THERE are two hurdles in taxing the cross-border income of multinational enterprises in a source country, in terms of the rules of the game that were laid down more than a century back and that, despite the recent turmoil in the field of international taxation, still governs the field.

As is well-known, the first hurdle for a country of source to tax the business income of such an enterprise is that there must be a permanent establishment in the country of source as a first condition for such taxation. The form of permanent establishment principle consisting of a fixed place of business has of course undergone changes and some other forms such as agency permanent establishment, service permanent establishment, permanent establishment created by construction activities, have got added to the list, thereby giving source countries wee bit more right of taxation of business, subject, of course, to lots of conditions and caveats.

Even when a permanent establishment is found, the next hurdle is the allocation of profit to such permanent establishment. When the rules of the game were being finalised, permanent establishments were predominantly of the brick-and-mortar variety and it was assumed that permanent establishment will maintain books of accounts such that the profits earned by it could be determined from such accounts and no detailed guidelines for the determination of its profits were formulated. Much later, in 2008, the OECD came out with its Authorised OECD Approach (AOA) that was however, not acceptable to source countries with the result that the UN Model categorically rejected the OECD approach that was adopted in 2010. India, being a champion of source country taxation obviously rejected the same. The problem of attribution of profit to a PE in tax treaties therefore continues.

In practice, most of the time the very existence of a permanent establishment representing an intimate connection of the enterprise in the economic life of the source country is denied by multinational taxpayers. Assuming that in such a hotly debated case, even if it is conceded that there is a permanent establishment, it then becomes a problem for the tax authorities to allocate appropriate profit to such permanent establishments, considering that it is only the profits arising from the activities of the permanent establishment in India that can be taxed both under the domestic law and also under the relevant article 7 of the tax treaty. In India, this has been a problem that has plagued the authorities as also the taxpayers for a long time. It is in that context that the analysis of the recent full bench decision of the Delhi High Court becomes important.

On 19 September, 2024, a full bench of the Delhi High Court in the case of Hyatt international solution Southwest Asia Ltd versus a DIT - 2024-TII-65-HC-DEL-INTL-LB, in the matter of the allocation of profit to a permanent establishment, overturned the ratio of a decision of a division bench of the same High Court in the case of Nokia Solutions and Networks OY rendered in the year 2022 - 2022-TII-29-HC-DEL-INTL. Earlier, also in the year 2022, a division bench of the Delhi High Court in the case of Hyatt international solution Southwest Asia Ltd versus a DIT - 2024-TII-65-HC-DEL-INTL-LB had doubted the correctness of the decision in the case of Nokia solutions on which reliance was placed by the taxpayer and had recommended the Constitution of a full bench to resolve the issue.

To understand the rationale of such an unusual divergence, one has to go back two decades, to the year 2005, when a Special Bench of the tribunal had examined and had laid down certain important propositions in relation to the existence of a permanent establishment in India and allocation of profits thereto in the case of three telecom service providers, namely Motorola, Ericsson, and Nokia - 2005-TII-10-ITAT-DEL-SB- INTL . The case involved a host of issues including validity of notices u/s 142(1), chargeability of interest, accrual of income, business connection and existence of permanent establishment, accrual of business income or royalty income and attribution of income to permanent establishment and runs into almost 200 pages. Thankfully, for the purpose of our discussion, we need to go into only a few paragraphs and that too relating to the case of Nokia Networks alone.

Broadly speaking, the ITAT held in case of Motorola and Ericsson that there was no business connection nor permanent establishment in the given fact situation. However, in the case of Nokia, the ITAT held that there was a PE and the question of attribution did arise. In Paragraph 287 of the order, the ITAT held as follows:

"287. We have carefully considered the arguments raised by the Department as well as the assessee. In the present case it cannot be disputed that the research and development activities and the manufacture of the GSM equipment took place wholly outside India. We have also found, for reasons stated earlier, that the title and risk in the equipment also passed wholly outside India. The only activities which the assessee carried on in India through its PE were:

a) Network planning,

b) Negotiations in connection with the sale of equipment, and

c) The signing of the supply and installation contracts.

