In a recent decision by the Mumbai Tribunal, it was decided that the outsourcing of diamond grading activities by Indian subsidiaries of a U.S. parent company cannot result in the U.S. parent company constituting a fixed place, agency or a service permanent establishment (PE) in India under Article 5 of the India–U.S. tax treaty (tax treaty).
The Gemological Institute of America (taxpayer) (ITA No. 1138/MUM/2015), a U.S. tax resident, is engaged in the business of diamond grading and preparation of dossiers. The taxpayer executed third party contracts with a “consolidator” whereby the consolidator coordinated diamond collection from India for the taxpayer to grade and issue grading reports. Under the consolidator arrangement, the cost to the customers was divided in a ratio of 90:10 between the taxpayer and consolidator, respectively.
The arrangement was used before the establishment of an Indian subsidiary and continued thereafter. The Indian subsidiary had limited technical capability to grade diamonds up to a certain threshold, therefore grading of diamonds beyond these limits was outsourced under a “GIA Gem Grading Services Agreement” to other affiliates of the taxpayer’s group entities across the globe, including the taxpayer.
The Indian subsidiary started grading diamonds with a higher threshold scaling up its technical capacity, maintaining the same ratio of 90:10 under the consolidator arrangement for grading services, where the entity requesting grading services retains 10% of the fees collected from its customer and the balance of 90% is payable to the grading service provider.
The revenue authority (revenue) argued that the taxpayer constitutes a PE in India under Article 5 of the tax treaty in the name of the Indian subsidiary through which it carries on business.
As a result, a profit percentage on the total income towards grading fees received by the taxpayer overseas arising from the Indian subsidiary was attributed to the Indian PE under Article 7 of the tax treaty as taxable in India.
The taxpayer filed an appeal before the Mumbai bench of Income-tax Appellate Authority (Tribunal) challenging the PE allegation.
Fixed Place PE
The transaction of grading services arrangement between the taxpayer and Indian subsidiary cannot be perceived as a joint venture, as the Indian subsidiary secures client orders based on its independent expertise and capabilities.
The Indian subsidiary directly enters into client contracts and bears all risks of credit, client delivery, etc. Separately, it also bears the risk of loss or damage while the articles are in transit and stored at the location of taxpayer’s facilities for service.
The arrangement between the parties was not intended to contribute the share capital to undertake economic activity for joint control, but relates to the sub-contracting assignment of services specifically in light of technology/capacity constraint for grading purposes.
The Tribunal observed that the service arrangement was simply accepted as rendering of grading services by the Transfer Pricing Authority (TPA) in the case of the Indian subsidiary as well as the taxpayer.
The Tribunal also stated that the economic risk of gems grading services rendered by the taxpayer vis-à-vis stones/diamonds of the customers was borne by the Indian subsidiary, negating any joint venture association between the parties.
Hence, the Tribunal stated that the fact that the taxpayer had controlling interest in the Indian subsidiary did not regard the Indian subsidiary as a “fixed place PE” of the taxpayer in terms of Article 5(1) and Article 5(6) of the tax treaty.
The Indian subsidiary was directly responsible for grading services of its Indian customers and bears service risk and all client facing risks vis-à-vis the gems sent to the taxpayer for grading purposes as per the Transfer Pricing Study Report.
Considering the functions, assets and the risks assumed by the Indian subsidiary vis-à-vis its business activities in India, the transfer pricing analysis was recognized by the TPA both in the case of the Indian subsidiary and the taxpayer.
The Tribunal observed that the Indian subsidiary did not have any authority to conclude contracts and neither concluded any contracts on behalf of the taxpayer nor secured orders for the taxpayer in India.
Therefore, the Indian subsidiary was not acting in India on behalf of the taxpayer. The Tribunal referred to the landmark case of Formula One World Championship Ltd for concluding that the Indian subsidiary was operating independently and revenue could not prove that it was an agent of the taxpayer in India. Thus, the Indian subsidiary could not be regarded as constituting an “agency PE” of the taxpayer in India under Article 5(4) and 5(5) of the tax treaty.
The taxpayer renders “grading services” and “management services” to the Indian subsidiary. The Tribunal observed that ex-employees as graders with the taxpayer were employed and on the payrolls of the Indian subsidiary, working under the control, direction, instruction and supervision of the Indian subsidiary. The grading services outsourced were rendered outside India for which no employees had traveled to India.
The Tribunal relied on the Supreme Court decision of E-Funds which stated that employees deputed to E-Funds India did not create a service PE as the salary cost was borne by E-fund India and they were working under the control and supervision of E-fund India. Accordingly, it was concluded that the occurrence of service PE was not triggered under Article 5 of the tax treaty.
The determination of PE of a foreign company in India is controversial and contested before the courts.
It is interesting to observe that the Tribunal referred and highlighted the Supreme Court judgment in the case of Formula One World Championship Ltd to conclude in favor of the taxpayer. Rightly so; while executing grading services, no part of the main business and revenue earning activity of the taxpayer is carried on through a fixed business place in India which has been put at its disposal.
The Indian subsidiary merely renders support services that enables the taxpayer to complete its client’s commitment overseas and such outsourcing of work to India would not give rise to a fixed place PE in India. The reference of E-Funds manifests the principle of outsourcing activities by Indian affiliates cannot explore a foreign affiliate to constitute a taxable presence in India (though it is worth referring to the recent case of GE Energy Parts Incwhere the leased space of the Indian affiliate was constantly at the disposal of the foreign enterprise through its staff, concluding that GE’s activities in India were wholly or partly carried on through a fixed place of business).
The Tribunal ruling may be open to further litigation in the Higher Court in the absence of distinguishing the facts of the GE Energy Parts Inc. case and also the determination of a PE is fact-specific, so it is important to analyze the details of each case to mitigate any risk of PE exposure in India.
Shailendra Sharma is a chartered accountant associated with a multinational financial services firm, India.
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