Virtual Permanent Establishment: Indian High Court Rejects Clamour to Expand Tax Treaty Contours

The standard models of these tax treaties support taxation rights relating to business income being predominantly invested with the resident State and limited taxation rights being made available to source State.

Setting the context

The current regime of international taxation is predominantly based upon bilateral tax treaties which distribute taxation rights between tax treaty partner countries. The standard models of these tax treaties, namely, the Organisation for Economic Co-operation and Development (OECD)¹ and the UN², both support taxation rights relating to business income being predominantly invested with the resident State and limited taxation rights being made available to source State. As an exception, source State assert taxation rights over business income where a non-resident (NR) entity carries out business in the source State through a permanent establishment (PE). In such scenario, the source States generally tax the NR entity to the extent of its income being attributable to the PE in the source State. Thus, the existence of the PE and the delineation of its scope and contours under the tax treaty are of critical importance and, consequently, often contested.

Fixed establishment, or fixed place PE as it is colloquially referred, as a species of PE, is generally found to exist in most treaties. Recently, the Supreme Court of India³ had assigned a rather expansive scope to fixed place PE by declaring that right of over hotels available to an NR entity under the strategic oversight and operational agreement qua such hotels constituted fixed place PE of such NR.⁴ In another recent judgment, the Delhi High Court had the occasion to examine a rather emerging trend, namely, “virtual permanent establishment”.⁵ The decision presents an opportunity to engage in this interesting aspect which requires detailed consideration in view of the wide ramifications and gain centre-field in the contemporary paradigm considering the significant impetus on technology-driven business. Given that, particularly since COVID-19, there is excessively increasing reliance upon virtual meetings, virtual networking, and virtual collaborative business models, etc. in the commercial world, this development is of vital interest to both the businesses and policy-makers alike.

Dispute before the High Court and its decision

The decision of the Delhi High Court has been issued in the context of an appeal by the tax administration against a decision of the Appellate Tribunal in the case of a prominent international law firm having business activity in India — Clifford Chance Pte. Ltd. v. CIT⁶. Plainly described, the Revenue sought to tax Clifford Chance on the premise that its activities in India constituted a service PE in India under the India-Singapore Double Taxation Avoidance Agreement (DTAA). While the DTAA stipulates a threshold of “183 days in any fiscal year” for the creation of a PE in context of “a building site or construction, installation or assembly project”, qua service PE the DTAA considers sufficient “a period or periods aggregating more than 90 days in any fiscal year” in other cases, and “a period or periods aggregating more than 30 days in any fiscal year” where the services are performed for a related enterprise.⁷

The Appellate Tribunal interpreted the DTAA provision to conclude that “actual performance of service in India is essential and accordingly only when the services are rendered by the employees within India with their physical presence during the financial year… shall be taken into account for computing threshold limit for creation of a service PE of the assessee in India”. In concluding so, the Appellate Tribunal had stressed upon the judicial guidance from the Supreme Court⁸ that for the purpose of examining the existence of service PE in India, the customers of the NR must receive services in India.

In appeal against the determination of the Appellate Tribunal before the High Court, the Revenue specifically urged that the “Tribunal erred in holding that the assessee does not have a virtual service permanent establishment in India.” Acknowledging that “although the employees of the [NR] were not physically present in India”, the decision of the High Court records that the Revenue urged before it that “the Tribunal ought to have appreciated that there is no mention of the word ‘physical presence’ of employees for constitution of permanent establishment under Article 5(6) of the DTAA. It merely states that furnishing of services within the contracting State should continue for 90 days or more and hence it is only “the continuance of services for the threshold limit of 90 days that matters and not the physical presence of the employees”.

