Revisiting Distinct Status of Permanent Establishment in International Taxation

by Tarun Jain*

Permanent Establishment in International Taxation

Introduction

Unlike the indirect tax laws, where the levy of tax is on the transaction, under the income tax laws, the levy of tax is on a person. It is thus the status of the person which is relevant for determining taxability and other implications under the income tax law. For illustration, an individual is treated differently from a corporate entity, a resident taxpayer is treated differently from a non-resident taxpayer, etc.

The international tax principles have introduced the concept of permanent establishment as a legal fiction, which detracts the non-residential status of a foreign taxpayer to treat its branch or other establishment of such foreign entity as a distinct person. A recent decision of the Full Bench of Delhi High Court has addressed the issue as regards the distinct status of a permanent establishment, which serves as the context to revisit the concept.

Foundational tenets

In order to appreciate the issue, it is appropriate to appraise the foundational tenets of a permanent establishment with the aid of an illustration. There is a company which is a tax resident of Country R. The company substantially carries out business also in Country S but is not a tax resident of Country S. Applying the ordinary rules of international tax law, the company would be treated as a non-resident in Country S and thus Country S will have limited taxation rights of the company. However, this is inequitable to the tax residents of Country S as they pay full taxes on similar activities carried out by them as are carried out by the company in Country S. Accordingly, the international tax law has evolved the concept of permanent establishment (PE) to address the inequitable anomaly. Subject to meeting the tests which are necessary for a non-resident entity to constitute a permanent establishment in another country, such establishment is considered a distinct enterprise from the non-resident entity and is subjected to tax fairly similar to a tax resident. Thus, in this example, if the company satisfies the test of permanent establishment in Country S, its establishment in Country S will be taxed in Country S accordingly.

Most international tax treaties (commonly known as the double taxation avoidance agreement in India — DTAA — or double taxation convention — DTAA — elsewhere) have now standardised the concept of permanent establishment, generally following the Model Tax Conventions of Organisation for Economic Co-operation and Development (OECD) and United Nations. Thus, the tax treaty related provisions of permanent establishment are fairly synchronised. However, there are different kinds of permanent establishments under the domestic tax laws of the different countries. To illustrate, Dependent Agent Permanent Establishment (DAPE), service PE, construction PE, etc. are some species of permanent establishments. Each of these species of permanent establishment have their own distinct rules and qualifying criteria wherein the conjoint application of both the domestic tax law and the tax treaty provisions are relevant to appreciate whether in a given set of circumstances a non-resident entity constitutes a permanent establishment in the other country or not. Extensive jurisprudence has also developed on each of these aspects and qua the salient features of permanent establishment generally and their different species specifically.

Distinct status of permanent establishment

One of the key aspects of permanent establishment, which is perhaps now well-settled both in the tax treaty and the domestic law context, is that a permanent establishment is considered a distinct enterprise contradistinguished from the (parent) non-resident entity of which the permanent establishment is a part. It is not necessary that the permanent establishment also constitutes a distinct legal person.1 For example, a subsidiary of a foreign holding company may constitute a permanent establishment and it would also be a separate legal entity. However, as another example, a branch office of a foreign company may also constitute a permanent establishment but it would not be a separate legal entity. In either case, however, the permanent establishment is to be treated as if it is a distinct enterprise and accordingly its profits have to be computed distinctively. Colloquially understood, it implies that the non-resident enterprise and its permanent establishment have to be assessed to income tax as if they are dealing at arm’s length with each other.2 On the basis of such computation, the profits of the permanent establishment are subjected to tax in the host country.

