Liaison Office – A taxable presence?

Introduction

1. An enterprise having established itself in its home country, usually tests its waters outside its domestic boundaries, with an endeavour to obtain its share in the universal pie of globalisation fruits. In its initial phase of establishment of its business in the host country, a multinational corporation (‘MNC’) conducts market research, develops strategies to explore the foreign markets, formulates plans, maintains liaison with the government officials, etc. Post-such preliminary activities, MNCs commence their operations for their foreign markets, either controlled or managed from their home country or in the foreign host country.

In order to undertake such exploratory or precursory activities, MNCs establish a Liaison Office (‘LO’) in the host country. The Reserve Bank of India (‘RBI’) also permits an MNC to establish its LO in India subject to the condition that it is venturing into certain limited arena of permitted activities only. Undertaking any activity beyond the rigours of permitted activities requires application for conversion of such LO into a Branch Office (‘BO’) or Project Office (‘PO’) or any other body corporate, as the case may be, besides any other consequences, as may be prescribed under the FEMA regulations.

Position under the Legal Tax Provisions

2. Relaxation is also provided under the taxation laws, both under the domestic tax laws of India, i.e., Income-tax Act, 1961 (‘Act’) as well as India’s Double Taxation Avoidance Agreements (‘DTAA’) with various countries. Under the Act, section 9 provides for taxation of income only to the extent income is reasonably attributable to the operations carried out by MNC’s business connection in India. Also, under the DTAA, relief is provided to the LO by way of certain exceptions contained in Article 5 of the DTAA so as to exclude the activities from the garb of Permanent Establishment (‘PE’), which are ‘preparatory or auxiliary’ in nature. Under the DTAA, LO may be treated as a ‘Fixed place of business’, however, such fixed place of business may not necessarily be deemed to be MNCs’s PE in India, provided the activities carried out through such fixed place of business are ‘preparatory’ or ‘auxiliary’ in nature.

Jurisprudence in India has also time and again held similar view. Various judicial forums have attempted to define the terms ‘preparatory’ or ‘auxiliary’ which are not otherwise defined under the Act nor under the DTAA. The terms ‘preparatory’ has been explained to mean something done before or for the preparation of the main task. Similarly, the term auxiliary has been interpreted to mean an activity ‘aiding’ or supporting the main activity.

Therefore, in order to determine whether a LO of an MNC constitutes its PE, an acute analysis needs to be made based on the factual information available, i.e., considering the nature of activities undertaken by the LO, business of the MNC and the overall facts and circumstances of the case. Inference may be drawn from the judicial precedents on the subject.

For such purposes, following is a brief synopsis of the legal principles held in various judicial precedents on the issue of determination of an LO as PE of its MNC in India, considering the distinct activities undertaken by such LOs in India.

3. Indian jurisprudence

3.1 Research/Information collection and precursory/aiding Activities-Initial research, information collection and preliminary advertising undertaken by a LO in India, has been held to be in the nature of ‘preparatory’ or ‘auxiliary’ activity and, thus, it has been held that the LO does not constitute PE of its MNC in India.

Authority for Advance Ruling (‘AAR’) in the case of KT Corporation, In re [2009] 181 Taxman 94held that the activities in the nature of:

(i)		Holding seminars, conferences;
(ii)		Receiving trade enquiries from the customers;
(iii)		Advertising about the technology being used by the MNC in its products/services and answering the queries of the customers;
(iv)		Collecting feedback from the customers/prospective customers, trade organisations and not playing any role in pre-bid survey, etc., before entering into the agreement with its customers, nor involving itself in the technical analysis of the products/services

are in aid or support of the ‘core business activity’ of the MNC and, thus, fall under the exclusionary clauses (e) and (f) of Article 5(4) of the DTAA between India and Korea. It is pertinent to note that the AAR also noted that the LO confined to from carrying out preparatory and auxiliary activities only.

Recently also Mumbai Tribunal in the case of Nagase & Co. Ltd. v. Dy. DIT [2018] 96 taxmann.com 504 (Mum. – Trib.) held that in the absence of any material or evidence brought on record by the revenue authorities to the effect that the LO was executing business or contracts independently with the customers in India, the plea of the assessee that it was engaged in carrying out only preparatory or auxiliary activities needs to accepted and, accordingly, the taxpayer’s LO in India did not constitute its PE in India.

