PROJECT instances, machinery or equipment; – ii. this


)  The concept of permanent establishment (hereinafter”PE”) has gained considerable importance with the growing trend ofglobalization. The concept of a PE is important for several Articles of theConvention1;and the concept or its cognate, also appears in the domestic laws of somecountries. In India we have the concept of ‘business connection'(“BC”). Further, where a tax treaty is in operation, the crucialquestion is whether a foreign enterprise is carrying on business through a PEin the country where the profits are earned. If the enterprise does not have aPE then it can be taxed only in the country where it is a resident. However,where the enterprise operates through a PE, the profits attributable to it, maybe taxed by the country where the PE is located, leaving the country ofresidence to give relief from double taxation.

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Thus it may be possible for anenterprise with overseas trading operations to avoid foreign taxes by carefullystructuring its operations to come below the PE threshold. Where a PE is inexistence, the country where it is located may also tax its capital gains,dividends, interest and royalties that are effectively connected to such PE. ThePE concept marks the dividing line for businesses between merely trading with acountry and trading in that country.2Thus, a legal concept, PE is a compromisebetween source state and residence state for purposes of taxation of businessprofits.

 1.      CONCEPT OF PERMANENT ESTABLISHMENT AS PER UN MODEL 1.1   Definition in Art 5 (1): The general rule: the PE must be a fixed place of business at thedisposal of the enterprise through which the business of the enterprise iscarried on. The official commentary 3onthe OECD Model explains the basic criteria for the existence of a PE as follows:-                                i.           theexistence of a ‘place of business’,i.e.

, a facility such as premises or, in certain instances, machinery orequipment; –                              ii.           thisplace of business must be ‘fixed’, i.e., it must be established at a distinct place with a certaindegree of permanence; –                           iii.           the ‘carrying on of the business’ ofthe enterprise through this fixed place of business. This means usually thatpersons who, one way or another, are dependent on the enterprise (personnel)conduct the business of the enterprise in the State in which the fixed place issituated.From this definition it can be seen thatthere are two types of PE contemplated. First, an establishment which is a partof the same enterprise and under common ownership and control- an office,branch, etc.

This is covered by Article 5(1) to (4), which can be referred toas ‘Associated PE’. The second type is an agent who is legally separate fromthe enterprise, but is nevertheless dependent on the enterprise to the point offorming a permanent establishment. This is covered by Article 5(5) and (6),which can be referred to as ‘Unassociated PE’.1.2  Specific Inclusion in Art 5(2) –contains a list of places of business,which prima facie constitute PE, provided they satisfy the requirements ofArticle 5(1). hese establishments are: Placeof management, Branch, Office, Factory, Workshop and Mine, oil or gas, quarryor any other place of extraction of  natural resources.

The establishmentsmentioned are more by way of illustration. Hence, even an establishment whichis not mentioned therein could well constitute a PE.It may be noted that merely because anestablishment is of the nature mentioned in Article 5(2), it need not betreated as PE.

For such an establishment to be treated as PE, it should firsthave the indicia of a PE that are set out in Article 5(1).1.3  Special rule for construction &installation sites Article 5(3) – Article 5(3) specifically includes two kinds of activities, whichtogether with an establishment would constitute PE. These activities constitutewhat are commonly referred to as ‘construction’and ‘service’ and the ruleswhich determine the existence of the PE are referred to as ‘construction rule’and ‘service rule’.

Under construction rule, PE if an enterprise has abuilding site, a construction, assembly or installation project or supervisoryactivities in connection therewith, a PE would come into existence if suchsite, project or activities continue for more than six months. Under servicerule, PE if an enterprise furnishes services (including consultancyservices) through employees or other personnel engaged by it for furnishingsuch services, a PE would come into existence if such activities continue for aperiod or periods aggregating more than six months within any twelve monthperiod. 1.4  Activities which may be carried on at a fixedplace of business without giving rise to a PE Article 5(4): Art.

5(4) provides that use of thefacilities for certain kinds of activities would not constitute a PE. These are:·        Use of facilitiesfor storage or display of goods(the OECD Model Convention also includesdelivery together with storage and display).·        Maintenance ofstock of goods solely for storage or display.

·        Maintenance ofstock of goods solely for processing by another enterprise.·        Maintenance offixed place for purchasing merchandise or for collecting information.·        Maintenance offixed place of business for carrying out activities of preparatory or ancillarycharacter.·        Maintenance offixed place of business solely for any combination of above activities providedthe overall activity of fixed place of business resulting from this combinationis of preparatory or ancillary character.

