The attribution of profits to a permanent establishment (PE) has long been a contentious international tax issue. For example, a situation may arise where a PE generates profits from its activities, but losses are incurred at the global level, which gives rise to the question whether any profit should be attributed to the Indian PE. In a noteworthy decision issued by the full bench of the Delhi High Court (Delhi HC) on 19 September 2024, the court concluded that an Indian PE of an overseas entity must be treated as an independent taxable entity and the source state has the right to tax its profits. Moreover, a PE’s activities should be independently evaluated for purposes of attributing profits, irrespective of any profit or loss at the global level for the taxpayer. The Delhi HC further clarified that profit attribution is based on the activities conducted in India, regardless of the foreign entity’s global financial performance.
Double tax avoidance agreements (DTAAs) typically provide that income may be taxed on the basis of a source rule or a residence rule. Unless the income (such as royalties, fees for technical services, etc.) is covered by a specific article in the relevant DTAA, the income of a multinational enterprise (MNE) can be taxed only if it has a PE or a business connection in India.
As per India’s DTAAs, where a foreign company has a PE in India, only the income that is attributable to the PE is taxable in India. However, as noted above, a situation may arise where the foreign company incurs losses at the global level even though the PE has positive income. In such cases, it becomes pertinent to understand how the profit attribution mechanism would function.
The Delhi HC constituted a full bench to revisit its 2022 decision in the Nokia Solutions & Networks OY case, where the court held that profit attribution to a PE in India was necessary only if the entire enterprise earned profits—attribution was not warranted if the global entity incurred losses.
The case before the Delhi HC involved a foreign company (the taxpayer) that was incorporated in the United Arab Emirates (UAE) and had a PE in India. The head office provides management services to various hotels, including hotels in India and the Indian PE manages specific hotel properties.
During the relevant FY, the foreign head office incurred losses from its global operations and took the position that no profit should be attributed to its Indian PE. The Indian tax authorities sought to attribute profits to the PE under article 7 of the India-UAE DTAA. The taxpayer contested this attribution relying on the Nokia Solutions decision, arguing that since the global entity was in a loss-making position, no income should be attributed to the Indian PE and it filed a petition with the court with respect to the applicability of article 7(1).
The Delhi HC rejected the taxpayer’s argument, ruling that the PE must be treated as a distinct and separate entity for tax purposes. The court emphasised that any profits generated by the PE in India could be taxed, irrespective of the global losses incurred by the head office. This conclusion diverges from the court’s decision in Nokia Solutions.
In reaching its decision, the Delhi HC referred to Klaus Vogel’s esteemed treatise on double tax conventions and the court overturned its decision in Nokia Solutions. The court held as follows:
Indian tax officers apply Rule 10 of the Income-tax Rules, 1962 (IT Rules) to attribute profits to a PE. With a view to ensuring more clarity and predictability in this area, the Central Board of Direct Taxes established a committee to examine how profits are attributed under a DTAA and recommend changes. The committee issued a draft report in 2019 (a final report is still awaited), recommending a mixed approach as follows:
The existence of an MNE in India has always been a contentious issue and the attribution of income has frequently been subject to litigation. Following a comprehensive analysis, the Full Bench of the Delhi HC has confirmed that a PE should be treated as a separate and independent entity and accordingly profit should be attributed to it, a conclusion that is in line with the OECD Commentary and the India-UAE DTAA. The court also observed that in the converse situation (i.e., where the PE has incurred losses and the MNE has earned profits), the tax authorities would have the power to tax even in a case where the entity is profitable and the PE incurred losses, which is not the import of article 7 of the DTAA.
Further, it should be noted that some of India’s DTAAs contain a “force of attraction” clause, under which profits of a PE, as well as profits from the sale of similar goods/business activities (as done through a PE), are taxed in the host country. Although the India-UAE DTAA does not contain a force of attraction clause, it may be necessary to analyse whether the Delhi HC decision would apply where a DTAA does contain such a clause.
Companies doing business in India should comprehend the Delhi HC decision as it highlights the need for MNEs to fully understand and comply with Indian tax obligations, regardless of their financial performance at the global level.
Jagat Mehta
Mihir Gandhi
Shilpa Sethia
BDO in India
Background
Double tax avoidance agreements (DTAAs) typically provide that income may be taxed on the basis of a source rule or a residence rule. Unless the income (such as royalties, fees for technical services, etc.) is covered by a specific article in the relevant DTAA, the income of a multinational enterprise (MNE) can be taxed only if it has a PE or a business connection in India.As per India’s DTAAs, where a foreign company has a PE in India, only the income that is attributable to the PE is taxable in India. However, as noted above, a situation may arise where the foreign company incurs losses at the global level even though the PE has positive income. In such cases, it becomes pertinent to understand how the profit attribution mechanism would function.
