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TMI Blog2024 (9) TMI 1202X X X X Extracts X X X X X X X X Extracts X X X X ..... principles which imbue the DTAA also. As was noticed hereinabove, the profits of an enterprise do not become subject to taxation unless it be found that it functions in the other Contracting State through a PE. Article 7 further postulates that it is only such income which is attributable to the PE which would be subjected to tax in the source State. As is pertinently noted in the OECD and UN Commentaries, it would be wholly incorrect to found taxation on the basis of the overall activities or profitability of an enterprise. The source State is ultimately concerned with the income or profit which arises or accrues within its territorial boundaries and the activities undertaken therein. As those commentaries pertinently observe, the profits attributable to a PE are not liable to be ignored on the basis of the performance of the entity as a whole. This position also finds resonance in the decisions of the Supreme Court in Morgan Stanley and Ishikawajama [ 2007 (7) TMI 201 - SUPREME COURT ] and relevant parts whereof have been extracted above. 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ision of the Special Bench in Motorola Inc. [ 2005 (6) TMI 226 - ITAT DELHI-A ] 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. We would thus answer the Reference by holding that the tentative view expressed by the Division Bench in these set of appeals as well as the doubt expressed with respect to the findings rendered in Nokia Solutions [ 2022 (12) TMI 700 - DELHI HIGH COURT ] was well founded and correct. The Reference stands answered in terms of our conclusions set forth above. The papers of these appeals may now be placed before the appropriate Roster Bench for disposal in light of our conclusions recorded hereinabove. - HON'BLE MR. JUSTICE YASHWANT VARMA HON'BLE MR. JUSTICE SANJEEV NARULA AND HON'BLE MR. JUSTICE PURUSHAINDRA KUMAR KAURAV For the Petitioner Through: Mr. S. Ganesh, Sr. Adv. with Mr. U.A. Rana, Mr. Himanshu Mehta, Advs. For ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ead as under: *** **** *** 11. The Tribunal has returned a finding of fact, that the respondent/assessee recorded a global net loss in the relevant assessment year, and therefore no profit been attributed to it. 13. We may also note, that a plain reading of the Article 7 of the Double Taxation Avoidance Agreement between India and Finland also persuades us to take the same view as that which is taken by the Tribunal. 13.1 A plain reading of the Article 7 (1) would show, that the issue of taxability would arise qua the respondent/assessee only if profits accrue to the respondent/assessee, and that too only to the extent they can be attributed to its PE in India. 6. He submits that in view of the said decision, the question whether any taxable income could be attributed to PE, would not arise in the event, the assessee incurs a loss. 7. It is noted that although the observations made in the said decision appear to be squarely in favour of the appellant, it is also apparent that various other contentions relevant for addressing the said question have not been considered. This is also perhaps because the Court had not framed any question regarding the applicability of Article 7 of the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... w and on facts in holding that service charges received by the Appellant under the various SOSA Agreements were taxable as royalty? 2. Similar questions were also raised in other connected appeals. 3. After hearing the parties, this Court is of the view that the questions require to be slightly modified. The questions that arise for consideration in these appeals are restated as under: (i) Whether the Tribunal misdirected itself both in law and on facts in holding that service charges received by the Appellant under the various SOSA Agreements were taxable as royalty? (ii) Whether the Appellant has Permanent Establishment in India within the meaning of the Double Taxation Avoidance Agreement? (iii) Whether the findings recorded by the Tribunal, in paragraphs 56, 57 and 59 are perverse and contrary to the terms of the Strategic Oversight Services Agreement (SOSA)? (iv) Is Article 7 (1) of the DTAA at all applicable to the Appellant, having regard to the fact that it has incurred losses in the relevant financial years? 4. Insofar as the fourth question is concerned, this Court had, on 16.01.2023, expressed its view that the said question is required to be considered by a larger Bench ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... answered in the affirmative. The Court while considering Question (iii) came to hold that the findings rendered by the Income Tax Appellate Tribunal [Tribunal] on payments being liable to be viewed as royalty under Article 12 were unsustainable. 6. Question (iv), in light of the earlier orders of 16 January 2023 and 14 March 2023, was reserved and referred for our consideration. It however becomes pertinent to take note of the following observations which appear in the final judgment insofar as the issue of attribution is concerned. We deem it apposite to extract paragraphs 33 to 36 of the final judgment hereinbelow: - Re: Question No. (iv) 33. One of the principal contentions advanced by the Assessee is that even if it is assumed that the Assessee has a PE in India, there is no question of attributing any amount as income chargeable to tax under the Act to its PE, as it has incurred a loss on an entity level (global basis). According to the Assessee, income chargeable to tax under the Act could be attributed to its PE in India only if the Assessee had made profit on an entity level. Concededly, the said issue is covered in favour of the Assessee by a decision of the Coordinate Ben ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ring a challenge to a decision rendered by the Tribunal and which in turn had sought to draw sustenance for holding that global profit or loss would constitute a relevant factor for attributing income to a PE on the basis of a decision rendered by a Special Bench of the Tribunal in Motorola Inc. Vs. Deputy Commissioner of Income Tax, Non-Resident Circle New Delhi (and vice-versa) 2005 SCC OnLine ITAT 1. 