Chapter Twelve

PE Issues Impact Indian Transfer Pricing

Multinational Taxpayers increasingly must address the fact that tax collectors in a myriad of states are developing increasingly sophisticated tax collection strategies. One such strategy of critical importance is the penchant of the tax authorities to investigate potential permanent establishment (PE) activities. If the tax authority can ascertain the presence of these PE activities, it develops a transfer pricing adjustment in favor of itself. Such multinational taxpayers are increasingly facing the risk of extensive double taxation.

One major country making extensive use of ascertaining PE activities and developing transfer pricing adjustments is India. The long arm of the Indian tax authorities extends outward, reaching beyond the geographical confines of the country itself. This long arm often reaches the activities of Indian-based activities taking place abroad as well as those of foreign-based enterprises undertaking activities in India.

Double taxation arises as the U.S. tax authorities also extend outward, imposing taxes on the same income that others would tax. Tax authorities within the United States and foreign countries are also increasing their tax jurisdictions. These long arms of the tax law often reach the activities of non-Indian companies abroad as well as Indian-based activities located outside India.

India, the United States, other treaty partners, and states within the United States seek to impose taxation on the aforementioned activities based on their specific PE concepts, relying when necessary on their aggressive transfer pricing regimes. It is no wonder, then, that the risk of double taxation is an important factor in the ordinary life of a multinational corporation, especially when it involves India or one of its trading partners.

BACKGROUND

The reader is cautioned that significant areas of double taxation exist between India and the United States and between India and other jurisdictions, in part because of the differences in source rules, in part because of aggressive tax enforcement, and in part because India follows the United Nations tax treaty model rather than the Organisation for Economic Co-operation and Development (OECD) model tax treaty. The advance pricing agreement process will alleviate some of these double taxation issues when India puts the advance pricing regime into force.

Prudence would dictate that the multinational taxpayer should undertake the process of aggregating its total effective tax costs, determined on a worldwide basis, taking into account the tax base and tax rate in each jurisdiction. The multinational taxpayer is likely to find that its aggregate tax base, determined on a worldwide basis, is more than 100% of the company’s aggregate income. In fact, the multinational taxpayer to likely to find that its aggregate tax income base that involves India and OECD countries is likely to be substantially more than 100% of its aggregate income. As a result, and very importantly, the multinational taxpayer is well advised to address the conflicting tax systems simultaneously from a PE–transfer pricing perspective.

There is a commonplace myth among tax practitioners that “Asians do not litigate.” Relying on that idea, some multinational taxpayers make it a point of ignoring Indian tax litigation. As we shall see, nothing could be further from the truth when it comes to Indian tax litigation. We examine more than 20 PE transfer pricing cases promulgated in India during the past years, together with a state case involving an Indian parent company, with a view toward examining current tax PE transfer pricing approaches.

NEXUS, EFFECTIVELY CONNECTED STATUS, AND PERMANENT ESTABLISHMENT

It is hornbook law that a country seeking to impose income taxation on a foreign entity can impose its income tax if the foreign entity has a connection or nexus to the entity. Tax treaties, for the most part, seek to limit this access to taxation by one of the contracting states by imposing a high threshold of effectively connected status that necessitates a PE in that jurisdiction. India is developing an extensive tax treaty network that includes its treaty with the United States and many of its trading partners, including the Netherlands, Canada, Korea, Japan, and elsewhere.

As a start in examining PE issues, the country in which the subsidiary is located might be able to tax the subsidiary because of the subsidiary’s activities in the country. But the 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.

FOUR FACT-BASED PERMANENT ESTABLISHMENT INQUIRIES

A non-Indian company doing business in India is well advised to examine four facets of the PE process in India: the presence of

The non-Indian company doing business in India is well advised to examine the likelihood that the Indian tax authorities will seek a PE determination, based on its Indian-related activities. The Indian tax authorities will then seek to impose the transfer pricing process on the Indian business and on its offshore affiliate. Here is the examination process that we recommend Indian-related businesses undertake to determine their tax exposure:

IMPACT OF THE MORGAN STANLEY CASE

The Indian tax collector brought suit against Morgan Stanley & Co. Inc., emanating from the claim of the Indian government to tax the U.S.-based Morgan Stanley & Co. Inc. as well as taxing Morgan Stanley’s Indian subsidiary. In the case Morgan Stanley & Co. Inc. v. Director of Income Tax, Morgan Stanley was successful in India’s Supreme Court in Mumbai in July 2007. India’s revenue authorities then brought a review petition in India’s Supreme Court. India’s Supreme Court rejected the revenue authorities’ review petition effective January 24, 2008, and ruled in favor of Morgan Stanley. The Court’s decision is now final.

The Indian tax authorities claimed Morgan Stanley’s operations in India itself caused Morgan Stanley’s operations to be subject to tax in India. That claim on the part of the Indian tax authorities was in addition to Morgan Stanley’s subsidiary in India that was already subject to tax in India. Morgan Stanley operated its back-office services company in India to take advantage of the differential between wage rates in the United States and in India.

The claim made by the Indian tax authorities was unsuccessful. The Indian Supreme Court rejected the tax authorities’ claim because Morgan Stanley’s activities in India did not result in having a fixed location in India or a permanent establishment. Morgan Stanley’s Indian company did not carry on any business of the U.S. company.

