Delhi ITAT rules on constitution of PE in case of outsourcing of services to an Indian affiliate and on attribution of profits to such a PE
Court : Delhi Income Tax Appellate Tribunal
Citation :eFunds Corporation and eFunds IT Solutions Inc.
Brief :The ITAT held that the relationship of the Taxpayers with their Indian subsidiary to whom the Taxpayers had sub contracted/ assigned provision of software development and call center services, resulted in a permanent establishment (PE) of the Taxpayers in India under the India-USA Double Taxation Avoidance Agreement (DTAA). The ITAT held that a PE was constituted on account of activities of the subsidiary which effectively resulted in the Taxpayers carrying on their business in India.
The ITAT, subject to some adjustments, broadly upheld the approach adopted by the Indian Tax Authority of attributing profits to the PE by allocating the global profits based on a proportion of Indian assets to global assets. The ITAT also held that the conclusions reached in a Mutual Agreement Procedure (MAP) for a particular financial year could form the basis for the Tax Authority to reach a conclusion for other years, if there are no differences in facts for the years.
Background and facts- eFunds Corporation (eFunds) is a company incorporated under the laws of the USA and a tax resident of that country. The other principal operating entities of the group are eFunds IT Solutions Group Inc. (eFunds IT), a U.S. corporation, and eFunds International India (P) Ltd.(eFunds India), an Indian company. The Taxpayers provide various services to financial institutions, retailers, electronic funds transfer networks, government agencies and others under the following four broad business segments: (a) ATM management services; (b) electronic payments; (c) decision support and risk management and (d) professional services.
eFunds India, a tax resident of India, is a wholly owned indirect subsidiary of the Taxpayers. It is carrying on business in India and is providing services to the Taxpayer by way of (a) call center services; (b) financial shared services and data entry and (c) software development services. For such services, eFunds India is being compensated by way of remuneration.
The Tax Authority initiated audit proceedings against the Taxpayers for the financial year (FY) 2002-03. The Tax Authority made a determination that the Taxpayers had a taxable presence in India under the Indian Tax Laws (ITL) by way of a business connection. The Tax Authority also asserted that the Taxpayers had a PE in India as defined under Article 5 of the DTAA. According to the Tax Authority, the facility of eFunds India from which services were rendered to the Taxpayers constituted a PE of the Taxpayers. The Tax Authority, thereafter, sought to attribute profits to the PE by allocating the worldwide profits of the Taxpayers based on a proportion of Indian assets to global assets.
The Taxpayers also initiated MAP under Article 27 of the DTAA for resolving the dispute. Even though the US Competent Authorities disagreed on the technical merits relating to existence of a PE, a resolution was reached between the Competent Authorities with a view to avoid double taxation. As per the resolution, income was attributed to India by applying certain developed and acquired tangible and intangible attribution factors to operating income. The resolution, in addition to providing for correlative adjustment, also stated that the resolution is not binding for subsequent years.
The Tax Authority had also initiated audit proceedings for some of the financial years preceding and succeeding the FY 2002-03 and asserted a PE and attributed profits to the PE on a similar basis as determined for FY 2002¬03. The Tax Authority also relied on the MAP resolution reached for FY 2002-03 to argue its position on PE and profit attribution for prior and subsequent years.
The Taxpayers proceeded under the appellate process of the ITL for these years and preferred an appeal before the first appellate authority which upheld the taxability of the Taxpayers.
Aggrieved by the above order, the Taxpayers appealed before the ITAT.
Business connection and PE
The Taxpayers did not have any business operations in India and no operations carried on by eFunds India (in India) can be held to be attributable, directly or indirectly, to the earning of income by the Taxpayers. There was no real and intimate connection between the operations of eFunds India and the business of the Taxpayers outside India.
The operations of eFunds India cannot be held to be the operations of the Taxpayers as they have a principal to principal relationship. Mere fact that some activities were outsourced by the Taxpayers cannot create a business connection in India as per the ITL.
The Taxpayers do not have any fixed place of business in India. They neither carry out any activities in India nor do they have any liaison office or any store/premise which is used as a sales outlet in India.
Back office operations and software development carried out by eFunds India do not, in any manner, constitute a PE of the Taxpayers in India. Support was drawn from a decision of the Supreme Court in the case of DIT (International) V. Morgan Stanley & Co. [292 ITR 416].
The facilities of eFunds India were never at the disposal of the Taxpayers. Further employees in India were employees of eFunds India and were not under the control of the Taxpayers.
eFunds India does not create an ‘Agency PE’ of the Taxpayers under the provisions of the DTAA. The Taxpayers have compensated eFunds India on an arm’s length basis and, hence, eFunds India is an independent agent. The Tax Authority has not disputed that the arm’s length basis of the remuneration paid.
eFunds India did not have an authority to conclude contracts on behalf of the Taxpayers, nor did it secure orders or maintain any stock/merchandise on behalf of the Taxpayers. Also there was no basis to allege that activities of the eFunds India were devoted wholly or almost wholly on behalf of the Taxpayers.
The US MAP authorities have not agreed with the existence of a PE in India. It has reached a mutual agreement and provided for the computation of the Taxpayers’ taxable income in India.
The MAP resolution could not be arbitrary and mechanically be made the basis for determination of taxable income of the Taxpayers in India. The MAP resolution was for the specific tax year only and, therefore, could not be applied to any other tax years.