9. While noticing the aforesaid, the Court in Nokia Solutions had held as follows:- 10. We may note, that the impugned order passed by the Tribunal has proceeded on the basis, albeit on a demurrer, that the respondent-assessee has a permanent establishment ( PE ) in India, and thereafter gone on to discuss, as to whether any profits could be attributed to it. 11. The Tribunal has returned a finding of fact, that the respondent assessee recorded a global net loss in the relevant assessment year, and therefore no profit could have possibly been attributed to it. 11.1 A discussion on this aspect is set forth in the following paragraphs of the impugned judgment passed by the Tribunal (page 88 of 97 ITR (Trib)) : The assessee emphatically denies that the appellant has a permanent establi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ed 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 per cent. shall be attributed to the permanent establishment to cover the three activities mentioned above. The Assessing Officer is directed to compute the income of the permanent establishment as directed above.' The Revenue appealed before the hon'ble Delhi High Court against the said Special Bench judgment and the only ground raised by the Department was with regard to the rate of net profit (20 per cent.) applied by the Special Bench and not with regard to the method of taking the net profit rate of the foreign enterprise. The Revenue Department has thus accepted the finding of the Special Bench with regard to the net profit margin method and has allowed that finding to become final. The same method of attribution of profits to the perma ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... hich would be taxable in India. The Assessing Officer has taken gross profit margins of the appellant-company for 2009 and 2010 as per its audited accounts instead of the net profit margins. The gross profit margins of the appellant-company for 2009 and 2010 were positive, and that was how the Assessing Officer could attribute profits to the permanent establishment. In so adopting the gross profit margins of the appellant-company, the Assessing Officer has acted in a manner which is directly contrary to article 7 (1) of the Double Taxation Avoidance Agreement and also contrary to the said Special Bench judgment. It is the net profit margins which are to be considered as for attribution as per the Double Taxation Avoidance Agreement. The computation made by the Assessing Officer in his assessment order is incorrect as the Assessing Officer has not allowed the payments made by the appellant to NSN India for the services rendered by NSN India as a deduction from the profit attributable to the alleged permanent establishment. If the said payments are allowed as a deduction from the gross profit figures taken by the Assessing Officer, then again the resultant figure would be losses. Con ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... f Rs. 38,99,98,921 has been taken as the taxable income from hardware and is taxes @ 55%. A similar procedure has been adopted in the assessment year 1998-99, except that tax has been charged @ 48%. The CIT (Appeals) in paragraph 7 of his order for the assessment year 1997-98 has reduced the income to 5% of the sales to Indian parties. While doing so he has noted that the profit and loss account relating to Indian operations of the assessee is not substantiated with any documents and is, therefore, not reliable for the purpose of computing the income from sale of hardware. He has accordingly taken the assistance of Rule 10 of the Income-tax Rules to compute the profits on the basis of assessee s global accounts. He has noted that the global accounts showed a net profit of 10.8%. The net profit on Indian sales was, therefore, taken at 10.8% but the CIT (Appeals) held that since the whole of this profit cannot be attributed to the Indian operations as the activities relating to manufacture and development of the products were undertaken outside India, he has ultimately held that the profits attributable to operations in India should be taken at 5% of the sales to the Indian parties. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... igning 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., 31 Taxman 444. 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. We may clarify here that the network planning activity is different from the activities which are of the preparatory or auxiliary character. 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 case. 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 attributa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... be attributed to its PEs . 13. The Tribunal also appears to have borne in consideration the fact that the Revenue while pursuing its appeal before this Court against the judgment rendered by the Special Bench in Motorola Inc. had confined it to the ultimate rate of net profit which had been applied. It thus took the view that the Revenue would be deemed to have accepted the legal position as propounded by the Special Bench, namely, of global profit or loss being relevant and determinative. 