The Indian tax authorities claimed Morgan Stanley’s operations in India caused the company to be subject to tax in India because of Morgan Stanley’s agency relationship with its Indian subsidiary. The tax authorities asserted that the Indian company incurred such a relationship with its U.S. parent because the Indian company had the authority to negotiate, bind, enter into, or conclude contracts on behalf of the U.S. parent company. The Indian Supreme Court concluded that such agency relationship did not apply to the Morgan Stanley facts because the Indian subsidiary did not have the agency authority and did not attempt to exercise such agency powers.

PERMANENT ESTABLISHMENT TRANSFER PRICING LITIGATION IN INDIA

The Indian tax authorities have been taking an aggressive stance on potential PE issues and are making PE claims outside of the transfer pricing context. Although the Indian tax authorities can rely on conventional transfer pricing analysis, on other occasions the Indian tax authorities can split the profits between the entities with the transfer pricing context.

GALILEO

Galileo International Inc., a U.S. entity, is in the business of maintaining and providing electronic distribution systems to the travel industry in approximately 100 countries. Galileo provides computer reservations distribution services to airlines, hotels, tours, and cabs. Galileo’s network connects to its travel agents’ computer reservations distribution services through hardwire and computer connections. Galileo had close relationships with two entities in India:

The assessing officer (AO) imposed income tax on Galileo under a PE concept, reasoning that Indian travel agents completed their reservations through Galileo’s installed hardware. The AO determined that Galileo had a PE in India under Article 5 in the India–U.S. Income Tax Treaty and that income was taxable as business income under Article 7 of that treaty.

The AO held that InterGlobe was a PE in India under Article 5 in the India–U.S. Income Tax Treaty. InterGlobe was independent from Galileo. Nevertheless, the AO rationalized PE status based on these agency-type activities:

• InterGlobe was “economically dependent” on Galileo for its source of business.
• InterGlobe conducted its activities wholly and exclusively for Galileo.
• InterGlobe entered into and concluded contracts on behalf of Galileo.

Galileo appealed the results to the Commissioner of Income Tax (Appeals) [CIT(A)], who held that Galileo in fact had a PE in India because Galileo’s computers constituted a fixed place of business through which Galileo carried out its activities. Galileo then appealed the CIT(A) result, this time appealing to the Delhi Income Tax Appellate Tribunal (ITAT).

Galileo argued before ITAT that all of its data processing took place through its master computer system in the United States and that the computers merely displayed the information in India, so that Galileo had no connection in India. ITAT disagreed with Galileo’s position as to its activities undertaken. ITAT looked to Galileo’s booking of transactions that took place using Galileo equipment in India. ITAT noted the computerized reservation system partially existed in computers installed at subscribers’ premises. In fact, Galileo controlled the shifting of computers even within the premises of subscribers. ITAT determined that those Galileo activities constituted a fixed place of business that constituted a PE in India.

ITAT then examined InterGlobe’s relationship with Galileo, finding that the relationship was that of dependent agency. InterGlobe had the authority to enter contracts with subscribers, provided specialized services in India, and trained subscribers to use all of the computerized reservation system. InterGlobe was in India exclusively because of its relationship with Galileo, making InterGlobe a dependent agent.

ITAT sought to allocate the functions, activities, and risks in the United States and in India. ITAT, in making that determination, attributed to India 15% of Galileo’s revenue based on bookings in India. ITAT, in making that determination, gave credence to the master computer system being outside India and being in the United States.

Galileo paid InterGlobe for the services that InterGlobe rendered to Galileo based on its distribution agreement. ITAT permitted Galileo to deduct the entire payments it had made to InterGlobe as expenses. We suspect that ITAT apportioned expenses to Indian operations and to U.S. operations on a 15%/85% split.

In summary, ITAT applied two separate facets in applying income taxation:

HOTEL SCOPEVISTA

Hotel Scopevista is a hotel management service in India. It entered into an agreement with a foreign contractor under which the contractor was to render “project management services” for the construction of a hotel in India. Hotel Scopevista sought to make payments to the foreign contractor without making withholding payments. Hotel Scopevista, in essence, claimed that those payments are not taxable by India in the hands of the foreign contractor. Hotel Scopevista argued that the ultimate aim of the contractor in providing these services was the construction of the hotel, and the fees were for technical services, which excludes construction activities.

The AO rejected Hotel Scopevista’s no-withholding-tax claim, holding that the payment was for management services, not for construction. The AO directed Hotel Scopevista to withhold 20% of the payments to the foreign contractor. Hotel Scopevista appealed to the CIT(A), who sided with the AO and required Hotel Scopevista to withhold the tax.

Hotel Scopevista then appealed again, this time before the ITAT. ITAT focused on the nature of the treaty exemption, stating that the character of the exemption was to shift the activities to a net income basis. The foreign contractor was not otherwise subject to tax in India; ITAT required payments to be made at source.

It appears that the court did not address PE issues, perhaps because the foreign contactor had already left India.

WORLEYPARSONS

WorleyParsons Services, Pty. Ltd. is an Australian company that provides engineering, procurement, and project management services. WorleyParsons entered in a contract with the Gas Authority of India, Ltd. (GAIL) to monitor a pipeline. WorleyParsons requested a ruling as to whether the payments it received from GAIL were in the nature of royalties, or, alternatively, whether the payments that WorleyParsons received were business profits.

