LAW OF TAXATION- 1

CONCEPT AND EVOLUTION OF PERMANENT ESTABLISHMENT IN

INDIA

Submitted by:
Ragvendra Singh Khichi, 16B122
Submitted to:
Mrs. Prabhavati Baskey
ASSISTANT PROFESSOR OF LAW
GUJARAT NATIONAL LAW UNIVERSITY

“I LIKE TO PAY TAXES. WITH THEM, I BUY CIVILIZATION.” 

― OLIVER WENDELL HOLMES JR.

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 ACKNOWLEDGMENT

I would hereby like to acknowledge that the content of this project has been the outcome of
the research carried out by me and it is indeed my privilege to present this project to Mrs.
Prabhavati Baskey (Assistant Professor of Law).
Also, I would like to express my deepest gratitude to Prof. (Dr.) S. Shanthakumar,
Director, Gujarat National Law University, for providing this wonderful opportunity to carry
out research on this significant topic.
At Last, I would also like to thank everyone –Faculty, and peers – for giving valuable
information and help to formulate ideas through stimulating discussions and a cohesive work
environment to turn those ideas and stray thoughts into a purposeful project.

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 TABLE OF CONTENTS

INTRODUCTION……………………………………………………………………...
………....4

RESEARCH METHODOLOGY………………………………..…….………………………..
…5

CONCEPT AND SIGNIFICANCE OF PERMANENT ESTABLISHMENT……..

…………….6

DETERMINATION OF EXISTENCE OF PERMANENT

ESTABLISHMENT……………….7

RECENT DEVELOPMENTS IN THE CONCEPT OF PERMANENT ESTABLISHMENT:

MASTERCARD CASE…………………………………………………………………….
………9

COMPARSION OF PERMANENT ESTABLISHMENT IN INDIA AND

CANADA………...10

CONCLUSION…………………………………………………………………………………
..13

BIBLIOGRAPHY………………………………………………………………..
……………….14

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 INTRODUCTION
The concept of permanent establishment is gaining significance in recent times because it
makes the process of determination of taxability of a foreigner company is India much easier.
Traditionally, in order to avoid double taxation in the home country as well as any other
country a company operates in; it is entitled for tax concession under Double Taxation
Avoidance Treaties. However, if a company has permanent establishment in a country then it
is liable to pay taxes for the income they have created in that country.

As per common parlance in India, ‘permanent establishment’ is referred to as a ‘business

connection’ which essentially is a fixed place of business, fully or partially owned by a non-
resident businessperson. The definition of business connection is very wide and “inclusive”
in nature.12 As per the Finance Act, 2016 the amended section 6 of the Income Tax Act, 1961
which lays down two criteria to decide whether or not a company is resident in India. Firstly,
it talks about the ‘place of effective management’ (POEM) should be in India during the year
of determination. The section further explains that POEM would essentially be a place where
key management and commercial decisions are made. These decisions should be necessary
for the conduct of business of an entity as a whole. However, there are various other facets to
PE and its evolution other than place of effective management which are discussed in the
further chapters.

1
CIT v R.D. Aggarwal & Co. 1965 AIR 1526.
2
Income Tax Act 1961, s 6.

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 RESEARCH METHODOLOGY

OBJECTIVE

This Paper aims to throw light on the concept and evolution of Permanent Establishment in
India. It also attempts to study various aspects pertaining to it in order to attain a complete
understanding.

SCOPE

The scope of this project is extended to Indian as well as Canadian laws, and three model
conventions United Nations, Organization for Economic Cooperation and Development and
United States of America.

RESEARCH METHOD

The method employed by the researchers to conduct research is qualitative. It is descriptive

and involves case law analysis.

RESEARCH QUESTIONS

Q1. What is Permanent Establishment and what is its significance in present world?

Q2. What are the main challenges this jurisprudence faces in recent times?

Q3. How can a Permanent Establishment be determined?

SOURCES

This doctrinal research has been done by using both primary sources and secondary sources.
The primary sources include the Income Tax Act, 1961, as well as three model conventions
United Nations, Organization for Economic Cooperation and Development and United States
of America and various Indian case laws. The secondary sources include mainly books by
prominent authors, research papers and journals on tax law.

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CONCEPT AND SIGNIFICANCE OF PERMANENT ESTABLISHMENT

In this era of globalization with technological advancement that leads to an easy way of
access between various countries in terms of communication and transportation irrespective
of their physical presence. “Today the world has shrunk to a global village, where no
destination is inaccessible”. Various corporates in this world have their branches in other
nations, if not then they are establishing it, for expansion of their business into foreign
markets that results in increase in profits of an organization or corporation.