14. Our Court while ultimately upholding the view taken by the Tribunal in the case of Nokia Solutions dismissed the appeal of the Revenue holding that the view expressed by the Tribunal did not merit consideration. However, while doing so, the Court also observed that a plain reading of Article 7 persuades it to affirm the view that was taken by the Tribunal. This was further reiterated with the Court observing that the issue of taxability could arise only if profits had accrued to the assessee and that too only to the extent attributable to its PE in India. 15. Appearing for the assessee, Mr. S. Ganesh, learned senior counsel, at the outset contended that once the Revenue had accepted the form ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... refrained from rendering any definitive findings as would be apparent from the operative parts of that decision. Learned counsel sought to make good the aforesaid submission by inviting our attention to the following observations as appearing in that order of dismissal: - 12. Having regard to the following finding of fact returned by the Tribunal, we are of the view that the proposed questions of law, i. e., A and B would not arise for consideration. 13. We may also note, that a plain reading of the article 7 of the Double Taxation Avoidance Agreement entered into between India and Finland also persuades us to take the same view as that which is taken by the Tribunal. 13.1 A plain reading of the article 7 (1) would show, that the issue of taxability would arise qua the respondent-assessee only if profits accrue to the respondent-assessee, and that too only to the extent they can be attributed to its permanent establishment in India. 14. Given this position, we are not inclined to entertain the appeal. 19. It was thus sought to be contended by Mr. Kumar that this Court ultimately declined to entertain the appeal of the Revenue in light of the findings of fact which had come to be re ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 2008 and 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 i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... lves unable to place any credence on the profit and loss account of the Indian PE since it had not been substantiated. It then proceeded to outline the steps that would be involved in computing the income attributable to the PE. It was in the aforesaid context that it observed that First the global sales and the global net profit have to ascertained. It then proceeded to observe that the global net profit had been identified to be 10% and 6.8% in the first appeal proceedings. It thus held that it would be appropriate to set apart 20% of that figure as the net profit of the PE. 28. It is therefore apparent that the observations appearing in Motorola Inc. have clearly been misinterpreted and read wholly out of context. The decision of the Special Bench cannot possibly be read as being an authority for the proposition which is canvassed for our consideration by the appellants in these proceedings. The Tribunal in Nokia Solutions had ultimately held that .as the Appellant has global net loss as per audited accounts, no profit or income can be attributed to the PE. The Tribunal too appears to have completely misconstrued Motorola Inc. as purporting to enunciate a binding legal principle ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ivities continue for the same project or connected project for a period or periods aggregating more than 9 months within any twelve-month period. 3. Notwithstanding the preceding provisions of this Article, the term permanent establishment shall be deemed not to include : (a) the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise ; (b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery ; (c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise ; (d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise ; (e) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character. 4. Notwithstanding the provisions of paragraphs (1) and (3), where a person - other than an agent of independent status to whom paragraph (5) applies - is acting on behalf of an ent ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the provisions of and subject to the limitations of the tax laws of that State.] 4. Insofar as it has been customary in a Contracting State to determine the profits to be attributed to a permanent establishment on the basis of an apportionment of the total profits of the enterprise to its various parts, nothing in paragraph (2) shall preclude that Contracting State from determining the profits to be taxed by such an apportionment as may be customary ; the methods of apportionment adopted shall, however, be such that the result shall be in accordance with the principles contained in this Article. 5. No profits shall be attributed to a permanent establishment by reason of the mere purchase by the permanent establishment of goods or merchandise for the enterprise. 6. For the purposes of preceding paragraphs, the profits to be attributed to the permanent establishment shall be determined by the same method year by year unless there is good and sufficient reason to the contrary. (7) Where profits include items of income which are dealt with separately in other Articles of this Agreement, then the provisions of those Articles shall not be affected by the provisions of this Article. 