By Ashesh Safi, Kripa Ray and Karan Vakharia
Clarity finally delivered on long standing issue of Permanent Establishment exposure for Liaison Offices in India!
Recent decision of the Hon’ble Supreme Court in the case of UOI & Anr. Vs U.A.E. Exchange Centre (Civil Appeal No. 9775 of 2011)
Introduction
Multi-National Companies (‘MNCs’) are allowed to set up their presence in India subject to the Foreign Direct Investment policy and other relevant regulations. One such presence that MNCs typically try to build is in the form of a liaison office (‘LO’) in India. Such offices are set up by foreign enterprises to understand the Indian market and to carry out certain pre-defined limited activities. For setting up an LO, necessary approval is required.
An LO is a temporary office of a foreign company in India set up for carrying out liaising activities in relation to its business; without any exchange of commercial value. So, the scope of activities permitted to be done by an LO, is fairly restricted and well defined. All expenses of an LO in India are required to be borne by its head office outside India, as the LO cannot and does not earn any income in India. In a nutshell, the LO merely acts as a communication channel between its head office and entities in India.
The regulatory governing body to provide approvals and to monitor activities of an LO in India, is the Reserve Bank of India (‘RBI’). Since LO is permitted to carry out only restricted activities, often the issue that arises is whether an LO can be considered as a Permanent Establishment (‘PE’) of a foreign enterprise in India.
PE exposure and LO
An LO in India faces the risk of being considered as a ‘business connection’ of its group foreign entity / entities in India in terms of section 9(1)(i) of the Income-tax Act, 1961 (‘the Act’). Alternatively, it could also be treated as a ‘PE’ of its group foreign entity / entities in India, in view of Article 5 of the relevant tax treaty (Article 5 deals with PE).
Nonetheless, a few exceptions to the aforesaid deemed tax exposure in India are also specified under the Act and in relevant tax treaties, e.g., operation for the purchase of goods in India for the purpose of export. Also, Article 5(3) of tax treaties inter alia generally mention that if activities carried out in India are preparatory or auxiliary in nature, PE is not constituted.
The common position adopted vis-a-vis LOs’ is that since they do not undertake any commercial or business activity in India and their operations in India are limited to the extent of approvals granted in the RBI’s approval letter, no profits earned by their foreign parent should be attributable to the activities undertaken by the LO in India.
However, judicial authorities in India have delivered contradictory judgements on whether a particular activity of an LO constitutes PE of its group foreign entity in India or not. All these judgements are based on given facts and hence they cannot be simply applied unless the facts are same.
Recently, the Hon’ble Supreme Court of India (‘the Hon’ble SC’), in Civil Appeal No. 9775 of 2011, dealt with the issue of whether activities carried out by an LO in India, constituted a PE of its foreign enterprise in India. The brief facts and ruling of the Hon’ble SC have been discussed in the ensuing paragraphs.
Brief facts of the case
The taxpayer, a company incorporated in UAE, was engaged in offering remittance services to non-resident Indians (‘NRIs’) vis-a-vis transferring amounts from UAE to India. The taxpayer had obtained permission from the RBI to set up an LO in India to carry out certain activities, such as:
- Respond quickly and economically to enquiries from correspondent banks with regard to suspected fraudulent drafts;
- Undertake reconciliation of bank accounts held in India;
- Act as a communication centre for receiving computer advices (via modem) of mail transfer, T.T. stop payments messages, payments details, etc., originating from UAE and transmission to Indian correspondent banks;
- Printing Indian Rupee drafts with facsimile signature from the Head Office and counter signature by the authorised signatory of the office at Cochin.
Further, the RBI approval prohibited the following:
- The LO should not carry on any trading, commercial or industrial activity;
- The LO shall not charge any commission / fees; and
- All expenses of the LO should be met out of funds received from abroad.
The activities carried out by the LO were in line with the terms and conditions mentioned in the RBI approval. The taxpayer entered into contracts with NRI customers in UAE for providing remittance services and charged a one-time fee of Dirham 15. Post collection of funds from the NRI remitters, the taxpayer made remittance of the said funds to India in the following two ways:
a) By telegraphic transfer through bank channels; or
b) On the request of the NRI remitter, it sent instruments/cheques through it’s LO to the beneficiaries in India.
The entire expenses of the LO in India were met exclusively out of funds received from UAE through normal banking channels.
The taxpayer had always been filing its return of income in India showing NIL income, and these were being accepted by the tax department. However, with a view to obtaining tax certainty, the assessee filed an application before the Authority for Advance Rulings (‘AAR’) seeking a ruling on whether any of its income accrued/was deemed to accrue in India from the activities carried out in India. The AAR ruled that income shall be deemed to accrue in India from the activities carried out by the LO in India. Further, the taxpayer was liable to pay tax in India, as it had carried on business through a PE in India. The AAR specifically observed that the activities of the LO are a significant part of the main activities carried out by the taxpayer in India and hence, they cannot be deemed to be preparatory and auxiliary in nature. Accordingly, it was held that the LO in India constitutes a PE in terms of Article 5 of India-UAE tax treaty.
