INSIGHT: India—Beneficial Method of Calculating Permanent Establishment

Following a recent ruling, preparatory work before tendering an oil and gas installation contract cannot be encompassed in the threshold period of 12 months for permanent establishment purposes under the India–Cyprus tax treaty.

Facts

Bellsea Ltd (“taxpayer”) is a nonresident company incorporated in Cyprus engaged in dredging and pipeline services for oil and gas installations. It secured an installation sub-contracting order from Indian contractors appointed for extraction of gas and laying gas pipeline.

The taxpayer under the installation sub-contract had to place rock in the seabed to lay gas pipelines and provide sub-structures in an oil and gas field developed at a Basin. Pursuant to the terms of the contract, the completion date of the contract was to be calculated from the date of issuance of the completion certificate.

In this case, the completion certificate was issued nine months after the date of commencement. The revenue authorities, including the Dispute Resolution Panel, contended that the contract commenced prior to the effective date of contract due to the visit of the taxpayer’s employees in India to collect data and information for the contract.

The revenue authorities also alleged that the contract was for diverse functions and not merely for rock placement. Consequently, the role of the taxpayer is not limited to fall within the ambit of Article 5(2)(g) of the India–Cyprus tax treaty (“tax treaty”).

In the event, the taxpayer’s view was accepted; such activities under the sub-contract constitute an installation permanent establishment (“PE”) under Article 5(2)(g) of the tax treaty since the activities exceeded a 12-month period. Accordingly, 10 percent of the gross receipt was attributable to tax at the rate of 10 percent under the deeming provisions of Indian domestic tax laws.

The taxpayer countered the arguments of the revenue authorities to state that the contract was limited to the ancillary work allotted that commenced only at the prescribed date.

The employees’ visit to India was merely towards preparatory work to facilitate tendering and not for any form of installation activities. Thus, activities undertaken prior to awarding of a contract cannot be regarded as part of an installation activity pursuant to Article 5(2)(g) of the tax treaty, relying on the Delhi High Court judgment of National Petroleum Construction Company v. DIT (386 ITR 648).

Aggrieved by the revenue authority’s judgment, the taxpayer appealed before the Delhi Income-tax Appellate Tribunal (“Tribunal”).

Tribunal Ruling

The Tribunal observed that the revenue authority incorrectly interpreted the scope of work of the sub-contract which was to undertake rock transport and delivery, supply of material and equipment, construction, installation of temporary facilities, rock dumping activities, etc. as installation services.

Practically, the taxpayer did not establish any form of project office or develop a site before entering into the contract for the preparatory work.

The PE clause under Article 5(2)(g) of the tax treaty emphasizes “such site project or activity constitutes for a period of more than 12 months” means 12 months duration per se specific activity qua the site, construction, assembly or installation project. In the absence of a contract during site visit by the employee, any form of preparatory activity for tendering does not result into existence of any activity as stipulated under PE.

Effectively, auxiliary and preparatory activities such as pre-survey engineering, investigation of site, etc. supported by the employees prior to execution of contract for the purpose of tendering, without commissioning any activity of economic substance or active work qua the project should be excluded for the computation of installation PE threshold of 12 months.

The Tribunal stated that the threshold period of 12 months was not exceeded in the taxpayer’s case and thus, no PE is constituted in India in terms of Article 5(2)(g) of the tax treaty owing to:

• the period from which the PE is reckoned to perform activities for the installation project or site, etc. is in substance when the business activity commences in fact, the taxpayer began work only from the effective date of the sub-contract and not prior to preparatory work for tendering purpose;
• the completion certificate refers to the conclusion date within 12 months, evidenced by the Customs authority’s documents confirming demobilization of the last barrage sailing out or decommissioning from India;
• evidence placed on record that consideration for the contract was received by the taxpayer on or before the contract completion date; and
• no evidence that any activity post contract completion beyond the project conclusion date was undertaken.

Accordingly, the Tribunal concluded that no part of the income under the executed contract by the taxpayer is taxable under Article 7 of the tax treaty.

Planning Points

The method of calculating PE by the taxpayer has always been a matter of debate with the revenue authorities, in spite of numerous guidance available from commentaries like Klaus Vogel on Double Taxation Conventions which refers to the period for PE computation only when the entity begins to perform business activities ”on the spot” in connection with a building site or construction or assembly project.

It is also imperative to analyze the proposed multilateral instruments (“MLI”) incorporating Organisation for Economic Co-operation and Development (“OECD”) BEPS Action Plan 7 especially where transactions are structured to deal with anti-fragmentation rules.

However, under the MLI, India has adopted complete exemption of PE only where overall activities of the fixed place of business are preparatory or auxiliary in nature.

Thus, it is important to justify in cases where overall activities are not preparatory or auxiliary and the preliminary activities before business in the source country does not result in cohesive business operation.

In any case the commentaries deal with the issue of profits attributable to each PE as derived from distinct activity of the cohesive business operation carried on by the PE if, it were a separate and independent enterprise performing the corresponding activities, taking into account the potential effect on those profits of the level of integration of these activities.

A careful implementation of tendering the contract would be essential relying on the Delhi High Court ruling of National Petroleum, including guidance available from commentaries to prevent taxable presence and attribution risk to such contracts in the source country.

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