Most Foreign Companies engaged in turnkey engineering, procurement, construction and installation projects are commonly seen setting up project offices (‘PO’) in India for carrying out their activities in India. In this article, authors Pradnya Shetty and Mihir Patwa (Chartered Accountants) have identified and discussed some of the key interesting tax and regulatory aspects governing a Project Office set up. The authors highlight that in deciding whether a PO has to be set or a company incorporated in India, various factors will play a deciding role like expected duration of the projects, acceptability to the extent of additional governance and compliances a company set up will attract and mandate, etc. Further, the authors discuss the nuances of the approvals required from RBI, and applicable TDS provisions on the payments to the PO. To sum up, the authors opine that PO set up is most favoured and common set up by foreign companies who are awarded contracts for turnkey EPC projects in India, both from commercial and tax perspective. However, they caution that it involves various tax and regulatory nuisances as discussed above, which the foreign companies need to be cognizant about and take necessary steps to achieve their objective. 

Project Office - Tax & Regulatory aspects

In this Article, we have identified and discussed some of the key interesting tax and regulatory aspects governing a Project Office (‘PO’) set up. Most of the Foreign Companies (‘FCO’) engaged in turnkey engineering, procurement, construction and installation projects are commonly seen setting up project offices (‘PO’) in India for carrying out their activities in India. Generally, such projects are for a specific duration in India. The Foreign Exchange Management Act (‘FEMA’) regulations governing the eligibility and procedure for setup of a PO [The PO is defined in rule 2(f) of Regulations as ‘Project Office' means a place of business in India to represent the interests of the foreign company executing a project in India but excludes a Liaison Office]  have evolved to be relatively simplified. There is a general permission to non-resident companies to establish POs in India, provided they have secured a contract from an Indian company to execute a project in India and other conditions provided in the FEMA for set up of PO are satisfied. Further, the permission is subject to fulfillment of stipulated conditions failing which a prior approval of Reserve Bank of India (‘RBI’) is required to be sought.

In the ensuing paragraphs, some interesting tax and regulatory aspects applicable for a PO are discussed: 

1. PO versus Company set up in India

Setting up a business office in India is one of the initial steps considered by FCO’s for starting its business in India. As per the FEMA regulations, FCO’s intending to have a business presence for a considerable period of time can consider various options of set up like liaison office, branch office, project office or company in India depending upon the operations and duration of operations to be carried out in India. If  FCO is looking for a limited presence and does not envisage any further operations in India, PO structure may be best suited from administrative cost, flexibility, compliance, repatriation of funds, exit, etc. perspective compared to a company set-up. Also, as Liaison office is not allowed to be involved in commercial activities and acts more like a communication channel, this option is also not feasible for undertaking turnkey projects operations in India. However, if the FCO intends to execute more projects in India and wishes to continue in India for a foreseeable future, subsidiary set up of entity may be suitable primarily on account of less operating restrictions (and especially because of the newly introduced beneficial tax regime, as per which an Indian company is subject to tax at a lower corporate tax rate compared to a FCO having a PO in India). However, various factors will play a deciding role like expected duration of the projects, acceptability to the extent of additional governance and compliances a company set up will attract and mandate, etc. The choice of form of entity set up will certainly depend on specific business requirements of the FCO and comparative advantages (commercial and tax) on the form of set up.

2. Approval of RBI required for set up of PO in certain cases – aspects in law which require consideration

There is a general permission to non-resident companies to establish POs in India, provided they have secured a contract from an Indian company to execute a project in India. Also, the project must have secured the necessary regulatory clearances; and is funded directly by inward remittance from abroad; or the project is funded by a bilateral or multilateral International Financing Agency, or a company or entity in India awarding the contract has been granted Term Loan by a Public Financial Institution or a bank in India for the Project. Now, lets look at some interesting aspect around this approval provision.

Contract with an Indian company:

As seen from above, there is a general permission for FCO to establish a PO in India, inter alia, if they have secured a contract from an Indian Company to execute a project in India. If the contract is not awarded by an Indian company, assuming other conditions are satisfied, RBI approval will be required. Indian company generally means a company incorporated in India. Generally, in EPC projects, it is possible that the project owner is an unincorporated JV entity (SPV set up for a project) wherein the one of the JV partners could be FCO. Such a JV which does not qualify as an Indian company and will not be covered in a case of general permission and hence, RBI approval would be required in such a case.

