying on business or operations through a place that is accessible, under the control of and use by, the enterprise [See, Formula One World Championship Ltd. v. CIT [2017] 394 ITR 80 (SC)]. In absence of either of these conditions, it would lead to non-existence of the PE. Similarly, these principles would be applicable for determination of the construction PE and if the construction site is not accessible and used and controlled by the contractor, it would fail to satisfy the essential test to constitute a PE itself.

This Article 5(3) forms part of major tax treaties. A reference is made to certain tax treaties which provides a much lesser duration test than test of 12 months—(a) India-Australia, India-Japan, and India-UK provides for six months; (b) the India-China and India-Singapore double tax avoidance agreements (DTAAs) provide for 183 days; (c) the India-U.S. DTAA provides for 120 days in 12 months period; and (d) India- the United Arab Emirates provides for nine months.

The express inclusion of the construction site is an extension of the PE concept. The rationale behind inclusion is that by maintaining a construction site for more than a short period, by usually employing considerable tangible assets, the enterprise is participating to a material degree in the economy of the state concerned. And it is, therefore, justifiable to treat places of business of this kind as being permanent establishments [See, Klaus Vogel on Double Taxation Convention].

Further, the 12-month test applies to each individual site or project [See, Paragraph 51 of the Model Tax Convention2017]. The duration for the PE test begins from the date on which the contractor begins his work on the site in a foreign jurisdiction and continues to exist until the work is completed or permanently abandoned [See, Para 55 of the Model Tax Convention 2017].

The expression “begins his work and continues to exist until the work is completed or permanently abandoned” is too general and can be subjected to many interpretations based on a diverse set of facts. This expression has led to several controversies due to the broad and undefined expression.

IMPACT OF INTERRUPTIONS IN CONSTRUCTION ACTIVITY

Abandonment or Cessation of Activities v. Temporary Interruption

Whilst carrying out the construction activity in a foreign jurisdiction, it may so happen that the construction activity is suspended for a certain period because of bad weather, shortage of material, or labor. Often a question arises as to whether the period during which construction activities could not be carried on, would be included or excluded for computing the 12 months (or the threshold as provided under the respective tax treaties) period test? The OECD provides that a construction site shall not cease to exist when the work is temporarily discontinued and hence, a period of seasonal and other temporary interruptions should be included in determining the life of a construction project in the foreign jurisdiction [See, Para 55 of the Model Tax Convention2017]. The usual interruptions that occur in the normal course of the activities should be included in determining the minimum period. These interruptions do not break the functional relationship of the construction site with the foreign jurisdiction.

Whether disruption caused by Covid-19 is in the nature of ‘temporary interruption’?

Due to the outbreak caused by Covid-19 followed by stringent restrictions on carrying on of economic activities, contractors are unable to carry out the construction activities, leading to cessation or abandonment of activities. This inability of access and use of sites would have the effect of cessation of permanent establishment for a period until when such inability exists. Can such inability be regarded as ”temporary cessation”?

A cursory look at the prevailing situation would reveal that the subject interruption caused by Covid-19 is not “temporary cessation.” The pandemic has resulted in abandonment or cessation of the activities, which is much more severe and lasting than “temporary interruptions.” The words “temporary” or “temporarily” mean a situation that would last for a limited time period or short-time period and not those situations that would last for a perpetual or indefinite period or long duration [See, Black’s Law Dictionary]. In short, when a situation or its effects, prevails for an uncertain future period, it would be incorrect to regard it as “temporary” or “temporarily.” The current distress situation has led to “abandonment” or “cessation of activities” for an uncertain period thereby restricting the carrying on of activities.

In DIT v. National Petroleum Construction Company [2016] 383 ITR 348 (Del.), an interruption in the normal course of activities such as a weekly day off would undoubtedly be included in the duration of the PE, but in cases where interruption exceeds a substantial period, which represents cessation of the activities at the site, it would be difficult to accept that the building/project site continues to represent a fixed place of business of an enterprise.

