Global Tax Alert | 13 February 2014

India’s Delhi High Court rules that outsourcing of services by US company to Indian affiliate does not constitute PE

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Executive summary

This Tax Alert summarizes a recent decision of India’s Delhi High court (HC) in the case of E Funds Corporation and its group entities1 on whether outsourcing of services to an Indian affiliate results in a permanent establishment (PE) in India for the Foreign Corporation (FC) under the provisions of the India-US Double Taxation Avoidance Agreement (the Treaty). The HC held that a subsidiary constitutes an independent legal entity for taxation purpose, and hence the relationship of holding-subsidiary or control exercised by a parent on its subsidiary by itself does not result in a PE of the FC in India unless the contrary is proved.

On facts, the outsourcing of activities to the Indian affiliate was found not to result in either a fixed place or agency PE in India. Deputation of employees of the FC to carry out stewardship activities to protect the interests of the FC does not result in a service PE in India. Similarly, employees of the subsidiary who work under the supervision and direction of the Indian affiliate also do not result in a service PE India. On attribution of profits, the assets and activities of the PE (and not of the subsidiary) should be considered to determine if there is any need to attribute any further profits to the PE. In the present fact pattern, as no PE was found to exist, there were no profits that could be taxed in India and further no income of the subsidiary could be attributed or assessed in the hands of the FC.

Detailed discussion

Background

E Funds Corporation and E Funds IT Solutions Inc. (Taxpayers) are companies incorporated and residents of USA. E Fund India (Indian affiliate) is an Indian company and an indirect wholly owned subsidiary of E Funds Corporation. All the three companies are part of the same group.

The Taxpayers were engaged in the business of electronic payments, ATM management services, decision support and risk management. The Indian affiliate supported the Taxpayers as its back office and also carried out data entry operations in respect of the above businesses of the Taxpayers.

The Tax Authorities contended that the Taxpayers had a taxable presence in India as per the Indian Tax Laws (ITL) by way of business connection as well as a PE as defined under Article 5 of the India-USA Treaty. On appeal, the Tribunal upheld the Tax Authorities’ contention that a PE exists. However the Tribunal did not agree with the method of attribution adopted by the Tax Authority in estimating profits attributable to the PE.2

The Taxpayers as well as the Tax Authority appealed to the HC against the ruling of the Tribunal.

HC’s Ruling

Business Connection

The Indian affiliate was providing information and details to the Taxpayers for the purpose of entering into contracts with third parties. Subsequently the said contracts were also performed fully or partly by the Indian affiliate as an assignee or sub-contractor. Therefore, based on the ratio of Supreme Court decisions in R.D. Aggarwal and Company3 and Ishikawajma-Harima Heavy Industries Ltd,4 a business connection of the Taxpayers did exist in India. However, as the Taxpayers were residents of the US, they could apply the more beneficial provisions under the Treaty where a threshold of PE needs to be crossed for the Taxpayers to be taxable in India.

Whether the mere existence of a subsidiary constitutes a PE

The existence of a subsidiary does not, of itself, constitute that subsidiary a PE of its parent, until the opposite is proved. It is a general legal principle that a subsidiary constitutes an independent legal entity for the purpose of taxation. It is different from a FC, which directly carries on business through its own branches/ offices, and personnel.

Factors not relevant in determining whether the Taxpayers had a PE in India

The HC held that the factors considered by the Tax Authorities for contending that the Taxpayers had a PE in India such as: (i) ;Taxpayers and its Indian affiliate were closely connected; (ii) the Indian affiliate provided services to and was dependent on the Taxpayers for its earnings; (iii) the Indian affiliate did not bear sufficient risk; (iv) intangible software was provided by Taxpayers to the Indian affiliate free of cost, and (v)& Taxpayers were sub-contracting work/services to India, with an intent and purpose to save costs and to increase profitability are not relevant in deciding whether the Taxpayers had a PE in India.

Fixed Place PE

The Taxpayers did not have any assets or a licensed office as their presence in India. The fact that the Indian affiliate provides various services to the Taxpayers and was dependent for its earning on the two Taxpayers was not the relevant test to determine and decide location PE. The fact that the Indian affiliate was remunerated on a cost plus mark-up basis, or the allegation that the Indian affiliate does not bear sufficient risk, is irrelevant in determining the existence of fixed place PE. Assignment or sub-contract of an agreement to the Indian affiliate is also not a factor which is to be considered to determine existence of fixed place PE. There was no evidence that the Taxpayers had the “right to use” or “disposal right” over the premises of the Indian affiliate. Hence, even though the Indian affiliate was carrying on core activities for the Taxpayers, it would not constitute a Fixed place PE of the Taxpayers in India.