33. I ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... on in such a case. The shares, debt claims, rights or property must form part of the assets of the permanent establishment respectively the fixed base or must be otherwise effectively connected with that establishment or base. This view is also put forward in Tech Mahindra Ltd. v. Commissioner of Taxation [[2016] FCAFC 130; 2016 ATC 20-582; (2016) 103 ATR 813.], where the Australian Federal Court stated that profits which are made liable to tax in the source State under the force of attraction notion are not attributable to a permanent establishment and therefore not effectively connected with it. The US Technical Explanation gives the example of dividends derived by a dealer in shares or securities from shares or securities that the dealer held for sale to customers. However, in respect of debt claims, rights and property, the UN Model Convention allows a limited force of attraction under article 7 (1) (c) : Business activities in the source State of the same or similar kind as those effected through the permanent establishment may also be taxed in the source State. Consequently, interest received from debt claims and royalties received from rights and property effectively connect ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ation of that holding, debt claim, right or property. In the opinion of this author, the term economic ownership is not appropriate for the allocation of assets to a permanent establishment. A permanent establishment itself can never be owner of an asset because it is not a separate legal entity. As a result, it can never be the economic owner of an asset as well. The term is therefore misleading. It also guides away attention from what is actually relevant for answering the question of what assets must be allocated to a permanent establishment : The significant people's functions. The author believes that this is an activity test and has nothing to do with an ownership test, and therefore is of the opinion that the relevant test is, or should be, whether the shares, debt claims, rights or property, as the case may be, are managed and their exploitation is directed and controlled by people active in or from a permanent establishment. If so, the asset concerned is effectively connected with that permanent establishment and the income received from it (i.e., dividend, interest respectively royalty must be attributed to that permanent establishment (see supra m. No. 124)). Whether ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ast but most elaborate of the articles which contain general definition of terms relevant throughout many different treaty articles (infra m.no. 4 et seq.). The article determines the threshold that functions as the essential demarcation line between short-term or ephemeral activities in the source State and 'permanent establishments (PEs) (i.e., solidified sources of income which serve as a (primary or secondary) basis for the taxpayer in a State other than his or her State of residence). To a large extent, a PE does not only resemble the concept of residence in appearance but may also trigger similar, though not identical legal consequences. Since the early 1920s, the PE threshold has been commonly used in DTCs to determine whether a particular kind of income shall or shall not be taxed in the country from which it originates . Wherever distributive rules use the PE concept (infra m.no. 4 et seq.). they reconcile requirements of international justice (prerogative of source-based taxation) and practical prudence (prerogative of residence-based taxation). In connection with those rules, Article 5 OECD and UN MC serves to simplify and facilitate taxation of cross-border activiti ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... D Model (see no. 35 OECD MC Comm. on Article 5). None of the current MCs provide a specific productivity test. It follows that POBs may constitute a PE even if they perform activities which have mainly or exclusively expenditures to show for. 137 Likewise, the 'carrying-on' requirement does not imply an activity in the sense of an active and visible work . It includes even stand-by services and omissions. This gains significant relevance where the omission is profitable (e.g., in the case of a POB earning money in the source State simply by fulfilling, for whichever period of time, a non-competition agreement relating to the territory of that State). 138 However, a diffuse passivity which equals a (temporal or lasting) suspension of the activities which the POB has been designed for may indicate that the POB is not permanent . For details, see supra m.no.87 et seq. 139 Thirdly, the phrase 'through which' indicates that the taxpayer makes use of the POB in that he employs it as an instrument (equalling or resembling an operating asset) for his entrepreneurial activities . This third aspect of the functional integration is by far the most disputed one. 140 Historicall ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... n for the characterisation of the famous painter example (i.e., the fictitious case of a painter who, for two years, spends three days a week in the large office building of its main client) as a service PE. In substance, the view of the OECD MC Comm. limits the meaning of 'through' to the first two instead of all three semantic aspects required by Article 5 (1) OECD MC (supra m.no. 135 et seq. and 139 et seq.). 