WorleyParsons submitted a request to the Authority for Advance Ruling (AAR) seeking to ascertain the applicable tax treatment that WorleyParsons would receive. Based on the preceding facts, WorleyParsons contended that the payments it received were in the nature of PE activities pursuant to the Australia–India Income Tax Treaty taxable as business profits rather than being royalties. WorleyParsons asserted that:

• WorleyParsons performed most of its services in India.
• WorleyParsons’ employees were present in India for 165 days.
• Nearly 90% to 95% of the work that WorleyParsons performed pursuant to contract was in India.

The AAR determined that WorleyParsons’ technical supervisory services were not in the nature of a royalty but that these technical supervisory services were of the nature of PE that are subject to tax as business profits. The India–Australia Income Tax Treaty uses a “more than six months” time horizon. The AAR appears to have tacked the 165-day period to other time periods to reach the “more than six months” time horizon.

KNOWERX EDUCATION

KnoWerX Education (India) Private Limited was an educational intermediary, collecting exam fees for applicants in India and transmitting these exam fees to foreign institutes. The AAR held that KnoWerX was not obligated to withhold tax payments, the payments were not of a dependent agent, and the payments were not taxed in India.

KnoWerX provided various activities in India: private corporate training, open attendance-based public training, management consulting, publishing, and distribution of educational material. KnoWerX undertook these activities on behalf of professional examination organizations and certification programs. Those professional examination organizations and certification programs had no establishments of their own in India. The professional examination organizations and certification programs undertook these activities in India:

• Hiring other entities to conduct the examinations
• Evaluating answer sheets and awarding certificates outside India

KnoWerX asserted that some of the professional examination organizations and certification programs were tax-exempt in the United States, and thus, those entities would receive no U.S. foreign tax credit benefits. As a result, KnoWerX argued, the professional examination organizations and certification programs would receive no offset under the India–U.S. Income Tax Treaty. The CIT(A) determined that the professional examination organizations and certification programs would be taxable on the receipt of exam fees based on business income.

The AAR held that the examination fees that KnoWerX collected on behalf of the professional examination organizations and certification programs would be taxable. The AAR further determined that the professional examination organizations and certification programs were exempt from U.S. taxation under Internal Revenue Code section 501(c)(6), were liable to pay federal income tax, and, at least explicitly, were eligible to receive the U.S. foreign tax credit.

Nevertheless, the AAR concluded that the relationship between KnoWerX and the professional examination organizations and certification programs was that of independent agent rather than dependent agent. In making that determination as to the independent agency relationship, the AAR noted these facts:

• KnoWerX concluded no contracts between the applicants and the professional examination organizations and certification programs.
• KnoWerX did not maintain stocks of merchandise belonging to the professional examination organizations and certification programs.
• KnoWerX did not secure orders wholly or almost wholly for the professional examination organizations and certification programs, or bind them in the professional examination organizations and certification programs in India.
• There was no financial, managerial, or any other type of participation between KnoWerX and the professional examination organizations and certification programs.

The AAR did not require KnoWerX to withhold taxes from the professional examination organizations and certification programs because of that independent agency relationship, implicitly suggesting that the taxes would be imposed if a dependent agency relationship existed.

ICICI BANK

ICICI Bank is India’s second largest commercial bank and the largest private-sector bank in India. In July 2008, the U.S. Ex-Im Bank approved a $250 million delegated authority for Indian infrastructure. India’s Ministry of Finance has estimated that India will need more than $500 billion to finance development of its infrastructure.

Prior to that date, ICICI Bank planned to issue floating-rate euro notes. ICICI appointed Moody’s Investors Service to provide a rating for these notes. ICICI paid Moody’s for rendering that service. ICICI made the payments to Moody’s without withholding a portion of the payments. The AO took the approach that ICICI erroneously failed to withhold taxes from its payments to Moody’s. ICICI contended that:

• The withholding is inappropriate because Moody’s operations are outside India.
• ICICI paid the amounts to Moody’s outside India, making withholding impractical.

The AO held that ICICI’s payments to Moody’s were covered by the technical fee clause under the India–U.S. Income Tax Treaty, and that treaty required withholding at source. ICICI appealed the matter to the CIT(A). ICICI made two arguments:

The CIT(A) rejected ICICI’s claim and held that ICICI’s payment was covered within the definition of services under the India–U.S. Income Tax Treaty. As a result, the CIT(A) held that ICICI had an obligation to withhold tax pursuant to the treaty.

ICICI appealed the decision by the CIT(A), making that appeal to ITAT in Mumbai. The issue before ITAT was whether Moody’s service of providing a credit rating to ICICI was “included services,” as defined by the India–U.S. Income Tax Treaty, Article 12. ITAT held that Moody’s did not carry on a business or profession in India and that Moody’s did not have a PE in India. Accordingly, ITAT held that Moody’s was not subject to tax in India under the business profits article of the India–U.S. tax treaty. As a result, ITAT held that ICICI was not responsible for failing to withhold tax on its payments to Moody’s.

ZIMMER AG

Zimmer AG, a German company, was a manufacturer of plant and equipment. Zimmer entered into three separate agreements with an Indian company to build a resin manufacturing facility in Halida, India:

The manufacturer paid Zimmer outside India pursuant to the engineering and know-how agreement. Zimmer recognized no liability in India for receiving that payment. The AO held that the payment that Zimmer received from the Indian manufacturer pursuant to the engineering and know-how supply agreement constituted a royalty under Indian law and under the Germany–India Income Tax Treaty. Zimmer appealed the AO’s determination. The CIT(A) accepted Zimmer’s claim holding that the payment made by the Indian manufacturer to Zimmer was not a royalty. India’s tax collector appealed the CIT(A) decision to the ITAT.

