AAR rules on whether a liaison office can constitute a permanent establishment

SUMMARY OF THE AAR

This alert summarizes a recent ruling of the Authority for Advance Ruling (AAR) [2009-TIOL-12-ARA–IT] in the case of K.T. Corporation (Applicant) on the issue of whether a Liaison Office (LO), acting as a communication channel, will constitute a Permanent Establishment (PE) of the Applicant under the Double Taxation Avoidance Agreement between India and Korea (Tax Treaty). Considering the facts of the case, the AAR held that the activity carried on by the LO in India are in ‘aid’ or ‘support’ of the main activities and are preparatory and auxiliary in nature. Hence, the LO will not constitute a PE of the Applicant.

Facts of the case

The Applicant is a company incorporated in Korea and is a telecommunications carrier/reseller.

The Applicant set up a LO in India to act as a communication channel between the Head Office (HO) of the Applicant and the concerned parties i.e. Indian companies. For this purpose, the Applicant obtained a license from the Reserve Bank of India (RBI). The RBI permitted opening of the LO, subject to certain conditions:

(i) The LO wil not undertake any other trading activity.

(ii) No commission/fee will be charged or any other remuneration earned by the LO, for the liaison activities rendered by it.

(iii) Entire expenses of the LO wil be met out of the funds received from abroad.

(iv) LO cannot borrow or lend money from or to any person in India without prior permission of the RBI.

(v) LO shal not hold, transfer or dispose of any immovable property in India without prior permission of the RBI.

(vi) LO will furnish an auditors certificate to the RBI, as required under the exchange control regulations.

(vii) LO will not render any consultancy or any other services.

(vii ) LO will not have any signing/commitment powers, except those required for normal functioning.

(ix) LO can open a HO account in its books, subject to the condition that it should represent funds received from the HO.

(x) The activities may be verified/examined by the RBI, when found necessary.

 The LO was involved in carrying out activities such as (i) organizing seminars, conferences (ii) receiving trade enquiries from the customers (ii ) advertising for the Applicant (iv) col ecting feed back from the prospective customers/consumers, trade organizations etc.

Pursuant to setting up the LO, the Applicant entered into a reciprocal services agreement (Agreement) with Vodafone Essar South Ltd (VESL). VESL is a company registered in India and is a telecommunications carriers/reseller. As per the terms of the Agreement, the 2 parties agreed to interconnect with each other and to purchase and provide the services to each other. The costs incurred by the Applicant were borne by the Applicant itself. In respect of these services, the parties were required to raise invoices during each calendar month. As per the terms of the Agreement, the invoiced party would need to make payments to the invoicing party.

Prior to the inception of this Agreement and post its signing, the Applicant prepared certain documents viz. (a) pre-bid survey, (b) a feasibility report and conducted a technical analysis of the project. In this regard, the LO was involved in preparing a report dealing with India’s market scenario in mobile as well as broadband segments.

In light of the above, the Applicant filed an application with the AAR on tax implications arising from the above transaction in India.

Issue for consideration

Whether the LO can constitute a PE of the Applicant under the Tax Treaty?

Contentions of the Tax Authority

The Tax Authority asked the Applicant to provide additional information in respect of certain queries, in the absence of which, it would not be possible to conclude whether the LO constituted a PE for the Applicant:

(i) What was the role of the LO in the pre-bid survey carried out before entering into the Agreement?

(ii) How was the feasibility report prepared; did the LO play any role in it?

(ii ) Were the employees of the LO involved in the technical analysis of the project?

(iv) Is the LO involved either in the technical analysis of the project or the execution of any part of the contract?

? In addition to the above, it was contended that the payments received by the Applicant from VESL, under the Agreement, will be taxable as either royalty or fees for technical services, as per the Indian Tax Laws (ITL) and the Tax Treaty.

Contentions of the Applicant

In response to the request for additional information, the Applicant provided details regarding the RBI approval and the conditions specified therein (the same have been discussed in the facts of the case above). It was contended that the LO is only a representative office of the Applicant and the RBI has permitted it to act only as a communication channel between the Applicant and the parties, subject to conditions as prescribed by the RBI.

• The LO does not undertake any trading activity and neither has it entered into any business contracts on behalf of the Applicant.
• The LO has not rendered any consultancy or any other services.
• The LO was not involved in the pre-bid survey, preparation of feasibility report or any technical analysis of the project.
• The LO is not a fixed place of business through which the business of the Applicant is, either whol y or partly, being carried on. It is a fixed place (an office) which undertakes only preparatory or auxiliary work. Hence, the LO cannot be regarded as PE as per the provisions of the Tax Treaty.
• The LO has not transgressed the conditions imposed by RBI.

Ruling of the AAR

• PE means a ‘fixed place of business’ through which the business of a foreign enterprise is whol y or partly carried on in another contracting state. The PE provision in the Tax Treaty also enumerates certain activities which are considered as preparatory and auxiliary vis-à-vis the main business of the foreign entity. These activities are exceptions to the basic concept of PE and are deemed not to contribute to the profit generating activities of the enterprise.
• As per the statutory provisions, the activities of a LO are restricted and it could not legal y secure orders from customers. The LO may be a ‘fixed place’ and the activities conducted by it are seemingly business activities, but these are restricted to preparatory or auxiliary activities only.
• The issue to be analysed is whether the activities carried on by the LO are only supporting the main business or is the LO undertaking the main functions of the business.
• It was observed that the LO did not transgress the parameters and the terms prescribed by the RBI.
• Based on a perusal of the facts, it was concluded that the LO has not performed any ‘core business activity’ and has confined itself to preparatory and auxiliary activities.
• The work carried on by the LO would come within the ambit of supplying information which is preparatory to and auxiliary to the formation of the final contracts entered into by the applicant with VESL. The preparation of reports dealing with India’s market scenario in mobile as well as broadband segments etc. are in ‘aid’ or ‘support’ of the main activities and, accordingly, are in the nature of preparatory and auxiliary activities.
• The LO is covered within the exclusionary clause of the PE provision in the Tax Treaty.
• It was observed that if the activities of the LO extend beyond the parameters fixed by the RBI or if the Tax Authority come across any concrete material, which substantially impacts the authenticity of the facts, as represented by the Applicant, then the Tax Authority can take appropriate steps under law.

Our Comments

A ruling by the AAR is binding only on the Applicant, in respect of transaction in relation to which the ruling is sought and on the Tax Authority, in respect of the Applicant and the said transaction. However, it does have persuasive value and the Courts in India, Tax Authority and the Appellate Authorities do recognize the principles and ratio laid down by the AAR, deciding other cases.

The guidelines issued by the RBI, which is the central bank of India, permits foreign companies to set up LOs in India, subject to obtaining the prior approval of the RBI. While the RBI allows LOs to function as a communicating channel between the HO and the companies in India, it specifically prohibits such Loss from undertaking any commercial, trading, industrial activities and any other income generating activities, directly or indirectly.

This ruling affirms the position that LOs, which are engaged in merely liasioning with or facilitating the main activities of the head office, should not constitute a PE for the foreign company.