In the case of Ahmadbhai Umarbhar -2002-TIOL-579-SC-IT-CB, the Supreme Court held that the income attributable to the manufacturing activity should be more than the income attributable to the activity of sale. In the case of Annamalai Timber Trust & Co. v. CIT -2003-TIOL-270-HC-MAD-IT, the Madras High Court approved the Tribunal's decision that 10% of the income can be attributed to the signing of the contracts in India. The Calcutta High Court also approved the same percentage as income attributable to the signing of the contracts in India in the case of CIT v. Bertram Scott Ltd. = 2003-TIOL-577-HC-KOL-IT. We have kept the principles laid down in these judgments in mind. In the present case, as already noted, in addition to the signing of the contracts in India, the preliminary negotiations for the contracts and the network planning were carried out through the PE. (…). In respect of signing of contracts, alone, the income attributed is 10%, in the decisions cited above. Two more activities have been carried out by the PE in India and, therefore, we have to attribute a higher income than what was attributed in the decided cases. The negotiations which ultimately lead to the signing of the contracts may involve more effort on the part of the PE and the signing of the contracts is only the fructification of those efforts. Obviously, therefore, the income attributable to the negotiations part should be more and in addition to the income attributable to the signing of the contracts. Some income has to be attributed to the net work planning also. Taking all these into consideration, we consider it fair and reasonable to attribute 20% of the net profit in respect of the Indian sales as the income attributable to the PE.

The following steps are involved in computing the income attributable to the PE:

First the global sales and the global net profit have to be ascertained. From the accounts presented before us as well as before the Income-tax authorities, the global net profit rate has been ascertained at 10.8% and 16.1% by the CIT (Appeals), to which no objection has been taken by either side. This percentage has to be applied to the Indian sales and by Indian sales, we mean the total contract price for the equipment as a whole and not the bifurcated price which the Assessing Officer has referred to in the assessment order. This will also be consistent with our view that the software and the hardware constitute one integrated equipment. The resultant figure would be the net profit arising in respect of the Indian sales: Out of this figure of net profit 20% shall be attributed to the PE to cover the three activities mentioned above. The A.O. is directed to compute the income of the PE as directed above." (Emphasis added)

The revenue appealed before the Delhi High Court and apparently no question of law was framed. For a subsequent year the only ground raised by the Department was with regard to the rate of Net Profit (20%) applied by the Special Bench and not with regard to the method of taking the net profit rate of the foreign enterprise.

The High Court therefore concluded in the case of Nokia Networks Solution and Networks OY (order dated 02 December, 2022) = 2022-TII-29-HC-DEL-INTL that the revenue department has accepted the finding of the Special Bench with regard to the Net Profit margin method and has allowed that finding to become final.

The High Court also pointed out that the same method of attribution of profits to the P.E, on the basis of the Net Profit rate of the foreign enterprise has been applied by the revenue in the cases of three other taxpayers who were in the same field of business viz. ZTE, Huawei and Nortel. Each of them was also engaged in the supply of telecom equipment to Indian telecom operators. The High Court observed that the ITAT order passed in the case of Nortel specifically records that in the cases of each of these taxpayers, the revenue had adopted the Net Profit rate of the foreign enterprise for determining the amount of profit income which was attributable to each enterprise's respective P.E

The High Court referred to Article 7(1) of the treaty between India and Finland that states as follows:

"1. The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment."

From the same, the High Court concluded that on a plain reading of Article 7(1) of the DTAA, the question of attributing profits to the P.E. arises only if the foreign enterprise is making a profit which is the condition precedent. If it is making a loss then no question arises at all of attributing any profit to the P.E., which would be taxable in India.

At the outset, it is noted that the High Court in the aforesaid case read only Article 7(1) and did not refer to other parts of the Article, in particular to Article 7(2) and dismissed the department's appeal. In the said decision, the High Court did not refer to any Commentary and it is also not known what arguments the revenue had put before it.

Be that as it may, a similar question cropped up before the High Court in another case and that is the main subject of our discussion. In the case of Hyatt International Southwest Asia Ltd. - 2024-TII-65-HC-DEL-INTL-LB, a company incorporated under the Companies Law, Dubai International Financial Centre and a resident of the UAE entered into two Strategic Oversight Services Agreements with Asian Hotels Limited that owned hotel Hyatt Regency. Essentially, the taxpayer rendered some strategic services through its employees whose stay in India was less than 180 days. Since the India-UAE tax treaty does not contain an article relating to fees for technical services, the taxpayer claimed that it did not have any PE in India and its income from the services rendered were not taxable in India. Obviously, the tax department did not agree with the same and the AO, after examining the strategic agreement, held that the income concerned represented royalties. It was also argued that the taxpayer had a PE in India in that the premises of the hotel were at the disposal of the employees of the taxpayer and therefore the royalites being connected to the PE were taxable on a net basis in India and since the taxpayer apparently had not provided the details asked for, 10% of the gross receipts was taxed in India. On appeal, the Tribunal held that the amounts represented royalties and that the taxpayer had a PE in India following the ratio of the SC decision in Engineering Analysis case. As for the argument of the overall loss suffered, the tribunal directed that an opportunity of submitting the working of apportionment of revenue, losses etc on financial year basis with respect to the work done in entirety by furnishing the global profits earned by the taxpayer, so that the profits attributable to the work done by the PE be determined judiciously.