Dispute before the Full Bench and its decision

The decision of the Full Bench of Delhi High Court is in Hyatt International Southwest Asia Ltd. v. CIT3. The issue was referred to the Full Bench in view of a doubt raised by a Division Bench of the High Court on an earlier decision of another Decision Bench in CIT (International Taxation) v. Nokia Solutions and Networks OY4. In that case, according to the taxpayer, it had been concluded that a permanent establishment in India of a non-resident entity would not be taxed in India even if such permanent establishment was profitable in the event the non-resident entity as a whole was not profitable and instead was a loss-making entity. Accordingly, to the taxpayer, in Nokia case5 the Delhi High Court had accepted an interpretation that the tax treaty and the domestic law permit only taxability in India of an Indian permanent establishment only if the non-resident entity was globally profitable. This view in Nokia case6 was doubted by the Division Bench of the Delhi High Court and accordingly referred the matter for reconsideration by a Full Bench of the High Court, which led to the instant decision.

In its decision, the Full Bench in Hyatt International case7 disagreed with Nokia case8 principle and has concluded that the global profitability of a non-resident entity is irrelevant to determine whether its Indian permanent establishment would be subjected to tax in India. According to the Full Bench of Delhi High Court, even if globally the non-resident entity is a loss entity, still it can be taxed in India to the extent its Indian permanent establishment is profitable.

Legal exposition by the Full Bench

Relying upon the exposition of the law in Ishikawajma-Harima Heavy Industries Ltd. v. CIT9 and GVK Industries Ltd. v. CIT10 and making extensive reference to the internationally understood status and dynamics of permanent establishment, as summarised in Klaus Vogel on Double Taxation Conventions, etc. the Full Bench decision exemplifies many legal propositions in context of PE. Accordingly, it is expedient to appreciate the distinct dimensions of the Full Bench decision under different heads.

A. Permanent establishment as an independent functional business unit

The Full Bench has characterised permanent establishment as an independent functional unit which just does not have a business function and utility (for the non-resident entity) but is also recognised as such in the international tax context. Highlighting the basis and consequences of these commercial and legal dimensions of PE, the Full Bench has explained the generic reason for this legal conclusion in the following terms:

42. The concept of a PE is based upon the undertaking of economic activity in a particular State irrespective of the residence of an enterprise and the same being understood to be in the nature of a conglomerate or an entity which may have many arms or independent functional units situate in various fiscal jurisdictions. Any entrepreneurial activity which gives rise to income or profit thus becomes liable to be taxed at source irrespective of the ultimate recipient or owner of that income. Source here would mean the location which gives rise to the accrual of profits or income or which is the location where the same arises. The PE principle thus enables the assignment of tax to the State which constitutes the source. The PE concept thus creates a functional relationship and connect between the principal entity and the place of business whose activities give rise to the income or profit. It is this fictional creation of an independent economic center in a contracting State which informs the allocation of taxing rights. Once the DTAA confers an independent identity upon the PE, it would be wholly erroneous to answer the question of taxability basis either the activities or profitability of the parent or the entity which seeds and sustains the PE.

43. The contracting State in which this imagined entity is domiciled and undertakes business thus becomes identified as an independent profit or revenue earning center which is liable to be taxed. Once such an entity is found to exist in one of the contracting State, it is viewed as a unit which contributes to the economic life of that State and thus be liable to tax. It is these basic precepts which convince us to debunk the theory of taxation in the source State being dependent upon a global profit or taxation being subject to income or profit having been earned at an entity level.

44. The identity which attaches to a PE for the purposes of ascertainment of a taxing liability cannot possibly be doubted bearing in mind the succinct observations of the Supreme Court in Morgan Stanley case11 and where Their Lordships without a degree of equivocation acknowledged the distinction that is liable to be drawn between a PE with respect to income earned in the contracting State where it is domiciled or deemed to exist and the global enterprise of which it may be a part. Vogel explains the PE concept as constituting the threshold and the “essential demarcation line” in the source State which sanctions the imposition of a tax in a fiscal jurisdiction other than the State of residence. This would clearly appeal to logical since the right of taxation which inheres in the source State is connected to the “economic life” of that transnational enterprise which is moored and berthed by virtue of the existence of a PE which may be found to exist. Regard must also be had to the fact that right of the source State to tax does not extend to profits which are not allocable to the PE. All of the above, thus clearly leads us to hold that the existence and identity of the PE is separate and distinct and subject to tax to the extent of activities that it may undertake in a State distinct from that of its principal.

