Monday, April 17, 2006

India: telecommunications, PE issues and attribution of profits

Following the increased attention by tax practitioners and scholars on Indian Case-Law, I decided to analyse a recent Indian decision of 2005 dealing with permanent establishment issues and attribution of profits.

The Indian Income Tax Appellate Tribunal (ITAT) delivered last year a judgement in a high profile case featuring three of the most recognized brands of telecommunications, namely Motorola, Ericsson and Nokia (2005-TIOL-103-ITAT-DEL-SB). These cases, which deal with the taxability of income arising from the supply of equipment and software to Indian telecom operators, raise several permanent establishment (PE) issues that deserve to be analysed in more detail.

According to the facts of the cases, the companies in question entered into contracts with Indian telecom operators in India. Primarily the contracts involved the sale of hardware and software. In a second instance, there were installation contacts between the Indian telecom operators and the branch/subsidiaries of the respective non-resident companies. In addition there was marketing and business promotion agreements in place between the Indian subsidiaries/branches and the non-resident companies.

The dispute aroused because Indian tax authorities assessed the non-resident companies on the income derived from the sale of hardware and software. The tax authorities stated that the separation into three phases, namely supply, installation and marketing agreements, was intended to avoid tax. In their view, the agreements were in effect works contract and not a mere sale of goods and since the non-resident companies had a business connection in India, the income from the sale of hardware and software to Indian telecom operators was taxable in India (domestic law issue). In addition, the tax authorities contended that the non-resident companies also had a PE in India and the income from the supply of hardware and software was attributable to such PE (Treaty Issue I). Finally, the tax authorities contended that the consideration for supply of software amounted to a royalty, which would therefore be taxable in India, irrespective of whether the three non-resident companies had a PE in India or not (Treaty Issue II).

The court’s discussion of existence of a “business connection” is simply a domestic analysis and therefore we skip this issue. As regards the remaining questions, I will focus on the PE issue and leave the qualification of part of the payments made by the network operators as royalties to another opportunity.

Ericsson PE

In the Ericsson case, the contention was that since the employees of the non-resident came frequently to India and since the Indian company provided facilities to these employees, the Indian office constituted a fixed place of business for the non-resident company.

After mentioning the OECD commentary, namely to the criteria that form the PE definition, the Court noted that the tax authorities failed to establish that Eriksson India had made certain space available to its parent company at its disposal.

In other words, the Court considered that there was nothing to indicate that whenever any employee of the parent company visited India, he could straightway walk into the office of the subsidiary and occupy a space or a table!

The Physical PE argument was denied because the Court considered that it could not be said that the parent company had at its disposal, as a matter of right, certain space, which could be characterized as a fixed place of business. In order to reach its conclusion, the Court cited French case law, where a travel agency in Paris had made an office available to the German company from time to time, and the manager of the German company had a flat in Paris. In that French case, the Court held that the travel agency did not have a PE in France.

The tax authorities also attempted to argue that under the overall agreement, since the non-resident company had the overall responsibility for the commissioning of the project, the installation site constituted a PE for the non-resident in India. On this point, the court swiftly ruled out the existence of a Construction PE under Art. 5(3).

As regards to the existence of an Agency PE, the court noted the independent status of the subsidiaries, notwithstanding the fact they belong to the same group. The Court held that such subsidiaries of the non-resident company would not give rise to an Agency PE of the non-resident company since such subsidiaries do not habitually exercise, in India, an authority to conclude contracts on behalf of the non-resident company.

The Court mentioned that, event if they promote its products in India, the subsidiaries cannot bind the non-resident company in any manner. Therefore, the non-resident company decides the final terms of the sale contracts.

In order to determine if there was any type of authority to conclude the contracts on behalf of the non-resident, the Court cited Vogel which himself referred that such question (authority to bind) must be decided not only with reference to private law but must also take into consideration the actual behaviour of the contracting parties. In this case, the Court stated that there was no finding that the non-resident companies were instrumental or even participated in the negotiations with the Indian operators. As such, it could not be held that the non-resident company had an Agency PE an India. In conclusion, the Court held that no income accrued to Ericsson in India as it had no PE in India.

Motorola PE

The case of Motorola was slightly different from the case of Ericsson, where the Court held that the Indian company cannot be considered as the fixed place PE of Ericsson in India, since the Swedish company, had no right to enter the office of the Indian company for the purpose of carrying out the activities of the Swedish company.

In case of Motorola, US employees were apparently using the premises of the Indian subsidiary, working for both companies. The Court noted that the Indian subsidiary was reimbursed on a cost plus 5%, which covered bonuses given by the Indian subsidiary to the US employees. The Court held this reimbursement of expenses lead to the perception that there was a projection of the Motorola in India in the form of the place of business of its Indian subsidiary and thus there was a fixed place PE of the Motorola in India, within the meaning of Art. 5(1) of the tax treaty.

Nevertheless, the business activities of such PE (such as market survey, industry analysis, economy evaluation, product information, etc) were considered activities of preparatory or auxiliary character, which therefore excluded the existence of a PE under Art. 5(1). As such, the Court held that no PE of Motorola was constituted in India.

Nokia PE

The issue in the Nokia case was also whether its liaison office and or its subsidiary give rise to a PE of Nokia Finland in India, and if there was such a PE, what would be the income attributable to it.

The Court started by referring that the liaison office cannot constitute a PE of Nokia in India, As regards Nokia Indian subsidiary, the Court, differently from the previous cases, considered the existence of a PE of Nokia in India.

The Court argued that the Indian subsidiary is the virtual projection of Nokia in India. In that respect it noted that services rendered by Nokia Indian subsidiary to its parent company under the “marketing agreement” were compensated on the basis of cost plus 5%. The court referred that because of the close connection between the parent company and its subsidiary, it was possible to look upon Nokia Indian subsidiary as a "virtual projection" of Nokia in India. Several facts/factors contributed to the existence of a PE in Nokia’s case

Differently than Motorola, where the PE was deemed not to exist because of the preparatory or auxiliary character of Motorola activities in India, the activities of Nokia were considered to be in nature something more than preparatory or auxiliary. Unfortunately, the Court was not very detailed on this aspect of the decision

The next question related to the attribution of the income. Under Indian domestic law, all income accruing or arising, whether directly or indirectly, through or from any business connection in India shall be deemed to accrue or arise in India. Now the question is “how much” India could tax under the respective tax treaty.

The Court started by referring that Art. 7 (1) states that profits of an enterprise of Finland shall be taxable only in Finland, unless the enterprise carries on business in India through a PE situate therein. In the enterprise carries on business in India through a PE, the profits of the enterprise may be taxes by India, but only so much of the profits as are attributable to the PE.

As regards the attribution of profits to the PE of Nokia, the Court enumerated the activities which Nokia carried on in India through its PE, namely network planning, negotiations in connection with the sale of equipment, and signing of the supply and installation contracts.

The Court, in order to reach the amount attributable to the PE, referred to principles included in previous judgments. Under the first mentioned judgment, the income attributable to manufacturing activity should be more then the income attributable to the activity of sale. Under another judgment 10% of the income can be attributed to the signing of the contracts in India.

The Court reasoned, taking into account such principles, that in addition to the 10% of income to be attributed in respect of the signing of contracts, a higher income should be attributable to compensate with the two additional activities carried out by the PE (negotiations and network planning).

The Court applied a two-step method to compute the income attributable to the PE. First it determined the global net profit ratio of the contract for supply of both, equipment and software. Secondly, it determined that 20% of the respective net profit would be the adequate attributable amount in order to cover the three activities of the PE.



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