The taxpayer filed a writ petition before the Delhi High Court (‘HC’) against the ruling of the AAR. The Delhi HC reversed the AAR ruling and ruled in favour of the taxpayer. It observed that no income had accrued or could be deemed to have accrued in India. The Delhi HC held that since the activities carried out by the LO in India were preparatory / auxiliary in nature, these were covered by the exclusions from the scope of PE, as specified in Article 5(3) of the IndiaUAE tax treaty. Further, the Delhi HC relied on the Hon’ble SC’s decision in the case of ‘DIT(IT) vs Morgan Stanley & Co. 7 SCC 1 (2007) (SC)’ and held that the activity carried on by the LO in India did not contribute to earning of profits or gains by the taxpayer in UAE and activities of LO were only supportive to the transaction carried out in UAE.
The tax department challenged the Delhi HC decision by filing a Special Leave Petition before the Hon’ble SC.
Observations and ruling of the Hon’ble SC:
- The Hon’ble SC observed that the core issue which had to be addressed was whether the stated activities of the taxpayer would qualify to be of preparatory or auxiliary character or not.
- Considering the activities carried out by the taxpayer in India through the LO, it appeared that the taxpayer was engaged in ‘business’ and had a ‘business connection’ in India. Hence, by virtue of deeming provisions of section 9 of the Act, it would be a case of income deemed to accrue or arise to the taxpayer in India. So, in a nutshell, taxability under the Act did exist vis-à-vis the LO’s activities in India.
- Moving further, the Hon’ble SC placed reliance on various case laws and held that the current matter required analysis under the provisions of the India-UAE tax treaty.
- In view of the findings recorded by the Delhi HC, the Hon’ble SC observed that the LO qualified to be a fixed place of business of the taxpayer in India through which the business of the taxpayer was wholly or partly carried on. Hence, the LO would be covered under the term “permanent establishment” as per Article 5(2) of the India-UAE tax treaty. However, Article 5(3) of the India-UAE tax treaty begins with a non-obstante clause and provides that notwithstanding the preceding provisions of the concerned Article, which would mean clauses 1 and 2 of Article 5, if any of the clauses in Article 5(3) are applicable, a PE would not be created.
- Article 5(3)(e) of the India-UAE tax treaty specifically provides that if the activities carried on in the fixed place of business are in the nature of preparatory and auxiliary activities, the said fixed place of business would not be considered as a PE. Accordingly, it all now rested on whether the activities of the LO in India were preparatory and auxiliary in nature as per Article 5(3)(e) of the India-UAE tax treaty or not.
- The Hon’ble SC observed that the key activities of the LO were downloading particulars of remittances, printing cheques / drafts and couriering / dispatching them to beneficiaries in India. While doing these activities, the LO remained connected to the main server in UAE.
- Further, the activities carried out by the LO were in conformity with the conditions mentioned in the RBI approval. Few prohibitory conditions mentioned in the RBI approval were that the LO would not enter into any business contracts without prior approval of the RBI or undertake any trading, commercial or industrial activity or render any consultancy or any other services. Also, the LO could not even charge commission/fee or receive any remuneration or income in respect of the activities undertaken by it in India. Accordingly, the Hon’ble SC, after referring to its own earlier decisions in the cases of ‘ADIT-1 vs. E-Funds IT Solutions Inc. 13 SCC 294 (2018) (SC)’, concluded that based on the onerous stipulations levied by the RBI, it could be safely deduced that the activities of the LO in India were restricted by the RBI permission, and were preparatory and auxiliary in nature.
- Thus, the activities carried out at the fixed place (i.e. the LO) in India did not qualify as a ‘PE’ of the taxpayer as per Article 5 of the India-UAE tax treaty.
To conclude:
This is a welcome ruling by the Hon’ble SC on PE exposure for LOs set up in India by foreign companies and embroiled in similar litigation. This has been a long-standing issue demanding tax certainty, and rightly so, since all LOs in India work as per the RBI guidelines, which permit the LO to conduct only basic activities. If the LOs were to indeed perform PE like activities, it would mean that they are somewhere breaching the RBI stipulations and going way beyond their permitted activities. Of course, while this ruling does not offer blanket PE risk immunity to every single LO in India, it does provide a line of direction, and also once again echoes and re-affirms prior SC decisions on this matter. It goes without saying that each LO would have to evaluate their activities to determine PE exposure in India. The PE exposure would be predominantly determined by the facts of each case and the specific activities carried out by LO in India.
The key caution point here would be to restrict the activities of the LO to preparatory and auxiliary. Further, the LO should not venture into or towards activities which could be viewed as commercial or core activities undertaken on behalf of the foreign entity or its group entity. If so done, not only could the LO trigger a PE risk in India, but it could also be seen as going beyond the domain of the activity permissions granted by the RBI. Further, appropriate documentation should be maintained to prove that the activities of the LO are preparatory and auxiliary in nature – for instance the RBI approval letter in the present case, which reflected that the activities of the LO were mere support services to the foreign parent entity.
Also, while analysing the ‘preparatory and auxiliary’ activities, one may additionally need to be mindful of the BEPS Action Plan 7 and Article 13 of the Multi-Lateral Instruments (‘MLI’), which deals with the issue of artificial fragmentation of activities between various group companies to avail the benefit of ‘preparatory and auxiliary’ activities.
All in all, this ruling does lend tax certainty and a disciplined and ring-fenced framework for LOs to operate in India without triggering a PE risk.
Information for the editor for reference purposes only and not to be published
