THE common perception about the Indian revenue is that it is always eager to find a PE of a foreign enterprise doing any business in India. There are some who sneer that even if one passes through the Indian airspace, one may create a PE in India. Exaggerated though this claim is, it is a fact that if the only way to tax business income of a foreign enterprise is dependent on the existence of a PE, the revenue authorities will obviously try to assert that the enterprise creates a PE in India. At the level of the judiciary however, most of these efforts come to naught.

But, do you know that there are instances where the tax planners will assert that there is a PE of the enterprise in India? This will of course be the case when it suits their convenience. For, one thing, under tax treaties a PE can only be taxed on a net basis that is after allowing for the expenditure. Source States are allowed to tax certain items of income like dividends, royalty, fees for technical services etc., on a gross basis. The tax rates here are normally lower than when net basis of taxation is adopted. So, when gross basis of taxation of these items of income result in more tax outgo, one may claim the existence of a PE since the general rule is that if these items are effectively connected with a PE then again only net basis of taxation is allowed. Secondly, a PE is taxed only on the income that is attributable to the activities of the PE. In many decisions, Indian Courts have taken the position that activities carried out outside India cannot be attributed to the PE.

Indian tax authorities figured out long back that MNCs take out substantial profits by claiming payment for the so called 'technical services'. Therefore, the source rule in India was changed and a specific provision was incorporated in the Act for taxing such fees on a gross basis. Indian treaties also followed, incorporating an FTS clause in line with the article relating to royalties.

The FTS provision in Indian treaties normally provides that if however the fees are 'effectively connected' with a PE, then these should be taxed on a net basis as in the case of business income.

The term 'effectively connected' is an extremely confusing one and arose because of the difference in the practice of taxation in civil law countries as compared to taxation in common law countries. One must remember that the comprehensive income tax that we intuitively associate with is a relatively recent phenomenon. Only the UK and other common law countries with British influence followed this. The Continental Europe had the concept of real taxes. The rules of business taxation, the most important source of income that was really the reason for the development of tax treaties was different in common law and civil law countries. For example, in common law countries, certain types of income like interest, dividend, royalties will not be considered business income of the enterprise carrying on the business while in civil law countries, these will always form a part of the business income of the enterprise. As a result the drafters made several compromises in the language and their legacy is being felt by courts trying to interpret the provisions adopted in tax treaties.

Thus the apparently harmless and obvious expression 'effectively connected' has become a subject of litigation in a number of Indian cases and recently of the Australian Federal Court involving unsurprisingly an Indian taxpayer , Satyam (Tech Mahindra). Before we analyze the Australian case, it will be instructive to see how the expression has been understood by the Indian Courts.

In P No of 13, 1995 [2002-TII-04-ARA-INTL], a French company ABC was providing complete project services to an Indian taxpayer.It was stated that although ABC had requisite expertise, knowledge, etc., to render all services in time, ABC could by way of sub-contract get part of the work done through their affiliate office/third parties while retaining the overall responsibility with them. In such circumstances, one of the questions posed before the AAR was whether the activities of ABC conducted outside India were effectively connected with the activities conducted inside India by its permanent establishment in India.

The taxpayer argued that Article 13(6) of the India France DTAA takes out of the purview of Article 13 and transposes to Article 7 all payments received as royalties or technical fees which are effectively connected with the permanent establishment in India; that all the royalties, etc., that may be received by ABC under the agreements, either for services, etc., in India or outside India, are effectively connected with the permanent establishment and are to be considered for assessment under Article 7. Article 7, however, provides for a bifurcation of the profits into profits attributable to the operations in India and others and restricts the assessment to the former alone.

The department argued that the entire profits from the contract accrue in India where the plant and complex are set up and the entire discussion about "outside" and "inside" activities involving various kinds of services was totally artificial and irrelevant.

The AAR agreed with the taxpayer's contention that all the outside activities are directed towards the installation of the manufacturing plant and industrial complex in India. Though carried out elsewhere, they are integrally connected with the project in India. The designs, basic engineering services and other services are based on information collected in India and the use of the process and technologies have to be adapted to the needs of, and prove workable in, Indian conditions. It held that the permanent establishment in India has an undoubted voice over the outside activities as well and the royalties and fees in question cannot but be described as effectively connected with it.