  1.5   Dependentagents constitute a PE Article 5(5) provides that Under Article5(5) where an enterprise doesn’t have its own establishment, it could have a PEthrough an agent provided the following tests are satisfied:·        ObjectiveTests:- Any person,whether an individual or a company, could be an agent. It is not necessary thatthe agent should be resident of the Source Country.

The agent should beauthorised to conclude contractson behalf of the principal. The authority may be general or specific or limited. However, it should be suchthat the agent’s action would bindthe enterprise.

The authority should be withrespect to business of the enterprise. Normally, solicitation ofbusiness and negotiation of contracts that are subject to the approval of theprincipal would not constitute agency PE. The authorisation should be construedin substance and not in form. Thus, if an agent has the authority to negotiateall parts of the contract in a manner, which is binding on the principal butthe contract is signed outside the Source Country, the agent could be said tohave the authority to conclude contract.Under Article 5(b), agency PE could come intoexistence even if the agent has no authority to conclude contracts but hehabitually maintains stock of goods from which he regularly delivers goods onbehalf of the enterprise. Again, the term ‘habitually’ indicates that thestocking should be repeated.

Also, the term ‘regularly’ indicates that thedelivery should not be on an exceptional basis.·        SubjectiveTests:-  Only agent whoare dependent upon theprincipal may constitute a PE. The dependency would, generally, be commercialdependency.

Thus, assurance as regards the agent’s expenses, minimum guaranteedremuneration, etc. would indicate commercial dependency. Another instance wouldbe a case where the agent has only one principal and devotes all his time to thisprincipal. ·        FunctionalTests:- The authority tobind the principal should be for the purposes which are essential andsignificant to the principal’s business and not for administrative purposessuch as conclusion of contracts for stationery, rent, office, cleaning ormanpower contracts. Mere fact that the agent has the authority to concludecontract would result in agency PE. It is also necessary that the agenthabitually exercise such authority. The term ‘habitually’ indicates that theauthority should be used repeatedly and not merely in isolated instances.

 1.6  PE in case of Insurance Business Article5(6)- Article5(6) identifies certain forms of independent agents who do not constitute a PE.Article5(6) doesn’t have a corresponding provision under the OECD Model Convention. Itprovides that an enterprise carrying on insurance business shall be deemed tohave a PE in the Source Country if: It collects premium in the territory of theSource Country; or If it insures risks situated in the Source Country through aperson other than an independent agent referred to in Article 5(7).

 1.7  An associated company will not necessarilygive rise to a PE Article 5(7) states that – Article 5(7) provides for an exception to agency rule PE.An enterprise is not deemed to have a PE in the Source Country merely becauseit carries on business in that country through a broker, general commission agent or any other agent of anindependent status if such person is acting in the ordinary course of business.

The exception mentioned above would, however, not applyin a case where the activities of such person are devoted wholly or almostwholly on behalf of that enterprise and conditions are made or imposed betweenthat enterprises and the agent in their commercial and financial relation whichdiffer from those which would have been made between two independententerprises. 1.8  No PE by virtue of Relationship: Article5(8)-  Article 5(8) clarifies that the company whichcontrols, or is controlled, by another company which is resident of the sourcestate would, by itself, not constitute either company a PE of the other. Thus,a subsidiary company would not constitute a PE of the holding company merelybecause it is controlled by the holding company or a holding company would notconstitute a PE of the subsidiary company merely because it controls thesubsidiary company.

 2.      BUSINESS CONNECTION IN INDIA U/S 9 OF IT, 1961BCis the Indian equivalent of PE. It is much wider in connotation and has beenvery effectively used by the revenue authorities to tax the income ofnon-residents in India. Despite being referred to in the ITA, the term was notdefined till the Finance Act, 2003 inserted a somewhat cryptic explanation toSection 9 of the Indian Income Tax Act, 1961 (“ITA”).TheSC in the landmark judgment of of CIT v. R.D. Aggarwal & Co4stated that a stray or isolated transaction is not normally regarded as abusiness connection.

Business connection may take several forms. It may includecarrying on a part of the main business or activity incidental to the mainbusiness of the non-resident through an agent , or it may merely be a relationbetween the business of the non-resident and the activity in the taxableterritories which facilitates or assists the carrying on of that business. Arelation to be a business connection must be real and intimate and through orfrom some income must accrue or arise directly or indirectly to thenon-resident.

