Himanshu SinhaPartner
Aishwarya PalanSenior Associate
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Permanent establishments as separate taxable entities: recent judicial developments
A permanent establishment (PE) is a form of taxable presence of an entity in another country. The rules regarding the formation of a PE of a non-resident entity in India are governed by the terms of a double taxation avoidance agreement (tax treaty) between India and the non-resident entity’s jurisdiction. If a PE is constituted in India, the profits of the non-resident entity, to the extent attributable to the activities or operations or functions performed by the PE, will be subject to tax in India on a net of expenses basis, at the rate of 35% (plus the applicable surcharge and cess).
In the context of attribution of profits to a PE, the question as to whether profits can be attributed to a PE even when the non-resident entity has incurred losses at a global level was addressed by the Delhi High Court in two separate cases. Interestingly, with two different conclusions.
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Differing views of the Delhi High Court on the question of profit attribution to permanent establishments
In 2022, the Delhi High Court, in the case of Nokia Solutions and Network OY,1 addressed this question and held that profit attribution to a PE would be warranted only if the entity as a whole had earned profits.
However, the full bench of the Delhi High Court in the case of Hyatt International Southwest Asia Limited2 recently reversed this finding and held that a PE must be viewed as a separate taxable entity, and its profits must be assessed independently regardless of the overall financial performance of the entity.
In reaching this determination, the Court analysed the relevant provisions of the India-UAE tax treaty, including the definitions of ‘enterprise’ and ‘permanent establishment’ and rules for attributing profits to a PE under Article 7. Through this analysis, the Court made certain notable findings and observations, discussed below.
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Analysis of the key findings and observations of the Delhi High Court on taxation of permanent establishments
The Court’s analysis was three-pronged:
- Separate entity principle: Article 5 of the tax treaty defines ‘permanent establishment’ to include a varied nature of establishments which need not necessarily be those that have a separate legal persona. These can range from a place of management to a mine or a building site and is not confined to a juridical entity as is ordinarily understood in law. Given this wide ambit, the Court relied on its decision in International Management Group (UK) Limited3 which briefly discussed that a PE is viewed as a separate and distinct centre for the purposes of taxation.
- Treatment in international tax commentaries: The Court observed that the Organisation for Economic Co-operation and Development (OECD) commentary on Article 7 and the commentary on the United Nations Model Double Taxation Convention between Developed and Developing Countries 2021 note that viewing a PE as a separate and independent centre for the purposes of fiscal treatment and taxation is necessary for attribution and recognition of income generated by it independently.
Concept of source-based taxation: The PE principle enables the assignment of tax to the country which constitutes the ‘source’, i.e., the location which gives rise to the accrual of profits or income. PE is a fictional creation of an independent economic centre in a country which informs the allocation of taxing rights. Therefore, the Court observed that once the tax treaty views the PE as an independent entity for tax purposes, it would be incorrect to determine the taxability based on the activities or profitability of the parent or the entity which seeds and sustains the PE.
In this context, the Court analysed Article 7 of the tax treaty which first provides that profits of an entity are taxable only in the country of its residence. Article 7 then expands the scope of taxability by prescribing that if the entity was carrying on business through a PE situated in another country, its profits would become liable to be taxed in the other country, to the extent that those profits are attributable to that PE.
Therefore, Article 7(1) in clear and unequivocal terms distinguishes between the profits that may be earned by an entity on a global scale and those which are attributable to a PE.
The Court stated that it would be an incorrect interpretation of Article 7 to ignore the income generated pursuant to activities undertaken by a PE in one of the countries and make the exercise of attribution dependent upon the profits or the income that may otherwise be earned by the entity globally. The Court observed that the OECD commentary on Article 7 supported this view as it explained that the taxation right of the source country depended on the existence of a PE. The OECD commentary referred to the participation of a non-resident entity in economic activity within the territory of the source country as constituting a ‘separate source of profit’. The Court also noted that the OECD commentary discussed the possibility of profits being attributed to the PE even though the entity as a whole had never earned any profits.
The Court found that this position resonated with the decision of the Supreme Court in the case of Morgan Stanley4 which acknowledged that a distinction must be drawn between a PE with respect to income earned in the country where it is domiciled or deemed to exist and the global enterprise of which it may be a part.
The Delhi High Court opined that the argument of the appellant that if an enterprise at an entity level had suffered a loss in a financial year, no profit or income attribution would be warranted insofar as the PE is concerned, based on the decision of the Special Bench in the case of Motorola Inc.,5 was misconceived and premised on a stray observation. To elaborate, the reference to global sales and global net profit in the Motorola case was made in the backdrop of the parties having failed to produce adequate material to have independently established the profit margin of the PE in India. It is in this light that the Special Bench held that a net profit of 20% must be attributed to the PE in respect of the Indian sales based on the global profits of the entity.
On an overall consideration of the above points, the Court concluded that the contention of global income being determinative of the question of profit attribution was unsustainable. It held that the activities of a PE are liable to be independently evaluated irrespective of the profits or income being earned at the ‘entity level ’.
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Impact of the ruling
The Court’s decision has shaken the view held so far on the attribution of profits to a PE. This was anticipated since the model convention commentaries and academic literature on tax treaties also highlight the antithesis of the Court’s judgment in Nokia Solutions and Networks OY. The Hyatt International ruling referred to above sets a significant precedent and will have far-reaching implications for multinationals operating in India through PEs. Non-resident entities that have relied on the decision in the case of Nokia Solutions and Networks OY may need to reassess their positions based on the decision in the case of Hyatt International. The Hyatt ruling may open the doorway for Indian tax authorities to undertake a detailed scrutiny, particularly of non-residents operating in India through PEs and which incur global losses. It would be interesting to see if the decision is challenged before the Supreme Court to demystify the ultimate stance on PE attribution in such scenarios.
[1] Commissioner of Income-tax (international taxation) v Nokia Solutions and Networks, OY TS-960-HC- 2022(DEL)
[2] Hyatt International Southwest Asia Limited v Additional Director of Income Tax, TS-693-HC- 2024(DEL)
[3] International Management Group (UK) Limited v Commissioner of Income Tax (International Taxation), TS-474-HC-2024(DEL)
[4] Director of Income-tax (International Taxation) v Morgan Stanley & Co., [2007] 162 Taxman 165 (SC)[09-07-2007]
[5] Motorola Inc. v Deputy Commissioner of Income Tax, Non-Resident Circle New Delhi, TS-21-ITAT-2005(DEL)
