Global Tax Alert | 10 July 2013
Mumbai appellate Tribunal rules on dependent agency permanent establishment
This Tax Alert summarizes a recent ruling of the Mumbai Income Tax Appellate Tribunal (ITAT)1 in the case of Varian India Pvt Ltd, a US company with an Indian Branch (Taxpayer). The Taxpayer is engaged primarily in the marketing and distribution of products manufactured by its group entities worldwide, resident in countries such as Australia and Italy.
On the facts, the ITAT held that the distribution and representation activities of the Indian branch such as serving as a liaison, marketing and promotion of products of its group entities does not create a permanent establishment (PE) in India for any of the group entities. Since the Indian branch represents many group entities, its activities cannot be said to be devoted wholly or almost wholly on behalf of one particular enterprise. Further, its transactions with its group entities were determined to be at arm's length. Accordingly, it cannot be considered as a dependent agent of any of the enterprises it represents. In the absence of a PE, the force of attraction rule under the India-US Double Taxation Avoidance Agreement (US DTAA), the India-Australia Double Taxation Avoidance Agreement (Australia DTAA), and the India-Italy Double Taxation Avoidance Agreement (Italy DTAA) cannot be applied.
Varien India Pvt Ltd (VIPL) is a company incorporated in the US and is a wholly owned subsidiary of Varian Inc., USA. VIPL has only one Indian Branch that is primarily engaged in the distribution of Varian products manufactured by Varian Group of Companies (VGCs) from all over the world.
The Indian branch has a Distribution and Representation Agreement (DRA) with five of its VGCs. Under this arrangement, the Indian branch is engaged in two types of sales activities. The first one being direct sales in which the Indian branch directly imports products from VGCs and sells them to Indian customers on a principal-to-principal basis. The second is the indent sale activity where the products are directly sold by the VGCs to the Indian customers but the Indian branch carries out pre-sale activities like liaising, marketing and other incidental post-sale support activities for which it is entitled to a commission. Incomes from both these activities have been subject to tax in India by the Indian branch of VIPL.
The Tax Authority however assessed an additional 10% of the profit margin of three of the VGCs (US, Australia, and Italy) as additional income of the Indian branch on the basis that the Indian branch constitutes a dependent agency PE (DAPE) of these companies. Accordingly, it attributed the additional assessment of the group companies by invoking the force of attraction rule under the relevant DTAAs (India's DTAAs with the US, Australia, and Italy).
The Taxpayer contended that the whole arrangement under the indent sales mechanism was promotion and sales support services of the various products of its group companies and it was not acting as a dependent agent for any of the VGCs. Further, the transaction between entities was at arm's length and this was affirmed by the Transfer Pricing Officer (TPO). Therefore no PE arises in India in the instant case and accordingly the question of attribution of additional profits to a DAPE does not arise.
The First Appellate Authority upheld the Tax authority's view. It held that VIPL through its Indian branch acts as a dependent agent of the VGCs and all the conditions given in the relevant articles of the respective DTAAs were met. On application of domestic provisions of ITL for attributing the profits, the First Appellate Authority confirmed the rate of 10% on operating profit assessed by the Tax Authority.
The Taxpayer appealed before the ITAT, the Second Appellate Authority.
Mumbai ITAT ruling
Dependent Agency PE
In order to treat an agent as a PE within the meaning of Article 5(4) and 5(5) of the US DTAA, such agent must fit into the description of “dependent agent” and has to perform at least one of the activities mentioned in Article 5(4). Otherwise, it cannot be held that the agent constitutes a PE of the foreign enterprise.
Under Article 5(4) of the US DTAA, a person is said to be a dependent agent only when one of the following three conditions is satisfied:
- • Has and is habitually exercising an authority in India to conclude contracts on behalf of the US enterprise.
- • Has no such authority but habitually maintains stock of goods in India from which goods are regularly delivered on behalf of the US foreign enterprise and some additional activities are carried out in India contributing to the sale of goods.
- • Habitually secures orders in India wholly or almost wholly for the US enterprise.
The language in the Australia DTAA and Italy DTAA are similar. Additionally these DTAAs also include the activity of manufacturing or processing goods belonging to the foreign enterprise.
In the present fact pattern, the Indian branch does not book the indent sale and corresponding purchase in its books of account because it is not a party to any legal contract with the VGC's Indian customers. It does not take any title or own any risk of loss in relation to such products and it also does not issue any invoice to the Indian customers or collect funds from them. Therefore, the test of covered activities for a DAPE fails for the following reasons:
- • Indent sale orders booked are not binding on the VGCs as they may accept or reject the orders completely at their own discretion. From the DRA, it is clear that the Taxpayer has no authority and also cannot negotiate or conclude contracts on behalf of the VGCs. It further does not have any power or authority to act for or bind or commit the supplier for any of the activities carried out in India. For its support activities, the Indian branch is only entitled to a certain percentage as commission on sales made directly by the VGCs from Indian customers.
