The impact of BEPS Action Plan And Finance Bill, 2018 on artificial avoidance of permanent establishment under the Income Tax Act, 1961

The advent of globalisation has not only paved way for deeper trading relations but also increased complexity within taxation as well. Such cross-border transactions give rise to two regimes i.e. (a) doing business with a country; and (b) doing business in a country. While the position of doing business with a country is clear, there persists a lack of clarity over the latter. This gives rise to a pertinent question i.e. which country has the right to tax the business profits earned by the foreign company due to its physical presence in a country?

The concept of permanent establishment

Article 7 of the OECD Report on the Attribution of Profits to Permanent Establishments, 2008 defines permanent establishment as a fixed place of business through which the business of an enterprise is wholly or partly carried on.[1] The concept of PE was used to solve this taxation confusion, by the usage of which taxability was imposed if a business had a PE in the country.[2] For India, the concept of PE was recognised via Article 5 of its tax treaties[3] and vide Section 92-F of the Income Tax Act.[4] Under the Indian laws, a PE is a fixed place of business, which may be owned partially or fully by a non-resident business person.[5] For instance, if a multinational corporation has its branches in India; it shall constitute a PE in India.

The inclusion of Base Erosion and Profit Shifting Action Plan in the Finance Bill

Earlier, the requirement for constituting a PE was high, which led to various entities deploying aggressive tax planning strategies to artificially shift profits to low tax jurisdictions with limited or no economic activity.[6] To curb this, measures such as the Base Erosion and Profit Shifting (BEPS) Action Reports were brought in and they sought to eradicate double non-taxation, end treaty abuse and ensure that profits are taxed at the place of value creation.[7]

Recently, the BEPS Action Plan (AP) 15 was devised. The AP aims to resolve international tax evasion and other tax related concerns, such as those arising from the greater digitisation of business.[8] There are 15 APs in total, and are summarised in a multilateral instrument (MLI). India being a signatory to the MLI and a member to the OECD, it has thereby impliedly accepted the AP as it has not submitted any reservations[9] and the AP seems reflected in the recent Bill. The key features of the AP are:

(i) Application of the preparatory and auxiliary condition

The treaties entered into by India with other nations usually contain certain exclusion clauses to taxability. The AP provides that such exclusions will only be available if the activities are preparatory or auxiliary in nature, as against earmarked activities defined in existing tax treaties.[10]

(ii) Prevention of fragmentation of business operations: Principle purpose test

A method of tax evasion deployed by entities is fragmentation of business operations, especially in construction PEs.[11] AP restricts a company from fragmenting a cohesive business operation into several small operations in order to show that each of these is only engaged in a preparatory or auxiliary activity. It proposes the principal purpose test (PPT) wherein the taxpayer has to show that tax avoidance was not one of its principal purposes for setting up a structure in a particular jurisdiction or undertaking a transaction in a particular manner.[12]

(iii) Virtual PE (Section 4 Explanation 2, Bill)

The AP acknowledges the digital economy and virtual space as a medium for business and trade. It suggests a shift from PE to significant economic presence. Earlier, an entity was taxable only if it had a physical presence in India, however now that is immaterial as even a non-resident company that generates revenue from Indian residents through digital means, even without having a physical presence in the country, will constitute an “economic presence”.[13] The Finance Bill, 2018 via Section 4 proposes an amendment to the existing Section 9(1)(i) of the Income Tax Act, 1961 to lay down an indicative list of factors which shall determine significant economic presence.

(iv) Dependent Agent Permanent Establishment

The AP calls for the adoption of the Dependent Agent Permanent Establishment (DAPE) wherein as against the earlier rule under which the actions of the agent did not constitute PE, they shall be taxable now. The threshold has been modified and now even if a person does not habitually conclude contracts in the name of the enterprise but plays the principal role leading to the conclusion of contracts, it shall constitute a PE.[14]

Subsequent steps to be undertaken by Indian Government

The MLI now requires the Indian Government to undertake the following activities for its effective implementation.

(i) Treaty negotiation

Countries such as the United Kingdom, Japan, the Netherlands, Spain and Italy have also accepted MLI’s recommendations and therefore, India needs to negotiate its treaties with such similar nations so as to balance the MLI’s requirements. On the contrary, the United States which is India’s largest trading partner has not signed the MLI. Therefore, India would need special negotiations with the US to reconcile the MLI with US laws.