ITAT looked at the entirety of Zimmer’s relationship with the Indian manufacturer, viewing that relationship as “a composite supply” and the engineering documents as being an integral part of the process. ITAT viewed the transfer of documents to the Indian company as being complete, constituting a transfer of title and interest. ITAT agreed with CIT(A), holding that the payment is not a royalty because the manufacturer purchased the technology from Zimmer on an outright basis.

INTERGRAFICA

Intergrafica Print and Pack, GmbH, a German company, coordinated with MAN Roland Druckmashinen AG, another German company, to supply equipment to Bennett, Coleman & Company in Mumbai. Intergrafica’s head office in Germany and its branch office in India arranged for the order and its subsequent supply. Intergrafica allocated 60% of the profit from the commission to the Indian branch office and allocated 40% of the profit from the commission to the home office. However, the AO asserted that all of the operations for the sale and for operations after the sale took place in India and treated all of the profits as taking place in India. Intergrafica appealed the assessing officers’ conclusion to the CIT(A).

On appeal, the CIT(A) reviewed the functions that the head office and branch office each performed and determined that the appropriate allocation of profits was 75% to the branch office and 25% to the head office. The CIT(A) noted that the branch office had no authority to approve the contract. Intergrafica then appealed the CIT(A) decision.

ITAT focused on the nature of the home office operations, noting the home office had engineers on its payroll and provided assistance during installation and other times when the branch office so required. The functions of the branch office, according to ITAT, were limited after the end of the warranty period. ITAT accepted Intergrafica’s allocation of 60% of the profit from the commission to the Indian branch office and the allocation of 40% of the profit from the commission to the home office.

RANBAXY LABORATORIES

Ranbaxy Laboratories is a multinational company that manufactures and sells pharmaceutical products in India and in 17 associated enterprises. Ranbaxy applied the transactional net margin method (TNMM) for transfer pricing purposes, treating the associated enterprises together as the tested party and treating the profit on sales as the profit level indicator. The net profit margin before tax for the entire group’s business is lower than the average net margin before tax of the comparable overseas companies. Ranbaxy asserted that it met the arm’s length standard because of that differential in profit margins.

The AO accepted that Ranbaxy’s transfer pricing was at arm’s length, and the AO did not require an adjustment. The CIT(A) then initiated an action under section 263 of the Indian Income Tax Act, arguing that:

• The AO was to refer the case over to the transfer pricing officer (TPO), which the AO failed to do, to determine whether the transaction was at arm’s length.
• Ranbaxy appeared to have used the TNMM incorrectly by combining the results from the associated enterprises operating in diverse conditions as the tested party, while in fact reliable comparative data was available in India.

Ranbaxy argued that it should not be penalized because of the AO’s failure to transfer the case over to the TPO. Ranbaxy further argued that the Revenue Department was correct in using the affiliated enterprises as the tested party as their activities are less complex than Ranbaxy’s activities.

ITAT looked to the failure of the AO to ascertain an in-house comparable, suggesting that the AO should have ascertained names of the products and quantities of the products Ranbaxy had sold to independent concerns. Further, ITAT was concerned that the AO failed to address the characteristics of the transactions and failed to provide a profile or location for eight of the comparables.

ITAT suggested that the AO should have compared the company’s profits with the profit margin of pharmaceutical companies of the same size carrying on similar transactions in India. ITAT implicitly accepted the taxpayer’s power to select the tested party but required the taxpayer to provide the relevant information to the taxing authorities unless the comparison data are publicly available. Here ITAT felt that it made sense to view Ranbaxy as the tested party as comparable data were available.

ITAT found that Ranbaxy provided no justification for grouping fundamentally separate and independent transactions carried out at different times and related to different parties. The case is now on appeal before the Delhi High Court. Ranbaxy will contend that the company is applying the “most appropriate [transfer pricing] method.”

DEVELOPMENT CONSULTANTS

Development Consultants Pvt. Ltd., an Indian company, had operations in the Bahamas and in the United States through its related entities. The assessment years were 2003–2004 and 2004–2005. The Indian transfer pricing regulations require a company engaged in transfer pricing to file and to furnish an accountant’s report to the TPO. Development Consultants failed to furnish its required accountant’s report for the assessment years but did file other necessary documents with the TPO during its audit proceedings in 2004–2005.

The TPO adjusted the results during the assessment years. The CIT(A) confirmed the additions to tax that the TPO had made. Development Consultants filed an appeal before ITAT. The issue was whether pricing should be determined on a transaction-by-transaction method, as Development Consultants contended, or be aggregated, at the tax authorities contended.

Before ITAT, the Revenue Department examined the relationship between Development Consultants and its subsidiary in the Bahamas, DCIL. The taxpayer sought to portray DCIL as being an entrepreneur having significant intangibles and argued that Development Consultants should be the tested party. The Revenue Authorities rejected Development Consultants’ approach, selected DCIL as the tested party, and applied the resale price method. The Revenue Department, then, viewed DCIL as distributor of services as to its engineering, drawing, and design services, and adjusted the profits for the first of the assessment years. ITAT dispensed with the Revenue Department’s assertion that DCIL was a sham company established to avoid taxes.