The Delhi HC constituted a full bench to revisit its 2022 decision in the Nokia Solutions & Networks OY case, where the court held that profit attribution to a PE in India was necessary only if the entire enterprise earned profits—attribution was not warranted if the global entity incurred losses.
Facts of the Case
The case before the Delhi HC involved a foreign company (the taxpayer) that was incorporated in the United Arab Emirates (UAE) and had a PE in India. The head office provides management services to various hotels, including hotels in India and the Indian PE manages specific hotel properties.During the relevant FY, the foreign head office incurred losses from its global operations and took the position that no profit should be attributed to its Indian PE. The Indian tax authorities sought to attribute profits to the PE under article 7 of the India-UAE DTAA. The taxpayer contested this attribution relying on the Nokia Solutions decision, arguing that since the global entity was in a loss-making position, no income should be attributed to the Indian PE and it filed a petition with the court with respect to the applicability of article 7(1).
Delhi HC’s Decision
The Delhi HC rejected the taxpayer’s argument, ruling that the PE must be treated as a distinct and separate entity for tax purposes. The court emphasised that any profits generated by the PE in India could be taxed, irrespective of the global losses incurred by the head office. This conclusion diverges from the court’s decision in Nokia Solutions.In reaching its decision, the Delhi HC referred to Klaus Vogel’s esteemed treatise on double tax conventions and the court overturned its decision in Nokia Solutions. The court held as follows:
- The concept of a PE enables the allocation of taxing rights to the source country. It creates a functional relationship and connection between the principal entity and the place of business whose activities give rise to the income or profit. It is this fictional creation of an independent economic centre in a contracting state that informs the allocation of taxing rights.
- Once a DTAA confers an independent identity on a PE, it would be erroneous to answer the question of taxability based either on the activities or profitability of the parent or the entity that “seeds” and sustains the PE.
- Article 7(1) of the DTAA envisages the profits of a PE being liable to be independently taxed notwithstanding that the PE is a constituent of a larger enterprise, which may be domiciled in the other contracting state.
- Article 7(2) clearly provides that where an enterprise carries on business through a PE in the other contracting state, profits would be liable to be attributed to that PE as if it were a distinct and separate enterprise engaged in similar activities and independent of the enterprise of which it may be a part.
- The OECD Commentary to the model tax treaty explains that the taxation rights of the source state depend on the existence of a PE.
- The profits of an enterprise do not become subject to tax unless it is determined that it functions in the other contracting state through a PE.
- As noted in the OECD and UN Commentaries, it would be incorrect to base taxation on the overall activities or profitability of an enterprise.
- The source state is ultimately concerned with the income or profit that arises or accrues within its territorial boundaries and the activities undertaken therein.
- Article 7 does not expand its scope to the overall operations or profitability of an MNE. It is concerned only with the profits or income attributable to the PE.
Committee Report on Rule 10 and Delhi HC Decision
Indian tax officers apply Rule 10 of the Income-tax Rules, 1962 (IT Rules) to attribute profits to a PE. With a view to ensuring more clarity and predictability in this area, the Central Board of Direct Taxes established a committee to examine how profits are attributed under a DTAA and recommend changes. The committee issued a draft report in 2019 (a final report is still awaited), recommending a mixed approach as follows:
- Determining the profits derived from the Indian operations of the enterprise. Where the enterprise incurs global losses or if its global operational profit margin is less than 2%, the profits derived from India will be deemed to be 2% of the revenue or turnover derived from India.
- Attributing profits from the Indian operations of the enterprise to the PE based three factors, i.e., sales (33% weight) and manpower and assets (combined 67% weight).
- Deducting any profits from the Indian operations of the enterprise any profits that have already been taxed in India.
BDO Insights
The existence of an MNE in India has always been a contentious issue and the attribution of income has frequently been subject to litigation. Following a comprehensive analysis, the Full Bench of the Delhi HC has confirmed that a PE should be treated as a separate and independent entity and accordingly profit should be attributed to it, a conclusion that is in line with the OECD Commentary and the India-UAE DTAA. The court also observed that in the converse situation (i.e., where the PE has incurred losses and the MNE has earned profits), the tax authorities would have the power to tax even in a case where the entity is profitable and the PE incurred losses, which is not the import of article 7 of the DTAA.Further, it should be noted that some of India’s DTAAs contain a “force of attraction” clause, under which profits of a PE, as well as profits from the sale of similar goods/business activities (as done through a PE), are taxed in the host country. Although the India-UAE DTAA does not contain a force of attraction clause, it may be necessary to analyse whether the Delhi HC decision would apply where a DTAA does contain such a clause.
Companies doing business in India should comprehend the Delhi HC decision as it highlights the need for MNEs to fully understand and comply with Indian tax obligations, regardless of their financial performance at the global level.
Jagat Mehta
Mihir Gandhi
Shilpa Sethia
BDO in India