There are two types of inter-countries transactions: ‘doing business with a country’ and
‘doing business in a country’. ‘Doing business with a country’ includes the foreign
companies carries out their business activities without having any establishment in that
country like selling of goods to its residents, are involved in business transactions with the
residents of a country but transferring the titles and risks, signing of contracts outside the
country. In this kind of situation, foreign companies are not liable to pay tax in the country
where the buyers of their goods are located as they do not have an official presence or
undertake any of the business activities. ‘Doing business in a country’ means the presence of
a company in a country which is not its residence country. The businesses of foreign
companies are undertaken by merely establishing its presence. All activities related to
business are conducted by its agent, an employee or from a fixed place from where business
is conducted. The problem related to taxing foreign companies is quite complicated. The tax
authority of a country in which foreign company is carrying over business transaction varies
from one country to another because all the countries have signed different national as well as
international treaties.

Their tax mechanism should avoid double taxation. Many countries across the world
recognize the concept of PE as well as subsequent profit attribution methods and have
incorporated in their domestic taxation laws and international treaties. OECD and UN have
published guidelines for attribution of profits for PE.

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 DETERMINATION OF EXISTENCE OF PERMANENT
ESTABLISHMENT

Existence of a Permanent Establishment has always been a tricky process and the subjective
circumstances of cases have a major role to play. The following tests are laid down by the
UN double taxation model convention and are adopted by Indian courts from time to time.
I. OBJECTIVE TEST

A. PLACE OF BUSINESS TEST

This test establishes that there must be a “place of business” which is “fixed” in terms of
location. The place is understood together with physical objects which one would primarily
require to carry on a business activity. It should be noted that presence of employees is not an
essential criterion according to this test and a place of business can exist even without any
employee. For instance, equipment (such as credit/debit card mechanism, pipelines, vending
machines or telephone lines/network) which can function on its own without involvement of
any employees after it is installed would constitute a PE if other conditions mentioned in
Article 5(1) are satisfied. A place of management requires an existence of an office or a
similar facility for it to qualify as a PE.

B. LOCATION TEST

This test is derived from ‘base theory’, which requires establishment of a fairly fixed place of
business in the other country.3 The essence it hat it should be linked to a specific geographical
point in the source country. It excludes place of business that is mobile, however, may
include a movable one, for instance a petroleum drilling rig.

II. SUBJECTIVE TEST

A. THE RIGHT OF USE TEST

This rule envisages that the pace of business should be at the disposal of the enterprise. Thus,
the key aspect is the right to use the place and not the manner in which such a right has been
secured, therefore, it is immaterial whether the place is owned or rented. This right could
either be a legal right or even a factual right. The facilities and the premises of the place
should be at the disposal of the enterprise. In other words, the enterprise should be able to
3
Texas Instruments (India) Pvt. Ltd. A.A.R. No 1330 of 2012.

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carry on its business without any hindrance. For instance, in case of when a lawyer uses the
facilities of his client then such a place will not be considered as a PE. It is essential to
distinguish the abovementioned with a mere user of a place. However, if the lawyer by virtue
of an agreement with the client acquires a portion of the his premise t be at his disposal then
it may be considered as a PE.

III. THE PERMANENCE TEST

This test propounds that the place of business should have a certain degree of permanence.
Therefore, a temporary place of business would not constitute a PE. Herein, the intention is of
the essence, for instance, if the intention was to set up a business for a long time at a
particular place, it could constitute PE even if the intentions are not fulfilled subsequently.
“Permanence” here is construed as continuing for an indefinite period of time as opposed to
lasting forever or perpetual. There is no specific period of time that would establish
permanence, however, in some cases and several countries even a six month period is
considered sufficient enough to constitute a PE.

IV. FUNCTIONAL TESTS

In order to constitute a PE, the existence of a fixed place of business or the ownership of
assets should be coupled with actual carrying on of business activities. This test demands that
this business activity should be the business of the enterprise which can be determined
through four checkpoints.

● Firstly, the business activity undertaken by the company should be

distinguished from other income generating activities or investments and must
constitute a business under the domestic law of the country wherein the PE is
to be established.
● Secondly, if the abovementioned condition is met, it should be treated as
business activity under article dealing with business profits. For instance,
Article 7 in case of UN model convention.
● Thirdly, the business activity should be the primary activity of the company
and not a secondary or auxiliary one (Article 5(4) of the UN model).
● Fourthly, the business activity should have a substantial connection to the
place of business.