145 This abridging interpretation of Article 5 (1) OECD and UN MC is not convincing, though. It sets the term through as a synonym of; in or at . It is certainly not harmful, under Article 5 (1) OECD and UN MC, if the taxpayer carries on his business also in the POB. However, it is not sufficient. Given that the terms 'in' or 'at' have been used in a considerable number of bilateral DCs and, above all, that the OECD Model has intentionally replaced the word in by through in 1977 (supra m.no.45), the deviation in the text of the OECD MC is to be regarded as meaningful. The ordinary meaning of 'through' and 'par l'interm diaire de' is different from, and goes beyond, the ordinary meaning of 'in' or 'at' (cf. Article ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... saction be adjusted, if necessary, to reflect the conditions of a similar transaction between independent enterprises. Assume, for instance, that the permanent establishment situated in State S of an enterprise of State R acquires property from an associated enterprise of State T. If the price provided for in the contract between the two associated enterprises exceeds what would have been agreed to between independent enterprises, paragraph 2 of Article 7 of the treaty between State R and State S will authorise State S to adjust the profits attributable to the permanent establishment to reflect what a separate and independent enterprise would have paid for that property. In such a case, State R will also be able to adjust the profits of the enterprise of State R under paragraph 1 of Article 9 of the treaty between State R and State T, which will trigger the application of the corresponding adjustment mechanism of paragraph 2 of Article 9 of that treaty. 39. The OECD Commentary then proceeds to summarize the scope and extent of paragraph 1 as under: Paragraph 1 10. Paragraph 1 incorporates the rules for the allocation of taxing rights on the business profits of enterprises of each C ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t some bilateral tax conventions include a limited anti-avoidance rule based on a restricted force of attraction approach that only applies to business profits derived from activities similar to those carried on by a permanent establishment, the general force of attraction approach described above has now been rejected in international tax treaty practice. The principle that is now generally accepted in double taxation conventions is based on the view that in taxing the profits that a foreign enterprise derives from a particular country, the tax authorities of that country should look at the separate sources of profit that the enterprise derives from their country and should apply to each the permanent establishment test, subject to the possible application of other Articles of the Convention. This solution allows simpler and more efficient tax administration and compliance, and is more closely adapted to the way in which business is commonly carried on. The organisation of modern business is highly complex. There are a considerable number of companies each of which is engaged in a wide diversity of activities and is carrying on business extensively in many countries. A company may ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ary on the United Nations Model Double Taxation Convention between Developed and Developing Countries 2021 [UN Model Convention 2021] while explaining the concept of a PE makes the following pertinent observations: - 7. It could perhaps be argued that in the general definition some mention should also be made of the other characteristic of a permanent establishment to which some importance has sometimes been attached in the past, namely that the establishment must have a productive character, i.e. contribute to the profits of the enterprise. In the present definition this course has not been taken. Within the framework of a well-run business organisation it is surely axiomatic to assume that each part contributes to the productivity of the whole. It does not, of course, follow in every case that because in the wider context of the whole organisation a particular establishment has a productive character it is consequently a permanent establishment to which profits can properly be attributed for the purpose of tax in a particular territory (see Commentary on paragraph 4). 41. The concept of a PE is more lucidly explained in the commentary as follows: - 41. Also, a permanent establish ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... depends on domestic law and it is therefore possible that, in some countries, the term joint venture would refer to a distinct enterprise. 43. In the case of an enterprise that takes the form of a fiscally transparent partnership, the enterprise is carried on by each partner and, as regards the partners respective shares of the profits, is therefore an enterprise of each Contracting State of which a partner is a resident. If such a partnership has a permanent establishment in a Contracting State, each partner s share of the profits attributable to the permanent establishment will therefore constitute, for the purposes of Article 7, profits derived by an enterprise of the Contracting State of which that partner is a resident (see also paragraph 56 [of the Commentary on Article 5 of the 2017 OECD Model Tax Convention] below). 44. A permanent establishment begins to exist as soon as the enterprise commences to carry on its business through a fixed place of business. This is the case once the enterprise prepares, at the place of business, the activity for which the place of business is to serve permanently. The period of time during which the fixed place of business itself is being se ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... y is found to exist in one of the Contracting State, it is viewed as a unit which contributes to the economic life of that State and thus be liable to tax. It is these basic precepts which convince us to debunk the theory of taxation in the source State being dependent upon a global profit or taxation being subject to income or profit having been earned at an entity level. 