By S.S. Palwe, Samir Gandhi, Tehmina Latiwala and Mital Patel (Mumbai)
In a recent decision that could have significant implications for companies operating in India through dependent agents, the Mumbai Tribunal held on April 20, 2007, that the income of a foreign company in India may be taxed even when the foreign company pays an arm's length remuneration to its dependent agent in India (Dy Director of Income Tax v. SET Satellite (Singapore) Pte Ltd.). Until this decision, the prevailing view in India was that the payment of arm's length remuneration by a foreign enterprise to its dependent agent extinguished the foreign company's Indian tax liability.
A foreign company can conduct business in another country (the host country) through an entity that facilitates the sale of the foreign company's products/services to customers in the host country. Depending on the facts and circumstances, there may be instances in which the relevant activities of the entity in the host country constitute an "agency permanent establishment" (agency PE) of the foreign company. A highly debated issue in international tax concerns the attribution of profits to an agency PE, and whether a payment by the foreign company to a dependent agent extinguishes any further tax liability of the foreign company in the host country.
The OECD issued a report in December 2006 on the attribution of profits to a PE, in which the OECD observes that a mere arm's length payment by a foreign enterprise to its dependent agent in the host country does not necessarily lead to the extinguishment of the tax liability of the foreign enterprise in the host country.
Facts of the case
The taxpayer, SET Satellite (Singapore) Pte Ltd., is a foreign telecasting company resident in Singapore. SET Satellite is in the business of creating and operating satellite television channels, marketing and distributing such channels in India, and providing related support services to Indian customers. SET Satellite appointed an agent in India to market air time slots to various advertisers in India on its behalf. The agent in India constituted a PE of the taxpayer in India, and SET remunerated the agent on an arm's length basis for the services rendered regarding the marketing of air time.
The Indian assessing officer determined that SET Satellite earned income taxable in India and computed the tax base at 10 percent of the advertisement revenue. However, the commissioner of Income Tax (Appeals) affirmed the taxpayer's position that because the remuneration was made on arm's length terms, it had no further tax liability in India. The tax authorities further appealed to the Income Tax Appellate Tribunal.
Arguments of the parties
According to SET Satellite, the profits of a foreign company to be taxed in India are the profits attributable to a PE of the foreign company in India. Under article 7(2) of the India-Singapore tax treaty, the profits attributable to the PE are "the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a PE." This language corresponds to the arm's length principle.
In this case, the taxpayer argued, there was no dispute that it remunerated its Indian agent on an arm's length basis (in the form of a commission) for services rendered in India. Thus, no additional income was attributable to the Indian operations; accordingly, the profit attributable to SET Satellite cannot exceed the profits earned by the dependent agent by way of the commission. To support its argument, the taxpayer relied on the commentary of various authors, guidance issued by the Indian tax authorities (such as Circular No. 5 of 2004 on BPO taxation and Circular No. 23 of 1969 on the taxation of nonresidents), a decision of the Authority for Advance Ruling (AAR) in the case of Morgan Stanley & Co. Inc., and a decision of the Mumbai Tribunal in the case of Roxon OY.
SET Satellite also contended that the OECD report on the attribution of profits to a PE suggests (in the preface) that article 7 of the OECD Model Treaty, as well as the Commentary, require revision because the existing version of article 7 does not support the proposed interpretation of the OECD in the report, and further, that the OECD report seeks to establish what the law should be and not what the law is.
The Indian tax authorities, on the other hand, argued that a mere payment of arm's length remuneration to a dependent agent cannot extinguish the foreign company's tax liability in India. In this connection, the tax authorities relied on the OECD's 2006 report on the attribution of profits to a PE, as well as a paper issued by the Australian Tax Office (ATO), entitled "Attribution of Profits to a Dependent Agent of a PE," in which the ATO addresses the principles and approaches to be applied for the attribution of profits to a dependent agent of a PE.
Tribunal decision
Dependent Agent vs. DAPE. The Mumbai Tribunal first concluded that a dependent agent and a dependent agent PE (or DAPE) are distinct entities. A DAPE is not the dependent agent per se, but rather a DAPE exists (hypothetically) by virtue of an enterprise having a dependent agent. Under article 5(8) of the India-Singapore tax treaty, when an agent, other than an independent agent, satisfies at least one of the tests set out in article 5(8), "the enterprise shall be deemed to have a PE" in the other contracting state. Thus, the tribunal held that the profits attributable to the PE in accordance with article 7 of the treaty are the profits of the foreign company and not of the dependent agent.
Mere payment of arm's length remuneration to a dependent agent does not necessarily extinguish the tax liability of the foreign company in India. The tribunal stated that the DAPE is a hypothetical establishment, the taxability of which depends on the income from the activities of the foreign company that are attributable to the PE, which in itself is based on the functions performed, assets deployed, and risks assumed (FAR) by the foreign company in respect of the activities carried out in India. In other words, the income generated as a result of the FAR of the DAPE is considered the "hypothetical" income of the DAPE, with a deduction allowed with respect to all expenses incurred by the foreign company, including any remuneration paid to the dependent agent.
The Mumbai tribunal rejected the taxpayer's arguments that it should take into consideration the 2006 ruling issued by the Indian AAR in the Morgan Stanley case, in which the AAR ruled that the payment of arm's length remuneration by a foreign enterprise to its dependent agent does extinguish the tax liability of the foreign enterprise in India. The tribunal said that AAR rulings apply only in the context of the taxpayer to whom the ruling was issued, and therefore the Morgan Stanley ruling was not binding in the case at hand.
Implications
The Mumbai tribunal's decision will have implications on the taxability of foreign companies with an agency PE in India. Potentially affected foreign companies should closely analyze the FAR to determine whether the income being offered for taxation in India is commensurate with the activities undertaken by a dependent agent in India.
The Morgan Stanley case is on appeal to India's Supreme Court, which may ultimately resolve this controversy regarding the interplay between the attribution of profits to a PE and an arm's length payment.