ITAT then examined Development Consultants’ relationship with its U.S. entity. Here, in contrast to the Bahamas situation, ITAT found that the U.S. entity was an entrepreneur that created significant intangibles over the years and accepted Development Consultants as the tested party. ITAT found the transactions to be at arm’s length.

ITAT looked at the level of profits that Development Consultants obtained by transferring its employees. Development Consultants used Indian databases to substantiate its profits and was successful with the ITAT.

ITAT then turned its attention to data entry services. DataCore USA, an entrepreneurial company, provided software and back-office work to its customers. DataCore USA uploaded the work to DataCore India, both being subsidiaries of Development Consultants. Development Consultants’ profit margins in India were higher than in comparable companies during the related assessment years, and ITAT held that these amounts were all at arm’s length.

PERFITTI

Perfitti SPA, an Italian company, owned 100% of Perfitti India Ltd. Perfitti SPA supplied machinery and raw materials to Perfitti India Ltd. The AO asserted that Perfitti SPA’s income was taxable in India because Perfitti SPA undertook these activities:

• Perfitti SPA supplied machinery continuously for nearly a year in India.
• Perfitti SPA’s managing director and other expatriates received salaries from Perfitti SPA, and Perfitti SPA had total control over the Indian operations.
• Perfitti SPA took orders for the machinery in India for more than a year.
• The prices were not at arm’s length and were too high.

The AO did not have Perfitti’s global balance sheet nor did the AO have its Italian accounts, but assumed a 20% margin. Perfitti challenged the AO’s order and went before the CIT(A). The CIT(A) agreed with Perfitti, deciding that Perfitti had no business connection in India and thus had no permanent establishment. The Revenue Department appealed to ITAT, but ITAT held in favor of Perfitti, finding that:

• The Revenue Department had the onus to establish overinvoicing of the cost of the machinery but had failed to do so.
• The goods were properly shipped to Perfitti India Ltd.
• The Italian company properly shifted the employees to the Indian company.
• The quality control manager and technologists were in India for a short period of time; there was no evidence that Perfitti supervised construction operations; there was no business connection in India; and there was no permanent establishment.

DATA SOFTWARE RESEARCH

Data Software Research Co. (P) Ltd. was an Indian company. Data Software had a branch in the United States. Data Software Research Co. (P) Ltd. had claimed that its profits from the U.S. branch were not subject to tax in India because the United States already had taxed that income. The AO claimed that an Indian resident, such as Data Software Research, is to include all income, from whatever source, and that the India–U.S. Income Tax Treaty permitted India to tax the profits of a U.S. branch.

Data Software Research Co. (P) Ltd. appealed the AO’s determination, claiming the inclusion of branch income would result in double taxation. The CIT(A) determined that Data Software Research Co. (P) Ltd. was correct. The Income Tax Department then appealed to ITAT. ITAT determined that Data Software Research Co. (P) Ltd. must compute its worldwide income, including that of its U.S. branch, but that this inclusion does not lead to double taxation because the U.S. branch can apply for a foreign tax credit.

Before ITAT, Data Software Research Co. (P) Ltd. had argued that it had a PE in the United States in the form of a branch company, that the permanent establishment’s profits were taxable under U.S. law, and that this income could then not be taxed in India. The Revenue Department argued that the onus of double taxation fell on the United States through its foreign tax credit mechanism.

ITAT recognized that two methods exist to eliminate double taxation: the exemption method and the tax credit method. The Indian government can select between these two elimination methods through the income tax treaty it signs. Relying on Article 25.2(a) of the Income Tax Treaty between India and the United States, ITAT concluded that the AO was correct in determining Data Software Research Co. (P) Ltd. income on a global basis. The U.S. branch could then claim its foreign tax credit.

SNC LAVALIN/ACRES INC.

SNC Lavalin/Acres Inc. was a Canadian-based company having the responsibility of building and setting up the Chamera Hydro Electrical Project in India. The company had a site office in Chamera and established a PE in India. A dispute arose between the company and the AO as to the percentage of profits that were taxable in India. The company first took the position that the entire income from the project was attributable to the PE in India and filed its tax return on that basis. The company later took the position that the income of the project was to be divided between the home office in Canada and the PE in India. The company determined that 19.63% of the income was taxable in India and submitted a letter, not a revised income tax return, to change the initial result.

The AO dismissed the taxpayer’s claim, stating that all of the income was from the Chamera project. The taxpayer appealed to the CIT(A). The CIT(A) approved the AO’s determination. The taxpayer then appealed to ITAT.

ITAT accepted the taxpayer’s letter claim from a procedural standpoint because the AO and the CIT(A) had accepted the taxpayer’s approach. Then ITAT addressed the taxpayer’s substantive claim.

The initial issue that ITAT had to face was the interpretation of the India–Canada Income Tax Treaty as to the attribution of profits. The taxpayer took the approach that the India–Canada Income Tax Treaty applied the OECD model treaty, thus narrowing scope of attribution of profits concept. The taxpayer treated the home office as a separate functional entity, pointing out that the home office assumed the entire risk, including performance guarantees, and that the home office received all of the contractual proceeds. India’s Revenue Department asserted that the “force of attraction” attribution of profits was broader, as the India–Canada Income Tax Treaty applied the UN treaty approach. ITAT agreed with the Revenue Department’s approach.

