Wriiten by CA Jagrit Khanna
The concept of “Permanent Establishment” has always been a vexed issue with a chequered history in spite of various judgements by the Supreme Court (“SC” or “Court”). This concept has been prone to litigation and has been under intense scrutiny by the taxmen.
Recently, the Apex Court has decided a case in favour of the taxpayer and held that mere setting up of a Project Office (‘PO’) for preparatory and auxiliary functions could not be covered under the shadows of Permanent Establishment (‘PE’), absent discharge of core functions by the PO.
Understanding the facts of the case
- Samsung Heavy Industries Company Ltd. (“Samsung” or “Assessee”), a company incorporated in South Korea, was awarded a ‘turnkey contract’ by ONGC in February 2006, being a contract for “work”, inter alia, surveys, design, engineering, procurement, fabrication, installation and modification at existing facilities, and start-up and commissioning of entire facilities covered under the ‘Vasai East Development Project’ (“Project”).
- In May 2006, the Assessee set up a PO in India, to act as a ‘communication channel’ between the Assessee and ONGC – prior RBI approval was taken for setting up such PO.
- For A/Y 2007-08, the Assessee filed the return of income showing a loss, due to expenses incurred in relation to the activities carried out by it in India.
- The Assessing Officer (“AO”) during assessment held that the project was a single indivisible turnkey project (based on the agreement between the Assessee and ONGC) and resultantly, profits arising from the successful commissioning of the project would arise only in India. As a result, the AO went on to attribute 25% of the revenues allegedly earned outside India as income of the Assessee taxable in India.
- The Dispute Resolution Panel (“DRP”) dismissed the Assessee’s objections and AO’s Order was upheld by DRP.
- Further, ITAT concurred with the view of the AO and DRP that attributed 25% of the revenue earned outside India as income taxable in India in the hands of the Assessee. The ITAT also pointed out that the onus is on the Assessee to prove that there is no PE in India and the activities undertaken by the Assessee fall under the exclusionary sub – article 5(4) under Article 5 of India – Korea DTAA.
- Pursuant to ITAT judgement, the Assessee filed an appeal before the Uttarakhand High Court (“High Court”). The HC set aside the judgement of ITAT and held that neither the AO nor the ITAT had brought on record any evidence to justify attribution of 25% of the profits to the PE.
- Aggrieved, the department filed an appeal against the HC order, in the SC.
Ruling of the Supreme Court
The limited question before the SC was that whether the activities carried out by the PO in India constitute a PE in India with respect to DTAA between India and Korea. Following arguments were put forward before the SC:
- Based on facts, the PO consisted of only 2 employees, neither of them whom had any technical qualifications whatsoever.
- Assuming that there is a PE in India through which core business activity of the Assessee was carried out, no taxable income can be attributed since the audited accounts showed that there were no profits, in fact the Assessee incurred losses on such project.
- Sub – article 5(4) of India – Korea DTAA carves out certain exceptions such that activities falling under the said sub- article would not constitute a PE of the Assessee. Sub – article 5(4) starts with a non-obstante clause for sub-articles 5(1), 5(2) and 5(3) which define PE.
- Preparatory or auxiliary activities in trade or business of the enterprise would be outside the ambit of PE due to the exception carved out under sub – article 5(4).
- The court discussed catena of its own judgements on the concerned subject. The SC mentioned its own judgment in the case of Morgan Stanley (“MS”) where the subject matter was with reference to India – USA DTAA. In this case, the Indian arm of MS was providing support services to the US entity and the court while analysing Article 5 of India – USA DTAA held that such services would not constitute PE in India.
- The SC also discussed the judgement of Hyundai Heavy Industries and while applying this ruling in the present fact of the case held that profits from supply of fabricated platforms by the Assessee to ONGC cannot be attributed to its PE in India.
- Further, the SC while delivering its judgment in the case of Ishikawajma-Harima Heavy Industries Ltd, held that distinction between the words ‘business connection’ and ‘PE’ is clear and explicit:
- Concept of business connection is relevant for section 9 of Income-tax Act, 1961 whereas the concept of PE is relevant for assessing income under DTAA
- The DTAA between India – Japan clearly provides that only income arising from activities wherein the PE has been involved can be attributable to the PE. Income from off – shore services rendered outside India cannot be attributed to the PE in India, if the PE has not been involved in providing such services.
- Lastly, the SC in its judgment, held that the onus is on revenue and not on the Assessee to first show that the Assessee has a PE in India. By applying this principle, the SC in the present case, struck down ITAT’s conclusion that the initial onus is on the Assessee to prove that there is no PE in India.
- The court also analysed the Board resolution passed by the Assessee and the approval accorded by the RBI for setting up of the PO:
- The Board resolution provided that the Assessee would appoint its General Manager as the legal representative for establishing the PO and coordinating and executing delivery of documents in connection with construction of off – shore platform and modification of existing facilities for ONGC.
- Finally, based on the arguments, documents and plethora of judgments passed by the SC in the past on similar matters, the Court held that the PO was not involved in the core activities for project execution, the fact that only two persons were working in the PO, neither of them of whom were qualified to perform any core activity for the Assessee further strengthens that only ‘preparatory and auxiliary activities’ were performed by the PO. Therefore, the SC upheld the view of the HC and decided in favour of the Assessee.
The existence of a PE depends on number of factors such as nature of operations and activities of the shop set up in India qua the activities of the overseas entity. The underlying documents such as Board resolution, RBI approval supporting the claim are quite relevant and once again emphasis the fact that drafting of such documents/ agreements is paramount.
The Supreme Court also shed light on the fact that initially the onus is on the revenue and not the Assessee to establish the existence of the PE in India.
This ruling from the Apex Court is a welcome judgment for overseas investors/ entities who may want to undertake turnkey projects with their Indian customers. The ruling spells out the dictum for the permissible operations of the PO under the ambit of ‘preparatory and auxiliary activities’.
Interestingly, given the fact that a lot of countries have signed the Multilateral Instrument (“MLI”) under the BEPS project, the business models would need to be examined afresh keeping in sight the changes provided under the MLI vis-à-vis DTAA provisions.
 DIT (International Taxation) Vs Samsung Heavy Industries [Civil Appeal no. 12183 of 2016]
 DIT Vs Morgan Stanley  162 Taxman 165 (SC)
 CIT Vs Hyundai Heavy Industries  [7 SCC 422]
 Ishikawajma – Harima Heavy Industries Ltd Vs DIT  [3 SCC 481]
 ADIT Vs E-Funds IT Solution Inc.  86 Taxmann.com 240 (SC)