Reliance was also placed on the Supreme Court’s (SC) decision in Morgan Stanley & Co.5 The SC had observed that back office operations by the Indian subsidiary to the parent to support the main office functions and IT enabled services such as data processing and support center do not satisfy the requirement of “carrying on the business of parent in India” through such fixed place. Hence the activities of subsidiary do not result in a fixed place PE of its parent.

Service PE

The Indian affiliate was a service provider to the Taxpayers. Thus, merely because the Taxpayers, to protect their interest, for ensuring quality and confidentiality had sent its employees to provide stewardship services, will not make the Indian subsidiary, a PE of the Taxpayers in India. The nature and functions performed by the seconded employees and who exercises control and supervises them needs to be examined. If such employees provided stewardship function, no PE exists for the FC seconding such employees.

The words “employees“ and “other personnel” have to be read along with the words “through” and furnishing of services by the Taxpayers within India. The employees and other personnel must be of the Taxpayers. The employees of the Indian affiliate were de facto and de jure employed by the Indian affiliate and hence were not to be considered as employees of the Taxpayers.

In the present fact pattern, none of the employees of the Taxpayers had visited India even for a short period. Even the two employees of the Taxpayers who were transferred to the Indian affiliate were working for the Indian affiliate and their entire expenditure was also born by the Indian affiliate Hence they were not rendering any services in India on behalf of the foreign Taxpayers.

Agency PE

A subsidiary by itself cannot be considered to be a dependent agent of the parent as it would negate the overriding effect of Art. 5(6) of the Treaty that seeks to give recognition to separate legal entity principle associated with juristic incorporated enterprises. However, a subsidiary may become

dependent if it satisfies the tests provided in the Treaty for creation of an Agency PE.

As per the Treaty an Agency PE is created, when a dependent agent who has and habitually exercises an authority to conclude contracts on behalf of the principal or habitually maintains stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the principal or habitually secures orders almost wholly or wholly for the principal.

It is not uncommon for an FC to enter into contracts, assign or sub-contract work or service to its subsidiary. The subsidiary may also render services to a third party on behalf of the principal. This by itself would not lead to a subsidiary becoming a dependent agency PE of the FC in India.

Although the Indian affiliate was engaged in providing inputs and information to the Taxpayers to enable them to enter into contracts which were sub-contracted to it, it does not mean that the Indian affiliate had participated in the negotiations of the Taxpayer with the third parties.

Thus the Indian affiliate does not constitute an Agency PE of the Taxpayers as it was not authorized to conclude contracts on behalf of the Taxpayers and did not maintain any stock or merchandise or secure orders on behalf of the Taxpayers.

Implications

Globalization has led many multinational enterprises to outsource business process and

information technology services to affiliates in India. The Indian affiliates are typically set up as captive service providers, contractually insulated from significant risks and entitled to a stable return for their services. Whether such arrangements could result in a PE for the foreign enterprises and the attribution of profits if a PE exists in such scenario has been a contentious issue in India. This decision provides guidance on the issues that are relevant as well as factors that are not relevant in making this determination.

The HC has ruled that the premises or facility of the Indian affiliate that provides services to its foreign group company under a sub contract arrangement does not by itself result in a PE of the foreign enterprise. The ruling clarifies that even if the core activities of the foreign enterprise are outsourced to an Indian affiliate under a sub contract arrangement, with the Indian affiliate bearing limited risk, it should not create a PE for the foreign enterprise if the foreign enterprise does not have right of use of the premises or facility from the services are delivered. The ruling also confirms that visits by personnel of the foreign enterprise for stewardship activities or secondment of personnel who work under the direction and control of the Indian affiliate should not result in a PE under the service PE rule.

Multinational enterprises that outsource functions to Indian affiliates should review the impact of this ruling on their existing outsourcing arrangements.

Endnotes

1. TS-63-HC-2014 (DEL).

2. See EY International Tax Alert, Delhi ITAT rules on constitution of PE in case of outsourcing of services to an Indian affiliate and on attribution of profits to such a PE, dated 26 November 2010.

3. [1965] 56 ITR 20.

4. [2007] 288 ITR 408.

5. 292 ITR 416. See EY Alert dated, 22 October 2008.

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP (India), Mumbai
  • Sudhir Kapadia
    +91 22 6192 0900
    sudhir.kapadia@in.ey.com
Ernst & Young LLP (India), Hyderabad
  • Jayesh Sanghvi
    +91 40 6736 2078
    jayesh.sanghvi@in.ey.com
Ernst & Young LLP (United Kingdom), Indian Tax Desk, London
  • Nachiket Deo
    +44 20 778 30862
    ndeo@uk.ey.com
Ernst & Young Solutions LLP, Indian Tax Desk, Singapore
  • Gagan Malik
    +65 6309 8524
    gagan.malik@sg.ey.com
Ernst & Young LLP, Indian Tax Desk, New York
  • Tejas Mody
    +1 212 773 4496
    tejas.mody@ey.com

EYG no. CM4177