Safe harbour Rules Vs Permanent Establishment
Government has notified Safe
Harbour rules (SHR) to provides certainty to Indian associate enterprise of MNC
group in its Transfer Pricing Assessment
The bigger question is that whether safe harbour will really provide
certainty to MNC group as whole in connection with taxation in India
To bang upon the subject, I have considered the case of Software
Development Services, as provided in safe Harbour rule
An enterprise engaged in
Software Development services, can avail the benefits of SHR, if it is engaged
in either of following activities relating to:
a)
Business Application software and information
system development using know methods and existing software tools
b)
Support for existing systems
c)
Converting or translating computer languages
d)
Adding user functionality to application
programmes.
e)
Debugging of Systems
f)
Adaptation of Existing Software
g)
Preparation of User Documents
Further to avail, benefits
under the SHR, for enterprise engaged in software development services,
following FAR should be satisfied, as under:-
|
Particulars
|
Foreign Principle
|
Indian Associated Enterprise
|
|
Functions
|
Critical functions –
Conceptualisation and design of Product, providing strategic direction and
framework and entire Supervision of Indian Associated Enterprise
|
Perform the work assigned
under the supervision of Foreign Principle
|
|
Asset
|
Capital, funds and other
significant assets including intangibles are provided by Foreign principle
|
No ownership right, legal or
economic on any intangibles generated during the course of rendering services
|
|
Risk
|
Assume all economically
significant Risk
|
Do not assume any significant
risk.
|
Though by subjecting itself to
SHR, Indian associate enterprise will be protected from uncertainty and high
pitch transfer pricing adjustments
But there is other side of the story also.
Based on activities enumerated,
aforesaid FAR analysis and other incidental factors, analysed hereinafter
below, will the foreign principle be liable to taxation in India on account of
presence of PERMANNET ESTABLISHMENT.
To elucidate the concept,
Consider a case where Foreign Holding Company (H) is having wholly owned
Subsidiary (S) in India and S is engaged in Software Development services and
it has availed the SHR.
Further I have considered here
UN model of DTAA, since Indian most of DTAA are based on this model only
The question for consideration is whether S will be considered as PE of
H and if so, whether S reporting margins (20%/22% of operating expenses) as
mandated in safe harbour rules, will be sufficient attribution of profit of H
to PE under Article 7(2) or their needs further attribution of profits of H to
PE.
Existence of Permanent Establishment -Analysed
1.
In instant case, Existence of PE is to be
evaluated from fixed PE (Article 5(1) ) and agency PE (Article 5(5)(a))
perspective.
2.
Fixed PE-
For Fixed PE, following test to be satisfied:-
a)
Place of Business Test
b)
Power of Disposition Test
c)
Permanence Test
d)
Business test
3.
In circumstances of Instant case, Place of
business test and Permanence test can be easily be satisfied, only remaining
other tests need to be satisfied.
4.
Power of Disposition Test
a)
Test is satisfied when place of business of S is
at the disposal of H or should be freely available to H for the purpose of
business activities of H.
b)
Since it is condition of SHR that employee of S
has to work under the supervision of H and if it is a case where employees of H
are freely using the S’s place of business for supervision of S employee for
business purpose, power of disposition test can be deemed to be satisfied.
5.
Business Test
a)
Business test is satisfied when foreign
enterprise is carrying core of peripheral activities in India, excluding the
activities of auxiliary or preparatory in nature
b)
Based on list of activities enumerated in
‘”Software Development Services”, possibility of satisfying the business test
is established in following cases.
|
Activities
|
Business Test
|
|
Business Application
software and information system development using know methods and existing
software tools
|
Core Activity- Business Test
satisfied
|
|
Support for existing systems
|
Auxiliary Activities –
Business Test not satisfied
|
|
Converting or translating
computer languages
|
Peripheral Activities –
Business Test satisfied
|
|
Adding user functionality to
application programmes.
|
Peripheral Activities –
Business Test satisfied
|
|
Debugging of Systems
|
Peripheral Activities –
Business Test satisfied
|
|
Adaptation of Existing
Software
|
Peripheral Activities –
Business Test satisfied
|
|
Preparation of User
Documents
|
Auxiliary Activities –
Business Test not satisfied
|
6. Conclusion- Fixed PE- Thus if power of disposition test is
satisfied, there is possibility that AO may hold that H has PE in India, for
the afore-said core or peripheral activities being carried out by S.
7.
Agency PE
– Agency PE is satisfied when following conditions are met:-
a)
S is acting on behalf of H
b)
S has authority to CONCLUDE contracts on behalf
of H.
c)
S is not an independent agent, satisfying the
following conditions:-
i.
The activities of S are devoted exclusively on
behalf of H
ii.
The transactions between S & H are not at
ALP
8.
Authority to Conclude contracts – in the instant
case, S can be deemed to have authority to conclude contracts on behalf of H,
where S is engaged in following activities, rendering services to Indian
Customers on behalf of H:-
a)
Adding user functionality to application
programmes.
b)
Debugging of Systems
c)
Adaptation of Existing Software
9.
Independent Agent – In the instant case, S
status of being independent agent is doubtful on account of following:-
a)
The entire activities of S are wholly devoted on
behalf of H
b)
Whether adoption of margin by S stated in SHR,
will deem that transaction will between S & H will be at ALP, is not free
from doubt.
10. Conclusion- Agency PE- There is possibility
that S , being treated as agency PE of H.
Attribution of Profit to Permanent Establishment
Article 7(2) regulates the
attribution of Profit of H to PE and provides that profit be attributed based
on following assumptions:
a)
The PE is separate distinct enterprise.
b)
It was dealing wholly ad independently with
foreign enterprise of which it is PE.
Critical Point
If PE is found to exist based on afore-said reasoning, the important
point for consideration is whether adoption of stipulated margin by S as per
SHR is sufficient attribution of profit to S, being PE of H or further
attribution of profit of H to PE is required.
Analysis
1.
As per decision of Hon’ble Supreme Court in
Morgan Stanley (2007) 292 ITR 416, if the transactions with PE are at ALP, then
there is no need to further attribute the profit to PE.
2.
As per afore-said FAR analysis, S is only
performing low risk functions, without ownership of any asset and in that
scenario SHR mandated that S should earn 20%/22% of its operating expenses and
based on that it will deemed that transaction between S & H are at ALP
3.
All important functions, major assets and risk are
on the part of H. If it is established that H is having PE in India in the
business of S, then there is every possibility that AO will further attribute
the profit of H, for functions performed, assets owned and risk taken relating
to business of S in India.
4.
Further under rule 10, AO may attribute the
profit of H to S based on assets, revenue etc. if unable to attribute profit
based on FAR analysis.
5. Thus in spite of opting for safe harbour
rules, based on function profile as stated in said rules, there is every
possibility of AO invoking PE existence in the hands of H and levying tax in
the hands of H on Profits attributable to S less than profits of S.
6.
I think it is high time that Government should
come up with clarity on this aspect, otherwise objective of carving SHR will be defeated ,
since Income Tax department always try to prove the existence of PE, whenever
they see business connection of Foreign
Enterprise in India.