PO to be opened within the timelines

Further, once the approval is granted for setting up of PO (after issuance of approval letter by AD Bank), the FCO is obligated to open the foreign office(s) within 6 months from the date of approval letter, as after the expiry of such period, the approval shall in strict technical terms lapse. An extension for a further period of 6 months may be granted subject to the satisfaction of AD bank that the inability to open office has occurred due to the reasons beyond control. Any further extension of time shall require prior approval of RBI.

At times, the approval process by AD banks does take long due to unexpected circumstances (additional information called for, paperwork, compliances, etc.). In such situation, as the Indian project operations would have ordinarily commenced due to strict project commitments and FCO’s would be struggling between formal pending approvals and committed milestones for project work. Pending such approvals, the FCO’s also may face other administrative challenges like opening of bank account, applying for registrations etc.

Some key tax aspects:

From Income-tax Act, 1961 (‘Act’) perspective, the PO constitutes a Permanent Establishment (‘PE’) of a FCO in India and the net income of such PO becomes taxable in India @ 40% plus surcharge and health and education cess which is applicable to a non-resident. 

3. TDS deducted at 40% on gross basis or 10% on gross basis on the payments to the PO providing ‘technical services’ to the Indian resident

As per section 195, a payer, paying to a non-resident, has to deduct TDS at the rates in force on any sum chargeable under the provisions of the Act. As per Part II – ‘Rates for deduction of TDS in certain cases’ of the First Schedule to the Finance Act, in case of payments by way Fees for Technical Services (‘FTS’) payable by an Indian concern (subject to certain stipulations), tax may be withheld at 10% (plus applicable surcharge and cess) on gross basis. It does not give any reference to existence or non-existence of a PE. So, though the final taxation is on net income basis (i.e. whether or not the non-resident has a PE in India), withholding tax at the rate of 10% on gross basis could be applied, inter alia, where the FTS payments are made by an Indian concern / Indian Government. In practice, especially considering the significant exposure of disallowance of expenses in case of non-deduction of tax on payments to non-resident entities, this approach is not applied in most cases. However, it is observed that the PO in most of the cases applies for a lower tax withholding certificate under section 197(1) of the Act since the final taxability is on net income basis and accordingly, the withholding by the payee is as per the certificate issued under section 197(1) of the Act.

The other important aspect here is that the payment should be from an ‘Indian concern’, the term which is not defined under the Act. So, if the payer is not an Indian concern, tax withholding rate will be 40% on gross basis. For example, the payment to the PO is from a Joint Venture (of resident and non-resident partners), being an unincorporated entity, a question arises whether the such Joint Venture can be said to be an 'Indian concern'. The term ‘Indian Concern’ is not defined anywhere in the Act and accordingly, the same has to be understood basis the relevant judicial precedents in this context. The Courts Craigmore Land and Produce Co. Ltd. [TS-5612-HC-1976(Madras)-O], Dorr-Oliver (India) Ltd [TS-5683-HC-1993(Bombay)-O], IBM World Trade Corporation [TS-5388-ITAT-1986(Bombay)-O] have given contrary views on the subject. Considering, it is highly arguable that the Joint Venture being an unincorporated one and having a non-resident as a member, an issue which needs considerations is accordingly, whether it may qualify as an Indian Concern or not. If not, withholding tax rate of 40% on gross basis may be attracted.  

4. Deductibility of Head office (‘HO’) expenditure (i.e. general, executive and administrative overheads incurred outside by HO outside India and allocable to the Indian PO) where no taxes have been withheld, non-fulfillment of the stipulations under section 43B of the Act, etc.

There are certain provisions under the Act like section 40(a), which limits the deductibility of the expenditure (including any payment made to a non-resident) on which tax is required to be deducted but has not been so deducted and / or deposited with the Government. Such expenses will subsequently be allowed in the year in which the TDS has been withheld and / or deposited. Further, Section 43B lists down certain expenses which are allowable only on actual payment basis.

Article 7 (para 3) has been worded in several treaties with countries (like India- US and India - Netherlands) expressly providing a limit on the deductibility of expenses subject to the limitations of the domestic law. At the same time, it is important here to note that as per some other tax treaties like India – Japan, it can be observed that there is no reference of limiting the deductibility of expenses in accordance with and subject to the provisions of the income-tax law. In India – Japan Tax Treaty, except in case as provided in Para 7 of the Protocol of India – Japan Treaty for HO expenditure i.e. for general, executive and administration overheads. Section 44C of the Act limits the deductibility of HO expenditure incurred outside India and allocated to the India PE to a prescribed ceiling.