44. The identity which attaches to a PE for the purposes of ascertainment of a taxing liability cannot possibly be doubted bearing in mind the succinct observations of the Supreme Court in Morgan Stanley and where their Lordships without a degree of equivocation acknowledged the distinction that is liable to be drawn between a PE with respect to income earned in the Contracting State where it is domiciled or deemed to exist and the global enterprise of which it may be a part. Vogel explains the PE concept as constituting the threshold and the essential demarcation line in the source State which sanctions the imposition of a tax in a fiscal jurisdiction other than the State of residence. This would clearly appeal to logical since the right of taxation which inheres in the source State is connected to the economic ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... p of economists to study the issue of double taxation. That group is stated to have identified the fundamental factors worthy of consideration to be (a) the origin of wealth or income, (b) the situs of income, (c) enforcement of rights connected with the above and (d) domicile of the person vested with the power to use or dispose of that income or wealth. It was the factor pertaining to origin of income which led to the enunciation of the source rule bearing in mind the need to identify the primary source of creation of income and the residence of its owner. It is these fundamental precepts which led to the formulation of measures to determine the economic presence of an entity in a given State and the functional integration of such an entity in the economic activity undertaken in that State. 48. Vogel while speaking on taxing rights of nations makes the following pertinent observations [Vol. I, Fifth Edition, page 551 to 552] :- Paragraph 1 10. [Taxing rights on business profits] Paragraph I incorporates the rules for the allocation of taxing rights on the business profits of enterprises of each Contracting State. First, it states that unless an enterprise of a Contracting State h ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ons include a limited anti-avoidance rule based on a restricted force of attraction approach that only applies to business profits derived from activities similar to those carried on by a permanent establishment, the general force of attraction approach described above has now been rejected in international tax treaty practice. The principle that is now generally accepted in double taxation conventions is based on the view that in taxing the profits that a foreign enterprise derives from a particular country, the tax authorities of that country should look at the separate sources of profit that the enterprise derives from their country and should apply to each the permanent establishment test, subject to the possible application of other Articles of the Convention. This solution allows simpler and more efficient tax administration and compliance, and is more closely adapted to the way in which business is commonly carried on. The organisation of modern business is highly complex. There are a considerable number of companies each of which is engaged in a wide diversity of activities and is carrying on business extensively in many countries. A company may set up a permanent establish ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Commentary on Article 1. Paragraph 2 15. [Determination of attributable profits] Paragraph 2 provides the basic rule for the determination of the profits that are attributable to a permanent establishment. According to the paragraph, these profits are the profits that the permanent establishment might be expected to make if it were a separate and independent enterprise engaged in the same or similar activities under the same and similar conditions, taking into account the functions performed, assets used and risks assumed through the permanent establishment and through other parts of the enterprise. In addition, the paragraph clarifies that the rule applies with respect to the dealings between the permanent establishment and the other parts of the enterprise. 16. [Fiction of independence: arm's length principle] The basic approach incorporated in the paragraph for the purposes of determining what are the profits that are attributable to the permanent establishment is therefore to require the determination of the profits under the fiction that the permanent establishment is a separate enterprise and that such an enterprise is independent from the rest of the enterprise of which ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... should be determined under the provisions of paragraph 2. 20. [Two-step determination] As explained in the Report, the attribution of profits to a permanent establishment under paragraph 2 will follow from the calculation of the profits (or losses) from all its activities, including transactions with independent enterprises, transactions with associated enterprises (with direct application of the OECD Transfer Pricing Guidelines) and dealings with other parts of the enterprise. This analysis involves two steps which are described below. The order of the listing of items within each of these two steps is not meant to be prescriptive, as the various items may be interrelated (e.g. risk is initially attributed to a permanent establishment as it performs the significant people functions relevant to the assumption of that risk but the recognition and characterisation of a subsequent dealing between the permanent establishment and another part of the enterprise that manages the risk may lead to a transfer of the risk and supporting capital to the other part of the enterprise). 