THE common perception about the Indian revenue is that it is always eager to find a PE of a foreign enterprise doing any business in India. There are some who sneer that even if one passes through the Indian airspace, one may risk creating a PE in India. Exaggerated though this claim is, it is a fact that if the only way to tax business income of a foreign enterprise is dependent on the existence of a PE, the revenue authorities will obviously try to assert that the enterprise creates a PE in India. At the level of the judiciary however, most of these efforts come to naught.

But, do you know that there are instances where the tax planners will assert that there is a PE of the enterprise in India? This will of course be the case when it suits their conveniences. For, one thing, under tax treaties a PE can only be taxed on a net basis. So, if gross basis of taxation results in more tax outgo, one may claim the existence of a PE. Secondly, a PE is taxed only on the income that is attributable to the activities of the PE. In many decisions, Indian Courts have taken the position that activities carried out outside India cannot be attributed to the PE.

Indian tax authorities figured out long back that MNCs take out substantial profits out of the country by claiming payment for technical services. Therefore, the source rule in India was changed and specific provision was incorporated in the Act for taxing such fees as ‘fees for technical services' (FTS) on a gross basis. Indian treaties also followed incorporating an FTS clause in line with the article relating to royalties. With some limited exceptions, FTS can be taxed when the payer is the Government or an Indian company or even a PE. Mere payment from India will entitle source taxation on a gross basis, of course at a much reduced rate, generally @ 10% only.

The FTS provision in a treaty normally provides that if however the fees are ‘effectively connected' with a PE, then these should be taxed on a net basis as in the case of business income. The term ‘effectively connected' borrowed from other passive income articles, is an extremely confusing one and arose because of the difference in the practice of taxation in civil law countries as compared to taxation in common law countries.

It may be noted that in common law countries, certain types of income like interest, dividend, royalties will not be considered business income of the enterprise carrying on the business while in civil law countries, these will always form a part of the business income of the enterprise. As a result, several compromises in the language were made by the drafters of the OECD Model Convention and their legacy is being felt by the various courts trying to interpret the provisions adopted in tax treaties.

One such problematic area relates to the provision contained in the fees for technical services that was introduced in Indian treaties but was modeled on the article relating to royalties. In terms of article 13 (4) of a separate FTS article or article 12 (4) of a combined royalty and FTS article, if the relevant royalty or FTS is ‘effectively connected' with a PE, then the income concerned retains the character of business income and should be taxed on a net basis as in the case of business income of a PE.

This apparently harmless and obvious expression has become a subject of litigation in a number of Indian cases and recently of the Australian Federal Court involving unsurprisingly an Indian taxpayer, Satyam (Tech Mahindra). Before we analyze the Australian case, it will be instructive to see how the expression has been understood by the Indian Courts.

In P No 13 of 1995 (2002-TII-04-ARA-INTL), a French company ABC was providing complete project services to an Indian taxpayer on single point responsibility basis starting from technology transfer to the commissioning of the plant. ABC, for the purpose of providing these services, would be operating from its head office in France as well as a project head office and a project site office in India. It expected to employ about 200 to 400 employees in India and about 800 employees outside India. The work to be done by ABC under all the agreements will involve activities in India as well as outside India. In such circumstances, one of the questions posed before the Authority for Advance Ruling (AAR) was whether the activities of ABC conducted outside India were effectively connected with the activities conducted inside India by its permanent establishment in India.

The taxpayer argued that Article 13(6) of the India France DTAA takes out of the purview of Article 13 and transposes to Article 7 all payments received as royalties or technical fees which are effectively connected with the permanent establishment in India; that all the royalties, etc., that may be received by ABC under the agreements, either for services, etc., in India or outside India, are effectively connected with the permanent establishment and are to be considered for assessment under Article 7. Article 7, however, provides for a bifurcation of the profits thus emerging into profits attributable to the operations in India and others and restricts the assessment to the former alone. Clause 3 of the India -France Protocol then steps in to make it clear that profits attributable to the permanent establishment can only mean those attributable to the "activities in India" and none others. Accordingly, the charge of tax on ABC should be so restricted.