The income which accrues or arises through or from the’connection’ must arise outside the taxable territories and not within. (Thisis because income arising within a taxable territory need not be brought withinthe scope of a deeming provision to subject it to tax in the taxableterritories).Applyingthese principles to the case of the firm, the Supreme Court came to aconclusion that no business connection existed in that case because thecontracts for the sale of yarn took place outside India, the price was receivedby the non-resident exporters outside India and the delivery was also givenoutside India. No operation such as procuring raw materials, manufacture offinished goods, sale of finished goods or delivery of finished goods againstprice took place within India. The definition of term PE was inserted inSection 92F(iiia) by the Finance Act, 2002. This definition is relevant onlyfor the transfer pricing provisions and is an inclusive definition. DefinitionThe term BC is discussed in Section 9(1)(i) in Explanation 2 of the ITA.Explanation 2 states that “business connection” shall include anybusiness activity carried out through a person who, acting on behalf of thenon-resident,—a.

       hasand habitually exercises in India, an authority to conclude contracts on behalf of the non-resident, unless hisactivities are limited to the purchase of goods or merchandise for thenon-resident; orb.      hasno such authority, but habituallymaintains in India a stock of goods or merchandise from which heregularly delivers goods or merchandise on behalf of the non-resident; orc.       habituallysecures orders in India,mainly or wholly for the non-resident or for that non-resident and othernon-residents controlling, controlled by, or subject to the same commoncontrol, as that non-resident:Provided thatsuch business connection shall notinclude any business activity carried out through a broker, general commissionagent or any other agent having an independent status, if such broker, generalcommission agent or any other agent having an independent status is acting inthe ordinary course of his business :Providedfurther that where such broker, general commissionagent or any other agent works mainly or wholly on behalf of a non-resident(hereafter in this proviso referred to as the principal non-resident) or onbehalf of such non-resident and other non-residents which are controlled by theprincipal non-resident or have a controlling interest in the principalnon-resident or are subject to the same common control as the principal non-resident,he shall not be deemed to be a broker, general commission agent or an agent ofan independent status.TheBombay High Court in CIT v NationalMutual Life Association of Australia 5 held that all that is necessary for aBC to exist is that there should be: (i) a business in India; (ii) a connectionbetween non-resident person or company and that ‘business’; and that thenon-resident person or company has earned an income through such connection.Section 9(1)(i) provides that income is deemedto accrue or arise in India if it accrues, directly or indirectly throughor from any business connectionin India or, through or from any propertyin India or through or from any assetor source of income in India, the transfer of a capital asset situate in IndiaExplanation to section 9(1)(i) provides forfollowing exemptions.                                              i.     In the  case  of business of which allthe  operations  are not carried  out  in  India, only such part  of  the income as  is reasonably attributable to the operations carried out in  India would be the incomedeemed to accrue or arise in India.                                            ii.

     No incomeshall be taxable in India if the operations of the non-resident  is confined to the purchase of goodsin India for  the purpose of export                                          iii.     In case ofnon-resident engaged in the businessof running a news agency or  of publishing newspapers, magazines orjournals, no income  shall be taxable in India if theactivities  confined  to the collection of news and views in Indiafor transmission out of India                                          iv.     In case of non-resident no income shall be taxable in India if the operations are confined to the shooting of anycinematograph film in India.                                            v.     in the case ofa foreign company engaged in the business of mining of diamonds, no incomeshall be taxable for activities which are confinedto the display of uncut and unassorted diamond in any special zonenotified by the Central GovernmentExplanation 5 of S.9 which was added after thenefarious Vodafone Case provides that clarified that an asset or a capital assetbeing any share or interest in a company or entity registered or incorporatedoutside India shall be deemed to be and shall always be deemed to have beensituated in India, if the share or interest derives, directly or indirectly,its value substantially from the assets located in India.

However,  in  each  case  thequestion whether  there  is  a business connection from  or through which income arises or accrues  must  bedetermined  upon the facts and circumstances of that case. 6 3.      CASE STUDY- MOTOROLA INC VS. DEPUTY COMMISSIONER OF INCOME TAX7In the cases of Motorola Communication Inc(‘Motorola’),Ericsson Radio Systems AB (‘Ericsson’) and Nokia Networks OY(‘Nokia’) (2005)95-ITD-269 (SB), the ITAT ruled on the cases of threetelecommunication companies in the light of three different sets of facts.The decision deals with a number of issues,which mainly affect taxation of non-resident in India.

