Mumbai Tribunal rules on computation of ‘duration test’ for determining existence of ‘Construction PE’

This Tax Alert summaries a recent ruling of the Mumbai Income Tax Appellate Tribunal (Tribunal) [2010-TIOL-195-ITAT-MUM] in the case of Valentine Maritime Mauritius Ltd (Taxpayer), on the tax ability of certain contracts executed in India. The issue primarily focused on how the ‘duration test’ of nine months under the India-Mauritius Tax Treaty (Tax Treaty) should be applied for determining whether the Taxpayer has a permanent establishment (PE) under the Construction PE rule of the Tax Treaty.

Considering the facts of the case, the Tribunal held that the number of days relating to each of the contracts cannot be aggregated to determine the ‘duration test’, as the activities carried out therein are not inextricably interconnected or interdependent and do not form a coherent whole in conjunction with each other. The ‘duration test’ would need to be applied independently for each contract executed, for determining a PE. In view of the fact that under each of the contracts, the time duration did not exceed the threshold of nine months, the same was held not to constitute a PE under the Tax Treaty.

Background and facts of the case

The Taxpayer is a company incorporated in Mauritius, possessing a Mauritius tax residency certificate and is eligible for the Tax Treaty benefits. The Taxpayer is engaged in the business of marine and general engineering and construction. During the relevant tax year, the Taxpayer executed the following contracts in India:

Under the Tax Treaty, a PE is defined to mean a fixed place of business through which the business of a foreign enterprise is wholly or partly carried on (Fixed Place PE rule). It also includes a building site or construction or assembly project or supervisory activities in connection therewith, where such site, project or supervisory activities continue for a period of more than nine months (Construction PE rule). Under the Tax Treaty, income in the nature of ‘business profits’ of a foreign enterprise (such as the Taxpayer) are taxable in India only if there exists a PE of the taxpayer in India.

Issue before the Tribunal:- The main issue before the Tribunal was whether the Taxpayer had a PE in India under the Construction PE Rule.

Ruling of the Tribunal

On the relationship between ‘fixed place PE’ and ‘construction PE’

• PE refers to a fixed place of business through which business of the enterprise is carried on and includes, inter alia, a building or construction project etc., where such a project continues for a period of more than nine months.
• The ‘duration test’ of the Construction PE rule limits the application of the general principle of permanence under the Fixed Place PE rule. Therefore, unless the specified activity crosses the time threshold, even if a PE exists under the general rule, it will be outside the ambit of the definition of PE.

On ‘fixed place PE’

• In order to be treated as a PE under the Fixed Place PE rule, there must be a fixed place of business through which the business of the Taxpayer is carried on.
• The business of the Taxpayer is giving barge on hire and the business activity is not carried out at the barge so hired out. As the business of the enterprise is not carried out at a fixed place, there is no basis for holding a barge to be a PE of the enterprise.

On ‘duration test’ under the Construction PE rule :-The Tribunal held that only the activities of a foreign enterprise on a particular site/ project, or supervisory activity connected therewith, are to be taken into account and not all the activities in the country as a whole. The Tribunal’s reasoning and the key observations in this regard are as follows:

• The expressions used in the Construction PE rule are in singular and there is no specific mention about aggregating the number of days spent on various sites, projects or activities. Various business activities of the enterprise in different locations are not so inextricably interconnected that these are essentially required to be viewed as a coherent whole.
• In a large number of India’s tax treaties, the relevant PE clauses are so worded that there is a specific mention for application of the aggregation principle for computation of the threshold time period prescribed in the ‘duration test’.
• When the aggregation principle is not specifically provided for in the relevant PE definition clause, normally, it cannot be inferred that such a principle needs to be applied. In the present case, the Tax Treaty does not specifically provide for aggregation of time spent on various projects for determining a PE under the Construction PE rule.
• There is unanimity in the Organization for Economic Co-operation and Development (OECD) and the United Nations (UN) Model Convention commentaries that the ‘duration test’ applies to each individual site or project.
• The OECD Commentary also recognizes that sometimes enterprises try to abuse the time threshold by splitting one contract into several parts. However, the onus would be on the Tax Authority to prove that the contract is split artificially to abuse the ‘duration test’.
• The OECD Commentary recognizes that a building site should be regarded as a single unit even if it is based on several contracts, provided it forms a coherent whole, commercially and geographically. The Tribunal observed that this test refers to such a degree of coherence that the different units, taken together, form a coherent whole, geographically and commercially. This is almost the same as different units being viewed as one place of business. The Tribunal also acknowledged that this test cannot be applied universally or conclusively due to various ambiguities surrounding it.
• The tests of ‘geographical coherence’ and ‘commercial coherence’, in isolation with the larger picture of all the units forming part of a coherent whole, are not only vague tests with little consensus on their scope, but they are also unworkable in practical situations.
• However, the ‘interdependence test’ is something that can be applied with lesser ambiguity vis-à-vis the ‘cohesion test’. The true test is in interconnection and interrelationship, in addition to geographical proximity and commercial nexus. There is no finding to the effect that the three contracts are inextricably interconnected, interdependent or can only be seen as a coherent whole in conjunction with each other.

The Tribunal, thus, upheld the order of the first appellate authority which held that the duration of the three contracts cannot be aggregated for the purpose of determining the existence of a PE. Accordingly, it held that there was no PE of the Taxpayer in India.

Comments

India’s tax treaties are based on a combination of the OECD and the UN Model Tax Conventions. Although India is not a member of the OECD, the courts in India (as in the present case) have often referred to the OECD Commentary for interpreting India’s tax treaties to the extent that the language in a particular tax treaty is consistent with the text of the OECD Model Convention.

In determining the ‘duration test’ under the Construction PE rule under tax treaties, unless the treaties themselves provide for aggregation of contracts, doubts sometimes arise on the applicability of the aggregation principle. The present ruling provides useful guidance on the factors to be considered while applying the ‘duration test’. In addition to acknowledging the OECD test of ‘commercial and geographic coherency’, the Tribunal has provided additional guidance by holding that factors such as nature of activities, their interconnection and interrelationship and whether these activities are required to be essentially regarded as a coherent whole in conjunction with each other, would require consideration.

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