Sunday, November 8, 2009

Auxiliary Activities and Permanent Establishments

We have discussed on several occasions the extent to which a liaison office of an MNC is taxed, and more generally, the concept of a “permanent establishment”. A series of decisions in 2009 has introduced some clarity in the analysis of what constitutes a permanent establishment and what does not. To briefly recapitulate, although s. 9(1) of the Income Tax Act, 1961, enumerates circumstances where income is “deemed to accrue or arise” in India, primarily through a business connection test, several DTAAs provide that income earned in one Contracting State may be taxed in the other Contracting State only if it is attributable to a permanent establishment in that State. Permanent establishment is invariably defined in these treaties, but often excludes entities that only perform “auxiliary activities” in the taxable State. It is thus important to determine what legal principle distinguishes an “auxiliary activity” from other activities, and this question arose most prominently in the context of the taxation of liaison offices.


In February 2009, the Delhi High Court held in UAE Exchange Centre v. Union of India (313 ITR 94) that the exclusionary clause of auxiliary activities must be construed broadly. In that case, the parent company, incorporated in UAE, performed remittance services for NRIs in UAE, where it transferred funds to the NRI’s family in India, on the payment of a fee. The contract was concluded in UAE and payment was received by the company in UAE, denominated in local currency. However, the company also used liaison offices in India to effect the transfer, and the liaison offices consequently had access to the company’s server in the UAE. The liaison office would then download the particulars of the remittance, make the necessary demand draft and despatch it in accordance with the instructions of the remitter. The Revenue argued that the contract was in effect performed by the liaison office – for the essence of the contract was the remittance of money – and that this could consequently not be regarded as “auxiliary”. The AAR had accepted this contention. The Delhi High Court quashed this order, and observed that “but-for” test is inappropriate in construing the exclusionary clause – in other words, the fact that the contract could not have been performed without the aid of the liaison office’s activities is not determinative of its status as an “auxiliary” activity or otherwise. The Court held that the test is broader, and that it was auxiliary because it was in “support” of the main activity entered into in the UAE, for payment in the UAE. In what is likely to be of some importance in subsequent cases, the court also observed that “[o]rganisations and companies operate transnationally. There is an eagerness to bring to tax by States income, by employing deeming fictions so that incomes which ordinarily do not accrue or arise within the taxing State are brought within the States' tax net. It is in this context that the expression "permanent establishment" appearing in the DTAA has to be viewed.” The case is also important for the proposition that the AAR constitutes a “Tribunal” for the purposes of Art. 227 of the Constitution.


This view has been followed. In Cable and Wireless Networks (315 ITR 72), decided in July, a branch office of a UK corporation performed network designing, network management services and other support activities. The AAR held that it did not constitute a permanent establishment since the activity is auxiliary. Similarly, in KT Corporation (181 Taxman 94), a Korean corporation opened a liaison office in New Delhi for the purpose of communicating with Indian banks and other commercial entities. The AAR referred to the OECD Model Commentary’s analysis that the activity must form an “essential and significant part of the enterprise as a whole” and held that the LO did not constitute a PE, relying on Morgan Stanley as well as UAE Exchange. In Hyosung Corporation (314 ITR 343), the AAR reached a tentative conclusion to the same effect.


These decisions are of some importance in enumerating the circumstances under which the head office may be liable to tax exposure on account of the activities of the liaison office. Moreover, the line that the cases have taken – of construing the exclusionary clause of auxiliary activities – appears to be correct and in consonance with the intention of the parties to the DTAA.

5 comments:

vswaminathan said...

I am not clear, rather have reservations, on two of the observations in this write-up:
1.My impression thus far has been that, under the scheme of the IT Act, any ruling by AAR cannot be taken up to High Court; if at all, it could be, by special leave, taken up in appeal to the Supreme Court.
2.So far as I am aware, the RBI, which is the competent authority, permits a foreign company to open a ‘liaison office’ in India, as such, on the specific condition that the office cannot engage itself in any ‘business’ activity, but must confine itself to purely ‘liaison’ activity and further, on a no profit basis- that is, all outgoings should be met only out of inward remittances from the H.O.

For any office set up in India to carry on any ‘business’ activity, it would require to be registered as a ‘branch’ in accordance with the Companies Act.
On the foregoing premises, the facts of and issues that arose in the cited Delhi HC case are not understood, not being at all reconcilable. Besides, strictly speaking, they seem to give rise to more serious questions verging on ‘irregularity’- in case one were to proceed on the basis of the facts as found by the tax authorities.-, though for their limited purpose.

The other cited court cases also would require to be looked into and studied, keeping in mind the aforementioned peculiarities attached to a ‘liaison’ office set up in India.

vswaminathan

V. Niranjan said...

Hello,

Thanks for your comment.

(1) In this case, a writ petition was filed by the assessee challenging the order of the AAR. A preliminary issue was framed by the Delhi High Court as to whether such a writ is maintainable. The Court concluded that an AAR is a "Tribunal" for the purposes of Art. 227 of the Constitution (para. 8) The Court further observed that

"It is now fairly well settled that superior courts can issue a writ of certiorari where there is an error of law which is apparent on the face of record as these are akin to errors of jurisdiction as against mere errors of law."