Attribution of Income
Even assuming that the Taxpayers create a PE in India and income was attributable to such PE, the income so assessed was unscientific and irrational.
Relying on the Morgan Stanley decision, where transactions are at arm’s length price taking into account all the risks and functions of the enterprise, no further income is attributable to the PE in India.
Tax Authority’s contentions
The Taxpayers are operating in India through eFunds India and the activities in India are income generating. There is a continuous, real and intimate connection between the two.
From the business model and interlinked operation, it is clear that the Taxpayers are doing its business through establishment of eFunds India and, therefore, business place of eFunds India constitutes a Fixed Place PE of the Taxpayer in India.
The Taxpayers are continuously, and throughout the year, providing services to its clients through eFunds in India, thereby fulfilling the threshold limit of 90 days stated under the DTAA. Further, since employees of eFunds in India are under the control of the Taxpayers, it constitutes a service PE of the Taxpayer in India.
eFunds India did not have the requisite material assets for rendering services independently as relevant software and database access are made available free of cost by the Taxpayers.
eFunds India does not bear any significant risk as ultimate responsibility lies with the Taxpayers.
The method followed by the Tax Authority for computation of income attributable to India and the method provided in the MAP resolution are similar subject to minor differences.
Relying on the Morgan Stanley decision, the argument that assessment of PE gets extinguished since eFunds India has been remunerated on arm’s length basis is not correct. eFunds India is remunerated by the Taxpayers for services provided by it to the foreign enterprise. However, the remuneration would not take into account the functions performed, risks assumed and assets utilized by the foreign enterprise in India.
Business connection & PE
The Taxpayers entered into contract with its clients. The same contract is either assigned or sub contracted to eFunds India. Therefore, the Taxpayers and eFunds India come under legal obligation to provide services.
Considering functions performed, assets used and risks assumed by the Taxpayers and eFunds India, it is clear that eFunds India does not have the requisite assets, software and database needed for providing the services. eFunds India also does not bear any significant risk.
The corporate office of eFunds India overseas operations of eFunds group entities globally and the sales team undertakes marketing efforts for affiliates of the group. These activities are carried out on a continuous basis over a period of years.
In view of the above the Taxpayers have a business connection in India.
The relevant provision of the DTAA prescribes a lower threshold with respect to existence of the PE. The basic definition of the term ‘PE’ means a fixed place of business through which the business of an enterprise is wholly or partly carried on. ‘Through which’ must be given a wide meaning so as to apply to any situation where business activities are carried on at a particular location that is at the disposal of the enterprise for that purpose.
Place of business need not be owned, rented or otherwise under possession or control of the enterprise in order to constitute PE.
The nature of activities of the Taxpayers cannot also be considered to be preparatory and auxiliary as they are the core income generating activities and the business of eFunds India is inextricably linked to the business of the Taxpayers.
In the facts of the case there also exists a PE under Article 5 of the DTAA in respect of the back office operation and software development services being carried out by eFunds India.
Attribution of Income
The proper method for estimating the profits attributable to the PE shall be worked out in the following manner:
1. Determination of proportion of Indian assets to global assets, including assets of eFunds India.
2. Aggregation of global profits of the group (inclusive of eFunds India profits).
3. Working of total profits attributable to India out of global profits in same proportion as (1) above
4. Aggregation of India attributable profits of group (X)
5. Less: eFunds India profits (Y)
6. Profits attributable to PE of Taxpayers (Z = X – Y)
It is not in dispute that entire activities of the Taxpayer in India are carried out by eFunds India. As eFunds India has not been remunerated on arm’s length basis as defined in the Morgan Stanley decision, attribution of profits to the PE is not extinguished.
It cannot be assumed that facts of the relevant tax years under appeal are different from that of the MAP years or any of the facts were not considered by the Competent Authorities.
Competent Authorities have considered the fact that it is a case of e-commerce, where business may be transacted on a global basis through various tax jurisdiction and income may be earned in various jurisdiction even though, theoretically, a case can be argued that conditions mentioned in the DTAA are not be fulfilled as they relate only to conventional business and not e-commerce.
This MAP resolution is to be viewed as an application of the DTAA to an e-commerce environment, where the literal application of the DTAA provisions may not lead to a correct representation of the taxing rights of the two tax jurisdictions.
The Taxpayers have not been able to point out any change in the business model in the relevant tax years as compared to the MAP years. It is clear that the Taxpayers have a PE in India in accordance with the above analysis and MAP resolution.
Existence of a PE in case of outsourcing of business process/IT services to an Indian affiliate and attribution of profits if a PE exists in such scenario has been a contentious issue in India.
Based on the facts of the case and the relationship between the parties, in the present case, the ITAT has ruled that the premises or facility of the Indian affiliate that provides services to its foreign group company would result in a PE. However, the present ruling does not through much light on the factors the ITAT considered decisive for determining that the place of business was regarded as being at the disposal of the foreign enterprise.
The ruling also highlights the importance of a robust transfer pricing analysis that takes into account the functions, assets and risks in India for extinguishing additional profit attribution in case a PE is created.
Foreign multi-national enterprises would need to review their outsourcing arrangements in India in more detail for managing the PE and profit attribution challenges.