The tax treaties entered by India generally provide that the business profits of a foreign enterprise would be taxed in India to the extent the same are attributable to its Permanent Establishment ('PE') in India. In absence of PE of a foreign enterprise in India, the business profits of such foreign enterprise are, generally, not liable for tax in India. The definition of PE included in tax treaties, therefore, becomes crucial in determining whether a foreign enterprise is taxable in India or not.
The definition of PE in tax treaties entered by India provide for certain exceptions in Article 5(4) of the OECD model tax convention. As per the said exceptions, amongst others, maintenance of a fixed placed of business by a foreign enterprise in India solely for the purpose of carrying on any activity of a 'preparatory or auxiliary' character is excluded from the definition of PE.
The Liaison offices ('LO') of foreign enterprises in India are mainly engaged in purchase coordination for the parent company, which includes vendor identification, review of data, uploading of material prices, vendor recommendation, quality control, monitoring of vendors to ensure compliance with parent companies policies, procedures, quality standards etc. The LO's in India are also engaged in providing back office services or other support services to the main business of the parent company outside India.
The issue whether LO's constitute PE of foreign enterprises in India has come up for determination before the Indian Courts various times. The Indian Courts in this regard, relying on exclusions provided in the definition of PE in Article 5(4), have consistently been holding that the LO's merely execute activities which are casual, isolated, preparatory or auxiliary in nature, and do not constitute PE of their foreign enterprise in India. Accordingly, the profits earned by foreign enterprises in such cases are not liable for tax in India.
It needs to be highlighted here that the exceptions in the definition of PE were introduced way back, pursuant to which, with the advent of digitalization and electronic business systems, there have been dramatic changes in the way business is conducted in modern world. Some business activities which were considered to be of a preparatory or auxiliary character earlier, may, in today's world constitute core business activity (main activity forming basis of the business). Due to such change in the mechanics of doing business, in today's era, certain crucial business activities, in substance, may appear to be constituting a PE of foreign enterprise in India, still, under the garb of exceptions to the definition of PE, they may not qualify for formation of PE in India, resulting in tax loss to the country.
For example, a warehouse which constitutes a preparatory activity for a shop of bricks and mortar may be a crucial activity or the basis of doing business in case of electronic/ online business of sale and purchase of goods. In the former case, the warehouse would fall in the exclusions provided in the definition of PE, while, in the latter case, the same may constitute a core business activity of the business resulting in formation of PE.
The G20 countries and OECD expressed their concern on the above issue and to tackle the same, Action Plan 7 was suggested as a measure to curb this Base Erosion and Profit Shifting ('BEPS') mechanism.
As per the OECD suggestions in Action Plan 7, the member countries have been advised to modify Article 5(4) of their tax treaties to ensure that exceptions to the definition of PE mentioned therein are strictly restricted to activities that are in reality (considering today's business mechanisms) of a preparatory or auxiliary character and do not constitute core business activity.
In the new legal scenario (pursuant to changes made by India in view of Action Plan 7), there may be circumstances, depending on the facts of each case, where certain LO's may constitute PE in India while others may continue to be covered by the exception to the definition of PE.
The LO's operating in India, in the changed legal scenario, would be required to test and analyse their business activities in India and make amendments in their business model/ activities to suit the new legal framework to avoid constitution of PE in India.
It is also important to highlight here that changes in legal scenario in this regard could be a hard nut to crack for India, since, the same would require willingness of both treaty countries to amend treaty to give effect to the suggestions in Action Plan 7 and accordingly enter into bilateral negotiations.
The above change in legal framework would be difficult to incorporate through a unilateral action from India vide changes made in domestic tax laws. However, one should keep fingers crossed to see if any changes in this regard are suggested by Government of India in the upcoming Budget 2016.
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