The present disruption caused by Covid-19 is also in the nature of ”cessation of activities” and not merely a ”temporary disruption.” When an activity shuts down the entire economy across the globe, it cannot be termed as a “temporary disruption.” Thus, the period of cessation of activities, cannot be included in determining as to whether a construction site existed for a period of 12 months.

The authoritative text of Klaus Vogel in Commentary on Double Taxation Convention(3rdEdition) has also subscribed to the view that long interruptions leads to a suspension of the minimum time period [viz. It means time period required to constitute a PE], if the continuation of the work is functionally related with the work performed prior to the interruption. Whether an interruption is long enough depends on its relationship to the total time of the project. If the present cessation of activities proves to be substantial in relation to the total duration of the project, then, it should be excluded in computing the duration test.

Au contraire, recently, the OECD has come out with a guidance report with its analysis and impact on tax treaties caused due to Covid-19. In the said report, it has opined that the present disruption should be included in determining the life of a site and therefore, will affect the determination whether a construction site constitutes a PE [See, OECD Secretariat Analysis of Tax Treaties and the Impact of the Covid-19 Crisis]. The OECD has relied on its existing Commentary on Article 5(3) which explains that the temporary interruption should be included in determining the duration of the site.

Although, an attempt may have been made to make the OECD nations decide on constitution of a fixed place PE and agency PE in a liberal manner owing to the factors arising from circumstances caused by Covid-19 pandemic, a view to include this time to determine the life of a project for construction PE analysis, lacks justification. The reference made by the OECD to its 2017 commentary to treat the current pandemic situation as “temporary interruption” lacks rationale. There is no comparison of the Covid-19 pandemic with that of situations like bad weather, shortage of labor, or shortage of material, as these situations may last for a very short and temporary period of time, unlike the Covid-19 pandemic, which does not seem to have a short-term agenda. Many economies have been imposing and/or extending lockdowns on their economies.

Effect of ‘Force Majeure’

”Force majeure” means superior or irresistible force and can be invoked when the parties are unable to perform their contracting obligations because of unforeseeable or unseen circumstances, such as acts of God or acts of war. The Indian Contract Act, 1872 governs the expression of “force majeure” u/s. 32 if there is an express clause in the contract or otherwise u/s. 56 of the Contract Act. If the parties have invoked the force majeure clause, then the performance of the contract is suspended for the period, as may be agreed between the parties, provided that this has been so contemplated in the contract.

Due to interruption caused by the Covid-19 pandemic, the parties may invoke the force majeure clause to avoid or defer carrying on of construction activities until the situation normalises from the Covid-19 outbreak. In effect, the construction activities are suspended. During this period, the contractor would not have access to, control of, or use of, the site. The contractor has suspended itself from execution of the contract.

To ascertain whether a place constitutes a PE or not, it is essential that the business of the enterprise is carried on “through” such place. For a construction site, it would mean that the place is being used for carrying on construction activity. However, if no activity is being carried on at such place, the essential “through” test of PE, fails to be satisfied. Thus, the period of suspension of activities ought to be not considered for determining the duration of the construction PE. The OECD in its recent guidelines has not considered the impact of the force majeure.

CONCLUSION

To constitute a “construction PE,” it is essential that the contractor has use/access/control of the site. The OECD itself has recognized existence of these test under Article 5(3) for including the sub-contractor time-period. If at any time, the contractor does not have access/use/control of the site, it is axiomatic that such duration should be excluded in computing the 12 months or the threshold under the respective tax treaties provided such disruptions are not “temporarily” in nature. The suspension or cessation of activities, on account of Covid-19 pandemic and/or consequential invoking of force majeure clause, has led to suspension or cessation of construction activities for an uncertain period atleast as it appears today. Thus, the disruption period caused by Covid-19 pandemic does not warrant inclusion in the minimum time period, which is required to constitute a construction PE.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Ravi Sawana is with Lakshmikumaran & Sridharan in Mumbai.