According to Article 5 of Double Taxation Avoidance Agreement (DTAA) and the concepts underpinning Permanent Establishment in India, any profits of an enterprise of one Contracting State are taxable in the other state, only if the enterprise maintains a Permanent Establishment in the second country, and only for profits are attributable to that Permanent Establishment. Thus, a Permanent Establishment is the legal compromise between your source country and resident country for the purposes of taxation of business profits. There are six categories of Permanent Establishment:
Avoidance of Permanent Establishment (PE) status of Non-Residents is made through various arrangements. Company structures their business in way that status of PE can artificially be avoided. The definition of permanent establishment included in tax treaties is therefore crucial in determining whether a non-resident enterprise must pay income tax in another jurisdiction. Strategies used to avoid taxable presence in a jurisdiction under the article 5 of tax treaties may cause cross border income untaxed or lower taxed.
Government observed that certain common strategies are being used to circumvent the definition of PE. Changes to the definition of PE are utmost importance. This task is undertaken by Organisation for Economic Co-operation and Development (OECD) under the Base Erosion & Profit Shifting (BEPS) action plan. BEPS Action Plan identified 3 issues and amendments were made under the Action Plan 7.
Identified common strategies used by Non-Resident for artificially avoidance of Permanent Establishment:
It is an arrangement where a person sells products or renders services in a country in its own name but on behalf of foreign enterprises. He buys goods from foreign enterprises and sells at a very small margin. We also called it ‘’Low risk distribution business’’. Foreign enterprises choose to have an independent agent for such selling so that they can avoid risk of Permanent Establishment.
With a view to avoid tax evasion BEPS action plan 7 has now been included in Article 12 of Multilateral Instrument (MLI) to which India is also a signatory. Consequently, provisions of DTAA (Article 5) will align with Articles of MLI (Article 12).
Large MNC fragmenting its operations into small businesses in order to argue that each part is just a preparatory and auxiliary activities benefiting from article of treaties. Preparatory and auxiliary are separate when viewed in isolation but constitute whole business activities when viewed on combined basis. BEPS Action plan 7 has addressed this issue and provided rules to it members. This Anti-Fragmentation rule will ensure that core activities cannot be inappropriately fragmented and prevented from preparatory and auxiliary activities.
Splitting up of contracts
According to the existing provisions and articles a PE arises when work on a contract is performed for at least 12 months. In order to circumvent the PE status company splits it long term contract to short term contract by bypassing the time threshold that trigger the Permanent Establishment. OECD has attempted to prevention of treaties abuse by introducing ‘’Principal Purpose Test’’. This rule is one of the outcomes of Action 6 of the BEPS project on the prevention of treaty abuse. According to this rule, if one of the principal purposes of a transaction or arrangements is to obtain treaty benefits, these benefits will be denied unless granting them would be in line with the object and purpose of the provisions of the treaty.
It’s a wake-up call for companies with commissionaire and similar structure. The local tax authority has been scrutinizing such arrangement and we have plethora of judicial precedents where assessee has been trying to prove their arrangement genuine, in contrast authority has differ views. Additionally, Indian government has enacted General Anti-Avoidance Rule [“GAAR”] which is effective in India from 1 April 2017 and is broadly applicable, where the revenue authorities believes that a transaction has been arranged in a manner where the main purpose of the arrangement (whether whole or part) is to obtain a tax benefit. GAAR provision attracts when assessee made an ‘’impermissible avoidance arrangement’’ and transaction is having lack of commercial substance. The monetary threshold for applicability of GAAR is INR 30 million and it must be determined with regards to all parties to the arrangement.
It is advisable to all the global companies who are structuring their international transactions to go through the above amendments made through the multi-lateral instruments.