On appeal to the High Court, four questions were raised- regarding the categorisation of the payments as royalty, the existence of a PE in India, the existence of a fixed place PE and whether any income can be attributed if the taxpayer has an overall loss. The HC agreed with the taxpayer that the amount in question was not royalty and held that since the taxpayer was in the business of providing services to hotels, it was business income instead. However, the High Court held that the taxpayer did have a PE in India, the hotel premises being a fixed place at the disposal of the senior employees of the taxpayer. And if a PE is found under article 5(1), it is not necessary to go into the existence of a PE again in terms of article 5(2) and consider the length of stay of the employees in India. However, what is most important for the purpose of our discussion is that the High Court doubted the correctness of the precedence sited by the taxpayer in the case of Nokia Networks that if there is a loss at the entity level on global basis, there is no question of chargeability of Indian tax to the PE. The HC directed the order to be placed before the Acting Chief Justice for referring the said question to a Larger Bench in view of the reservations in regard to the earlier decision in Commissioner of Income Tax (International Taxation) v. M/s Nokia Solutions and Networks -2022-TII-29-HC-DEL-INTL.

Thereafter the Larger Bench was constituted that finally rendered its decision on the 19th of September affirming the view that a PE is to be treated as an independent entity and if the PE has profits in India, the same will be chargeable to tax in India even if the enterprise as a whole makes a loss. The lengthy decision of the High Court draws profusely from the later edition of Klaus Vogel's Commentary as also from the later versions of OECD Commentaries when the OECD adopted the so-called Authorised OECD Approach for allocation of profits to a PE. But that does not detract from the correctness of the decision as regards the interpretation relating to the treatment of a Permanent Establishment as a fictional separate entity for the purpose of allocation of profits that such an establishment earns in the source State. In fact, this is so fundamental a concept in internation taxation that one wonders why such an issue is litigated for such a long time. That does not mean that there are no problems in the method of determining the profits/loss of a PE but that is a different issue and was not at all the subject matter of dispute.

The argument advanced by the taxpayer before the Larger Bench was that once the Revenue had accepted the formulation of the legal position by the Special Bench of the Tribunal in Motorola Inc. and had restricted its challenge only to the prescription of a profit percentage, it would not be permissible for them to re-agitate those question.

It was argued that for a foreign enterprise to be taxed in India, the following three conditions precedent would have to be conjunctively satisfied: -

A) The foreign enterprise must be making a profit;

B) The foreign enterprise has a PE in India; and

C) At least a part of the profit made by that enterprise is attributable to its PE in India and that part alone being liable to be taxed

OECD has since 2010 adopted its authorised approach and consequently changed the language of article 7, the departmental representative therefore referred to the OECD Commentary from its 2008 Model, in particular paragraphs 11 and 12 of the Commentary on Article 7 which read as follows: -

"11. When referring to the part of the profits of an enterprise that is attributable to a permanent establishment, the second sentence of paragraph 1 refers directly to paragraph 2, which provides the directive for determining what profits should be attributed to a permanent establishment. As paragraph2 is part of the context in which the sentence must be read, that sentence should not be interpreted in a way that could contradict paragraph 2, e.g. by interpreting it as restricting the amount of profits that can be attributed to a permanent establishment to the amount of profits of the enterprise as a whole.

Thus, whilst paragraph 1 provides that a Contracting State may only tax the profits of an enterprise of the other Contracting to the extent that they are attributable to a permanent establishment situated in the first State, it is paragraph 2 that determines the meaning of the phrase "profits attributable to a permanent establishment". In other words, the directive of paragraph 2 may result in profits being attributed to a permanent establishment even though the enterprise as a whole has never made profits; conversely, that directive may result in no profits being attributed to a permanent establishment even though the enterprise as a whole has made profits. (Emphasis added)

The Full Bench also distinguished the decision of the Special Bench in Motorola pointing out that the reference to global sales and global net profit was made therein in the backdrop of the parties having failed to produce adequate material which may have independently established the profit margin of the PE in India. It was in this backdrop that the Special Bench of the Tribunal held that a net profit of 20% should be attributed to the PE.

