Roadblock before Rolls Royce

Taxation of multinational corporations has been providing multiple challenges to India's tax administration.

The foreign company is liable to income tax in India, if it can be shown that it has a business connection in India or receives profits through a permanent establishment (PE) maintained in India.

Litigation revolves on these concepts of business connection and permanent establishment. Even if there is a permanent establishment, the problem arises, how to attribute profits to the PE in respect of Indian operations.

The Case of Rolls Royce PLC

Rolls Royce PLC is incorporated in the UK and is a tax resident in that country. It operates as a non-resident in India. It supplies spare parts and equipments to Indian defence establishments. It has an associate by name Rolls Royce India Ltd., incorporated under the English laws but having offices in India to render liaison services.

For this purpose, it gets remuneration on a cost plus basis. In respect of sale of goods to Indian customers, the Assessing Officer held that there was business connection between the two companies and that Rolls Royce India Ltd. was a PE for Rolls Royce UK. In determining the profits liable for tax in India, he attributed 100 per cent of profits earned for sale of goods to Indian customers in the years between 1997 and 2000 and 75 per cent of the profits in 2002 and 2003.

In the first appeal, it was decided that the profits attributable to the activities carried on in India through the PE should be limited to 75 per cent instead of 100 per cent as held by the Assessing Officer.

The Tribunal reduced the estimate to 35 per cent. In the appeal before Delhi High Court, several grounds were taken. Questions were raised as to the particular profits to be adopted for computing 35 per cent of global profits in respect of Indian sales.

Why should it not be estimated on net profits instead of trading profit? The Tribunal had pointed out that out of the global profits, 50 per cent should be attributable to manufacturing activity, 15 per cent to research and development and the balance 35 per cent to marketing activities carried out in India.

The Tribunal had given a finding that no part of R&D activities was carried out in India. It was this part of the company's activities that resulted in loss. Since it was not carried out in India, the expenditure involved on R&D must be ignored while computing global profits attributable to Indian operations.

Dependant agent

The Delhi High Court examined the issue of PE and found that the Indian company was set up as 100 per cent subsidiary and should be considered a PE. Rolls Royce India Limited must be held to be a PE for Rolls Royce PLC.

The extended scope for services rendered by the Indian subsidiary showed the existence of business connection in India. The true relationship between the two concerns was never disclosed to the department.

Only a survey brought out the truth about business connection. The Indian company also happened to be a dependant agent. It secured orders in India for the principle company.

It was not acting as a mere post office. It was operating as a fixed place of business at the disposal of Rolls Royce PLC. It was in the core activity of marketing, negotiating, and selling of the product. It was acting as sales office.

Its employees were wholly and exclusively working for Rolls Royce PLC. In terms of Article 5 of the Indo-UK DTAA, the Foreign Company can be set to have a PE in India. The income arising from its operations in India are chargeable to tax. The Delhi High Court upheld the Orders of ITAT and dismissed the appeals of the company and of Revenue 339 ITR 147.

A comparison of the concepts of business connection under Indian law and PE under the DTAA would indicate the nexus which is a basis for taxing the income of a non-resident in India. Business connection is a concept which is less precise.

The Authority for Advanced Ruling had delivered a landmark judgment in 223 ITR 416 analysing these concepts. It pointed out that the mere existence of a subsidiary will not constitute a PE.

This will be true when the subsidiary has significant independent activity of its own and operates on behalf of persons other than the holding company. How do we attribute profits to the PE?

What should be the period of activity in India? Will the mere establishment of a Liaison Office constitute a PE? The problems get confounded when we consider cases of money transfer services, software services etc.

The issues are confusing and matters concerning foreign taxation under Indian law lack clarity.

It is necessary that reasonable principles must be laid down in India for measuring the extent of global profits that can be attributed to the Indian PE.