The department argued that the entire profits from the contract accrue in India where the plant and the complex are set up and the entire discussion about "outside" and "inside" activities involving various kinds of services, elaborately dissected and particularized in separate agreements, was totally artificial and irrelevant.

The AAR rejected the department's argument holding that with modern advances in scientific technologies, a single point accrual to the execution of such projects cannot be attributed as is suggested by the Department. “It is too ingenuous to think, as was suggested by the Department, that what is essentially a simple transaction of "sale" of a "factory" in India has been artificially dissected and the various steps in the setting up of the "factory" magnified into a large number of separate agreements.”

On the other hand, the AAR agreed with the taxpayer's contention that all the outside activities are directed towards the installation of the manufacturing plant and industrial complex in India. Though carried out elsewhere, they are integrally connected with the project in India. The designs, basic engineering services and other services are based on information collected in India and the use of the process and technologies have to be adapted to the needs of, and prove workable in, Indian conditions. It held that the permanent establishment in India has an undoubted voice over the outside activities as well and the royalties and fees in question cannot but be described as effectively connected with it.

More importantly, on an examination of the domestic law provision and the treaty provision, the AAR held that the payments under the agreements are taxable in terms of Article 7 read with Article 13(6) of the DTAA and in terms of Articles 7(1) and 7(2) of the DTAA read with paragraph 3 of the Protocol, the profits of ABC attributable to the operations carried out by its permanent establishment in India will alone be liable to tax in India.

Ishikawajima Harima Heavy Industries Ltd Vs. DIT [2007-TII-01-SC-INTL] is a celebrated Supreme Court decision that laid down the theory of territorial nexus and led to an amendment in the Income tax Act. One of the less well known aspect of this case, is relating to the issue as to whether fees for technical services could be said to be effectively connected with a PE and what happens if the services are rendered from abroad.

In this case, the taxpayer formed a consortium with other taxpayers and entered into a turnkey project with Petronet for setting up a Liquefied Natural Gas receiving storage and degasification facility. The role and responsibility of each member of the consortium was specified separately. Each of the members of the consortium was also to receive separate payments.

Answering the question relating to taxability of various receipts, the AAR [2004-TII-17-ARA-INTL], on an analysis of the agreement in this case found the same to be indivisible and held that the taxpayer was liable to pay direct tax in India in respect of the offshore supply of equipment and materials, both under the provisions of the Act and the India-Japan Treaty. Accordingly, the entire amount received for offshore services was chargeable to tax under the Act and under the Treaty but at the rate not more than 20 per cent of the gross amount.

The taxpayer having filed an S.L.P, the Supreme Court overruled the ruling and held that since the taxpayer carries on business in India through a Permanent Establishment, they clearly fall out of the applicability of Article 12(5) of the DTAA and into the ambit of Article 7. And further without much explanation, the Supreme added held that “[t]he terms 'effectively connected' and 'attributable to' are to be construed differently even if the offshore services and the permanent establishment were connected.” In this case, since the entire services have been rendered outside India, and have nothing to do with the permanent establishment, the same would not be attributable to the permanent establishment and therefore not taxable in India.

These observations of the Supreme Court have been interpreted to mean that when there is a PE, even if technical services are connected with such PE, no tax can be levied in India if the services are rendered from outside.

It is true that the perils of such an interpretation were pointed out in other judgements/rulings. For example, in the case of Worley Parsons Services Pty Ltd [2009-TII-06-ARA-INTL], a case involving India-Australia tax treaty, the departmental representative argued that the exclusion provision in Article XII( 4) should be strictly confined to that part of the income arising from the services connected with the PE. Otherwise, an anomalous situation could arise in that a non-resident performing the entirety of services from abroad in respect of a project to be carried out in India, will have to pay tax on the entire of ‘royalty' income by reason of the fact that it has not set up a PE in India whereas a non-resident rendering few services through a small PE set up in India will be able to avoid the payment of tax on “royalty” income except in respect of those few services rendered through the PE. However, the AAR chose not to express any opinion on that issue, although it seems that the AAR did doubt the correctness of the Supreme Court's decision in IHI in several aspects.