AIRPORT AUTHORITY OF INDIA

The Airport Authority of India is a public sector enterprise that purchased equipment and software from Raytheon, a U.S. company. Raytheon was not involved in operating or maintaining the Airport Authority of India equipment. The Airport Authority of India subsequently entered into two contracts with Raytheon, one for equipment repair and the other for updates and to modify software. The Airport Authority of India then applied for a ruling with the AAR to ascertain whether it must provide for withholding on the payments it made to Raytheon. The Airport Authority of India asserted that its payments to Raytheon are business profits and not subject to withholding.

The parties to the litigation differentiated the consequences of the equipment repair contract and the software maintenance contract. The AAR initially accepted the Airport Authority of India’s argument that the amounts it paid to Raytheon in connection with the equipment repair contract were in the nature of business profits, but later the Revenue Department asserted that these activities constituted a permanent establishment.

The AAR determined that the software maintenance contract was in the nature of “fees for included services” and was subject to withholding. The AAR held that Raytheon did not have a PE in India because the equipment repair and software modification activities took place outside India and Raytheon’s personnel activities in India were sporadic. The AAR held that the Airport Authority of India had no obligation to withhold payment to Raytheon for equipment repairs but the Airport Authority of India had the obligation to withhold tax at the 10% rate on the software maintenance and upgrades that the Airport Authority of India paid to Raytheon.

RADHA RANI HOLDINGS

The issue in Radha Rani Holdings (P.) Ltd. was the situs of “control and management” activities and whether the control and management activities took place in Singapore or in India. The company had two shareholders. The Indian resident owned 99% of the company’s share capital; the Singapore resident owned 1% of the company’s share capital. The Singapore–India Income Tax Treaty potentially applied in this situation.

The AO determined that the company’s control and management took place in India exclusively, relying on passport documents that counteracted a board of directors meeting ostensibly taking place in Singapore, and that the 99% Indian shareholder was the source of the corporate funds. The company appealed to the CIT(A). The CIT(A) determined that AO was correct in determining that the entire control and management took place in India. The company then appealed to ITAT.

The taxpayer asserted that the control and management took place exclusively in Singapore, not in India, based on these facts:

• The company’s registered office was in Singapore.
• All of the company’s board meetings were held in Singapore.
• The company determined its day-to-day administrative and business matters in Singapore.
• The company maintained its statutory books of account in Singapore.
• The company maintained its bank accounts in Singapore.
• The company controlled the operation of its bank accounts in Singapore.
• The Singapore Tax Authority had issued the company a tax residency certificate.
• The company regularly filed its corporate tax returns in Singapore.
• One of the two company directors was a permanent resident and citizen of Singapore.
• The second of two company directors had been a resident of Singapore for three years. That director was not a resident in India during that time period.
• The company raised funds from abroad and made investments from abroad.
• The company made its loan and investment decisions, which were frequent, in Singapore.
• The company undertook stewardship operations to these entities in Singapore.

ITAT examined the meaning of “control and management,” viewing control and management as being the head and the brain, as indicated by the board of directors. ITAT took a formalistic approach to the case at hand, as witnessed by these findings:

• ITAT found that all of the company’s board of directors meetings took place in Singapore, never in India.
• ITAT concluded that the residence of the directors and the carrying on of day-to-day operations were unimportant.
• ITAT viewed both directors as having equal power even though one shareholder controlled 99% of the shares and the other director controlled 1% of the shares.
• ITAT diminished the importance of physical relationship of the directors, suggesting that the meeting could have taken place by telephone or by video conferencing.
• Further, ITAT viewed Singapore’s providing the company with a tax residency certificate as being determinative.

MASHREQ BANK PSC

The India–United Arab Emirates Income Tax Treaty came to the fore in the Mashreq Bank PSC case regarding taxing profits of a permanent establishment. Mashreq Bank PSC was a nonresident banking company headquartered in the United Arab Emirates operating in India through a branch and subject to the PE rules. The AO disallowed some expenses of the branch. The bank appealed this result to the CIT(A), asserting that the bank was entitled to all of its expenses, whether taking place in India or outside India. The CIT(A) determined that domestic Indian law applied to determine the deductibility of the expenses. The bank then appealed to the ITAT.

Citing other sources, ITAT concluded that the location of the expenses determines the deductibility, and tax treaties give the power over taxability to the tax authorities in the jurisdiction in which the taxes are imposed. Each contracting state can apply its own general principles in computing the profits it has a right to tax. In other words, ITAT took the approach that domestic law governs.

MENTOR GRAPHICS (NOIDA) PVT. LTD.

Mentor Graphics (Noida) Pvt. Ltd., an Indian company, was closely related to IKOS, both being engaged in software development. Mentor was engaged in rendering software services to IKOS. IKOS used the software to support IKOS’s hardware sold as a package on the open market. Mentor applied the TNMM based on a cost plus markup as the profit level indicator. Mentor used two “screens” to eliminate comparables:

The cost plus markup for the comparables that Mentor selected was 13.41%. Mentor’s own activities had a markup of 11.07%. Mentor claimed the transactions at arm’s length based on Income Tax Act section 92C(2), which provides for a variation of plus or minus 5%.

The TPO rejected Mentor’s reasoning and the use of data for years other than the year at issue. The TPO rejected some companies as comparables. The TPO then did its own search of comparables and had an average cost plus markup of 26.94%. Mentor had an average cost markup of 24.53% after making adjustments. Mentor appealed the result to the CIT(A). The CIT(A) upheld the TPO’s adjustment. Mentor then appealed to ITAT.