Similarly, the Hon’ble Delhi High Court in the case of Nortel Networks India International Inc.v. DIT [2016] 69 taxmann.com 47/241 Taxman 464/386 ITR 353 held that where Indian subsidiary of the MNC negotiated and entered into the contracts with the customers of the MNC (On the specific facts and circumstances of the case, Indian subsidiary was also held as not to constitute PE of the MNC in India.) (though to be ultimately performed by the MNC), LO of the MNC could not be held to be PE of the MNC in India, especially when the tax authorities had not brought on record any evidence that the LO had participated in the negotiation of the contracts.

3.2 Purchase Activities – On a similar footing, purchase functions or a part thereof, performed by a LO in India has been consistently held as outside the purview of such LO having any taxable income in India, under the domestic tax laws of India itself (It is pertinent to note that the question of claiming any treaty benefit would arise only when any income is taxable under the domestic tax laws.).

Hon’ble AAR in Ikea Trading (Hong Kong) Ltd., In re [2009] 176 Taxman 344/308 ITR 422 (AAR – New Delhi) has held that where the LO’s activities are confined only to facilitate the purchase of goods in India for the purposes of export outside India, such activities are covered by restriction/relief provided under clause (b) of the Explanation 1 to section 9(1)(i) of the Act and, accordingly, no income is deemed to accrue or arise in India with respect to the operations carried out by the LO in India..

Likewise, the Hon’ble Karnataka High Court in Columbia Sportswear Co. v. DIT (International Taxation) [2015] 62 taxmann.com 240/235 Taxman 349 reversing the decision of the AAR Columbia Sportswear Co., In re [2011] 12 taxmann.com 349/201 Taxman 214/337 ITR 407 (AAR) held that all the activities undertaken by LO of an MNC such as designing, manufacturing, identifying vendors, negotiating with vendors, ensuring quality control of the products manufactured by vendors, quality assurance, on-time delivery, acting as a conduit/’go between’, between the vendors in India/Egypt/Bangladesh and the MNC situated outside India, are ‘activities necessary’ for carrying out purchase function in India, as otherwise the goods purchased from would not find any customer outside India. Accordingly, such activities are not the ‘activities other than sale of goods’ as held by AAR, rather an extension/necessary part of the purchase function itself, so carried out by the LO in India. Accordingly, appropriate relief as provided under clause (b) of the Explanation 1 to section 9(1)(i) of the Act is required to be extended to the taxpayer.

Similar view was adopted by the Hon’ble Bangalore Tribunal in the case of Asstt. DIT (International Taxation) v. Tesco International Sourcing Ltd. [2015] 58 taxmann.com 133/69 SOT 107 (Bang.-Tri.) (URO)

3.3 Routine functions – Where routine functions are performed by the LO in India and for the purposes of performing such routine functions, LO has been given limited powers, it cannot be held that MNC has PE in India in the form of its LO.

The Hon’ble Delhi ITAT in the case of Kawasaki Heavy Industries Ltd. v. Asstt. CIT [2016] 67 taxmann.com 47/157 ITD 847 (Delhi – Trib.) has held that the powers/rights granted by MNC to its LO in India, such as:-

(i)		Signing of documents for rental of premises, equipment, services with any person including Municipal bodies, governments, etc., as may be required for the operation of LO;
(ii)		Execution of contracts for purchase of items for operation of LO;
(iii)		Negotiating, carrying on correspondence with banks, municipality, local or body transport, governments including electricity, railway, excise, customs, industry, telephone, facsimile, postal authority, etc.;
(iv)		Filing of applications with the RBI for setting-up of LO;
(v)		Employing persons, appoint or engage agents for the operations of LO;
(vi)		Appointing attorneys to represent before the governmental or judicial bodies

are specific to the operations of the LO and the stand of the AO, that the power of attorney is an ‘open document’ giving unfettered powers to the LO, would be outside the scope of the initial approval granted by the RBI. The tribunal further held that the revenue authorities have not brought on record any evidence that LO was conducting any core business activity/income generating activity and, hence, LO cannot be said to constitute PE of its MNC in India.