Let us now see how the expression has been interpreted in Australia in the Tech Mahindra case. Tech Mahindra v Commissioner of Taxation [2015] FCA 1082, 7/10/2015

As at 30 June 2012, the now defunct Satyam (merged with Tech Mahindra) employed over 29,000 people and provided information technology services in 41 countries, including Australia, to large-scale enterprise customers in various industries. Satyam established its Australian offices in the period 1998 to 2008 and, as at 30 June 2008, employed 821 staff in its Australian offices.

During the relevant year, some of Satyam's Australian Customers were companies incorporated and resident in Australia, while others were Australian offices of foreign entities. Satyam employees at the customer's offices in Australia typically provided Satyam's services. Where it was not necessary to provide services at the premises of the Australian Customers, it was open to Satyam to provide the work through staff located in the Australian offices or staff located in the Indian offices, subject to the approval by the Australian Customers.

In its income tax return for the relevant year, Satyam initially included income generated by the performance of the Indian Services, as well as the Australian Services. Subsequently, perhaps taking inspiration from the Indian cases, Satyam took the view that the income derived from the performance of the Indian Services was not liable to Australian taxation and should not have been returned as assessable income. On 23 January 2013 Satyam lodged an objection to the tax assessment for the relevant year on the ground that the income generated by the Indian Services was not liable to tax in Australia pursuant to Article 7 of the Indian Agreement and that the expenses referable to the Indian services were therefore not allowable deductions in the relevant year. As a consequence it objected to the notice of assessment on the ground that the taxable income was overstated by almost one third.

It may be noted that Article 12 of the relevant India- Australia tax treaty relates to royalty but the definition of royalty incorporates fees for included services. It may also be noted at the outset that article 7 of the India –Australia tax treaty contained a limited force of attraction rule in article 7(1) (b). Admittedly, Satyam had a PE in Australia. The Commissioner held that the support services and software development activities performed in India involve business activities of the same or similar kind as those carried on through the Australian PE and hence article 7(1) will allow Australia to tax the income from the Indian services. In the alternative, the Commissioner found that software development and modification is a service which must be provided by persons knowledgeable in the information technology field and results in the supply of computer code to the client and would fall within the definition of royalties under the treaty.

The Primary judge agreed with Tech Mahindra that the force of attraction principle will not apply. However, she agreed with the commissioner that some of the services would represent royalty that can be taxed by Australia. She did not agree with the taxpayer's claim that the FTS being effectively connected with the PE, Australia will lose its right of taxation of the FTS. It is this part of the order that is analyzed here.

Tech Mahindra's contention:

Before the Primary Judge of the Federal Court, Tech Mahindra contended that the Indian Services were performed in concert with the services performed through the permanent establishment. It was only the Indian Services in combination with the Australian Services that together satisfied the contractual obligations to the Australian Customers. The close relationship had the consequence that the Indian Services were effectively connected with the permanent establishment. (Note the similarity with the AAR's argument in P No 13 ).

The Australian tax department's contention:

The Commissioner submitted that Australia has the right to tax all or some of the relevant amount under Article 12(2) on the grounds that it constitutes a royalty. In contrast to the taxpayer, the Commissioner contended that Article 12(4) gives priority to Article 7 only where Australia has the right to tax profits under Article 7(1)(a) on the ground that they were attributable to the permanent establishment of the non-resident enterprise.

In this regard, the primary judge pointed out that Article 12(4) applies only where the payments in question are royalties as defined in Article 12(3).It therefore applies only where both Contracting States are entitled to tax those payments, subject to the cap to which reference has been made . By contrast, Article 7 prescribes that only the Contracting State of the enterprise may tax its profits subject to the limited exceptions in Article 7(1)(a) and (b).

To quote: “It follows on the applicant's construction that, while the Contracting States agreed that it is appropriate for the source State to tax royalties arising in its territory to a capped amount under Article 12(2), that State may “lose” any entitlement to tax the profits at all where there is an effective connection between the payments and the permanent establishment which does not satisfy Article 7(1)(a) or (b). While the applicant contends precisely for that result here, no reason or purpose is identified which would be served by such an outcome . The difficulties in identifying any comprehensible purpose are illustrated by contrasting a case where a connection exists between the payments and the permanent establishment albeit outside Article 7(1)(a) or (b), on the one hand, with a case where there is no effective connection between the payments and the permanent establishment, on the other hand. On the applicant's case, the source State would have no entitlement to tax the income at all in the first scenario, but retain its entitlement to tax royalties under Article 12 in the other.”