(ii) Amendment to domestic law

Under the scheme of laws in India, a treaty, convention or any international instrument becomes binding only when it is signed and ratified.[15] Accordingly, the Indian Government has introduced the Finance Bill, 2018 which incorporates several recommendations of the MLI. For instance, Section 4 of the Bill proposes to amend Explanation 2 of clause (a) of Section 9(1)(i) to add “habitually plays the principal role leading to conclusion of contracts”. This addition gives the section a flavour of DAPE as required under the MLI. Further, the section also inserts an explanation to clarify the meaning of significant economic presence to add provisions of downloading of data or software in India, engagement with number of users, etc. This is in line with the requirement of virtual PE.

However, there continue to exist, certain grey areas needing clarifications by the Government. For instance, whether solicitation or engagement with Indian users through digital means includes telephonic or e-mail solicitation. Also, the Government has not prescribed the taxable income threshold for a company to qualify as economic presence.

The impact on India

There is no doubt that by accepting the MLI recommendations, India has effectively lowered the threshold of establishing a PE, thereby making avoidance of constituting PE’s in India, extremely difficult. This indeed, is a step in the right direction from an anti-tax avoidance perspective. However, it raises questions of implementation.

For example, now in India all activities falling within the specific exemption must be of a preparatory or auxiliary nature. Unfortunately, these terms suffer from ambiguity, resulting in different interpretations by different forums. For instance, in Motorola Inc. v. DCIT[16], activities like market survey, industry analysis, procurement of raw materials, finance services and other market services were termed as preparatory or auxiliary in nature. Whereas in Brown and Sharpe Inc. v. CIT, the Allahabad High Court held, marketing services conducted could not be treated as preparatory or auxiliary.[17] Therefore, it is incumbent on the Government to step in and clear the air around these terms, something which the present Bill fails to do.

Further, it is common knowledge that jurisdictions like Mauritius, Singapore, etc. are considered favourable for claiming tax treaty benefits. However, such treaties shall significantly be hit by the PPT now. Experts say that this may also lead to impacting of economics of debt and/or mezzanine funds set up in these jurisdictions if they cannot satisfy the PPT.

Also, the Amendment Bill states that the Ministry shall consult the stakeholders to figure out threshold for the new measures. In the opinion of the author, given the complex nature of the Bill, the consultation should have preceded it.

 

* Fourth year student, Constitutional Law (Hons.) at National Law University, Jodhpur (India), e-mail: swapnil.tripathi221@gmail.com.

[1]  Art. 7, Action Plan on Base Erosion, (OECD).

[2] Are the Current Treaty Rules for Taxing Business Profits Appropriate for E-Commerce? Final Report, (OECD), available at <http://www.oecd.org/ctp/treaties/35869032.pdf>.

[3]  The concept has appeared in all Double Taxation Avoidance Agreements signed by India.

[4]  92-F, Income Tax Act, 1961.

[5]  Ibid.

[6]  About the Inclusive Framework on BEPS, (OECD), available at <http://www.oecd.org/ctp/beps-about.htm>.

[7]  Action Plan on Base Erosion.

[8]  Jeffrey Owens, Resolving international tax disputes: The role of the OECD, available at <http://oecdobserver.org/news/archivestory.php/aid/1290/Resolving_international_tax_disputes:_The_role_of_the_OECD.html>.

[9]  India—Status of List of Reservations and Notifications at the Time of Signature (OECD) available at <http://www.oecd.org/tax/treaties/beps-mli-position-india.pdf>.

[10]  Action Plan on Base Erosion, Art. 13.2.

[11]  K.C. Mehta & Co., Double Tax Avoidance Agreements, available at <http://www.kcmehta.com/pdf/basics_of_tax_treaties.pdf>.

[12]  Action Plan on Base Erosion, Art. 7.

[13]  Action Plan on Base Erosion, Preamble.

[14]  Action Plan on Base Erosion, Art. 12.

[15]  Maganbhai Ishwarbhai Patal v. Union of India, (1970) 3 SCC 400 : AIR 1969 SC 783; Indian Constitutions, Art. 253.

[16]  (2005) 95 ITD 269 (Del).

[17]  2014 SCC OnLine All 16145.

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