Stressing upon the need to acknowledge the contemporary paradigm, the Revenue further canvassed that “as a result of rapid digitisation, companies can now continue to provide services even without the physical presence of employees in the contracting State. Thus, a virtual service permanent establishment of the assessee company was established in India, making the receipts on account of those services are taxable in India”.⁹ The Revenue further highlighted that the concept of virtual service PE was earlier recognised by the Appellate Tribunal.¹⁰

Granting its imprimatur to the conclusion of the Appellate Tribunal, the Delhi High Court agreed that the DTAA did not envisage the concept of the virtual PE, observing as under:

42. Article 5(6)(a) of the DTAA reads “An enterprise shall be deemed to have a permanent establishment in a Contracting State if it furnishes services… within a contracting State through employees or other personnel…”. The words “within a Contracting State” and “through employees or other personnel” contemplate the rendition of services in India by the employees of the non-resident enterprise, while mandating a fixed nexus; a physical footprint within India. The term “within” has a certain territorial connotation and in the absence of personnel physically performing services in India, there can be no furnishing of services “within” India. A plain reading of the whole provision would thus reveal that, it such rendition of services by employees present within the country which would constitute a service permanent establishment.

43. Mr Rai has vehemently contended that receipts on account of virtual services rendered by the assessee must be held to be amenable to taxation in India, since a “virtual service permanent establishment” has been established. We find that no such eventuality is contemplated by the DTAA. The concept of a virtual service permanent establishment does not find mention anywhere in the DTAA. In the absence of any such provision, the argument of Mr Rai would be at variance that the express provisions of the DTAA which we have already interpreted above.

44. At this juncture, we find it necessary to acknowledge that the Revenue may potentially be justified in raising concerns regarding taxability of foreign entities in the increasingly open global virtual economy, and the diminishing requirement of physical presence of non-resident employees to furnish services. However, taxability of entities in such instances, as always, remains subject to the applicable provisions of law — both treaty and domestic.

45. The law insofar as the present controversy is concerned, is clear and unambiguous. The DTAA, which has been carefully drafted and executed after numerous rounds of bilateral deliberations and negotiations at the highest level, must necessarily be interpreted strictly. If something is conspicuous by its absence, the presumption is that it has deliberately been done so. It is not for courts to read in concepts which are not expressly provided for by the treaty. The guiding principle here is that language which is not explicitly included in treaty provisions cannot be artificially read into such provisions by way of judicial fiction.¹¹

The High Court, in the passing, duly noted the Government’s steps at the international tax platforms but refused to give effect to the political efforts until the amendments were effectuated in the DTAA and the legal framework. To this end, the following observations of the High Court are noteworthy:

49. That being said, it is necessary to note that the comments made by India as recorded in the OECD Model Convention, and also the concept of Significant Economic Presence (SEP) brought about in the domestic tax jurisdiction through the Finance Act, 2018, do reflect a deliberate policy to capture digital or virtual economic participation outside the traditional permanent establishment framework. It may also be true that certain jurisdictions have moved away from the requirement of physical presence of employees to constitute a service permanent establishment. However, the same has not been administratively recognised by India, and in the absence of any changes made to the treaty provisions of the DTAA, such developments do not alter the interpretive constraints imposed by the wordings of the DTAA, which is applicable on all fours to the instant case. In fact, until Article 5(6) of the DTAA is renegotiated or supplemented, the existing treaty framework does not extend to virtual or digital services provided from abroad.¹²

The High Court, furthermore, distinguished the other decisions relied upon by the Revenue, including decisions of foreign courts¹³, opining that they were rendered in a different factual setting and had no bearing to the determination of the question relating to virtual PE. Thus, the Delhi High Court has affirmatively ruled out virtual PE in the context of Indian DTAA and is arguably the first decision of an Indian High Court to conclude such.

Reflections

The anxiety to expand the scope of source State taxation rights is not exceptional. One would note that there has been hardly any progressive movement in the expansion of their taxation rights since the original evolution of the bilateral tax treaty models. No doubt, various anti-avoidance provisions, particularly those arising from OECD base erosion and profit shifting (BEPS)¹⁴ and Multilateral Instrument¹⁵ (MLI) have empowered the source State to deny tax treaty relief by addressing specific anti-avoidance devices and even anti-avoidance generally, with the enactment of the “principal purpose test”.¹⁶ Nonetheless, the taxation rights of the source State have not been revisited, barring certain exceptions, such as taxation of digital services.¹⁷ Furthermore, the decade long movement, pioneer by OECD towards adoption of the Two-Pillar Framework to expand taxation rights relating to digital economy and beyond¹⁸, is virtually at a standstill.