*        *        *

47. On a jurisprudential plane, the sovereignty concept is based on a State’s power over a territory and a set of subjects which accept its authority. It was these aspects which governed and regulated the right of a State to levy a tax. However, as trade and commerce transcended boundaries and borders, nations were confronted with profits and incomes being shifted and claimed as exempt. It is the aforenoted factors which appear to have moved the League of Nations in the early 1920s’ to constitute a group of economists to study the issue of double taxation. That group is stated to have identified the fundamental factors worthy of consideration to be, (a) the origin of wealth or income; (b) the situs of income; (c) enforcement of rights connected with the above; and (d) domicile of the person vested with the power to use or dispose of that income or wealth. It was the factor pertaining to “origin” of income which led to the enunciation of the source rule bearing in mind the need to identify the primary source of creation of income and the residence of its owner. It is these fundamental precepts which led to the formulation of measures to determine the economic presence of an entity in a given State and the functional integration of such an entity in the economic activity undertaken in that State.12

B. Recognition of permanent establishment’s distinct status under DTAA and domestic law

The Full Bench further highlighted that the independent and distinct status of a permanent establishment is not just a theoretical construct but is also accorded legal sanction insofar as, (a) the legally binding tax treaty postulates a valuable taxation right for the source/host State basis the existence of a permanent establishment in its territory; and (b) the fact that domestic law provisions13 create a charge on profits of such permanent establishment, fortuitously conclude the distinct identify of PE for purposes of its taxability in the source/host State.

45. It would also be pertinent to note that a cross-border entity may structure its operations in a manner where it operates in more than one taxing jurisdiction. If it be open for such an entity to assert that its global profits and income are not liable to be taxed on the basis of the source principle, it would be wholly impermissible for it to contend that the income which accrues or arises in the contracting State is also exempt from tax. In any case, the usage of the phrase “… so much of them as is attributable to the permanent establishment”. is a clear indicator of the DTAA warranting the PE being liable to be viewed as an independent centre of revenue.

46. The identifiable parts of Article 7 not only restrict the right of one of the contracting States to tax, it also provisions for the extent to which a tax may be imposed by that State. This becomes evident from it freeing a transborder entity from the Specter of a tax liability if it does not have a PE in the introductory part of that covenant. It then proceeds to restrict the impost by adopting the principle of attribution. It thus constructs an objective criterion for identification of a PE and when a foreign enterprise with sufficient economic presence would become subject to tax. All of the above, convinces us to hold against the argument of a PE not being taxable on an independent evaluation being misconceived.

*        *        *

55. Article 7(1) thus in clear and unequivocal terms constructs a dichotomy between the profits that may be earned by an enterprise on a global scale and those which are attributable to a PE situate in the contracting State. This becomes further evident from a reading of para (2) of Article 7 and which stipulates that where an enterprise carries on business through a PE in the other contracting State, profits would be liable to be attributed to that PE as if it were a distinct and separate enterprise engaged in similar activities and independent of the enterprise of which it may be a part.

56. This aspect is further amplified when we bear in consideration Article 7(2) employing the phrase “dealing wholly independently with the enterprise of which it is a permanent establishment”. Article 7(2) thus clearly bids us to view the PE as a distinct and separate entity engaged in undertaking business activity in its own right in a contracting State. It would consequently and on a fundamental plane be incorrect to fuse the incomes generated by an enterprise as a whole with the income that may be earned by a PE in one of the contracting States.

