Indian tax laws provide that whatever profits a foreign-based company operating in India would be taxed to the same degree that is attributable to its Permanent Establishment (PE) in India. Where the foreign company does not have a PE domiciled in India, whatever business profit it makes would not be subjected to tax in India. PE definition included in tax treaties is a critical factor in deciding whether or not a foreign company would be taxed in India.
According to the definition of PE based on the treaties signed by India, certain exceptions are provided for in Article 5(4) of the OECD model tax convention. As regards the exceptions, maintenance of a specific place of business in India by the foreign company exclusively to engage in any activity ‘preparatory or auxiliary’ in nature is not included in the definition of PE.
If foreign enterprises intend on starting a Liaison Office in India, they have to be aware that the main activities of Liaison Offices of foreign companies that are based in India are to coordinate purchases on behalf of their parent company. These activities include vendor identification of vendors, data review, vendor recommendation, uploading prices of materials, quality control, quality standards, monitoring vendors to make sure they comply with the policies of their parent company etc. Liaison Offices carry out back-office services or support services to the central business activities of the foreign-based parent company.
Whether or not a Liaison Office in India constitutes PE of a foreign company has been the subject of several litigations in Indian courts. The courts based their decisions on the exclusion of PE as contained in the definition of PE in Article 5(4). They have consistently upheld judgments that LOs merely carry out business activities that are isolated, preparatory or auxiliary by nature and therefore does not constitute PE of their foreign company in India. The profits earned by the foreign company are therefore not taxable in India.
It is worthy of note that the exceptions in the PE definition had been introduced a long time ago, consequent on which, there have been significant changes in the way business is now being done as a result of the advent of digitalization. Some business activities which were formerly considered to be auxiliary or preparatory may constitute main business activities in today’s business world.
Due to the change in business dynamics in today’s business world, some critical business activities may seem to constitute PE of a foreign company here in India. Under the guise of exceptions to PE definition, they may not be eligible for the formation of PE in India, resulting in a loss of taxes to the government.
For instance, a warehouse which would constitute a preparatory activity for a concrete shop may serve as a crucial business activity or the main basis of doing business such as online buying and selling of goods. In the earlier case, the warehouse would be under the category of exclusions given by the definition of PE while for the latter it constitutes the main business activity leading to the formation of a PE.
G20 countries and OECD expressed concerns on this issue. To deal with this issue, Action Plan 7 was mooted as a solution to tackle the issues of Base Erosion and Profit Shifting (‘BEPS’).
As per the OECD recommendations in Action Plan 7, the member countries have been advised to modify Article 5(4) of their tax treaties. The modification was suggested to ensure that exceptions to the definition of PE mentioned therein are strictly restricted to activities, which are in reality (considering today’s business mechanisms) of a preparatory or auxiliary character and do not form core business activity.
Consequent on changes made by India as regards this new Action Plan 7, there may be some cases in which some Los may constitute PE in India while others may yet be protected by the exception definition of PE.
The LO’s operation in India would be required to test and analyse their business activities in India, in the current legal scenario. They would then be advised to make amendments in their business model/ activities to suit the new legal framework to avoid constitution of PE in India.
Note that changes in the legal settings in this issue would be challenging for India to deal with. It would require the consent of all treaty countries to amend the treaty to give legal validation to all the suggestions in Action Plan 7. The required change, therefore, cannot be achieved unilaterally by India via changes to its domestic laws.
So before starting a Liaison Office in India, it is pertinent to know the impact of BEPS and MLI on the proposed LO.