Given the lack of forthcoming revisitation of taxation rights, it is not unnatural to expect countries and taxation authorities to explore if new ideas can be inseminated within the existing taxation paradigm. Virtual PE appears to be an outcome of similar approach where NR’s digital business are sought to be taxed within the PE framework. In this process, however, contemporary business realities are being tested on the touchstone of the finer text of tax treaties which have been negotiated in a different era and have been in vogue for decades, thereby having attained certainty on their scope and remit. Thus, whether it is the right approach on the part of the tax administrations to look for newer meaning in the scope of these tax treaties — which may not just be a manner of semantics but stretch the existing paradigm with consequential ramifications both domestically and internationally — is a moot question. No doubt, the decision of the Delhi High Court may not be the last word on the subject as the issue is likely to be retested in other judicial forum including by way of appeal to the Supreme Court. Nonetheless, as the decision reveals, the enforcement of such novelty and administration of such improvised concepts will have to be contested before the dispute resolution forums which are unlikely to abandon their traditional interpretative techniques only in the wake of securing additional taxation rights for the Government without any change in the legal setting or the statutory text of the tax treaties.

To be fair, the decision of the High Court acknowledges the Revenue’s desire to address the modern business practices and implores the Government to bring about suitable changes in the legal regime, thus setting right the scheme that the burden to tax is a legislative and executive exercise and it is not the judiciary’s responsibility to course-correct the tax treaties and their attendant legal framework through the process of their interpretation. At another level, the fact that this issue got litigated before the High Court (having already been rejected at the Appellate Tribunal level), illustrates the ongoing jostle between the tax authorities and the taxpayers to defend their respective positions which have been pedestaled on the fine text of the tax treaties as historically understood, never having been intended to address such emerging business paradigms. One can only anticipate rise in similar disputes with the increase in monetary stakes and progressive adoption of newer business models given the additional cost and commercial advantages offered by technological progression.

On the merits of the issue — whether a virtual PE is envisaged in the tax treaty paradigm — so far, the PE-related jurisprudence of India has only accommodated physical-structure based existence of PE. No matter how short or temporary the duration of stay, such as the Formula One World Champion Ltd. v. CIT¹⁹, where access to physical premises for a matter of few days was considered sufficient for a fixed place PE, nonetheless, even in that case there was physical access to immovable property located in the source State, and thus the importance of physical presence for the existence of a PE is overwhelming. The question which naturally arises, therefore, is that in a virtual setting when no physical access to a location in the source State is required, much less availed, how far PE can be considered to exist in the source State. There are certain precedents wherein technological innovations (such as website servers) have been accommodated within the tax treaty paradigm and it has been concluded that PE exists; however, the concept of virtual PE poses a different set of challenges and there appears to be academic consensus that virtual PE cannot be accommodated in the existing Indian tax treaty space and jurisprudence.²⁰

It is noteworthy that the domestic law has enacted a new taxation basis — “Significant Economic Presence” test — to tax virtually generated income in certain situations²¹ and thus the physical presence requirement cannot be insisted by NR without the benefit of tax treaties. Nonetheless, given the expansive tax treaty network of India, without formal amendment of these treaties, the domestic law progression may not be sufficient to tax NRs entitled to tax treaty protection.²² Thus, as the Delhi High Court has cautioned, the only way forward is that the tax treaty paradigm “is renegotiated or supplemented, [because] the existing treaty framework does not extend to virtual or digital services provided from abroad”. Given the ongoing bilateral attempts to renegotiate or modify tax treaties, it may not be a far cry to address the issue of virtual PE in similar setting. The WTO’s General Agreement on Trade in Services (GATS) envisages four-modes of trade in services wherein the very first mode “cross-border supply” addresses “services flow from the territory of one member into the territory of another member (e.g. banking or architectural services transmitted via telecommunications or mail)”.²³ Thus, the GATS template sheds invaluable guidance for the negotiation of tax treaty revisit qua virtual PE. Its mechanics may be factored by the tax treaty partners to refresh the tax treaties and modernise them by factoring the contemporary technology drivers of business.