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 RECENT DEVELOPMENTS IN THE CONCEPT OF PERMANENT
ESTABLISHMENT: MASTERCARD CASE

The concept of permanent establishment in India for taxation purposes has undergone a lot of
change over time. An expansive view was taken up by the taxation authorities in the recent
MasterCard controversy. The main issue before the authority was the taxability in India of
fees received from Indian banks and other financial institutions for MasterCard’s payment
processing services. MasterCard offered services which involved electronically processing
payments between a cardholder’s bank and a merchant’s bank using the MasterCard
network.4 Under royalty agreements signed by Indian financial institutions, MasterCard Asia
Pacific received transaction processing fees in exchange for authorization, clearing, and
settlement of card-based transactions, and additional fees for incidental services. Each
financial institution was provided with a MasterCard Interface Processor (MIP) – an
electronic device the same size as a standard personal computer –to be placed in the
institution’s premises, which connected the financial institution to the MasterCard network.
MasterCard Asia Pacific’s Indian subsidiary, MasterCard India Services Private Limited
(MasterCard India), owned and maintained the MIPs placed in Indian financial institutions
and also provided support services.

MasterCard denied its taxable liability claiming that it is not a permanent establishment in
India and hence should be exempt from paying taxes whereas the state contended otherwise.
The ruling was given by AAR (Authority for Advance Rulings) India which is a pre-trial tax
determination body. The AAR noted that MIPs provided several key elements of the payment
authorization process, such as PIN processing, validation of card codes, address and name
verification, fraud alerts, and data encryption. MIPs were therefore responsible for
preliminary examination and verification of the transaction, failing which the transaction
would not be authorized. This was held to be a significant activity and not merely a
preparatory or auxiliary one so this contention of MasterCard was rejected. The AAR ruled
that the MasterCard network constituted a fixed place PE of the MasterCard Asia Pacific in
India. The AAR observed that since a sister company of MasterCard Asia Pacific was
responsible for management and maintenance of the MasterCard Network, and since the

4
MasterCard Asia Pacific Pvt. Ltd. Singapore v. CIT A.A.R. No 1573 of 2014.

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application software used to access the MasterCard network was owned and controlled by the
MasterCard Asia Pacific, the MasterCard network was at the disposal of MasterCard Asia
Pacific.

The AAR further observed that since the employees of the Bank of India (the designated
settlement bank in India) carried out their functions in accordance with the instructions given
by the MasterCard Asia Pacific, such employees were under the control and supervision of
MasterCard Asia Pacific, and hence the space occupied by them in the Bank of India was
effectively at the disposal of MasterCard Asia Pacific. On that basis, the AAR ruled that
Bank of India also constituted a fixed place PE of MasterCard Asia Pacific in India.

The AAR noted that MasterCard India habitually secured orders for the MasterCard Asia
Pacific in India. Based on the narration of the MasterCard Asia Pacific, the AAR observed
that all agreements entered with Indian customers after the incorporation of MasterCard India
were in fact routed through MasterCard India. In the AAR’s view, this showed that
MasterCard India was habitually securing orders for MasterCard Asia Pacific, thereby
resulting in the constitution of a dependent agent PE of MasterCard Asia Pacific in India.
AAR relied on its previous finding on the functions performed, assets employed, and risks
assumed by MasterCard India on behalf of the MasterCard Asia Pacific, to conclude that the
remuneration paid by the MasterCard Asia Pacific to MasterCard India was not arm’s length.
Relying on the decision of the Supreme Court in a case the AAR concluded that there would
be a need to attribute further profits.5 On this basis, the AAR observed that the tax authorities
may consider a further attribution of profits to MasterCard India.

Interestingly, the AAR has held an Indian subsidiary of a foreign parent to be a PE; however,
the AAR’s findings on this point are fact driven and also based on prior conduct of
MasterCard with respect to its tax position. Setting up Indian subsidiaries and transacting on
an arm’s length basis with such entities has been a standard process for foreign MNEs
looking to establish presence in India. The ruling will have an impact on such structures, and
MNEs will need to evaluate the value attributed to their Indian entities vis-à-vis the functions
performed.6 Considering recent rulings, it appears that tax tribunals are moving towards a
5
DIT v. Morgan Stanley & Co, [2007] 292 ITR 416.
6
Anandapadmanabhan Unnikrishnan & Shipra Padhi, Mastercard Has A Permanent Establishment In India:
AAR < http://www.nishithdesai.com/information/news-storage/news-details/article/mastercard-has-a-
permanent-establishment-in-india-aar.html> Accessed on 21st September 2019.

