Preventing artificial avoidance of permanent establishment status
The OECD proposals make it imperative for MNEs to review their means of doing business in India
With the global economic recovery hanging in a humdrum, increasing curbs on welfare spending even within developed countries, and business boundaries being blunted in a virtual world with resources spread across the globe, developing a consistent set of tax rules poses a challenge. In this context, the OECD has set out to redefine a framework which tries to match pace with today’s business. Given that the existence of permanent establishment (PE) is fact-based exercise and cannot be defined in rigid terms, the action plan 7 is one among 15 plans which seeks to provide guidance on this key topic.
Commissionaire and similar models: what’s proposed?
Time and again, the issue on treatment of agents as PE has been subject matter of dispute, wherein courts have taken contrary views. Also, OECD wanted to change the terms of the dependent agent rule, primarily due to concerns about commissionaire and similar arrangements (which currently fall outside the purview of the rule). The predominant intention is to bring contracts materially negotiated in a contracting state but concluded in another contracting state.
Agents not acting in ordinary course of business or acting exclusively or almost exclusively for related enterprises would fall under the ambit of dependent agent permanent establishment. Risk exists in spite of agents getting remunerated at arms’ length.
The result is that MNEs would need to evaluate their hygiene factors such as terms of current business and authorisations to Indian persons etc. Substance and form rules might need to be rewritten with contract renewals and recitals, making terms of reference abundantly clear. Hitherto followed cost-plus models with adequate margins may not suffice to extinguish PE risk for the MNEs.
Specific exemptions under the treaty
Preparatory and auxiliary activities: Given that MNEs may alter their structures to obtain tax advantages, specific clarification has been brought that it is impermissible to avoid PE status by fragmenting a cohesive operating business into several small operations and each part is merely engaged in preparatory or auxiliary activities that benefit from the exceptions of Article 5(4). The terms ‘preparatory’ and ‘auxiliary’ need to be interpreted considering the principal activity.
With this, MNEs would have to pay attention to revised exclusions and would be advised to critically review their current operating model in India given that the activities of liaison office, brand office and project office have witnessed widespread litigation in terms of PE exposure and attribution related issues.
In the Indian context, with logistics sector hoping to get a leg up from GST and warehousing plans/Free Trade and Warehousing Zones being created, it would be crucial for MNEs not having a formal business presence in India—having just-in-time delivery models—to re-evaluate their business set up. Taxpayers using representative offices might want to evaluate developing a formal operating presence in India.
Fragmentation: Revenue authorities presume that taxpayers split their business activities among related enterprises to avoid PE. Certain illustrations have been brought in the context of anti-fragmentation rule which prescribe:
w Widening of tests in order to look into the essence of the transaction irrespective of legal existence (focus on substance over form).
* Any activity that is ancillary to PE would hitherto be swept as income of PE and would not be entitled to exemption.
* Activities carried on by closely-related parties to be viewed on a holistic basis.
It appears that a look-through approach has been suggested. Such proposals if not implemented fairly can result in increase in costs of capital for Indian borrowers, impact future off-shoring work and move certain business activities outside India permanently.
Splitting-up of contracts using multiple entities
The tax authority’s concern is ‘artificial’ division of contracts to avoid PE threshold for construction activities; it advocates reliance on action 6 work (General Anti-Abuse Rule); and the optional automatic rule prescribes aggregation of contracts for connected activities by related parties if they exceed threshold of 30 days/entity.
The rules do not seem to provide cognisance for commercial arrangements and structures that have been created for ease of business. Major disputes could arise applying the above rule, especially considering that India needs $1 trillion of infrastructure to be created.
MNEs would be advised to suitably plan their business by firming up advance rulings/private rulings or clarificatory circulars to be issued by the tax department since tax costs on infrastructure projects are quite high and bids do not permit pass-through of tax risk to the vendor.
The proposals make it imperative for MNEs to review their means of doing business in India. MNEs may need to put together an SOP/robust documentation to substantiate limited presence in India. This action plan no doubt arms revenue authorities with substantial ammunition which could have persuasive spillover value for open audits.
Taxpayers are well advised to evaluate how overall business efficiency can coexist with changing taxman perception.
Indian taxpayers who run global businesses will also be necessitated to comprehensively relook the way they run their overseas businesses (besides cover for Place of Effective Management) and ensure safeguards are in place to avoid unnecessary tax disputes.
