Pitfalls from cross-border services: where is the source of the income?

The Indian case discussed below is not a tax treaty case simply because there is (until now) no tax treaty between India and Luxembourg.

The case involves a Luxembourg company, which approached the Indian Ruling Authority on the question of certain marketing and promotion payments received from an Indian Hotel. Due to the absence of a tax treaty, the issue was simply whether the payments in question were under Indian domestic law qualified as business income, royalty or fee for technical services (so as to be taxable in India) or whether they were mere reimbursement of expenses incurred by the Luxembourg company for the benefit of the Indian hotel (so as not to be taxable in India).

Although essentially a domestic case it is still an interesting decision for several reasons. The case decided by the Authority For Advance Ruling (AAR) in 27 November 2006 is then a good exercise to analyze not only the pitfalls of international transactions when no tax treaty is in place but also the problem of some domestic wide definitions of source of income.

1. The case facts

International Hotel Licensing Company, SARL (IHLC) is a Luxembourg company, which is part of the well-known Marriott group. IHLC is engaged in the business of promoting enterprises and is conducting international advertising, marketing and sales programs for the Marriott chain of hotels in order to promote them in the foreign markets.

In connection with the plans to setting up of an Indian hotel to be constructed, furnished and equipped in Uttar Pradesh, IHLC entered into an agreement with an Indian company (Unitech) whereby Unitech (the owner of the Hotel) would participate in the marketing business promotion programs and IHLC would provide, inter alia, advertising space in magazines, newspapers and other printed media and electronic media which would be conducted by it outside India.

The agreement made it clear that the IHLC would not conduct any specific marketing activity for the Unitech. Under the agreement, the consideration that Unitech would pay to the IHLC was an annual contribution equal to 1.5% of the gross revenues of the hotel by way of reimbursement of expenses that the IHLC would incur for conducting and coordinating the international marketing activities for Marriott chain of hotels. This would be later adjusted based on the final annual figures.

Pursuant to the agreement, the IHLC had also to provide certain special programs such as the Marriott Rewards Program, (Marriott's award winning guest royalty program) for which the participants including Unitech are charged 3.4% of a Marriott Rewards Program member's room charge (including taxes) during his/her stay at the applicable hotel.

2. The Issues

The question referred to the AAR was whether the said contributions of 1.5% (marketing and advertising) and 3.4% (reward program) received by IHLC from Unitech, in connection with the marketing and business promotion activities essentially conducted outside India, would be taxable in India.

The tax authorities rejected the argument that the fees paid were simply expenditures and raised the issue of whether the payment was for technical services or for the use of the Marriott brand. The tax authorities basically submitted that under the agreement, IHLC had to provide advertising but that the expenditure for these activities are aimed not for the benefit of the Indian hotel but for the Marriott group as a whole. The tax authorities noted that the advertisements carry copyright of Marriott International Inc. and the connection between it and the IHLC is not clear. The tax authorities also argued that there was no nexus between the expenditure incurred by the IHLC in rendering the services and the consideration to be received by it. Therefore, according to the authorities the proposed payment of 1.5% of the gross revenues appears to be a payment towards royalty in a disguised form for the use of the brand "Marriott" and that the expenditure incurred by the IHLC in international advertising, is for building up of the brand. The tax authorities also considered that payments based on the gross turnover of the hotel owner have no nexus with the amount of expenditure incurred by IHLC.

In alterantive, the tax authorities considered that the proposed payment would also be consideration for rendering of any managerial, technical or consultancy service, within the meaning of "fee for technical services "(FTS), which is subject to Indian withholding tax. Finally, the tax authorities submit that the income in question would anyway be deemed to accrue or arise in India.

IHLC, on the other hand, considered that the payments being in the nature of reimbursement are not taxable in India. IHLC therefore responded by firstly refuting that it had any “business connection” (similar concept to permanent establishment) in India and that even assuming that a business connection exists, no operations are carried out by the IHLC in India. Secondly, it disputed that the payments under the agreement constitute royalty or FTS, since essentially they are not for any managerial technical or consultancy services.