- • The Taxpayer mainly facilitates the sale process. The title of the goods supplied by the VGCs is directly passed on to the Indian customers and the Taxpayer neither undertakes any risk or title of the product at any point of time.
- • The order relating to indent sale are only introduced and coordinated by the Taxpayer. The Taxpayer does not secure it. The orders are not binding on the VGCs until accepted by them. The Taxpayer has no authority to accept orders on behalf of any of the VGCs. Also, the Taxpayer does not deal with Varian Inc alone, but deals with multiple group entities.
- • In addition, none of the risks like market, product liability, R&D, credit, price, inventory or foreign currency is undertaken by the Taxpayer. Thus, the Taxpayer does not assume any kind of risk on behalf of the VGCs.
- • The Taxpayer also does not manufacture or process any other products developed or manufactured by the VGCs.
The Taxpayer only performs administrative support functions and does not perform functions as are envisaged under Article 5(4) of the US DTAA and the corresponding provisions in the Australia and Italy DTAAs.
Article 5(5) of the US DTAA lays down twin conditions, which need to be simultaneously satisfied to result in an agency PE.
- • First,the activities of such an agent are devoted wholly or almost wholly on behalf of the enterprise; and
- • Second, the transactions between the agent and enterprise are not made under the arm's length conditions.
A review of sales data for two years indicates that the percentage of commission income and sales from the three VCGs appear normal and with regard to Varian Inc. US, the activities of the Taxpayer as a proportion of total sales of the group in India are in the range between 5% to 7%. Therefore, it cannot be said that the Taxpayer is devoted wholly or almost wholly on behalf of any one VGC.
With respect to the second condition, the TPO found that the Taxpayer's transactions were at arm's length price which recognizes the fact that the Taxpayer was compensated by the VGCs at arm's length. Even the Tax Authority did not adversely hold that compensation in the form of commission was not at arm's length. The second condition also was not met.
Subsidiary as PE
Even if the Taxpayer is a 100% subsidiary of Varian Inc, VIPL or its Indian branch that would not automatically constitute a PE of Varian Inc in India. This is clear from Article 5(6) of the US DTAA that states that the mere existence of a subsidiary does not by itself constitute the subsidiary company as a PE of the parent. Hence the Indian branch of VIPL cannot be held to constitute a PE for Varian Inc, or any other VGCs.
ITAT also distinguished the decision of the Delhi High Court in case of Rolls Royce PLC2 on the basis that the facts of the case where not similar to the present case.
Application of the “force of attraction” rule
To fall within the ambit of the “force of attraction rule,” two basic requirements need to be satisfied:
(i) The foreign enterprise should have a PE in India for the purpose of selling goods and merchandise; and
(ii) The direct sale by the foreign enterprise is the same or similar kind of goods or merchandise as sold by the PE in India.
In this case, the Taxpayer does not constitute a PE for any of the VGCs. Therefore, the “Force of Attraction Rule” does not apply. Accordingly, attribution of 10% profit margin on the basis of global accounts of VGCs is not valid and was overturned on appeal.
In a global business environment, multinational companies often engage with affiliates. This ruling reaffirms the general principles for determining the existence of PE under the Agency PE Rule. The ITAT ruled that merely because one of the foreign group companies has an Indian branch, it cannot be held to be an agent of all the group companies that it represents in India unless the conditions laid down under the Agency PE rule are fulfilled. The ruling also clarifies that since the Taxpayer in carrying out its pre and post sales support activities had not borne any risks arising from sales of the group companies, it cannot be considered as a dependent agency PE of the group companies.
This ruling reinforces the need for multinational companies operating in India to review the scope of their Indian operations and the nature of their inter-company relationships to make an assessment of a potential PE risk.
2. See EY Tax alert dated 12 September 2011.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (India), Mumbai
- • Sudhir Kapadia
+91 22 6192 0900
- • Hitesh Sharma
+91 22 6192 0620
Ernst & Young LLP (United Kingdom), Indian Tax Desk, London
- • Nachiket Deo
+20 778 30862
Ernst & Young Solutions LLP, Indian Tax Desk, Singapore
- • Gagan Malik
+65 6309 8524
Ernst & Young LLP, Indian Tax Desk, New York
- • Tejas Mody
+1 212 773 4496
EYG no. CM3623