However, on a contrary note, the Hon’ble Mumbai Tribunal, considering the specific facts in the case of Micoperi S.p.A. Milano v. Dy. CIT [2002] 82 ITD 369 (Mum.) held that maintenance of a project office in India and incurring expenses for maintaining such office, such as postage, telex, etc., indicate that MNC has a PE in India.

3.4 Marketing Activities – Where the LO undertakes the preliminary activities of advertising, identification of customers, attending queries of customers, such activities would fall within the ambit of preparatory/auxiliary activities and, accordingly, LO would not qualify as PE of the MNC in India. However, where such activities cross the ‘thin-line’ of preparatory/auxiliary activities and kick-off performing income generating activities, such activities would require the LO to be treated as PE of the MNC in India. Let us now have a look at the judicial precedents as to when such ‘extended’ activities have resulted in constitution of an LO as PE of its MNC.

Hon’ble Bangalore Tribunal in the case of Dy. DIT(International Taxation) v. Jebon Corpn. India [2010] 125 ITD 340 held that where LO was the face of the MNC before its customers in India, even if the purchase orders/invoices/supplies were all done by MNC in Korea, LO was to be treated as PE of the Korean MNC for such activities would not fall under the scope of ‘preparatory and auxiliary activities’ as defined under Article 5(4)(e) of the DTAA between India and Korea. In this case, pursuant to the initial meetings with customers relating to product specifications, LO was also negotiating the pricing of the products, discounts, after adding appropriate margins to the base sale price received from Korean MNC.

Similarly, the Hon’ble Allahabad High Court in the case of Brown & Sharpe Inc. v. CIT [2014] 51 taxmann.com 327/[2015] 230 Taxman 69/[2014] 369 ITR 704 held that the activities such as:

(i)		Explaining the products to the buyers in India;
(ii)		Furnishing information in accordance with the requirements of the buyer;
(iii)		Discussions on the commercial issues pertaining to the contract through the technical representative, after which an order was placed by the Indian buyer directly to the Korean HO,

would be something more than ‘preparatory’ or ‘auxiliary’ activities and, accordingly, LO was PE of the MNC in India. Further, the incentive plan designed for remuneration of the employees of the LO indicated that the LO was undertaking not just the ‘advertising’ activities, rather such activities traversed the actual marketing of products of the MNC in India as it was only on the basis of the orders generated that an incentive was envisaged/organised for the employees.

Recently also, the Hon’ble Delhi High Court (‘DHC’) in the case of GE Energy Parts Inc. v. CIT, International Taxation [2019] 101 taxmann.com 142 delivered ruling on similar lines. Hon’ble Delhi High Court held that the LO of GE was its PE in India on the following counts:-

(a.)

Fixed Place PE – GE LO was a fixed place PE of its MNC because:-

(i)		There was a fixed place of business;
(ii)		The fixed place of business was at the disposal of the employees of the LO more so when GE had not contested that activities of ‘some form’ were not carried out from such premises and thus it was reasonable to assume that the activities were carried through such premises;
(iii)		Though the final word with respect to the pricing of the products was with the HO, however, that won’t mean that the LO was for mute data-collection/information dissemination. LO discharged the vital responsibilities or at least had a prominent role in contract finalisation, viz,:- extensive negotiations with its customers, customisation of the products with respect to the requirements of the customers, negotiating the financial parameters of the products and not allowing overseas entity to alter such terms without the consent of GE India, etc. Accordingly, LO was not performing merely the liaisoning activities. Defining the terms preparatory or auxiliary activities as ‘something remote from the actual realisation of the profits’, DHC held that the activities performed by LO would not fall within the exception provided under Article 5(3)(e) of India-USA DTAA.

(b.)

Agency PE – GE’s overseas entity had agency PE for the following reasons:-

(i)		Where the expats/employees performed activities for different entities of the same group, then it could not be construed that activities had been performed for a single enterprise. Accordingly, the GE India (through the employees of the LO and Indian subsidiary) constituted dependent agent of GE overseas MNC;
(ii)		Relying on the decision of the Italian Court in the case of Ministry of Finance (Tax office) v. Philip Morris (GmBH), Corte Suprema di Cassazione [No. 7682/02 of May 2002] held that the active and major participation/involvement of the employees/representatives in the negotiations/meetings with the customers indicated that the agents had ‘authority to conclude contracts’, even if final contracts were concluded by GE HO.