21. [First step: analysis] Under the first step, a functional and factual analysis is undertaken which will lead ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he jurisdiction on actual basis. If that be so, it may not be correct to contend that the entire income accrues or arises in each of the jurisdiction. The Authority has proceeded on the basis that supplies in question had taken place offshore. It, however, has rendered its opinion on the premise that offshore supplies or offshore services were intimately connected with the turnkey project. xxx xxx xxx 82. In Klaus Vogel on Double Taxation Conventions , it is stated: (g) No force of attraction principle. The second sentence of Article 7 (1) allows the State of the permanent establishment to tax business profits, but only so much of them as is attributable to that permanent establishment . The MC has thus decided against adopting the so-called force of attraction of the permanent establishment i.e. against the principle that, where there is a permanent establishment, the State of the permanent establishment should be allowed to tax all income derived by the enterprise from sources in that State irrespective of whether or not such income is economically connected with the permanent establishment. In line with the domestic law then prevailing in the USA, such a force of attraction was, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he appellant. Thus, having been excluded from the scope of taxation under the Act, the application of the Double Taxation Treaty would not arise. The Double Taxation Treaty, however, was taken recourse to by the appellant only by way of an alternate submission on income from services and not in relation to the tax of offshore supply of goods. xxx xxx xxx 92. Global income of a resident although is subjected to tax, global income of a non-resident may not be. The answer to the question would depend upon the nature of the contract and the provisions of DTAA. 93. What is relevant is receipt or accrual of income, as would be evident from a plain reading of Section 5 (2) of the Act. The legal fiction created although in a given case may be held to be of wide import, but it is trite that the terms of a contract are required to be construed having regard to the international covenants and conventions. In a case of this nature, interpretation with reference to the nexus to tax territories will also assume significance. Territorial nexus for the purpose of determining the tax liability is an internationally accepted principle. An endeavour should, thus, be made to construe the taxability of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Tax) 240.] and Barendra Prasad Ray v. ITO [(1981) 129 ITR 295 (SC); (1981) 2 SCC 693; 1981 SCC (Tax) 149.]. That being the position, the singular question that remains to be answered is whether the payment or receipt paid by the appellant to NRC as success fee would be deemed to be taxable in India under section 9 (1) (vii) of the Act ? As the factual matrix would show, the appellant has not invoked Double Taxation Avoidance Agreement between India and Switzerland. That being not there, we are only concerned whether the 'success fee as termed by the assessee is fee for technical service as enjoined under section 9 (1) (vii) of the Act. The said provision reads as follows: xxx xxx xxx 25. The principal provision is clause (b) of section 9 (1) (vii) of the Act. The said provision carves out an exception. The exception carved out in the latter part of clause (b) applies to a situation when fee is payable in respect of services utilised for business or profession carried out by an Indian payer outside India or for the purpose of making or earning of income by the Indian assessee, i.e., the payer, for the purpose of making or earning any income from a source outside India. On a stud ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... resident person, that is, a person resident in another country. The aforesaid principle sometimes is given a different name, that is, the territorial principle . It is apt to state here that the residence based taxation is perceived as benefiting the developed or capital exporting countries whereas the source based taxation protects and is regarded as more beneficial to capital importing countries, that is, developing nations. Here comes the principle of nexus, for the nexus of the right to tax is in the source rule. It is founded on the right of a country to tax the income earned from a source located in the said State, irrespective of the country of the residence of the recipient. It is well settled that the source based taxation is accepted and applied in international taxation law. 28. The two principles that we have mentioned hereinabove, are also applied in domestic law in various countries. The source rule is in consonance with the nexus theory and does not fall foul of the said doctrine on the ground of extra-territorial operation. The doctrine of source rule has been explained as a country where the income or wealth is physically or economically produced. (See League of Na ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e., because two (or more) States treat the same economic transaction or item of capital as having occurred or being situated in their territory). Thirdly, double taxation may arise because certain States tax the worldwide income of their citizens even when they are residents of another State (in particular the US and Eritrea; Bulgaria, Mexico, Myanmar, the Philippines and Vietnam gave up their earlier citizenship-based taxation). 