However, by the time the issue again arose for consideration of the Tribunal for AY 2010-11, it proceeded on the basis that the question of attribution already stood answered in light of the judgment of the Special Bench pertaining to Assessment Years 1997-98 and 1998-99 and since it was already held that it would be Nokia's worldwide net profit margin which was to be applied for determining the quantum of income attributable to the PE, the same principle should apply and govern the issue for AY 2010-11 as well. It thus held that since Nokia on a global scale had suffered a net loss, no profit or income could be attributed to its PE.

The Full Bench of the High Court pointed out that since the tax authorities were unable to place any credence on the profit and loss account of the Indian PE since it had not been substantiated, the Special Bench of the Tribunal proceeded to outline the steps that would be involved in computing the income attributable to the PE and in that context observed that "First the global sales and the global net profit have to ascertained." Thus, the reference to global sales and global net profit was made in the backdrop of the parties having failed to produce adequate material which may have independently established the profit margin of the PE in India.

The Full Bench also made some pertinent general observations that may be considered as International Taxation 101.

The Bench held that a cross-border entity may structure its operations in a manner where it operates in more than one taxing jurisdiction. If it be open for such an entity to assert that its global profits and income are not liable to be taxed on the basis of the source principle, it would be wholly impermissible for it to contend that the income which accrues or arises in the Contracting State is also exempt from tax. In any case, the usage of the phrase "…so much of them as is attributable to the permanent establishment." is a clear indicator of the DTAA warranting the PE being liable to be viewed as an independent center of revenue.

"Global income, as a fundamental precept, has always been invoked in respect of residents of a Contracting State. Most Nations have ultimately reverted to the source rule for purposes of taxation. We are thus called upon to deal with a regimen which concerns itself with the source from which income accrues or arises. This precept also stands mirrored in Section 5 of the Income Tax Act, 1961 (Act) and which jettisons the principle of territoriality only in respect of income earned by a resident. Thus, taxation based on worldwide income stands confined to natural residents. However, no Nation avows or waives its right to tax capital or transactions which are anchored to its own territory. It is this basic precept of source which continues to bind."

Besides, the Full Bench also pointed out the fallacy of the argument of the taxpayer holding that If the submission of the appellants were to be accepted, the Revenue would be recognised to have the power to tax even in a situation where the PE has incurred loss but the enterprise earns profit at a global level. That is clearly not the import of Article 7 of the DTAA, at least as it exists today.

"While protecting the right of an enterprise to be subject to tax in the State where it be resident, Article 7 places a negative stipulation in respect of cases where a PE is found to exist coupled with an attribution exercise being undertaken in respect of the domestic enterprise. The contention of the respondents essentially requires us to confer a judicial imprimatur upon the principle that the domiciled entity, namely a PE, would be liable to be taxed only if the global enterprise were profitable. This even though the income of that entity, by virtue of Article 7, stands restricted to the extent of income being attributable to the PE. In fact, Article 7 itself restricts the taxability of the enterprise to the extent of income or profit attributable to the PE. We are thus of the firm opinion that the argument of global income or profit being relevant or determinative is totally unmerited and misconceived. The submission is clearly contrary to the weight of authority which has been noticed hereinabove."

The High Court held that the decision of the Special Bench in Motorola Inc. has clearly been misconstrued and it, in any case, cannot be viewed to be an authority for the proposition which was canvassed on behalf of the appellants. Article 7 cannot possibly be viewed as restricting the right of the source State to allocate or attribute income to the PE based on the global income or loss that may have been earned or incurred by a cross border entity.

The Full Bench of the Delhi High Court lays down the correct position of the law in relation to one aspect of the issues that arise from the allocation of profits to a permanent establishment. There are many other aspects in relation to this important question such as the appropriateness of the application of the arm's length standard and use of FAR analysis for such allocation which is evident from the OECD's efforts at reaching a consensus of Pillar 1 that jettisons the arm's length standard at least for a very small part of the overall profits of the MNC. India had also constituted a committee for attribution of income and modify Rule 10. A report was released in 2019 for public consultation. One does not know the fate of the report.