More importantly, on an examination of the domestic law provision and the treaty provision, the AAR held that the payments under the agreements are taxable in terms of Article 7 read with Article 13(6) of the DTAA and in terms of Articles 7(1) and 7(2) of the DTAA read with paragraph 3 of the Protocol, the profits of ABC attributable to the operations carried out by its permanent establishment in India will alone be liable to tax in India.

Ishikawajima Harima Heavy Industries [2007-TII-SC-01-INTL] is a celebrated Supreme Court decision that laid down the theory of territorial nexus and led to an amendment in the Income tax Act. One of the less well-known aspects of this case is relating to the issue as to whether fees for technical services were effectively connected with a PE and what happens if the services are rendered from abroad.

In this case, the taxpayer formed a consortium with other taxpayers and entered into a turnkey project with Petronet for setting up a Liquefied Natural Gas receiving storage and degasification facility. The role and responsibility of each member of the consortium was specified separately. Each of the members of the consortium was also to receive separate payments.

Answering the question relating to taxability of the receipts, the AAR [2004-TII-17-ARA-INTL]. held that the assessee was liable to pay tax in India in respect of the offshore supply of equipment and materials, both under the provisions of the Act and the India-Japan Treaty. Also, the entire amount received for offshore services was chargeable to tax under the Act and under the Treaty but at the rate not more than 20 per cent of the gross amount.

On the taxpayer's appeal by special leave, the Supreme Court , however, held that since the taxpayer carried on business in India through a Permanent Establishment, they clearly fell out of the applicability of Article 12(5) of the DTAA and were into the ambit of Article 7. And further without much explanation, the Supreme Court held that "The terms 'effectively connected' and 'attributable to' are to be construed differently even if the offshore services and the permanent establishment were connected." The Supreme Court held that in this case, the entire services have been rendered outside India, and have nothing to do with the permanent establishment, and can thus not be attributable to the permanent establishment and therefore not taxable in India.

These observations of the Supreme Court have been interpreted to mean that when there is a PE, even if technical services are connected with such PE, no tax can be levied in India if the services are rendered from outside. It is true that the perils of such an interpretation were pointed out in other judgments/rulings. For example, in the case of Worley Parsons, [2009-TII-06-ARA-INTL] a case involving India-Australia tax treaty, the departmental representative argued that exclusion provision in Article XII (4) should be strictly confined to that part of the income arising from the services connected with the PE as otherwise, an anomalous situation could arise in that a non-resident performing the entirety of services from abroad in respect of a project to be carried out in India, will have to pay tax on the entire of 'royalty' income by reason of the fact that it has not set up a PE in India whereas a non-resident rendering few services through a small PE set up in India will be able to avoid the payment of tax on "royalty" income except in respect of those few services rendered through the PE. However, the AAR chose not to express any opinion on that issue, although it seems that the AAR did doubt the correctness of the Supreme Court's decision in IHI in several aspects.

Let us now see how the expression has been interpreted in Australia.

Satyam, which in the wake of a scam was amalgamated with Tech Mahindra, had established its Australian offices during 1998 to 2008 and, as at 30 June 2008, employed 821 staff in Australia. Satyam employees typically provided the services at the customer's offices in Australia. Where it was not necessary to provide services at the premises of the Australian Customers, it was open to Satyam to provide the work through staff located in the Australian offices or staff located in the Indian offices, subject to the approval by the Australian Customers. Thus Satyam rendered services both from Australia (Australian services) as also from India (Indian services).

In its income tax return for the relevant year, initially Satyam included income generated by the performance of the Indian Services, as well as the Australian Services. Under the Australian law, the return was deemed to be the notice of assessment and Satyam was required to pay taxes accordingly. Subsequently, Satyam took the view (possibly inspired by the Indian decisions mentioned earlier) that its Indian services were not taxable under article 7 of the India-Australia tax treaty and its taxable income was overstated by almost one third and therefore it lodged an objection with the tax Commissioner.

There is no dispute about the fact that Satyam had a PE in Australia. India- Australia tax treaty contains a limited force of attraction provision in article 7(1)(b) and the Commissioner,rejecting Satyam's contentions, took the view that the support services performed from India involved business activities of the same or similar kind as carried on through the permanent establishment and hence was attributable to the PE. In the alternative the Commissioner argued that the profits from the Indian services would be taxable as royalty that arose in Australia.