3. The decision

3.1. Whether the payments were mere reimbursement of expenses incurred by the IHLC for the benefit of the Unitech

As regards the first issue, the AAR analyzed in detail the agreements. The AAR first started by asserting the meaning ascribed by dictionaries to the word “reimburse”, namely "to pay back, make restoration, to repay that expended, to indemnify or make whole". Keeping that meaning in mind and after looking at the classification of the expenses under the agreement, the AAR noted that there was no direct nexus between the owners of the hotel, and the costs and expenses of providing the said advertising, marketing promotion and sales program services. The AAR mentioned that even if after adjustment the payments in the form of contributions equal to the total costs and expenses incurred by the IHLC, it would be difficult to accept that they would amount to reimbursement of costs and expenses.

The AAR also rejected the contention of IHLC that its primary object is not to make profit but to enable the owner to attract foreign tourists from all over the world as the cost of international marketing and promotion activities would be impossible for an owner of the hotel alone to incur and that in fact the IHLC is not earning any profit.

3.2. Whether the amounts in question qualified as business income, royalty or fees for technical services

The Luxemburg entity contended that the payments could not be deemed to accrue or arise in India as it had neither any “business connection” in India nor the income had any source in India, while the tax authorities submitted that the Luxemburg entity had a “business connection” as well as the source of income was located in India.

Under Indian domestic tax law, “all income accruing or arising, whether directly or indirectly, through or from any business connection in India” is deemed to accrue or arise in India. Basically, if the nonresident has a business connection in India, the non-resident is then liable to tax in India on the income earned, which is attributable to the operations carried out in India. It should be noted that the use of a dependent agent is also considered a business connection. Though not entirely defined, the term “business connection” has a wider meaning than the well-known term “permanent establishment”. For example, in the leading Indian case of CIT v. R.D. Aggarwal and Co. (1965), the Supreme Court of India held that “business connection” means something more than business.

According to the AAR, "the essential features of the business connection concept are:
(a) a real and intimate relation must exist between the trading activities carried on outside India by a non-resident and the activities within India; (b) such relation, shall contribute, directly or indirectly, to the earning of income by the non-resident in his business; (c) a course of dealing or continuity of relationship and not a mere isolated or stray nexus between the business of the non-resident outside India and the activity in India, would furnish a strong indication of 'business connection' in India."

Taking into account the above facts, the AAR considered that the first and the second requirements of business connection were satisfied. In as much as the agreement was valid for 25 years, extendable for a further 10 years, the third requirement was also satisfied. The existence of business connection was then sufficient to attract taxation to the amounts in question, especially in the absence of a tax treaty.

The AAR further considered that the question as to whether the source of income is in India is unnecessary but since both parties referred to it, the AAR decided to further analyze the issue. The Luxemburg company contended that the “source of income” was outside India, since (i) IHLC conducts international marketing and business promotion activities outside India; (ii) it has no form of presence in India nor is the owner of the hotel an agent of the IHLC; and (iii) that no activity of the owner of the hotel result in any earning of the income of the IHLC.

The issue highlighted by the AAR was that some of those advertising activities were also are carried out in India and even when they were primarily carried out from outside India, they had an extension in India as well. For example, the advertisements were not confined to magazines with circulation outside India and even samples of advertisements in Indian magazines were put forward. Further, the AAR considered that advertising on foreign TV channels is also very much accessible in India and they have the effect of advertisement in India. Therefore the AAR concluded that the payments by the owner of the Hotel for the purpose of service of advertisement has relation to the activities of the IHLC, which generate activities of the owner of hotel business. As such, the AAR held that the source of income was located in India.