It seems that Hon’ble Delhi High Court had adopted the intention of majority of the sovereign nations as provided under BEPS Action Plan 7 while interpreting the existing DTAA provisions pertaining to PE.

4. Position under BEPS

4.1 Preparatory or auxiliary activity – Under the BEPS Action Plan 7, an attempt has been made to define the terms ‘preparatory’ and ‘auxiliary’, which have still not been defined anywhere, apart from the reference drawn from the judicial precedents. The term preparatory has been defined to include the activities done prior to or in contemplation of any activity which forms significant part of the activity of the enterprise as a whole. It has been indicated that preparatory activities are usually performed for a shorter period of time, however, that doesn’t mean that the activities which require a relatively longer period (such as training of the employees for construction activities) would not constitute preparatory or auxiliary activity.

Similarly, the term auxiliary activity has been defined to be an activity which is carried in support of the main activity, without being significant and indispensable part of the activity of the enterprise as a whole, with a rider that where the activities require involvement of significant proportion of assets and employees, even if such activity is in ‘aid’ of the main activity, it cannot be treated as an auxiliary activity. An example has been given in case of an e-commerce company maintaining a warehouse in the source country, thereby employing significant employees to maintain its operations.

It is pertinent to note that most of the illustrations provided under BEPS Action Plan 7 have been given in a negation form as to what will not constitute preparatory or auxiliary activity in the source country?

Even under Article 13(1) of the Multilateral Instrument (MLI), it has been specifically provided that the activity or the series of activities performed need to collectively fulfil the tests of ‘preparatory’ or ‘auxiliary’ activity in order to fall under the exceptions of PE.

4.2 Anti-fragmentation Rule – Further, in respect of related enterprises, as endorsed by BEPS Action Plan 7, Article 13(4) of the MLI provides for an anti-fragmentation rule with an endeavour to curb the practices of the enterprises where they split up their activities not only over the different places of business of an enterprise but also across the places of business of the related enterprises or more specifically across its different group entities.

Article 13(4) of the MLI provides that the exceptions to the PE rule, usually provided under a DTAA (as further modified by the provisions of MLI), shall not apply to the fixed place of business maintained by an enterprise in the source country, where such fixed place of business is used by that enterprise or its related enterprise and,

(a)		Such fixed place of business constitutes a PE for the enterprise or its related enterprise; or
(b)		The activities carried on by the enterprise or the related enterprise from such fixed place of business do not constitute preparatory or auxiliary activity.

MLI has further conjoined it with a condition that in order for such fixed place of business to constitute PE of the MNC, activities performed by the enterprise or its related enterprise from such fixed place of business, should constitute complimentary functions that are part of a cohesive business function as a whole.

4.3 Dependent Agent PE – Similarly, under BEPS Action Plan 7, read with Article 12(1) of the MLI, in respect of dependent agency PE, it has been provided that where a person, acting on behalf of the MNC, habitually concludes contracts or habitually plays the principal role of leading to the conclusion of the contracts then such MNC would be deemed to have a PE in the source country in respect of the activities undertaken by such person, provided such activities if carried out through a fixed place of business should not fall under any of the exceptions to the PE.

Conclusion

5. As has been rightly held by, the Hon’ble Delhi High Court in GE Energy Parts Inc. case (supra), the enterprises do not necessarily organise the business principles (on which they function) into neat pigeon holes that the tax regimes (both the domestic tax laws as well as the DTAAs) envision. With dynamic changes in the manner in which businesses operate, coupled with the evolving judicial precedents on the subject, it is inevitable that an enterprise needs to have a proper check on its operations to ensure that it is not exceeding the PE threshold provided both under the domestic laws as well as the tax treaties.

As mentioned above, there is very thin/fine line as to what activities or the extent of activities actually performed by the enterprise or its employees in India would trigger PE of an MNC in India. This becomes all the more important with extended clarity/restrictions provided by OECD under BEPS Action Plan 7 and finally brought into action by MLI. Thus, it is now an inevitable obligation on the MNCs to have a thorough diagnostic review of its operations not only before the commencement of the operations but also at regular periodic intervals, so as to keep its operations abreast with the changing laws.

Reference: https://www.taxmann.com/topstories/105010000000016267/liaison-office-a-taxable-presence.aspx