*        *        *

61. Global income, as a fundamental precept, has always been invoked in respect of residents of a contracting State. Most Nations have ultimately reverted to the source rule for purposes of taxation. We are thus called upon to deal with a regimen which concerns itself with the source from which income accrues or arises. This precept also stands mirrored in Section 5 of the Income Tax Act, 1961 and which jettisons the principle of territoriality only in respect of income earned by a resident. Thus, taxation based on worldwide income stands confined to natural residents. However, no nation avows or waives its right to tax capital or transactions which are anchored to its own territory. It is this basic precept of source which continues to bind.

62. The distinction which needs to be borne in mind with regard to the income of a non-resident as opposed to an entity domiciled and stationed in one of the contracting States stands duly acknowledged in Section 5 of the Act and which subjects the global income of a resident alone to taxation. For non-residents, it is the principles of income accruing or arising which are decreed to govern. It is these broadly accepted and well-recognised principles which imbue the DTAA also.

63. As was noticed hereinabove, the profits of an enterprise do not become subject to taxation unless it be found that it functions in the other contracting State through a PE. Article 7 further postulates that it is only such income which is attributable to the PE which would be subjected to tax in the source State. As is pertinently noted in the OECD and United Nation (UN) Commentaries, it would be wholly incorrect to found taxation on the basis of the overall activities or profitability of an enterprise. The source State is ultimately concerned with the income or profit which arises or accrues within its territorial boundaries and the activities undertaken therein. As those commentaries pertinently observe, the profits attributable to a PE are not liable to be ignored on the basis of the performance of the entity as a whole. This position also finds resonance in the decisions of the Supreme Court in Morgan Stanley case14 and Ishikawajma case15 and relevant parts whereof have been extracted above.16

(emphasis supplied)

C. Irrelevance of global profitability of non-resident entity

Having dissected its status and concluded that both conceptually as also from a tax treaty perspective permanent establishment has a distinct status, the Full Bench unequivocally concluded that the naturally corollary of this legal position was that the fact as to whether at a global level the non-resident is profitable (or not) pales into insignificance and the only fact which matters is whether the permanent establishment as such (i.e. the operations within the source/host country) is profitable:

57. It would also be incorrect to interpret Article 7 as requiring us to ignore the income that may be generated pursuant to activities undertaken by a PE in one of the contracting States and making the exercise of attribution dependent upon the profits or the income that the enterprise may otherwise earn at an entity level. In fact, Article 7(1) itself excludes the profits of an enterprise from being subjected to tax till such time as such an entity carries on no business in the other contracting State through a PE.

58. Consequently, even though a PE may be merely a part of the larger entity, the profits generated from its activities undertaken in the other State becomes subject to taxation. Article 7(1) further requires us to undertake an exercise of identifying the extent of profits as are attributable to the PE. It is to that extent alone that the profits of the enterprise ultimately come to be taxed.

59. The view that we have taken above also finds support from the OECD Commentary on Article 7 and relevant parts whereof have been extracted in para 39 of this judgment. As the Commentary succinctly explains, the taxation right of the source State is dependent upon the existence of a PE. That since such an establishment participates in economic activity within the territory of the source State. It is in the aforesaid context that the Commentary refers to it as constituting a “separate source of profit”. Of equal significance are the observations in the Commentary and which bids us to bear in consideration the possibility of profits being attributed to the PE even though the entity as a whole had never earned the same.

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64. If the submission of the appellants were to be accepted, the Revenue would be recognised to have the power to tax even in a situation where although the entity be profitable, the PE may have incurred a loss. If the aforesaid logic were to be applied, in a converse situation, the contracting State would be countenanced to have the right to tax only if the assessee at a global level were found to have earned profit. That is clearly not the import of Article 7 of the DTAA. While protecting the right of an enterprise to be subject to tax in the State where it be resident, Article 7 places a negative stipulation in respect of cases where a PE is found to exist coupled with an attribution exercise being undertaken in respect of the domestic enterprise. The contention of the respondents essentially requires us to confer a judicial imprimatur upon the principle that the domiciled entity, namely, a PE, would be liable to be taxed only if the global enterprise were profitable. This even though the income of that entity, by virtue of Article 7, stands restricted to the extent of income being attributable to the PE. In fact, Article 7 itself restricts the taxability of the enterprise to the extent of income or profit attributable to the PE. We are thus of the firm opinion that the argument of global income or profit being relevant or determinative is totally unmerited and misconceived. The submission is clearly contrary to the weight of authority which has been noticed hereinabove.