ITAT reversed the results provided by the TPO in significant part because the TPO failed to properly assess the level of risk between Mentor and IKOS. Mentor was a captive software development service provider to IKOS. IKOS had most of the business risk, such as contract risk, market risk, credit risk, warranty risk, price risk, and so forth. IKOS owned the intellectual property rights to the intangibles that it provided to Mentor. Further, the TPO had asserted that the companies selected comparables not having any related party transactions, but the facts were otherwise.

MILLENNIUM INFOCOM TECHNOLOGIES LTD.

Millennium Infocom Technologies Ltd., an Indian company, set up Web site leasing servers in the United States. Millennium did not withhold payment it had made to the server owners but claimed these expenses on its tax returns. The AO disallowed the lease payment expense, relying on section 40(a)(i) of the Indian Tax Act, which denies a deduction paid to nonresidents. Millennium appealed this result to the CIT(A). The CIT(A) upheld the AO’s finding. Millennium then went before ITAT.

ITAT examined the implications of the India–U.S. Income Tax Treaty as well as changes to Indian domestic law in the context of the Millennium situation.

Millennium successfully sought relief under Article 26(3) of the India–U.S. Income Tax Treaty, which prohibits discrimination against nonresidents. ITAT held the treaty provisions are determinative, and Millennium prevailed against the Revenue Department.

VAN OORD ACZ INDIA

Van Oord ACZ Marine Contractors BV, a Netherlands company, was in the dredging business. It had a subsidiary in India, Van Oord ACZ India, that executed a dredging contract at an Indian port. The Indian subsidiary incurred mobilization and demobilization expenses, primarily for transporting surveying equipment and other plant and machinery from outside India to inside India and from inside India to outside India. The Dutch parent company owned the equipment, and the Indian company used the equipment in its dredging operations. The Dutch parent company reimbursed the Indian subsidiary for these expenses. The parties alluded to the presence of arm’s length pricing, but the Indian government did not address the bona fides of the intercompany lease.

The Indian subsidiary did not withhold tax on the reimbursed amounts it paid to its parent company. The Revenue Department ruled that the Indian subsidiary should have withheld tax, and because the subsidiary failed to withhold, the subsidiary could not deduct its dredging mobilization and demobilization costs pursuant to Indian domestic tax law. The Indian subsidiary appealed the Revenue Department’s determination and appealed to the CIT(A). The CIT(A) rejected the Indian subsidiary’s appeal, and the subsidiary went before ITAT. ITAT rejected the subsidiary’s claim.

The subsidiary characterized the payments to its parent company as being a conduit, a reimbursement of actual expenses, causing the subsidiary to earn no profit from that activity. The subsidiary argued that the payments were at arm’s length, an issue that the TPO confirmed. Nevertheless, the case did not further dwell on potential transfer pricing considerations. The Revenue Department argued that the parent company had a PE under the India–Netherlands Income Tax Treaty, but ITAT apparently did not address this issue further. ITAT rejected the subsidiary’s reimbursement-of-cost approach and determined that the subsidiary should have withheld tax and that the subsidiary could not deduct the reimbursement amounts.

TOKYO MARINE & FIRE INSURANCE CO. LTD.

Tokyo Marine & Fire Insurance Co. Ltd., a Japanese company, established a representative office in India and later entered into a joint venture with IFFCO, an Indian company, IFFCO-Tokyo General Insurance Co. Ltd. in India, for the purpose of underwriting general insurance in India. The Japanese head office paid representative office costs, including expatriate salaries, rent, travel, and legal expenses.

The Revenue Department determined that Tokyo Marine & Fire Insurance Co. Ltd. had a fixed place of business in India that constituted a PE under the India–Japan Income Tax Treaty. Tokyo Marine & Fire Insurance Co. Ltd. appealed to the CIT(A). The CIT(A) set aside the Revenue Department finding and ruled in favor of Tokyo Marine & Fire Insurance Co. Ltd. The Revenue Department then appealed the finding to the Delhi ITAT.

Before ITAT, the Revenue Department, in advocating PE treatment, focused on the rent that Tokyo Marine & Fire Insurance Co. Ltd. had paid, the presence of five expatriates and local staff, and the involvement in the IFFCO contract.

Tokyo Marine & Fire Insurance Co. Ltd. argued that the representative office was only a liaison office, had no authority to conclude contracts on behalf of Tokyo Marine & Fire Insurance Co. Ltd., and the Reserve Bank of India limited the scope of the representative office approval.

ITAT held that the revenue department failed to demonstrate that the representative office was undertaking commercial activities in India beyond the Reserve Bank of India’s limitations. Tokyo Marine & Fire Insurance Co. Ltd. conducted its business in India through its joint venture company, which was taxed separately. ITAT ruled against the Revenue Department’s approach, relying on Article 5, paragraph 6 of the India–Japan Income Tax Treaty, which provides an exemption of “preliminary or auxiliary” activities, holding that Tokyo Marine & Fire Insurance Co. Ltd. activities were in the nature of “preliminary or auxiliary” activities.

WESTERN UNION MONEY TRANSFER

Western Union Money Transfer, a U.S. company, was engaged in the business of transferring money. Western Union Money Transfer had a liaison office in India and had appointed unrelated agents in India to facilitate its money transfer business. The Revenue Department determined that the company’s money transfer activities in India constituted a PE of the U.S. company. Western Union Money Transfer appealed.

