INSIGHT: Franchise Arrangement Not a Permanent Establishment under the India–U.S. Tax Treaty

Domino’s (DCIT v. Domino’s Pizza International Franchising Inc. [2018-TII-152-ITAT-MUM
] INTL dated 18 May 2018) is a tax resident of the U.S. The taxpayer entered into a Master Franchise Agreement (“MFA”) with Jubilant Food Works Limited (“Jubilant”) an Indian company, for franchisee of Domino’s Pizza Store and Jubilant executed a sub-franchise agreement (“SFA”) with Indian sub-franchise. The MFA provides store opening consultancy services to Jubilant at an agreed fee. The franchise fee received by the taxpayer from Jubilant is for ongoing use of Domino’s trademark and for the right to use new technology, product development and system improvement. Domino’s pursuant to income earned from MFA as a percentage of Jubilant’s sales and on sale of its sub-franchise stores in India, filed its return of income in India. The revenue alleged that, Domino’s has exclusivity of the activities as per the MFA. The marketing and advertisement expenses are carried out in accordance with the MFA, where the quality of material and equipment used are approved by the taxpayer and the price is also decided by the taxpayer and not by Jubilant or its sub-franchise. Relying on the MFA the revenue held that, Jubilant does not have economic independence and its modus-operandi is not on a principal-to-principal basis. Considering the exclusive franchise rights in India, Jubilant is dependent on Domino’s. Accordingly, the revenue treated taxpayer’s receipt from Indian operations taxable as business receipt in India under Article 5(4) of the India–U.S. tax treaty.

Conversely, Domino’s claimed that the Indian company had complete independence of its business dealing and transactions where it does not act on behalf of or under the instruction of Domino’s. The taxpayer offered royalty income received from Jubilant including franchise fee and consultancy services provided to Jubilant for the new stores to tax under the India–U.S. tax treaty. The matter was contested before the Dispute Resolution Panel (“DRP”) and accepted taxpayer’s contention that, Jubilant did not constitute a dependent agent PE in India. Further, the revenue action to treat royalty income as business profits under Indian domestic tax laws was set aside. Aggrieved by the DRP order the revenue filed an appeal before the Mumbai bench of Income Tax Appellate Tribunal (“Tribunal”).

Ruling of the Tribunal

The agent should have authority to conclude contract in the name of foreign enterprises and the agent is authorized to conclude contract on behalf of the Principal where he is permitted to negotiate all aspect of the contract that might effectively bind its principal. The Tribunal observed that, SFA is executed between Jubilant and Indian sub-franchise and not with the taxpayer where Jubilant has the sole discretion for approval of all sub-franchises across India. The beneficial owner of business profits arising from the activities is Jubilant or the sub-franchise in India. The clauses in MFA and SFA entitles taxpayer to examine accounts, approve suppliers and allowing control over the advertisement, and it was observed that Jubilant or sub-franchise did not store goods on behalf of the taxpayer. Domino’s is only entitled to royalty and store opening fees from sub-franchise. Hence, the Tribunal as per the MFA and SFA arrangement observed that assertions of the taxpayer is found correct.

In respect of the clauses under MFA and SFA, the franchise is independent business entity and the restriction provided in MFA and SFA are only to safeguard the brand value and to ensure the correct receipt of royalty income as concluded by the DRP. Hence, the Tribunal did not find any infirmity in the DRP order pursuant to their direction. The decision relied by the revenue in the case of Formula One World Championship Ltd. relates to physical control of the circuit with Formula One World Championship Ltd. and its affiliates from inception, being distinguishable on facts of the present case. However, in the said case, there is no physical control on the franchise and sub-franchise business by the taxpayer in India.

The revenue treated the taxpayer to be a dependent agent relying on Article 5(4) of the India–U.S. tax treaty. However, on perusal of Article 5(2) of the India–U.S. tax treaty the Tribunal observed that, none of the conditions prescribed under clauses (a) to (l) of Article 5(2) were satisfied. Also, the Indian entity has no authority to maintain its stock or goods or merchandise on behalf of the taxpayer in India. In fact no activities are carried out by the Indian entity on behalf of the taxpayer in India which proves that Indian entities are legal and economically independent. The Tribunal concluded that, there is no applicability of dependent agency PE of Domino’s under Article 5(4) of the India–U.S. tax treaty.

Practical Points

The issue of nonresidents constituting a PE in India is a matter of wide litigation before the Courts/Tribunals in India. The Supreme Court in the case of E-funds IT Solutions Inc. dealt with the case of whether back office services outsourced by a foreign group to its Indian subsidiary constitutes a PE of the foreign enterprise in India where it was held that, E-funds India was neither authorized to exercise authority to conclude contracts on behalf of the taxpayers, nor any facts were corroborated to prove satisfaction of the conditions of dependent agency PE under Article 5(4) of the India–U.S. tax treaty.

As a trend, the subject of PE is widely disputed by the revenue relying on the Supreme Court ruling in the case of the Formula One World Championship Ltd where the conditions to constitute a PE was elaborately explained. Interestingly, OECD BEPS Action Plan 7 deals with “preventing the artificial avoidance of PE status” and recommends to expand the scope of dependent agency PE, owing to the involvement, negotiation and participation to conclude contracts. The Indian domestic tax laws in 2018 Budget made amendments on applicability of “business connection,” by accepting the suggestions of OECD BEPS Action Plan 7 to include, any business activity carried out through a person who is, acting on behalf of the nonresident has and habitually exercises in India, and has authority to conclude contracts on behalf of the nonresident or habitually concludes contracts or habitually plays principal role leading to conclusion of contracts. It would be interesting to see how the extended scope of dependent agency PE will impact determination of PE where countries are on the verge of implementing the multilateral instrument.

Shailendra Sharma is a chartered accountant with a multinational consulting firm in India.