Remain Vigilant on Indian Permanent Establishments, Even After the Favorable e-Funds Decision
The U.S. and Indian competent authorities are famously at loggerheads over the principles to be applied in transfer-pricing double-tax cases. Some of the important issues involved are: the appropriate markup on costs for services; when and how to reward location savings; and whether marketing intangibles exist. Virtually all of these double-tax cases involve a U.S. parent company ("U.S. Parent"), its Indian subsidiary, and a transfer pricing adjustment made by the Indian Revenue Service. In recent months, the two competent authorities have been in discussions to establish mutually agreeable principles for resolving the disputes.
But transfer pricing is not the only issue on the table. Many current competent authority cases involve the Indian IRS's assertion that a U.S. Parent has a permanent establishment ("PE") in India and that substantial profits should be attributed to that PE. The U.S. competent authority undoubtedly is seeking to establish principles for resolving PE cases as well, and was recently given a boost by the Delhi High Court's taxpayer-favorable decision in the e-Funds case (TS-63-HC-2014 (DEL)).
In this alert, we first discuss the very constructive PE principles laid down by the e-Funds court. We caution, however, that Indian PE risk remains high, and conclude by suggesting some concrete steps for mitigating that risk.
The e-Funds Case
The U.S. parent (e-Funds Corp.) and its indirect U.S. subsidiary (e-Funds, Inc.) conducted an electronic payments business, and engaged their Indian affiliate ("e-Funds India") to perform back office and data entry services. In a comprehensive and articulate analysis, the court drew on the holding of the Indian Supreme Court in the Morgan Stanley case, and addressed all three kinds of potential PEs – fixed place of business, services, and agency -- and resolved them in a manner consistent with international norms. The court found that neither of the U.S. companies (together, the "assessees") had a PE in India under the terms of the U.S.-India Treaty, and laid out some sensible principles for making that determination:
- The mere existence of an Indian subsidiary does not create an Indian PE of a U.S. Parent. Conversely, the fact that an Indian subsidiary exists does not preclude a finding that the U.S. Parent has a PE.
- A U.S. Parent will have a fixed place of business PE (under Treaty Article 5(1)) only if U.S. Parent (1) has the right to use a location in India (such as an Indian subsidiary's facilities), and (2) in fact carries out activities at that location (3) on a regular basis: "None of the authorities including the tribunal have held that the two assessee[s] had right to use any of the premises belonging to e-Fund India. . . .In the absence of any such finding Article 5(1) cannot be invoked and applied." Other fixed place of business PE considerations:
- The mere existence of a contract for services between U.S. Parent and the Indian subsidiary does not create a fixed place of business PE of U.S. Parent.
- U.S. Parent's access to an Indian location on the Article 5(2) list (e.g., "place of management", "branch", "office", "factory") does not necessarily create a PE. The requirements of Article 5(1) must first be satisfied.
- The following factors are not relevant to a fixed place of business PE analysis:
- "The fact that e-Fund India provides various services to the assessee and was dependent for its earnings upon the two assessees is not the relevant test to determine and decide location PE."
- "The fact that e-Fund India did not bear sufficient risk is irrelevant when deciding whether location PE exists."
- "The fact that e-Fund India was reimbursed the cost of the call centre operations plus 16% . . . is not relevant for determining location or fixed place PE."
- "Neither provision of any software, intangible data, etc. whether free of cost or otherwise, makes e-Funds India an agency or fixed place PE of the two foreign assessees."
- The "existence of [a] PE does not depend upon transfer of assignment or sub-contracting work/services to India, with an intent and purpose to save costs and to increase profitability of the assessee resident abroad."
- The "contention and finding recorded that e-Fund India had provided necessary input or information to e-Fund Corp or e-Fund Inc. to enable them to enter into contracts which were sub-contracted or assigned to e-Fund India, will not make e-Fund India a permanent establishment of the assessee."
- A services PE (Article 5(2)(l)) exists only if U.S. Parent's "employees or other personnel" perform services in India. The employees of the Indian subsidiary are not automatically U.S. Parent's "other personnel".
- Where U.S. Parent seconded employees to the Indian subsidiary, no PE exists if the employees' activities are stewardship in nature: "merely because the non-resident assessee[s] to protect their interest, for ensuring quality and confidentiality has sent its employees to provide stewardship services, will not make the Indian subsidiary or another entity, a PE of the non-resident company."
- The court also indicated, though it was not necessary to its opinion because of the particular facts of the case, that no PE exists if the seconded employees are controlled by and engaged in activities that are the business of the subsidiary and not the U.S. Parent.
- If the Indian activities of an enterprise are limited to "preparatory or auxiliary" activities described in Article 5(3), there is no PE, even if the PE requirements of Article 5(1)/(2) have been met: "Paragraph 3 . . . does not create a PE but has a negative connotation and activities specified when carried on do not create a PE."
- The U.S.-Indian treaty includes two agency PE provisions:
- Article 5(4) (based on OECD model) is the typical dependent agent PE provision, which the court found not to exist in the-Funds case:
- "It is not the case of the Revenue that e-Funds India was authorized and habitually exercised authority to ‘conclude' contract."
