The tax treaties provide for allocation of taxing rights between the residence state and the source state in respect of passive income^[1]. The passive income’s primary right of taxation is granted to the resident state through paragraph 1, though, paragraph 2 provides that such income may also be taxed in the source state in which it arises but at a limited rate of tax. An exception to the above allocation right exists where the passive income earned in the source state is effectively connected with the permanent establishment in the source state. The Indian tax treaties provide that in such cases, the provisions of Article 7 or Article 14, as the case may be, shall apply. Article 7 or Article 14 provides for taxation of profits to the extent attributable to permanent establishment.

Scope of this write up is limited to address whether the ‘permanent establishment exception’ given in passive-income-articles will apply only where the passive income is fully attributable to the permanent establishment and hence taxable in the source state.

This issue was addressed by a Full Bench of the Federal Court of Australia in a recent case of Tech Mahindra Limited vs CT [2016] FCAFC 130 (FCA). In this case, the taxpayer was a company resident in India and registered in Australia. The taxpayer provided software products and IT services to customers in Australia through its permanent establishment in Australia. The said services were performed in the relevant year partly by employees located in Australia, and partly by employees located in India (‘Indian services’).  The taxpayer did not dispute that Article 7(1)(a)^[2] of the tax treaty gave Australia the right to tax the income that the taxpayer received in respect of the services performed in Australia, but the issue was whether Australia had any taxing rights in respect of Indian services. It was an admitted position that the profits referable to the Indian services were not attributable to the permanent establishment in Australia under Article 7(1)(a).

The tax authorities interalia contended that the payments in respect of the Indian services were ‘royalties’ as defined in Article 12(3) and taxable in Australia under Article 12(2). The taxpayer in turn contended that the payments were not ‘royalties’ as defined in Article 12(3) but, if royalties, Article 12(4) was relevant and gave priority to Article 7, so that whether Australia had the right to tax those payments depended on whether the criteria in Art 7(1) were met which, it was submitted, they were not. 

The Full Bench of Australian Court while opining that Indian Services constituted ‘royalty’ held that the ‘permanent establishment exception’ given in royalty article will apply only where such passive income is attributable to the permanent establishment on the basis of the following reasons:

1. The essential competing difference in construction between the parties is whether Art 12(4) is simply a gateway to Art 7 so that whether the source state will have taxing rights under Art 7, will depend on whether the royalties “assimilated” to business profits are, relevantly, attributable to the permanent establishment in the source state through which enterprise carries on business. On the construction argued by the Appellant, a royalty may fall outside of the scope of the source state’s right to tax by virtue of Art 12(4), if Art 7 does not give taxing rights to the source state in respect of that royalty. The context and evident purpose of Art 12(4) does not give support for that construction.

2. Article 12(4) is to be construed in the context that Art 7(7) gives priority to Art 12 over Art 7. Without Article 12(4), royalties forming part of the business profits of an enterprise attributable to a permanent establishment in the source state would be taxable by the source state but subject to a limit on the amount of tax that may be charged. No evident object or purpose is indicated, and none was suggested by the Appellant, for construing Art 12(4) in a way that would disentitle the source state from the right at all to tax a payment otherwise within the scope of Art 12(2) but outside the scope of Art 7.  To the contrary, the evident purpose of Art 12(4) is to relieve the source state from the limitation on taxing rights imposed under Art 12 by taxing such royalties under Art 7, not to disentitle the source state from any taxing rights where otherwise Art 7 would not give such taxing rights. Such a construction gives effect to the language of Art 12(4) and is consistent with the extrinsic materials.

3. The explanatory memorandum is confirmatory 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 the right to tax such royalties under Art 7.

The Indian Courts have, however, interpreted the words ‘effectively connected’ and ‘attributable to’ differently. The Supreme Court of India in the case of Ishikawajima-harima Heavy Industries Ltd [TS-30-SC-2007-O] held that the term ‘effectively connected and attributable to are to be construed differently, even if the offshore services were connected.

The Authority for Advance Rulings in [TS-5004-AAR-1995-O] while opining that the technical services are effectively connected held that since the activities of preparation of design, basic engineering services, etc. were carried out abroad, the income from such services cannot be said to be attributable to the permanent establishment. As a result, the income escaped taxation altogether in the source state. The Income Tax Appellate Tribunal, Mumbai in the case of Nippon Kaiji Kyokoi [TS-5791-ITAT-2011(MUMBAI)-O] held that even after fee for technical services is effectively connected, then also only so much of the fee as is directly or indirectly attributable to the permanent establishment, can be brought to tax. The Income Tax Appellate Tribunal, Mumbai in [TS-5736-ITAT-2015(MUMBAI)-O] following the Supreme Court decision in [TS-30-SC-2007-O] held that offshore services even though effectively connected with the permanent establishment in India, would not be taxable in India as nothing was attributable.

The author is of the view that ‘permanent establishment exception’ given in the passive income articles will be applicable only where such income is fully attributable to the permanent establishment in the source state for the following reasons:

i) The intention of providing the permanent establishment exception in the passive income article, is to relieve the source state from any taxing limitation.

……………The paragraph merely provides that in the state of source the dividends/interest/royalty are taxable as part of profits of the permanent establishment there, owned by the beneficiary which is a resident of the other State, if they are paid in respect of holdings / debt-claims / rights or property forming part of the assets of the permanent establishment or otherwise effectively connected with that establishment. In that case, paragraph 4 / 4/ 3 relieves the state of source of the dividends from any limitations under the Article. [Excerpts from paragraph 31 / 24 / 20 of the OECD Commentary on Article 10 (4) / 11(4) / 12(3)]

…………….It follows from the rule that this Article will be applicable to business profits which do not belong to categories of income covered by the special Articles, and, in addition, to dividends, interest etc. which under paragraph 4 of Articles 10 and 11, paragraph 3 of Article 12 and paragraph 2 of Article 21, fall within this Article. [Excerpts from paragraph 62 of the OECD Commentary on Article 7 (7)]

ii) A reasonable interpretation of the words viz., ‘effectively connected’ and ‘attributable to’ would show that both the terms are same. A perusal of the India-USA tax treaty would substantiate the view. Further, as per Dr. Professor Klaus Vogel in substance, the usage of different words does not result in any difference from the rules of OECD model Commentary.

iii) Any other interpretation would defeat the very purpose behind the ‘permanent establishment exception’ i.e. the passive income may fall outside the scope of the source state’s right to tax altogether.

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[1] Income from dividend, interest, royalties and fees for technical services.

[2] The profits of an enterprise of one of the Contracting States 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:

(a) that permanent establishment