The AAR further rejected the argument of the tax authorities that what was being paid by way of contributions was nothing but "royalties”. As regards whether the payments constitute fees for technical services, the AAR discussed whether the amounts paid would in fact fall within the meaning of “consideration including any lump sum consideration for the rendering of any managerial, technical or consultancy services (including the provision of services of technical or other personnel)”. In this case, the AAR concluded that the services provided by the IHLC, both within and outside India, in the form of advertising, marketing promotion, sales program and special services, would amount to rendering managerial and consultancy services.

Accordingly, the AAR held that the amounts received by IHLC from the Indian Hotel owner in connection with the marketing and business promotion activities said to be conducted outside India would be taxable in India.

4. Source of income, the taxation of services and tax treaties

In an increasing global economy, it is simpler to carry on business activities and render services, without any physical presence. In the case above, the Luxemburg service provider claimed that the services were carried out outside India, but the AAR pointed that the facts made it clear that these service activities had extension in India and, therefore, the source of income was considered in India.

At a domestic tax level, tax liability usually arises either because of a personal or substantial economic attachment to a particular jurisdiction. Such attachment typically results on: (1) unlimited tax liability - worldwide income and assets (residence taxation); or (ii) limited tax liability (source taxation). Source taxation subjects income to tax because it is considered to arise within a certain jurisdiction. It can be for example the case of a company having a permanent establishment in a particular jurisdiction or deriving a defined category of income, such as dividends, interest or royalties, from a particular jurisdiction. Nevertheless, domestic provisions generally determine the source of an item of income in several different ways. Source may for instance refer to where the tangible or intangible property is located or used; where the services are performed or even where the payer is located.

For example, in the US income from services has generally its source where the services are rendered and is deemed effectively connected with the conduct of a US trade or business and taxed by the US on a net basis. The problem is that as technology and communications progresses it is increasingly more difficult to determine the jurisdiction where the services are actually performed. In addition, this case also demonstrates that services, even if conducted or primarily performed outside a jurisdiction, they may have an economic impact or a so-called extension in the source jurisdiction. Will this be sufficient connection to tax?

It should be noted that “source” and “origin” do not always mean the same thing, as Prof. Kemmeren (Tilburg University) exposed in its work called The Principle of Origin in Tax Conventions. Prof. Kemmeren believes that the essence for the allocation of tax jurisdiction does not lie in the “physical” place where income is formally generated, but rather the place of origin of income, that is, where the intellectual element is to be found or a substantial income-producing activity is carried on.

Regardless of whether there is a need for a new configuration of the source principle (especially for certain items of income such as passive income), the current framework of tax treaties only allow for residence taxation unless the profits from services (preformed in the Source State) are attributable to a permanent establishment situated in that same Source State. Therefore in this case the services would be taxable only in the Residence State.

Some States, such as India, are naturally reluctant to adopt the principle of exclusive residence taxation of services and therefore support additional source taxation rights under a treaty with respect to services performed in their territory. Such States may secure source taxation by including an extended permanent establishment provision to cover services (Service PE) or a special provision to cover the so-called technical services.

One important premise of a service PE provision is that source taxation should not extend to services performed outside the territory of the source State. Under the treaties that allow service taxation, such as the ones following the UN Model, it is therefore not only sufficient that the relevant services be furnished to a resident of the Source State, these services must also be performed in the territory of that Source State. Pay attention to the source/territory aspect found in the Model provisions:

See the UN Model Provision:
Art. 5(3) The term “permanent establishment” also encompasses: (…)
(b) The furnishing of services, including consultancy services, by an enterprise through employees or other personnel engaged by the enterprise for such purpose, but only if activities of that nature continue (for the same or a connected project) within a Contracting State for a period or periods aggregating more than six months within any twelve-month period.

Under the UN Model, even if the Luxembourg company furnishing the services would have no fixed place of business in India (under Art.5(1)), the mere fact that the service or the consultancy is supplied for a certain period of time, means it would be deemed to have a permanent establishment, and would consequently be taxed on the income by the source country. One of the conditions is that the activity of furnishing services or consultancy is performed within the source state. Services, which are performed in the residence state of the service-performer, or in any other state besides the source country, are not within the scope of this rule.