ITAT reversed the Revenue Department decision and held that the U.S. company had no PE in India. ITAT concluded that the liaison office was engaged in preparatory and auxiliary activities that the India–U.S. Income Tax Treaty had excluded from PE status. ITAT’s conclusion was based significantly on the fact the Indian agents were independent agents. ITAT held that the Revenue Department could tax none of the profits of the U.S. company.

CARGO COMMUNITIES NETWORK

Cargo Communities Network Pte. Ltd. was a cargo facilitator that served as an air cargo portal. Indian agents that were in the business of booking cargo on airlines could subscribe to access to Cargo Communities Network Pte. Ltd., a Singapore company. The access provided the Indian agents with details of the airlines’ flight schedules, cargo space availability, and so forth. Cargo Communities Network Pte. Ltd. signed its contracts with Indian agents outside of India. The Indian agents paid their subscription fees to Cargo Communities Network Pte. Ltd. outside of India. The AAR held that the payments that the Indian agents made to Cargo Communities Network Pte. Ltd. were in the nature of royalties and were taxed as such under the India–Singapore Income Tax Treaty.

HYUNDAI HEAVY INDUSTRIES

Hyundai Heavy Industries, Ltd., a Korean company, was in the process of designing, fabricating, and installing equipment, and undertook those activities for an Indian company for a location in India. The revenue authorities assessed the entire profits of the project as being in India and subject to Indian income tax. The Supreme Court held that India cannot tax the non-Indian operations. India was able to tax only the profits related to the installation and commission activities in India.

E. GAIN PVT. LTD.

E. Gain Pvt. Ltd. was an Indian-based captive software service provider, a subsidiary of a U.S. entity. E. Gain Pvt. Ltd. bore no risk emanating from the intercompany transaction; the U.S. parent company bore all the risk from the intercompany transaction. The company, recognizing that it was a captive software provider, charged its parent company at cost plus 5%. The TPO ignored the risk of loss issue, determined that the Indian subsidiary should apply the markup of cost plus 16%, and made an adjustment accordingly. It appears that the TPO relied on a broad base of software companies, some captive, some independent.

ITAT rejected the TPO’s analysis and focused instead on functional differences and different levels of risk. The Indian subsidiary in this instance was entitled to a lower cost plus margin because it had a much lower level of risk. ITAT accepted the taxpayer’s approach and applied the TNMM.

INFOSYS INTERNATIONAL ACTIVITIES IN NEW YORK STATE

Infosys Technologies Limited is a worldwide Indian-based software development and consulting firm. Infosys operates a self-described “global delivery model” in which Infosys matches small teams of targeted in-country engineers with offshore development centers in India. U.S. wages for engineers were approximately 10 times the amount of Indian wages for engineers in 2000 and 2001, the years under dispute.

Infosys is doing business in New York State and other U.S. locations, as well as in other countries throughout the world. A dispute arose as to Infosys income subject to New York State tax. The New York Administrative Law Judge (ALJ) reached its decision in favor of the New York State’s Division of Taxation. The New York Tax Appeals Tribunal affirmed the decision of the ALJ. DTA No. 820669, February 21, 2008.

The initial inquiry before the New York courts was the allocation methods that New York State can apply to determine the amount of Infosys income subject to New York State law:

• Can Infosys develop its own allocation method for purposes of allocating income to New York State, without seeking consent from New York State?
• Must Infosys use New York State’s allocation formula for purposes of allocating income to New York State?

The ALJ and the Tax Appeals Tribunal determined that New York’s allocation formula applies. The courts reached this decision on procedural grounds, stating that the New York allocation rules were logical and mandatory and that Infosys did not request an exception from the New York allocation method. Infosys’s approach, despite its assertion, does not constitute valid “separate accounting.”

The second inquiry was the basis on which Infosys was to determine the income subject to allocation:

• Should Infosys determine its taxable income for New York State to be allocated based on its taxable income connected with its U.S. trade or business, as reported on its Form 1120F federal tax return?
• Should Infosys determine its income to be allocated based on its worldwide income, thus disregarding the Form 1120F?

The courts determined that Infosys’s allocation to New York State was to be based on its entire worldwide income. The court held that the Form 1120F determination was not specifically relevant to the New York State apportionment issue.

The courts rejected Infosys’s approach to apply transfer pricing—comparable profits method—cost plus 7%:

• Courts in the United States and elsewhere prefer an allocation approach rather than transfer pricing because allocation is much easier and more certain than transfer pricing.
• The India–U.S. Income Tax Treaty provides that the treaty does not impact state and local taxes.

A question arose as to how Infosys should determine its receipts factor:

• Actual charges approach. An amount based on the actual amounts that Infosys billed to clients for work done within the state and outside the state
• A formulary approach. An amount based on a head count ratio or on a days-worked ratio (i.e., a time-spent ratio)

Infosys’s gross margin on employee costs in the United States was 42% to 43%. Infosys’s gross margin in employee costs was 87%, making Indian operations more profitable. The formula approaches would shift income toward the United States and thus to New York State. The courts concluded that Infosys could not use a “relative values” approach. Infosys was to use the actual amounts invoiced to New York taxpayers, the actual charges approach.

The India–U.S. Income Tax Treaty pertains only to federal taxation, not state taxation. The Infosys result might have been different if Infosys had set up a separate entity for its New York operations. The question remains whether New York State can tax profits in India that result from the New York services.