One such issue iswhether the activities of the non-residents, in the facts of the case, resultinto a business connection/ Permanent Establishment (‘PE’) in India, merelybecause the non-residents had wholly owned subsidiary in India.In this context, the following significantobservations of the Tribunal are relevant:                                        i.           Noincome is deemed to accrue in India to a non-resident from the sale of hardwareand software if such sale is effected outside India to an Indian purchaser eventough the non-resident supplier, along with other group companies, has enteredinto a turnkey contract for supply and installation of equipment in India andthe non-resident supplier assumes overall responsibility for the properexecution of said turnkey contract. In such a situation, as the sale of theequipment is effected outside India and the title and the risk therein passesto the Indian purchaser outside India, there is no business connection in termsof domestic tax law between the Non-resident supplier and the Indian purchaser.                                      ii.

           APE i.e., a fixed place of business of a non-resident would exist in India ifone is able to point to a physical location at the disposal of the non-residentthrough which its business is carried on in India. Employees of thenon-resident supplier having use of its Indian subsidiary’s office as a matterof right would constitute a PE of the non-resident supplier in India. Theexistence of a liaison office in India, of a non-resident does not, in itself,constitute its PE in India.                                    iii.           Awholly owned subsidiary of a non-resident in India would constitute its PE inIndia if, their mutual relationship leads to the distinction between these twocorporate entities becoming blurred and a reasonable inference can be drawnthat the subsidiary was a virtual projection of the supplier in India.In the case of Ericsson, the special bench held that it did not havea PE in India on account of there being no ‘fixed place of business’.

Also,there was no ‘Agency PE’ as the subsidiary of Ericsson’s group company couldnot be said to be a ‘dependent agent’ of Ericsson as it had no authority toconclude contracts on Ericsson’s behalf. Also, as the profits in respect of theinstallation had already been taxed in the hands of the Indian subsidiary, thesame could not be taxed once again in the hands of supplier (i.e. Ericsson).In case of Motorola, the facts of the case showed that theemployees of the Motorola was using the premises of the subsidiary not only forthe work of Motorola but were also working for Motorola’s Indian subsidiary.

While Motorola paid salaries to these employees, its Indian subsidiary providedthem perquisites, which Motorola reimbursed to the subsidiary with a mark up.The special bench held without discussion that this led to a perception of thesubsidiary being a projection of the activities of Motorola in India and hencea PE of Motorola could be said to be constituted in India. On facts it washowever established that the activities carried on by the employees (the PE)were preparatory and auxiliary in character and because, as per Article 5(3)(e) of the DTAA between India and USA, there was a specific exclusion from theconstitution of a PE by the carrying on of such activities, the Special Benchheld that no PE of Motorola was constituted in India.In case of Nokia, the Special Bench held that its liaisonoffice would not constitute its PE in India as it was not carrying oncommercial activities. In fact it was specifically barred by the Reserve Bankof India from doing so. The case of its subsidiary was different however, asthe facts led to a perception of the subsidiary being a projection of theactivities of Nokia in India.The Special Bench held that it need not beestablished that there was actually a projection of the activities of theNon-resident in India.

It was enough if the facts of the case resulted in aperception of the subsidiary being a projection of the non-resident in India.The facts which were found to be relevant in this context by the Special Benchin Nokia’s case are set out below:The contracts for the supply of equipment andsoftware were signed in India by an employee of Nokia’s liaison office. Thesame person took up employment with Nokia’s Indian subsidiary the very next dayand signed the contracts for the installation also. Nokia had given anundertaking to the Indian operators that it would not dilute its stake in the Indiansubsidiary to below 51 percent. 4.      CONCLUSIONItis pertinent to follow the “substance over form” principle for characterizationof a BC. Although law regarding BC is clear, it has been observed that incometax authorities unnecessarily trouble the non-resident entities by either erringon the determination of a BC or attributing profits to a BC. Therefore, it isadvisable for the non-resident entities to take a preliminary rulingconcerning their transactions from the Authority of Advance Rulings.

Also,great caution has to be undertaken by the income tax authorities in order todifferentiate between income attributable to a BC due to activities performedby it through a non-resident entity and income generated by a BC through itsactivities in India.1 The term “Convention”has been used in the context of the United Nations Double Taxation AvoidanceAgreement (“UN Model”) and the OECD Double Taxation AvoidanceAgreement (“OECD model”)2 Manual on the OECD Model TaxConvention on Income and on Capital by Dr. Philip Baker (hereinafter referredto as “Commentary by Dr Philip Baker”), page 5-2 para 5B.013 Para 2 of Article 5(1) of thecommentary to the OECD Model4 (1965) 56 ITR 20 / TS-6-SC-1964,5 1933 I ITR 350, 361 (Bom)6 Blue  Star Engg. Co.

(Bom.) P. Ltd. v CIT 73ITR 283 (Bom.)7 (2005) 95-ITD-269(SB)