See the new OECD Model (draft) Provision
"Notwithstanding the provisions of paragraphs 1, 2 and 3, where an enterprise of a Contracting State performs services in the other Contracting State
a) through an individual who is present in that other State during a period or periods exceeding in the aggregate 183 days in any twelve month period, and more than 50 per cent of the gross revenues attributable to active business activities of the enterprise during this period or periods are derived from the services performed in that other State through that individual, or
b) during a period or periods exceeding in the aggregate 183 days in any twelve month period, and these services are performed for the same project or for connected projects through one or more individuals who are performing such services in that other State or are present in that other State for the purpose of performing such services,
the activities carried on in that other State in performing these services shall be deemed to be carried on through a permanent establishment that the enterprise has in that other State, unless these services are limited to those mentioned in paragraph 4 which, if performed through a fixed place of business, would not make this fixed place of business a permanent establishment under the provisions of that paragraph."

Under the 2006 OECD draft, the proposed alternative provision is clear by stating it only applies to services that are performed in a State by a foreign enterprise. The example used in the draft mentions an enterprise that "provides telecommunication services to customers located in a State through a satellite located outside that State, the services performed through the satellite would not be covered by the provision because they are not performed in the State."

As mentioned above, the source state may also opt, instead of a Service PE, to have a special provision (or an extended royalty provision) to tax certain type of more technical services. The major difference with taxation of technical fees as “royalties” is that only the source of the payment is basically relevant. In this case, the assignment of tax jurisdiction is simply justified because of the payer’s location and taxation is levied on a gross basis.

The fact that under the OECD Model consideration for technical services is not to be treated as a royalty, led to the reaction by certain countries, which then concluded treaties including a technical fees provision in their own tax treaties.

Just a simple search in the IBFD database found 122 treaties, which include a fees for technical services provision. For example, in 1959 treaty (already not in place), Germany and India agreed to define "fees for technical services" as payments of any kind in consideration for services of a managerial, technical or consultancy nature, including the provision of services of technical or other personnel. Throughout the years, the definition found in treaties did not change significantly. For example, in the recently conclude treaty between Austria and Pakistan, "fees for technical services" means any services of a managerial, technical or consultancy nature. The problem lies sometimes in the fact that due to lack of further treaty definitions, it will be up to the local court to define what is a managerial, technical or consultancy service.

The final solution for this case, if there would be a treaty between India and Luxembourg that followed the OECD Model, would be that the marketing and business promotion activities would be only taxable in Luxembourg since there would be no arguments to conclude that a permanent establishment existed in India.

An additional issue is that in practice Indian treaties further deviate from the OECD model by including a provision covering “fees for technical services”. For the taxability of fees for technical services what is relevant is the place where services are utilized and not the place from where the services are rendered. Accordingly, the service income would be liable to tax (generally at rates from 10% to 15%) in India if the services would qualify as “fees for technical services”.

5. Conclusion

It is interesting to note that if we were faced with a tax treaty case, India would probably be prevented to tax (or would tax at reduced rates) the services performed outside the Indian territory. This case firstly demonstrates then the pitfalls of not having a treaty in place.

In a moment when the OECD is studying the possibility of clarifying the tax treaty treatment of services, this case also exemplifies how domestic (or treaty interpretations) may create further pressure on determining where the source of the income arises or the ill-effects of gross service taxation.

The OECD is now prepared to include in its Commentary on Art. 5 an alternative provision for States that whish to preserve source taxation rights on profits from certain services. This new draft includes a principle that taxation of services should not extend to services performed outside the territory of the source State. Nevertheless, the place were the services are performed and executed may perhaps deserve further consideration, especially for cases where services may have an “indirect” extension in the Source State.