So, can it be stated that unless there is an express covenant in the Treaty about the applicability of provisions of the domestic law for allowing expenses in accordance with and subject to the limitations of the taxations laws of the State, such provisions of the domestic law are not applicable Toyo Engineering Corpn. Depending upon the language of the respective Tax Treaty (limiting the deductibility of such expenditure), it may be possible to claim such expenditure as allowable even where no taxes have been withheld  / paid within the stipulated date as envisaged under section 43B of the Act. It is important to note that irrespective of the above position, non-withholding of taxes triggers interest and penal consequences under the Act which are governed by the provisions under the Act and not by the treaty. 

5. Tax deductibility of the cost of personnel deputed by the Head Office to PO and reimbursement to the HO in this respect – In case where the employees are deputed by the HO to PO for the purpose of execution of the project under secondment arrangements, it is typically seen that the part of their salary is paid by the HO in such employee’s account in their home country for administrative convenience. The PO then reimburses such costs paid by HO on back-to-back basis. Such reimbursement of costs (without any mark-up) should be allowable to the PO as salary cost of its employees while computing its taxable income. However, robust documentation (including secondment arrangements, time records, etc.) is/will be required to demonstrate that the employees deputed are in the control, supervision of the PO and they devote/spend their entire time to the PO’s operations in India. This is, however, subject to appropriate compliance of withholding tax obligations. 

6. Tax deductibility of the cost of personnel of HO working on the PO operations (working from home country) and reimbursements by the PO of such costs - PO making the payments of royalties, FTS, other charges to the HO for the specific services performed is not allowable to the PO unless it is in the nature of actual reimbursements. Reimbursement (without any mark-up) to the HO pertaining to the cost of HO’s personnel working on the PO’s operations should be allowable to the PO (to the extent of time devoted to the PO’s operations) subject to robust documentation (like time records, etc.). Further, withholding tax obligations in India may not trigger as such employees are rendering services from outside India and have not rendered any activities in India (though India treaties with respective countries needs to be analysed).  

7. Claim of excess TDS of one PO of FCO as credit against the tax liability of the other PO

FCO’s can operate in India with more than one PO in India, in case separate contracts are awarded to same FCO by different project owners and it entails establishing separate PO’s to execute such contracts by such FCO. Generally, based on estimates projections from the contract, each of such PO’s obtain separate tax withholding certificate under section 197(1) of Act on a yearly basis and tax is deducted at source from the receipts basis the tax rate provided in the certificate issued by tax authorities to the respective payer. Now, in case of any change in earlier estimates (given at the time of applying for lower withholding certificate) of one of the PO, there may be further tax liability for such PO considering the shortfall of TDS deducted. In such scenario, the question arises is whether such PO is required to pay advance tax or can first set off / take credit for excess TDS of other PO (having excess TDS over and above PO’s tax liability) and then consider to pay tax for balance tax payable. It is important to note here that for the purpose of Act, irrespective of the number of PO’s a Foreign company has in India, single tax return is mandatorily required to be filed in India and not separate for each PO. Consequently, profits of both PO’s have to be offered and consolidated net taxable income is computed, and tax liability is determined after considering the allowable TDS credits for the year based on corresponding income offered to tax. Similarly, for computing the quarterly advance tax liability, the profit / loss computed and tax paid for both the Projects are to be aggregated and adjusted. Further, even as per FEMA provision, it is noted that that there is no specific restrictions of considering credit of TDS of PO against the tax liability of other PO. As per the FEMA provisions, regulations related to set up of PO inter alia provides that prior permission of the RBI is required for any inter-project transfer of funds. The heading erstwhile FED Master Direction No. 10 / 2015-16 dated 1 January 2016 of the relevant provision of the FEMA regulation reads as ‘Intermittent remittances by PO in India’ and so the possible view could be that the term ‘remittance’, in this context, is to be interpreted as an actual transfer of funds and it does not envisage such inter-PO utilisation of TDS. Since here it is mere utilisation / adjustment of excess withholding tax credit pertaining to one Project against the overall tax liability of the FCO, one can say there is no actual transfer of funds or debit / credit of the funds of the PO as envisaged in the regulations. So, credit of excess TDS of one PO can be taken as credit for other PO.

To sum up:

PO set up is most favoured and common set up by FCO’s who are awarded contracts for turnkey EPC projects in India, both from commercial and tax perspective. However, it involves various tax and regulatory nuisances as discussed above, which the FCO’s needs to be cognizant about and take necessary steps to achieve their objective.