- A dependent agent PE is not created merely because a U.S. Parent assigns or sub-contracts services to its Indian subsidiary.
- Article 5(5) (based on UN Model treaty): An otherwise independent agent can become a PE if the agent's activities are both "wholly or mostly wholly on behalf of foreign enterprise and the transactions between the two are not made under arm's length conditions." The e-Funds court found no such relationship to exist because there was no dispute that the transactions were made under arm's length conditions.
Takeaway – Risk of PE Assessment in India Remains High
Although the Delhi High Court gave e-Funds a resounding win, the outcome likely would have been different if the Court had found some of the following facts, which were either not substantiated by the assessing officer or were found not to be present in the e-Funds case:
- U.S. Parent's employees made regular use of the Indian subsidiary's facilities;
- U.S. Parent's non-seconded employees and other personnel performed services in India, either for U.S. Parent or for the Indian subsidiary;
- Employees seconded from U.S. Parent to the Indian subsidiary performed non-stewardship activities and were under the control of or compensated by U.S. Parent;
- Employees of the Indian subsidiary managed operations outside of India (e.g., in the United Kingdom), which might have supported a "place of management" PE assertion;
- The Indian subsidiary had and habitually exercised authority to enter into contracts on behalf of U.S. Parent; or
- The Indian subsidiary acted wholly or mostly "on behalf of" U.S. Parent and their inter-company transactions were not priced at arm's length.
The wide-ranging opinion summarizes numerous other fact scenarios that might or might not have led to a PE determination. PE determinations in India thus remain highly fact-intensive and subjective.
In addition, the court's opinion left doubts on some key issues:
- When, under Article 5(5), will the activities of an agent for a foreign enterprise be treated as "devoted wholly or almost wholly on behalf of that enterprise"?
- What standards/whose views are applied in determining whether the transactions are priced at arm's length?
- What quantum of non-stewardship activities of employees seconded from U.S. Parent to the Indian subsidiary is sufficient to create a PE, and how is the pertinent control test evaluated?
Suggested Practices for Mitigating PE Risk
The e-Funds decision thus highlights the need for continued diligence on the PE front. In that regard, we believe the following practices can be helpful in mitigating PE risk, in India and elsewhere:
Know the local law: The e-Funds court found that U.S. Parent would have been taxable under local law, but that the Treaty trumped. Where a U.S. treaty is not available, local law will provide the rule and be determinative.
Set up and maintain consistent corporate governance: From board resolutions to invoicing, all documentation should be consistent with the chosen form for the local presence. The separate legal status of the local entity must be established and preserved. The entity must be functionally independent and adequately capitalized. Its documented and observed assets and risks must be consistent with the chosen structure. And personnel should be made aware of the chosen structure, and operate within that framework. Decide whether employees should receive regular training on the PE risk, and how that training should be provided to avoid simple mistakes.
Get your transfer pricing right: This is a good practice in itself, but also helps mitigate PE risk. Under the special terms of Article 5(5) of the U.S.-Indian treaty, getting the transfer pricing right will ensure that there is no independent agency PE. Article 5(5) may reflect that non-arm's length transfer pricing, if significant, calls into question whether the subsidiary has the substance – i.e., wherewithal – to fund its own operations. And from a practical standpoint, getting the transfer pricing wrong makes a PE assertion more likely as an alternate assessment for achieving the total local income that the tax authority believes is appropriate. Getting the transfer pricing right, on the other hand, may limit the damage if a (services) PE is found to exist; in the Morgan Stanley case, the Indian Supreme Court concluded that arm's length transfer pricing may fully compensate both the Indian subsidiary and any agency PE that it creates for the foreign parent.
Avoid creating a fixed place of business: In the e-Funds case, the U.S. Parent did not have a fixed place of business in India. But, it is easy to create a fixed place, if there is an office set aside at the subsidiary for use by foreign visitors, or if the foreign company regularly rents hotel or apartment rooms on a long-term basis. It is essential for the foreign party to avoid taking actions, intentionally or unintentionally, that could be found to create a fixed place of operations within India.
Decide whether a PE is unavoidable: If the local operation is highly integrated with one or more U.S. or other foreign operations, is a PE avoidable? If not, it may be preferable simply to admit a PE exists, and report accordingly. This ensures that the taxpayer will have good books and records to demonstrate the income attributable to the PE. In addition, a PE filing should help mitigate the local penalties for non-filing (e.g., loss of deductions, penalties, interest, confrontational posture with tax authority), and may reduce the tax authority's incentive to make transfer pricing assessments on the local subsidiary.
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The e-Funds case undoubtedly is a step in the right direction for Indian PE risk. The court referred to and relied on relevant OECD and UN commentary, as well as secondary sources, and reached the right conclusions. But it is only one court. The Indian IRS is likely to continue searching for PE issues, and those issues are likely to remain a major sticking point in the U.S.-India competent authority relationship.
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