Introduction
A. 7(1) of the India-United States Double Taxation Avoidance Agreement (‘DTAA’) states that the business income of companies incorporated in the US shall be taxable only in the US unless they have a Permanent Establishment (‘PE’) in India. In such cases, the income attributable to the PE may be taxed in India.
In the case of Director of Income-tax (International Taxation) v. Western Union Financial Services Inc.[i], the Delhi High Court addressed whether the ‘preparatory’ or ‘auxiliary’ activities conducted by the liaison office[ii] (‘LO’) of a US-based company could give rise to a PE in India. The Court also provided a detailed analysis of as. 5(2) and 5(3) of the DTAA and explaining their applicability.
Brief Facts
The respondent-assessee, a non-resident company registered in the US, has been engaged in the business of rendering money transfer services since 1890. The assessee’s operational process involved customers in the US transferring money in US dollars through the assessee’s outlets, whereby a unique Money Transfer Control Number (‘MTCN’) is generated and shared with the recipient in India. Recipients in India would approach the assessee’s agents, who verify the MTCN and disburse the funds after completing identity verification. To facilitate these transactions, the assessee appointed various commercial banks, Non-Banking Financial Companies (NBFCs), and tour agents as agents who earned commissions for their services.
The assessee established an LO in India after obtaining the necessary permission from the Reserve Bank of India (‘RBI’) under s. 29(1)(a) of the Foreign Exchange Management Act, 1973 (FEMA). The LO’s stated purpose was to act as a communication channel between the assessee’s headquarters and Indian agents, who were prohibited from engaging in commercial or industrial activities. Further, the LO submitted periodic activity reports to the RBI, disclosing training initiatives, software updates, and refresher courses for agents.
On 04.03.2004, the Assessing Officer (‘AO’) issued a notice to the respondent under s. 143(2) of the Income-tax Act, 1961 (‘IT Act’), alleging that income had arisen in India, thereby making it taxable. The AO relied on a. 5 of the DTAA to support this claim and held that the assessee had a PE in India based on a fixed place of business, Dependent Agent PE (‘DAPE’), and the ‘Voyager’ software installed in agents’ offices. The respondent challenged this before the Commissioner of Income Tax (Appeals) [‘CIT(A)’], who upheld the AO’s view, holding that the software ‘Voyager’, used by the LO, constituted a PE.
The matter subsequently escalated to the Income Tax Appellate Tribunal (‘ITAT’), which ruled in favour of the respondent. While it acknowledged that the LO passed the ‘business connection’ test, the ITAT held that its activities were merely ‘preparatory’ or ‘auxiliary’ in nature. An appeal was filed before the Delhi High Court against this decision by the Revenue.
The Revenue argued that the LO engaged in core business activities and that the software used played a central role in completing transactions, thus constituting a fixed place of business, i.e., a fixed place PE.
The respondent contended that the activities undertaken by the LO were limited to providing support services, such as training agents and facilitating communication between Indian agents and the principal company in the US. They also submitted that the software ‘Voyager’ merely assisted Indian agents in verifying transaction details and did not constitute a taxable presence.
Issues
Does training agents in India, interacting with local agents, conducting refresher courses, accounting, reconciliation, and aiding agents constitute a PE?
Does the installation of software at the LO in India establish a PE?
Held
The Delhi High Court dismissed the Revenue’s appeal. It noted that the LO in India did not have the authority to conclude contracts on behalf of the assessee, which is a key factor in determining whether the LO constitutes a PE. It further noted that the Indian agents were remunerated at arm’s length, thereby indicating that they acted independently, and the LO did not interfere with their activities to such an extent as creating a PE. The High Court held as follows:
There exists a difference between the positive inclusions in a. 5(2) and the negative exclusions in a. 5(3) of the DTAA. A. 5(1) of the DTAA defines PE, and a. 5(2) provides a positive list of establishments that qualify as a PE. A. 5(3), in contrast, excludes certain types of activities from constituting a PE, provided specific conditions are satisfied.
A. 5(3) begins with a non-observant clause and enumerates activities deemed not to constitute a PE, under which the LO, in this case, fell. One such exclusionary clause is found in a. 5(3)(e), which states that maintaining a fixed place of business solely for activities of a ‘preparatory’ or ‘auxiliary’ character does not constitute a PE.
The terms ‘preparatory’ or ‘auxiliary’ refer to marginal or incidental activities to the enterprise’s overall business plan. The characterisation of such activities depends on their type, sector, and intensity compared to the core business of the enterprise. Activities such as market research, promotional efforts, training, and software deployment did not breach the threshold of ‘preparatory’ or ‘auxiliary’ functions.
Software like ‘Voyager’ does not constitute a tangible PE under as. 5(1) and 5(2) of the DTAA, as these provisions focus on tangible premises and establishments, such as a place of management, branch, office, factory, or workshop. Intangible assets, such as software, lack the physical attributes required to meet the definition of a PE. In this case, the software was merely a tool for verifying and communicating transaction details and, hence, did not contribute to the core business activity of the assessee.
Our Analysis
This ruling provides crucial clarity for multinational corporations operating in India under the DTAA. The Court emphasized the distinction between core business activities and those considered ‘preparatory’ or ‘auxiliary’, clarifying that only activities integral to the company’s main operations constitute a PE. Notably, the High Court heavily relied on Klaus Vogel’s work[iii] on international taxation in rendering this decision.
The Court acknowledged the dynamic nature of international business and rightly held that merely using software or engaging in support functions does not create a taxable presence in India by itself. It also recognized the principle that Indian agents remunerated at arm’s length under transfer pricing (TP) guidelines do not attribute income to the LO. This decision is particularly beneficial for foreign companies, as it provides assurance that certain limited activities – when carefully structured – will not result in unexpected tax liabilities.
The judgment sets a significant precedent for determining the scope of PEs under the DTAA. It highlights the importance of analyzing the character and intent of activities undertaken by foreign entities in India. This ruling strikes a balance between preventing excessive tax burdens on foreign businesses and ensuring a fair tax environment for both domestic and international entities. The judgment fosters greater certainty and predictability in international tax matters by clearly delineating the scope of ‘preparatory’ and ‘auxiliary’ activities.
End Notes
[i] 2024 SCC OnLine Del 8913.
[ii] Regulation 2(e), Foreign Exchange Management (Establishment in India of a branch office or a liaison office or a project office or any other place of business) Regulations, 2016.
[iii] Klaus Vogel on Double Taxation Conventions, Edited by Ekkehart Reimer and Alexander Rust,
Wolters Kluwer, 5th edition, Vol. 1, 2022.
Authored by Aayan Birla at Metalegal Advocates. The views expressed are personal and do not constitute legal opinions.