In a landmark ruling, the Hon’ble Delhi High Court (“Delhi HC”) has held that profits generated by a Permanent Establishment (PE) in India shall be liable to tax in India, even if the parent enterprise has incurred losses on a consolidated basis. This decision overturns the previous judicial position set forth in the Nokia Solutions judgment and carries significant implications for global corporations operating in multiple jurisdictions.
Facts
In a significant case, a Full Bench of the Delhi HC was convened to reassess the precedent set in the well regarded and widely referred Nokia Solutions judgment[1] delivered by its Division Bench. The said ruling held that profit attribution to a PE in India was necessary only if the entire enterprise earned profits. Nonetheless, the Division Bench was sceptical of the notion that income attribution would be impermissible in the event that the enterprise had sustained global losses. It emphasised that regardless of the global financial outcome, a PE in India should be treated as an independent taxable entity and be subject to taxation on its profits generated in India. Pursuant to this, the matter was referred to a Full Bench.
Contentions of the Assessee
The Assessee, Hyatt International Southwest Asia, argued that Article 7 of the India-UAE DTAA clearly indicates that profits of a UAE-based enterprise would typically be taxable only in the UAE, not in India. The Assessee further asserted that if the UAE-based enterprise incurs a global loss, no tax liability arises in either of the jurisdictions. The Assessee contended that for a foreign enterprise to incur tax liability in India, three conditions must be satisfied: (i) the enterprise must generate profit, (ii) have a PE in India, and (iii) a portion of the profit must be attributable to that PE. Therefore, it was submitted that since the foreign enterprise in question was making a loss, no profit should be attributed to its PE in India.
Contentions of the Revenue Authorities
In contrast, the Revenue authorities argued that a PE must be treated as a distinct entity for tax purposes, independent of the global profits or losses of the parent enterprise. They also relied on the OECD Commentary on Article 7, which said that Contracting State can tax an enterprise’s profits only if attributable to a PE and that such attribution can occur regardless of the overall profitability of the enterprise. Therefore, the Revenue authorities contended that profits may be attributed to a PE even if the overall enterprise incurs losses.
Decision of the Delhi HC
The Delhi HC observed that theoretically, a state can tax a PE on income earned from economic activities within its jurisdiction, regardless of the enterprise’s residence or overall profitability. The PE is recognised as an independent entity for taxation purposes. Thus, once a PE is recognised under a DTAA, its taxability should not be assessed based on the parent entity’s activities or profits. The accepted principle under current double taxation conventions is that tax authorities, while taxing profits from a foreign enterprise, must assess each and every individual source of profits derived from the respective jurisdictions and apply the permanent establishment test accordingly.
The Delhi HC referred to the OECD and UN Commentaries to observe that the profits attributed to a PE are those it would expect to earn as an independent enterprise conducting similar activities under comparable conditions, considering its functions, assets, risks as well as transactions with other parts of the enterprise. The accepted approach employs the arm’s length principle, treating the PE as a separate entity independent of both the overall enterprise and any other parties involved.
Interpreting Article 7 of the DTAA, the Delhi HC observed that it establishes that an enterprise’s profits are generally taxable only in its resident state. However, it allows for expanded taxability if the enterprise operates through a PE in another Contracting State. Specifically, Article 7(1) stipulates that profits attributable to the PE’s activities in the other State are subject to taxation there. Thus, while the profits of an enterprise are primarily taxed in its home State, those generated by its PE can be taxed independently in the host State, limited to what is attributable to that PE. Therefore, Article 7 creates a clear distinction between the global profits of the enterprise and those specifically attributable to the PE. Article 7(2) reinforces this by requiring that the PE be treated as a separate entity conducting business independently, meaning that the profits of the overall enterprise should not be conflated with those generated by the PE. Thus, interpreting Article 7 as merging these income streams would be fundamentally incorrect.
The Delhi HC concluded that the submission of global income being determinative of the issue at hand is entirely unsustainable. It held that the activities of PEs are liable to be evaluated independently and definitively, emphasising that the notion of PEs as distinct taxable entities is beyond doubt. . The Delhi HC also concluded that Article 7 cannot possibly be viewed as restricting the right of the source state to allocate or attribute income to the PE based on the global income or loss that may have been earned or incurred by a cross border entity.
Along the above rationale, the Delhi HC ruled that the profits of a PE can be taxed even if the enterprise has incurred a loss at the enterprise level.
Significant Takeaways
The Delhi High Court conducted a comprehensive judicial and academic analysis, drawing on international commentaries to bolster its conclusions. It affirmed that a PE is treated as an independent entity for taxation purposes, establishing a clear distinction in tax liability. Furthermore, the Court undertook a jurisprudential exploration of the concepts of source and residence taxation, which significantly informed its decision.
However, this decision seeks divergence from the well-established principle that in case the entity has suffered a loss, then the “alleged PE” in India does not have to worry about being subjected to tax in India! The judiciary has several times, directly and indirectly, followed the Delhi High Court’s earlier decision on Nokia Solutions and Network OY[2] to decide on other matters. In cases like Rolls Royce PLC[3], Ericsson Telephone Corporation India AB (India Branch)[4], Arrow Electronics India Ltd. Liaison Office[5], etc., the income attributable to the PE was always determined to be a percentage of the global profits of the foreign parent entity. This decision has challenged the aforesaid principle and has raised the bar higher!
This decision has also not clarified how or on what basis the profits of the PE will be calculated and taxed if the global enterprise is incurring a loss. In the decision of Motorola Inc.[6], the profit percentage was calculated based on global accounts and the profit percentage was thereafter applied on Indian sales to determine the profits attributable to the PE in India. In that case, since the company had incurred a global loss, no profit was attributable to the Indian PE. However, since the Motorola case (supra) has been effectively overruled, how the profits will be attributed to the PE in India despite having global losses has not been answered. In the absence of profits, how an operating MNC is expected to attribute profits to its PEs worldwide, and who bears responsibility for the business risks they carry, are key aspects that require further study and investigation. This judgment is especially important for MNCs with PEs across various jurisdictions, as it clarifies that they remain liable to pay tax on the profits generated by these PEs, even in cases where the overall enterprise is incurring global losses. This ruling emphasises the necessity for MNCs to fully understand and comply with local tax obligations, regardless of their aggregate financial performance. It is anticipated that the taxpayer will carry the atter to the Supreme Court, who will have to give its final verdict on this matter! Till such time, the MNCs shall have to tread very carefully.
For further information, please contact:
S.R. Patnaik, Partner, Cyril Amarchand Mangaldas
sr.patnaik@cyrilshroff.com
[1] Commissioner of Income-tax (International Taxation) v. Nokia Solutions and Networks OY 2022 SCC OnLine Del 5088
[2] [2023] 445 ITR 157 (Delhi High Court)
[3] [2011] 13 taxmann.com 233 (Delhi)
[4] [2018] 96 taxmann.com 258 (Delhi – Trib.)
[5] [(2018) 94-taxmann-299
[6] [2005] 95 ITD 269 (Delhi)(SB)