65. Regard must also be had to the fact that Article 7 does not expand its gaze or reach to the overall operations or profitability of a transnational enterprise. It is solely concerned with the profits or income attributable to the PE. The taxability of income earned by a PE existing in a contracting State is not even remotely linked or coupled to the overall operations of the enterprise of which it may be a part. The argument of world-wide income is thus rendered wholly untenable.17

Appreciating the finesse of the Full Bench decision and way forward

The decision of the Full Bench is not just logical but is conclusion is also the natural sequitur of the distinct existence of a permanent establishment. It is rather strange that a contrary position even warrants consideration, must less received judicial imprimatur in the past which warranted delineation of the legal position by the Full Bench. Hence, the unequivocal exposition by the Full Bench is a welcome course correction.

At another level, the implications of these propositions are the need to apply the arm’s legal standard between the non-resident entity and its permanent establishment. Traditionally the arm’s legal standard has been deployed qua legally distinct yet related party entities. However, with the factum of permanent establishment being conceptually a distinct entity (even if not legally distinct) in view of the need to independently determine the profitability of the permanent establishment and give full force to the source/host State’s right to tax the permanent establishment, there is no reason not to apply the arm’s length standard even to permanent establishments. Then alone would the full fruits of the Full Bench’s decision and the underlying conceptual foundations of the permanent establishment shall be achieved, both in theory and practice.


*Advocate, Supreme Court of India; LLM, London School of Economics; BBA LLB (Hons.) (Double Gold Medalist) National Law University, Jodhpur. Author can be reached at: mailtotarunjain@gmail.com.

1. Hyatt International Southwest Asia Ltd. v. CIT, 2024 SCC OnLine Del 6546, this aspect has been addressed in the Full Bench decision in the following terms:

33. It becomes pertinent to note that Art. 5 while defining the expression “PE” brings within its ambit a varied nature of establishments and which need not necessarily be those which have a separate legal persona. As we view Art. 5, it becomes apparent that the nature of establishments which are included within the meaning of the phrase “PE” range from a place of management to a mine or a building site and thus not being confined to a juridical entity as is ordinarily understood in law. (Mark as RI1)

2. See also, Hyatt International case, 2024 SCC OnLine Del 6546, paras 34 to 39 of the Full Bench decision, wherein inter alia relying upon International Management Group (UK) Ltd. v. CIT, 2024 SCC OnLine Del 4558; CIT(International Taxation) v. Morgan Stanley & Co. Inc., (2007) 7 SCC 1; Klaus Vogel on Double Taxation Conventions (5th Edn.) it has been concluded that “imperatives of viewing the PE as a separate and independent centre for the purposes of fiscal treatment and taxation is necessitated for reasons of attribution and recognition of income generated by it independently”.

3. 2024 SCC OnLine Del 6546.

4. 2022 SCC OnLine Del 5088.

5. 2022 SCC OnLine Del 5088.

6. 2022 SCC OnLine Del 5088.

7. 2024 SCC OnLine Del 6546.

8. 2022 SCC OnLine Del 5088.

9. (2007) 3 SCC 481.

10. (2015) 11 SCC 734.

11. (2007) 7 SCC 1.

12. Hyatt International case, 2024 SCC OnLine Del 6546.

13. For illustration, Income Tax Act, 1961, S. 9(1)(i), referred therein as “business connection”.

14. (2007) 7 SCC 1.

15. (2015) 11 SCC 734.

16. Hyatt International case, 2024 SCC OnLine Del 6546.

17. Hyatt International case, 2024 SCC OnLine Del 6546.

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