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liberal interpretation of current tax laws to accommodate digitized transactions. Digital
business models are especially vulnerable to the changing tax landscape, given the lack of
clear jurisprudence in this space. fffff

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 COMPARSION OF PERMANENT ESTABLISHMENT IN INDIA AND
CANADA
I. PERMANENT ESTABLISHMENT IN INDIA

India follows the concept of PE in its international tax treaties under Article 5. There are
three model conventions are United Nations (UN) Model, Organization for Economic
Cooperation and Development (OECD) Model and United States of America (US) Model
which uses PE as an instrument for demarcating taxing jurisdiction over foreigner’s business
transactions. The PE was incorporated in domestic tax law as a measure of statutory Transfer
Pricing provisions that inculcate various types of PE. India’s tax laws accord the concept of
business connection under section 9 of the IT Act, 1961 and PE in section 92F (iii)(a) of the
IT Act, 1961. India follows the United Nations’ (UN’s) Model Tax Conventions (MTC) as its
bilateral tax treaties and has comprised certain facets of the OECD MTC. The UN Model also
provides for concept of a ‘fixed base’ used in professional services and other independent
activities. Article 5(1) provides for a PE and basic rules were laid down that a business
activity carried on a fixed place it will constitute as PE of the tax payer. Article 5(2) provides
for specific inclusion in PE definition. It also remark examples of fixed place of business.
Article 5(3) stipulates for “Preparatory or auxiliary activities not resulting in a PE”. Article
5(4) describes about Dependent Agency. Article 5(5) gives for rule for concluding when an
enterprise would be PE on being represented by an independent agent. Article 5(6) deals with
an enterprise carrying on an insurance business. There have been certain transactions which
are explicitly excluded from the ambit of PE.

II. PERMANENT ESTABLISHMENT IN CANADA

The Canada’s tax law are based on two significant concepts are source and residency. Income
earned by its own residents and income earned by non-resident are subject to income tax
according to Canadian tax laws. As per Income Tax Act of Canada, Canadian residents are
charged tax on their world-wide income while Non-resident are charged tax on Canadian
source of income that includes income which arises from a business activity carried in
Canada, services provided in course of employment in Canada or at the disposition of
Canadian taxable property.

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Business profits of Corporations will be subject to charge income tax on their income to the
extent that they are Canadian PE provided as per Canada’s tax treaties. Non-resident are
subject to pay ‘withholding tax’ on certain types of passive income that includes dividends,
interest, rents and royalties at the rate of 25%. Any business carried out through a Canadian
branch would be liable to pay a branch tax. The branch tax is reduced to certain extent due to
tax treaties.

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 CONCLUSION
It is imperative to note that the formation of a PE of a company in a country other than its
home country through its subsidiary shall depend on its existence as well as a defined set of
parameters. It should also depend on the commercial arrangement between the two entities as
a whole. Moreover, it was observed that the activities undertaken by such a subsidiary hold a
position of paramount importance. These activities should be core activities pertaining to the
head company and should not be an ancillary or secondary business.

The MasterCard case throws light on some of the vital aspects of PE in India. Further, the
concept of Permanent Establishment is one of the most important one in International
Taxation. The existence of a Permanent Establishment or otherwise, would in most cases
determine the exposure to domestic tax liability in the country of source. It is, therefore,
imperative to understand the concept fully before embarking on the structuring of activities in
another jurisdiction. Attribution of profits to a Permanent Establishment has also been one of
the major issues both for taxpayer as well as tax advisers.

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 BIBLIOGRAPHY

CASES

1. DIT v. Morgan Stanley & Co, [2007] 292 ITR 416.

2. MasterCard Asia Pacific Pvt. Ltd. Singapore v. CIT A.A.R. No 1573 of 2014.

3. Texas Instruments (India) Pvt. Ltd. A.A.R. No 1330 of 2012.

4. CIT v R.D. Aggarwal & Co. 1965 AIR 1526.

ONLINE SOURCES

1. Anandapadmanabhan Unnikrishnan & Shipra Padhi, Mastercard Has A Permanent

Establishment In India: AAR

BOOKS

1. Basic International Taxation: Principles by Roy Rohatgi

2. Indian Double Taxation Agreements and Tax Laws by D.P. Mittal

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