Chapter Thirty-Four

Permanent Establishment Parameters: Hong Kong versus India

Governments Across asia are increasingly willing to assert taxation over activities of an alien business doing business in their jurisdictions. These governments are more than willing to find that the activities of the alien business create a permanent establishment in that location. This permanent establishment assertion brings with it the taxability of that enterprise in that jurisdiction together with the ensuing transfer pricing considerations. This chapter compares and contrasts permanent establishment parameters in Hong Kong and in India.

India asserts permanent establishment status based on any of the five inquiries: direct business activities, agency relationships, more-than-stewardship activities, and the power shift personnel, as well as an “entirety of the operations” approach. In contrast, Hong Kong bases its permanent establishment activities on a more amorphous standard, “the economically significant activities and responsibilities” of the nonresident enterprise.

GENERAL PERMANENT ESTABLISHMENT CONSIDERATIONS

At the outset, the reader should distinguish between Hong Kong and India by three specific permanent establishment considerations:

The term “permanent establishment” presupposes the presence of a DTA between the parties involved. A country is free to impose tax on any activities of any sort that take place within that country if the parties are not members of such a double tax treaty. As a general matter, taxpayers that extend their activities offshore rely on the presence of a DTA to limit the possibility of double taxation in the countries in which they do business. As we shall see, however, governments are increasingly bending the envelope to justify PE claims in their home jurisdictions.

One strategy of critical importance for taxpayers is the penchant of the tax authorities to investigate potential PE activities. India has an extensive audit mechanism designed to assert its PE claims. Hong Kong’s approach in asserting PE claims is less developed. Both Hong Kong and India recognize the tie-in between PE and transfer pricing, a relationship that other countries are prone to ignore. The risk of double taxation is often higher in India than in Hong Kong. The difference seems to be a more aggressive stance on the part of the tax officials in India than to those in Hong Kong.

The long arm of the Indian tax authorities extends outward, often reaching beyond the geographical confines of India itself. This long arm often reaches the activities of Indian-based activities taking place abroad as well as to the activities of foreign-based enterprises undertaking activities in India. Hong Kong is less aggressive in that respect.

The DTAs of both jurisdictions provide “preparatory to” exemptions and “auxiliary from” exemptions. Thus, the treaties exempt activities that are “preparatory to” the underlying activities and activities that are “auxiliary from” these underlying activities.

PERMANENT ESTABLISHMENT CONSIDERATIONS IN INDIA

India asserts PE based on five fact-based inquiries:

India asserts that the presence of the parent company’s direct business activities causes a PE in India. As a result, a taxpayer doing business in India is well advised to ascertain whether the direct business activities that the parent company undertakes create a PE in the subsidiary’s location. The taxpayer’s review of the parent company’s direct business activities is a separate inquiry of the subsidiary’s operations themselves. The presence of a subsidiary is not necessary for the country to find PE status. Instead, activities in India can create taxability in India regardless of the form of the enterprise in India.

The presence of an agency relationship creates causes the enterprise to constitute a PE. As a result, a taxpayer is well advised to ascertain whether the indirect relationship between the parent company and its subsidiary constitutes an agency relationship. In fact, the presence of that agency relationship might bind the parent company to the subsidiary for PE purposes. Specifically, the subsidiary can serve as the parent company’s agent by negotiating, binding, entering into, or concluding contracts on behalf of the parent company. As a result, the taxpayer is well advised to examine the powers that the subsidiary exercises.

A non-Indian company engaging in activities in India that are more than stewardship might cause the Indian tax authorities to view these activities as being a PE. The taxpayer is well advised to ascertain whether the parent company’s activities as to the subsidiary go beyond the stewardship level, but stewardship activities themselves are exempt for PE characterization. The parent company’s more-than-stewardship activities on behalf of the subsidiary can create a PE on the part of the parent company.

The ability of the parent company to shift personnel among entities might create a PE. The taxpayer is well advised to ascertain whether the parent company’s personnel being shifted to the subsidiary create a PE on the part of the parent company. The parent company might have furnished personnel, might continue to payroll the subsidiary, or might take specific responsibility for the work of its employees at the subsidiary’s location.

The entirety of the operations in India, taken as a whole, may cause the Indian government to treat the enterprise in India as being a PE. Thus, the entirety of the operations in the country of operations may create PE status. The tax collector might ascertain PE as a basis of taxation apart from the four previously mentioned operational categories.

PE activities in and of themselves can cause double taxation. Thus, the country in which the subsidiary is located might be able to tax the subsidiary because of its activities in that country. This same country can impose an additional level of tax on the parent company headquartered elsewhere as well as on its subsidiary located in the jurisdiction. The country in which the subsidiary is located can look toward the activities of the parent company and then examine the relationship of the parent company toward the subsidiary. In essence, the country in which the subsidiary is located might be able to tax the parent company based on that parent company–subsidiary relationship.

PERMANENT ESTABLISHMENT CONSIDERATIONS IN HONG KONG

The Hong Kong transfer pricing guidelines provide a procedure under which Hong Kong is to enforce its attribution rules to determine the profits of a PE. This guidance governs the Hong Kong’s DTAs as to the allocation of taxing rights. As a general matter, it is necessary under Treaty Article 7 to attribute profits and expenses to the Hong Kong PE if the nonresident enterprise has a PE in Hong Kong. The Hong Kong transfer pricing guidelines list eight steps in the PE process. The taxpayer is to:

The Hong Kong transfer pricing guidelines provide two main provisions as to the attribution of income and expenditures concerning PEs:

The Hong Kong transfer pricing guidelines apply the “functionally separate approach” to determine taxability of the PE. Using the “functionally separate entity” approach, the Commissioner will treat a PE as being a separate enterprise as if this enterprise is operating at arm’s length. Such an enterprise must treat PEs in Hong Kong and elsewhere as reflecting its profits and expenses. The separate entity approach operates to produce the same outcome as would transactions between two enterprises at arm’s length.

The Commissioner can assess the profits of the PE of a nonresident enterprise. The Commissioner, in assessing the profits of the PE of a nonresident enterprise, can examine the separate sources of profit that the nonresident enterprise has derived from Hong Kong.

A profit is not booked in the PE in Hong Kong. Nevertheless, the PE might have to attribute the profit to the PE of the nonresident enterprise carrying on a business in Hong Kong. The PE is to reflect these PE amounts if the enterprise undertakes “economically significant activities or responsibilities” in Hong Kong.

The profit might be generated from “economically significant activities or responsibilities” outside Hong Kong. In that event, the profit will not be attributed to the PE of the nonresident enterprise in Hong Kong. The presence of “economically significant activities or responsibilities” outside Hong Kong occurs when there is another PE outside Hong Kong or when the head office undertakes the “economically significant activities or responsibilities.”

The Commissioner can attribute profits to the PE in Hong Kong under Article 7(2). The Commissioner, in making such attribution of profits, is also to consider these functions:

• The significant “people functions” of the PE
• The key entrepreneurial risk-taking functions of the PE (i.e., those functions that are relevant to the assumption or acceptance or management of risks)