She further held: “On the Commissioner's construction, however, in those cases where there is an effective connection between the payments and the permanent establishment or fixed base in the sense articulated by Article 7(1)(a) or 14 but the payments would also constitute royalties under Article 12, then the source State where the royalties arise is entitled by virtue of Article 12(4) to impose tax at the potentially more generous rates permitted under Article 7(1). That is manifestly, in my view, the purpose which Article 12(4) is intended to serve.”

Not satisfied, the taxpayer appealed before the full Federal Court. Before the full Federal Court the only issue that was agitated was the connection between article 12(4) and article 7(1). More or less same arguments were advanced before the Court. The full Court upheld the verdict of the single judge on the issue. [Tech Mahindra Limited v Commissioner of Taxation [2016] FCAFC 130, 22 September 2016]

More particularly, the Court held that Article 12(4) is to be construed in the context that Art 7(7) gives priority to Art 12 over Art 7. Without Article 12(4), royalties forming part of the business profits of an enterprise attributable to a permanent establishment in the source State would be taxable by the source State but subject to a limit on the amount of tax that may be charged. No evident object or purpose is indicated, and none was suggested by the Appellant, for construing Art 12(4) in a way that would disentitle the source State from the right at all to tax a payment otherwise within the scope of Art 12(2) but outside the scope of Art 7. To the contrary, the evident purpose of Art 12(4) is to relieve the source State from the limitation on taxing rights imposed under Art 12 by taxing such royalties under Art 7, not to disentitle the source State from any taxing rights where otherwise Art 7 would not give such taxing rights. The Court referred to the technical explanation and also the UN Commentary and held that such a construction gives effect to the language of Art 12(4) and is consistent with the extrinsic materials.

The Court held: “It is sufficiently clear that Art 7 and Art 12(4) have a coextensive operation, in that Art 7(7) contemplates that the business profits of an enterprise may include income covered by Art 12 as a royalty. Those royalties that may be taxed under Art 7 are the payments in respect of property, rights or services “effectively connected with” the permanent establishment of an enterprise in the source State and under Art 7(1)(a), profits that are “attributable to” that permanent establishment are taxable by the source State. This is not to base the construction of Art 12(4) upon an assumption that the purpose of Article 12(4) is to remove royalties from Article 12 only if the source State has the right to tax such royalties pursuant to Art 7(1)(a) but to give effect to the coextensive operation of the Articles.”

As for the argument that the Indian services were effectively connected with the PE, the full court held: “Thus, the question in the present case is whether the services of the kind in Art 12(3)(g) that the Appellant rendered in India for its Australian customers were “effectively connected with” its permanent establishment in Australia. The word “effectively” in this context qualifies the degree of connection that is required between those services and the permanent establishment to trigger the Article. In ordinary meaning, the word “effective” means “actual” or “existing in fact”. Used as an adverb in conjunction with “connected”, “effectively connected with” should be understood to mean having a real or actual connection with the activities carried on through the permanent establishment. Whether or not such a connection exists is not answered merely on the basis that the property, rights or services provided “serve to effect the purposes of the permanent establishment”.

Fees for technical services would normally be business income and cannot be taxed in the absence of a PE. To get over this fetter, some developing countries, particularly India, agreed with treaty partners that such services could also be taxed by the source state on a gross basis but at a low rate. However, in case a PE of the foreign enterprise is involved in the process, such FTS would still be taxable but on a net basis. From this, to arrive at a conclusion that the source state will lose complete taxation right if the FTS is connected with a PE but rendered from abroad required a massive intellectual gymnastics on the part of some Indian legal minds. The logic of the provision has now been made clear ironically by an Australian Court. It remains to be seen whether the Indian Courts follow the clear logic or keep their blinkered view on thereby depriving the source state of its legitimate revenue. The Australian Court's decision can perhaps be questioned on a different ground but that's another story.