In appeal before the Federal Court, the single judge [Tech Mahindra Limited v Commissioner of Taxation [2015] FCA 1082] agreed with Satyam that the limited force of attraction provision as contained in Article 7(1)(b) of the Treaty did not apply to services rendered from India. The India-Australia treaty also contains the 'make available' clause in the FTS article. Therefore the judge also agreed that those services that do not make available any technical knowledge would not be taxable in Australia. However, after analyzing the agreement and the nature of the services, she held that the royalty article would cover some of these.

Satyam argued that the Indian Services were performed in concert with the services performed through the permanent establishment; that it was only the Indian Services in combination with the Australian Services that together satisfied the contractual obligations to the Australian Customers. The close relationship had the consequence that the Indian Services were effectively connected with the permanent establishment. Therefore, in view of article 12(4), the service fees being effectively connected with its Australian PE was to be taxed only as business income under Article 7 and since the disputed activities were carried on in India, Australia did not have the right to tax the same.

The tax Commissioner, on the other hand contended that article 12(4) gives priority to article 7 only where the criteria in Article 7(1)(a) are met so as to permit Australia still to tax the profits of the Indian Services but on the different basis prescribed by Article 7. Article 12(4) therefore applies only where both Contracting States are entitled to tax those payments, subject to the cap.

The Single Judge pointed out the lacunae in Satyam's argument by contrasting a case where a connection exists between the payments and the permanent establishment on the one hand, with a case where there is no effective connection between the payments and the permanent establishment, on the other hand. It held that if Satyam's arguments were to be accepted, the source State would have no entitlement to tax the income at all in the first scenario, but retain its entitlement to tax royalties under Article 12 in the other. (Note that the DR had made the same point that was not considered by the Tribunal in Worley Parsons). She therefore agreed with the Commissioner's argument that in those cases where there is an effective connection between the payments and the permanent establishment but the payments would also constitute royalties under Article 12, the source State where the royalties arise is entitled by virtue of Article 12(4) to impose tax at full rates permitted under Article 7(1).

On further appeal, the only issue disputed was regarding the relationship between Article 7 and Article 12- whether in view of Article 12(4), article 7(1) gets priority and hence Australia cannot tax the Indian services. More or less same arguments were advanced before the division Bench. [Tech Mahindra Limited v Commissioner of Taxation [2016] FCAFC 130]

The Court held that in construing Art 12(4), it is important to consider how Art 7 and Art 12 interact. The Court held that subject to Art 7(7), the right to tax business profits is allocated to the enterprise's country of residence unless the enterprise carries on business through a permanent establishment in the other state. If there is a PE in the other state, that other state is allocated the right to tax the profits of the enterprise that are "attributable to" the permanent establishment.

Therefore there is circularity in these cases: the application of the business profits rule in Art 7(1) is subject to Art 7(7); where business profits include "royalties", Art 7(7) is subject to Art 12(4) which has the effect that Art 7, not Art 12, will be applicable. The Court pointed out that Art 7 is to apply to:

(1) business profits of an enterprise not covered by Art 12 that are attributable to apermanent establishment; and

(2) by Art 12(4), also to such of the business profits that are royalties where "the property, right or services in respect of which the royalties are paid or credited are effectively connected with" that permanent establishment.

The Court held that as a matter of construction, the "property, right or services in respect of which the royalties are paid or credited" referred to in Art 12(4) must be a reference to the property, rights and services listed in Art 12(3). Otherwise such royalties are to be dealt with under Art 12. Royalties thus are able to be taxed by the source State either as part of business profits under Art 7, where such royalties are attributable to a permanent establishment in that state, or separately under Art 12.

The Court held: "The language is somewhat loose in that it is not the royalties that must be effectively connected but the property right or services in respect of which the payment or credit in question is made as consideration ." Relying on the explanatory memorandum and the Commentary to the UN Manual, the Court held that the function of Art 12(4) is to remove the limitation on taxing rights under Art 12, not to remove the source country's right to tax such royalties unless otherwise the source country has right to tax such royalties under Art 7.

Satyam had also argued that the services in respect of which the royalties were paid discharged contractual obligations that were undertaken by the taxpayer through the permanent establishment and thus served to effect the purposes of the permanent establishment.

In that context the Court held that the word "effectively" qualifies the degree of connection that is required between those services and the permanent establishment to trigger the Article. "In ordinary meaning, the word "effective" means "actual" or "existing in fact". Used as an adverb in conjunction with "connected", "effectively connected with" should be understood to mean having a real or actual connection with the activities carried on through the permanent establishment. Whether or not such a connection exists is not answered merely on the basis that the property, rights or services provided "serve to effect the purposes of the permanent establishment."