INSIGHT: India Supreme Court Ruling on Permanent Establishment with South Korea

The Supreme Court of India (Supreme Court) dismissed the tax authorities’ (revenue’s) appeal to confirm that as the Indian project office (PO) (a communication channel between the South Korean and Indian company through the PO without engaging in any form of core business activity) did not incur expenditure relating to the implementation of a project or on the number (and qualification) of its employee it therefore did not constitute permanent establishment (PE) under Article 5(1) and specifically excluded under Article 5(4)(e) of the India–Korea (Republic of South Korea) tax treaty (tax treaty), which consequently means that no profits of the South Korean company are attributable to tax in India under Article 7 of the tax treaty.

Facts

Samsung Heavy Industries Co. Ltd, a South Korean Company (taxpayer) was awarded a “turnkey” project to undertake “work,” of surveys, design, engineering, procurement, fabrication, installation and modification at existing facilities start-up and commissioning of the entire facility under a consortium agreement by the Indian contractor. The taxpayer set up a registered Indian PO with the Indian Central Bank (RBI) simply to act as a communication channel between the taxpayer and the Indian contracting party for the work executed offshore. Subsequently, the platforms/facilities were acquired outside India.

The taxpayer filed a tax return in India declaring a loss for the activities carried out by it in India and claimed exemption of the offshore income. The revenue issued a notice to understand the reason for no profits but, dissatisfied with the reply, the revenue passed a draft Tax Order on reviewing the terms of the agreement to confirm that the PO is a single indivisible “turnkey” project, supposed to be acquired by the Indian contractor only after completion. Consequently, the profits arising from commissioning of the contract will arise only in India and attributable at 25% of the revenues earned outside India. The taxpayer filed an appeal before the Income-tax Appellate Tribunal (tribunal).

On reviewing the facts and documents of the case, the tribunal observed that the PO was neither restricted contractually nor under the RBI approval to undertake any activities in India. Accordingly, the tribunal concluded that the PO constituted a fixed place PE of the taxpayer to carry out the project in India. It also held that the nature of activities carried on by the PO were not merely preparatory/auxiliary in nature as all the activities of the project were routed through the PO that played a vital role in the execution of the contract. Hence, the tribunal affirmed the revenue’s decision to regard the contract as inseparable and refuted the taxpayer’s argument based on the premise that the maintenance of accounts was in the taxpayer’s control and the mode to maintain the accounts alone cannot determine the character of PE.

On losing the case before the tribunal, the taxpayer filed an appeal with the High Court (court), who observed that neither the revenue nor the tribunal had recorded any evidence or facts to justify that the PO of the taxpayer constituted a PE in India through which it carried on business for which profits are attributable to the business. The court set aside the tribunal order, considering the imposition of tax liability on the taxpayer to confirm that no tax liability was justified without establishing the fact that tax is attributable to the PE (PO in this case) of the taxpayer in India.

Supreme Court Ruling

The Supreme Court observed the conditions precedent for applicability of fixed place PE under Article 5(1) of the tax treaty, that it should have an establishment “through which the business of an enterprise” wholly or partly is carried on. Additionally, foreign enterprise constitutes a taxable presence only when the PO carries on a “core business” through such PE in India. The Supreme Court relying on the Board Resolution accompanying the RBI application to set up a PO in India noted that, the PO was established to merely coordinate and deliver documents in connection with the construction of offshore platform modification of the existing facilities for the Indian contractor.

The Supreme Court also observed that only two employees were working in the PO neither of whom were qualified to perform any form of core activity for the taxpayer on merits and confirmed that the tribunal and revenue orders were perverse as they should have taken cognizance of:

• not relying on selective reading of documents submitted by the taxpayer foreign company; and
• no expenditure relating to the contract was incurred in the books of accounts.

The Supreme Court, relying on the cases of Morgan Stanley & Co. Inc. and E-Funds IT Solution Inc. , held that primarily the onus to prove that the taxpayer had a PE in India is on the revenue, who could not confirm this in the immediate case.

Further, the taxpayer having an Indian office which simply acts as a support to the main function cannot constitute a PE in India. The Supreme Court accordingly accepted the taxpayer’s contention that the PO was merely an auxiliary office meant to act as a liaison/representative between the taxpayer and the Indian contractor and should fall within the exclusion or exception clause (e) of Article 5(4) read with fixed place PE under Article 5(1) of the tax treaty.

Therefore, on a comprehensive review of all the documents and contentions, the Supreme Court, relying on the rationale of the established cases, held that the PO did not constitute a fixed place PE of the taxpayer in India and ancillary activities carried out by the PO were regarded as preparatory and auxiliary in nature where no profits of the taxpayer is attributable to tax in India under Article 7 of the tax treaty.

Planning Points

The concern of taxable presence of nonresidents and their taxability of income from business activities of a registered PO, representative office, branch with communication or coordination activities has always been a subject matter of litigation for companies claiming that they undertake preparatory and auxiliary activities where they have to prove that no core business activities are carried on through such liaison/project/branch offices.

The Supreme Court decision relying on the exclusion of preparatory and auxiliary activities performed by a PO under Article 5(1) read with Article 5(3) and the settled precedence, gives respite to the PE cases arising from similar activities by the projects executing both onshore and offshore orders. It comes at a time where the Supreme Court recently in the UAE Exchange Centre case concluded that a registered Liaison Office (LO or representative office) of a UAE based company with the RBI engaged in fund remittance ancillary activities initiated from the UAE in India did not create a fixed place PE.

The Organization for Economic Cooperation and Development (OECD) Model Tax Treaty (Model Treaty) permits an entity to undertake specific exempted preparatory and auxiliary activities in a country without creating a PE because the activities exclude core or value-added activities. Interestingly, the Supreme Court ruled in favor of the taxpayer applying the principle of substance over form to arrive at the decision by considering the facts to conclude that the PO was merely involved in preparatory and auxiliary and not associated with any core business activities.

The Multilateral Instrument (MLI), included in the OECD BEPS Action Plan 7, where the transactions structured through splitting-up contracts are excluded within the exception provision of Article 5(3) of the Model Treaty, makes it vital to analyze such PE exemption only where the overall activities of the fixed place of business are preparatory or auxiliary in nature. Thus, it becomes a subject matter of justification for the taxpayers from a taxability perspective under the MLI where the overall activities in India are not preparatory or auxiliary and such activities are not cohesive to the main business operations performed in the source country.

It is worthwhile to note that the Supreme Court should have considered the decision of Formula One World Championship Ltd to achieve relative certainty before concluding that the PO does not in any form participate, or is associated, with the main business and revenue earning activity of the taxpayer and comprehensively after evaluating the facts of the case decides that it does not constitute a fixed business place in India.

Shailendra Sharma is a Chartered Accountant associated with a multinational financial services firm, India.

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