Permanent Establishment – An independent taxable entity distinct from the global entity

With the advent of globalization, businesses have increasingly structured their operations to function across multiple jurisdictions. This expansion has led to the issue of income being subject to taxation in more than one jurisdiction. To address this, double taxation avoidance agreements (DTAA) were established, ensuring that the income is taxed only in the state where the business primarily resides.

DTAAs also incorporate the concept of a Permanent Establishment (PE), which includes a fixed place of business through which the operations of an enterprise are wholly or partly carried out in another jurisdiction (distinct from the home country of the entity). Existence of a PE in a foreign jurisdiction has introduced complexities in attribution of income, as tax authorities in such foreign jurisdiction seek to tax the entire income generated by the PE within their territory. This situation leads to disputes over attribution of profits to the PE, particularly in situations where the enterprise at a global level incurs a loss and the PE in the foreign jurisdiction is profitable.

On this issue, recently, the full bench of Hon’ble Delhi High Court (High Court) in the case of Hyatt International Southwest Asia Ltd. v. ADIT has dealt with taxability of profit attributable to a permanent establishment, when the enterprise at the global level is incurring losses.

In this article, we have discussed the ruling of the High Court in the ensuing paragraphs.

Facts

The taxpayer i.e., Hyatt International Southwest Asia Ltd., is a company incorporated in UAE. It had entered into two Strategic Oversight Services Agreements (SOSA) with Asian Hotels Ltd., in India. These agreements were entered into to ensure that the hotel (in India) was developed and operated as an efficient and high quality international full-service hotel. The taxpayer filed its return of income declaring nil income. However, the Assessing Officer (AO) computed the tax payable and held that the taxpayer (i) has a PE in India; (ii) has provided its proprietary, written knowledge, skill, experience, operational and management information and associated technologies etc. Therefore, the service fee received by the taxpayer under SOSA will constitute as royalties and fee for technical services and will be taxed in India in accordance with Article 7 of the India-UAE Double Taxation Avoidance Agreement (DTAA). 

Aggrieved by the order of the AO, the taxpayer filed an appeal before the division bench of the High Court. The High Court held that (i) the income of the taxpayer is in the nature of business income and cannot be termed either as royalty or fees for technical services; (ii) the taxpayer has a permanent establishment in India, in consonance with the view taken by the AO.

In addition to this, the taxpayer relying on the case of CIT (International Taxation) v. Nokia Solutions and Networks, argued that even if it has a PE in India, there is no question of attribution of profits to the PE because the enterprise has incurred losses at the global level. The High Court referred this issue to a larger bench for consideration. Thus, the full bench of High Court has discussed in detail whether PE is an independent taxable entity, to determine the tax payable on the profits attributable to such PE.

Background

Prior to this, in the case of Nokia Solutions (Supra), the issue of attribution of profits to PE had come for consideration and the High Court had taken a view that for computing profits attributable to a PE, net profit margins of enterprise at the global level were to be applied and since the enterprise recorded a global net loss in relevant assessment year, no profit would be attributable to a PE. Further, the High Court had also ruled that “on a plain reading of Article 7(1) of the DTAA, the question of attributing profits to the PE arises only if the foreign enterprise is making a profit. This is the condition precedent. If it is making a loss, then no question arises at all of attributing any profit to the P.E., which would be taxable in India”.

Ruling of the High Court

Permanent Establishment – An independent taxable entity

Article 5 of the DTAA defines the expression PE and encompasses a wide range of establishments and which are not necessarily separate legal entities. Establishments included within the ambit of PE include a range of establishments including from place of management to a mine or a building site and thus not being confined to a juridical entity as is ordinarily understood in law.

Any PE comes into existence as soon as the establishment commences business through a fixed place of business. It ceases to exist with the disposal of such fixed place of business or with the cessation of any activity through it i.e., when all the acts and measures connected with former activities of PE are terminated. Accordingly, the concept of PE is based upon the undertaking of economic activity in a particular country irrespective of the residence of such enterprise.

Pursuant to this, the Court observed that “Any entrepreneurial activity which gives rise to income or profit thus becomes liable to be taxed at source irrespective of the ultimate recipient or owner of that income. Source here would mean the location which gives rise to the accrual of profits or income, or which is the location where the same arises. The PE principle thus enables the assignment of tax to the State which constitutes the source. The PE concept thus creates a functional relationship and connects 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 center in a Contracting State which informs the allocation of taxing rights.”

Further, when an entity is domiciled in a contracting state and undertaking the business therein, it is viewed as a unit which is contributing to the economic life of that State and thus identified as an independent profit or revenue earning center which is liable to be taxed. This appears fairly logical as the right of taxation which is inherent to the source state is connected to the economic life of the global enterprise. This connection is established by virtue of the existence of a PE within the source state. Consequently, the Court ruled that “the existence and identity of the PE is separate and distinct and subject to tax to the extent of activities that it may undertake in a State distinct from that of its principal.”

Interpretation of Article 7 of the DTAA

Article 7 stipulates that the profits of an enterprise shall be taxable only in that state, restricting the taxation of profits of an enterprise only to and in the state of which the enterprise is a resident. However, a cross-border entity may structure its operations in a manner where it operates in more than one taxing jurisdiction. Therefore, by virtue of the use of words ‘unless’ which precedes Article 7, it takes into account the existence of a PE in the other contracting state and expands the scope of taxability.

The Court observed that “Article 7 proceeds to clarify that if the enterprise were carrying on business through a PE in the other Contracting State, its profits to the extent attributable to that PE would become subject to tax in the other State.” Accordingly, a clear distinction is created between the profits that may be earned by an enterprise globally and those which are attributable to a PE domiciled in the Contracting State.

This has been further clarified through Article 7(2) employing the phrase “dealing wholly independently with the enterprise of which it is a permanent establishment”.  Accordingly, a PE shall be viewed as a distinct and separate entity, and it would be incorrect to combine the income of the global enterprise with the income of PE generated in one of the contracting states.

Conclusion

Applying the ‘source based’ theory of taxation, the High Court has unequivocally held that profits earned, or losses incurred at the global level cannot be a basis for taxation of income generated by the PE domiciled in the other contracting state. Activities of the PE shall be independently evaluated and ascertained in light of the language used in Article 7 of the DTAA. Ratio laid down in the judgment will be useful for a PE having losses in India, but generating profits globally. It is likely that businesses may need to be restructured for whom this judgment affects adversely, if there is significant outgo of taxes in India i.e. whether the operations should be continued through a PE or tax efficiency can be achieved by operating through an incorporated entity in India.

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