4 By contrast, the term economic double taxation is used to describe the situation that arises when the same economic transaction, item of income or capital is taxed in two or more States during the same period, but in the hands of different taxpayers (so-called lack of subject identity ). Economic double taxation will occur if assets are attributed to different persons by the domestic law of the States involved, as, for example, when the tax law of one State attributes an item of capital to its legal owner whereas the tax law of the other State attributes the item of capital to the person in possession or economic control. Economic double taxation may also arise if, for example, alimony paid by a husband to his wife is considered income and taxed in her h ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the other Contracting State through a PE, the profits earned from activities undertaken by such an establishment would become subject to tax in the other State coupled with the rider of the same being confined to the extent to which those profits are attributable to such an establishment. 54. As we read Article 7, it becomes evident that Paragraph (1) clearly envisages the profits of a PE being liable to be independently taxed notwithstanding that PE being a constituent of a larger enterprise which may be domiciled in the other Contracting State. The exemption from taxation which stands accorded to an enterprise of a contracting State would cease to be applicable by virtue of the use of the word unless which precedes the Article taking into consideration the existence of a PE of that enterprise in the other Contracting State. Article 7 (1) proceeds to clarify that if the enterprise were carrying on business through a PE in the other Contracting State, its profits to the extent attributable to that PE would become subject to tax in the other State. 55. Article 7 (1) thus in clear and unequivocal terms constructs a dichotomy between the profits that may be earned by an enterprise on ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... refers to it as constituting a separate source of profit . Of equal significance are the observations in the Commentary and which bids us to bear in consideration the possibility of profits being attributed to the PE even though the entity as a whole had never earned the same. 60. Proceeding further to explain the ambit of Paragraph 2 of Article 7, the OECD Commentary observes: - Paragraph 2 15. Paragraph 2 provides the basic rule for the determination of the profits that are attributable to a permanent establishment. According to the paragraph, these profits are the profits that the permanent establishment might be expected to make if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed through the permanent establishment and through other parts of the enterprise. In addition, the paragraph clarifies that this rule applies with respect to the dealings between the permanent establishment and the other parts of the enterprise. 16. The basic approach incorporated in the paragraph for the purposes of determining what are the profits that ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of income earned by a resident. Thus, taxation based on worldwide income stands confined to natural residents. However, no Nation avowes 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. 62. The distinction which needs to be borne in mind with regard to the income of a non-resident as opposed to an entity domiciled and stationed in one of the Contracting States stands duly acknowledged in Section 5 of our Act and which subjects the global income of a resident alone to taxation. For non-residents, it is the principles of income accruing or arising which are decreed to govern. It is these broadly accepted and well recognised principles which imbue the DTAA also. 63. As was noticed hereinabove, the profits of an enterprise do not become subject to taxation unless it be found that it functions in the other Contracting State through a PE. Article 7 further postulates that it is only such income which is attributable to the PE which would be subjected to tax in the source State. As is pertinently noted in the OECD and UN Commentaries, it would be wholly incorrect to found taxation on th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... led to the overall operations of the enterprise of which it may be a part. The argument of world-wide income is thus rendered wholly untenable. 66. On an overall consideration of the above, we come to the firm conclusion that the submission of global income being determinative of the question which stood referred, is wholly unsustainable. The activities of a PE are liable to be independently evaluated and ascertained in light of the plain language in which Article 7 stands couched. The fact that a PE is conceived to be an independent taxable entity cannot possibly be doubted or questioned. The wealth of authority referred to hereinabove clearly negates the contention to the contrary and which was commended for our consideration by the appellants. Bearing in mind the well-established rule of source which applies and informs the underlying theory of taxation, we find ourselves unable to countenance the submission of the source State being deprived of its right to tax a PE or that right being dependent upon the overall and global financials of an entity. The Division Bench in these appeals rightly doubted the correctness of taxation being dependent upon profits or income being earned ..... X X X X Extracts X X X X X X X X Extracts X X X X
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