(2) It is correct that the RBI permits a liaison office on the specific condition that it cannot engage in business activity. However, the activity that it engages in may be within RBI's mandate and yet outside the scope of the expression "auxiliary activities", in which event it cannot avail of exceptions to the permanent establishment rule. UAE Exchange is itself a good example of this principle, as is Cable and Wireless Networks, 315 ITR 72.

vswaminathan said...

Reproduced below is art 227 you refer.

"227. Power of superintendence over all courts by the High Court.—(1) Every High Court shall have superintendence over all courts and tribunals throughout the territories in relation to which it exercises jurisdiction.
(2) ………
(3)………
(4) Nothing in this article shall be deemed to confer on High Court powers of superintendence over any court or tribunal constituted by or under any law relating to the Armed Forces."

According to a harmonious reading of the article, I do not believe that, -
AAR can either be regarded a ‘court’; or, in any case, a ‘tribunal’ so as to come within the HC’s ‘power of superintendence’ as envisaged in the article.

Drawing useful guidance from the language of clause (4) (though it deals with a different situation), pointedly from the words - 'tribunal constituted by or under any law', in my opinion, one could validly urge that, in order that the HC can exercise the power, the subject authority must be a 'tribunal’, constituted as such by or under any law. Is AAR an authority so constituted - as a ‘tribunal’ - under the IT Act? Obviously, the answer is an emphatic – NO.

As regards the other point of my reservation, you seem to have gone off at a tangent; rather be on a different wavelength. I shall try and revert, if and when time permits.

vswaminathan

vswaminathan said...

To follow on:

I. For an appreciation in the proper light, of my other point of reservation, one will require to be focused on the following: -

(A) The two concepts of - ‘liaison office’ (in general) and ‘fixed place of business’ (PE) (as per the treaty) are basically different and mutually exclusive. Pithily stated, in the eyes of the domestic law and / or tax treaty, besides , of course, according to the government’s (RBI’s) policy (or philosophy, by whatever one may call it), - any ‘liaison activity’ must come to end, once any ‘business activity’ is begun as a result of such ‘liaison’ activity (that is, both should be coterminous). For this purpose, so far as I could imagine, there should be no difficulty in fixing such a ‘cut off stage’, regardless of whether the activity (ies) pertains to a single / one time ‘transaction’, or a series of transactions.
(B) As per treaty article specially covering the concept of PE (extracts below), even “any other activity of a preparatory or auxiliary character” as spoken of, according to the very scheme of things, would have been regarded, rightly so, to have the characteristics of ‘business’ activity, and accordingly attracted a PE situation, but for the deeming provision in (3) (e) (of the treaty article).

“ARTICLE 5 - Permanent establishment - 1. For the purposes of this Agreement, the term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on.
2. The term “permanent establishment” includes especially:
(a)….
(b) a branch ;
(c) an office ;
(d) to (i) …….
3. Notwithstanding the preceding provisions of this Article, the term “permanent establishment” shall be deemed not to include:
(a) to (d) ……
(e) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character.
4…………
5.. “

II. Also, one will require to be necessarily focused on, and examine in depth , the following typical propositions of every relevance in a treaty situation:

(a) Any treaty connected or related issue, going by the apex court’s incisive view handed down in the oft cited case of - Azadi Bachao Andolan, involves no ‘question of law’ within the strict meaning of that term as understood for the domestic tax law proposes.
(b) In the light / on the strength of (a) above, there is certainly a grave doubt as to whether a domestic tribunal or court (also AAR), can, in exercise of its vested powers under the IT Act, at all give any ‘binding ruling’; and. even if yes, in which circumstances / to what extent.
(These propositions have been discussed in detail in my published articles in Taxmann journals, on the subject of treaty related matters)

KEYNOTE: In my view, a foreign company cannot rightly/lawfully engage itself in any ‘business’ activity, using an office set up in India under the name of a ‘liaison office’ as permitted; even if that be a case where the company has good grounds to claim, and to conclusively establish, its operations in India to be by way of – ‘any other activity of a preparatory or auxiliary character’ (within the meaning of the treaty).

vswaminathan

V. Niranjan said...

Thanks for your comment.

(1) As to Art. 227, the Delhi High Court found that the AAR has the "trappings of a court", which is the test laid down by the Supreme Court to determine whether an entity constitutes a Tribunal. To make this finding, the observations of Justice Shah in Jaswant Sugar Mills, AIR 1963 SC 677 are relevant.

(2) In addition, the Court found that Art. 226 applies, because the AAR is conferred by statute the powers that are vested in a civil court by the CPC. These observations are found in paragraphs 5 and 6 of the judgment.

(3) As you have rightly pointed out, the RBI circumscribes the operations of a liaison office within a narrow range of operations. However, it may be that even some of those acts are "auxiliary". For example, Clause (iv) of the RBI licence in UAE Exchange Services permitted the liaison office only to "print drafts and dispatch[ing] the same to the addressees". The AAR had taken the view that this activity constitutes "performance" of the contract and is therefore not auxiliary. Therefore, the fact that an RBI licence is restrictive is not warrant for the proposition that the activity is auxiliary.

(4) Although the Supreme Court has clarified several treaty-related matters in Azadi, it is not the case that no question of law can arise in that respect. Any question of law (such as the scope of "auxiliary character") not settled by that decision requires adjudication, and indeed, the question of whether it is settled by Azadi is itself a question of law.