As a member of G20, India has been amending its domestic tax laws to bring it in line with the BEPS Action Plan. The introduction of Equalization Levy, limitation of interest deductibility etc., are some examples.   

The Finance Bill 2018 proposes to expand the scope of the ‘business connection’ test by introducing two changes. The first change is to align the scope of dependent agent stipulated in 'business connection' under the domestic tax law with the BEPS Action Plan 7 and Multilateral Instrument (MLI). The second amendment is to include ‘significant economic presence test’ for the purpose of determining the trigger of business connection for the entities in digital business.

We discuss in this article the first amendment in detail.  

What is Business Connection under the Income tax Act, 1961 (or the Act):

The domestic tax laws deems certain income to accrue or arise in India even though it may actually accrue or arise outside India. One such instance covered is the income accruing or arising through or from a business connection in India. In simple terms it can be equated with business presence.  

The concept of business connection has been in existence since the commencement of the Act though there was no definition of the same therein.  Various court rulings including the Supreme Court have interpreted this term considering the facts and circumstances of a given case.

A business connection involves a relation between a business carried on by a non-resident which yields profits or gains and some activity in India which contributes to the earning of theses profits or gains. A business connection can arise between a non-resident and a resident if both of them carry on business and if the non-resident earns income through such a connection. The expression “business connection” postulates a real and intimate relation between the trading activity carried on outside India and the trading activity within India, the relation between the two contributing to the earning of income by the non-resident in his trading activity.

Effective April 2004 an Explanation was introduced to clarify that the term business connection shall include any business activity carried out through a person (dependent agent), who acting on behalf of the non-resident, has and habitually exercises in India an authority to conclude contracts on behalf of the non-resident or maintains in India stock of goods which he delivers on behalf of the non-resident or habitually secures in India orders mainly or wholly for the non-resident.  

An exception was also carved out that if the activities of such agent was limited to the purchase of goods or merchandise for the non-resident, the same will not be covered under the ambit of business connection.

Tax Treaty position

The business presence equivalent in a Tax Treaty is the Permanent Establishment concept though the depth and degree of threshold could vary.  In most of the tax treaties entered by India, a Permanent Establishment (PE) is triggered through the agency activities carried out by a dependant agent. It provides that an enterprise is deemed to have agency PE only if a person (dependent agent) acting on its behalf habitually exercises authority to conclude contracts in name of enterprise.  Many treaties also trigger PE on account of stocking / delivery of goods and securing orders on behalf of the non-resident.   

One of the avenues used to circumvent the incidence of agency PE was that the agent acting on behalf of the non-resident would negotiate the terms of the contract which would finally be concluded by the non-resident in its own name.

The other means was by entering into a commissionaire arrangement wherein the agent would sell the products in its own name (though on behalf of the principal) and would be offering the remuneration (the commission) to tax rather than the profits arising on sale of goods in the foreign state.

OECD Commentary

The Commentary to the OECD Model Convention on paragraph 5 to Article 5 prescribes that the phrase “authority to conclude contracts in the name of the enterprise” does not confine the application of the paragraph to an agent who enters into contracts literally in the name of the enterprise; the paragraph applies equally to an agent who concludes contracts which are binding on the enterprise even if those contracts are not actually in the name of the enterprise.

It further clarifies that a person who is authorised to negotiate all elements and details of a contract in a way binding on the enterprise can be said to exercise this authority “in that State”, even if the contract is signed by another person in the State in which the enterprise is situated or if the first person has not formally been given a power of representation.

BEPS Action Plan

The OECD under BEPS Action Plan 7 reviewed the definition of PE with a view to prevent avoidance of payment of tax by circumventing the existing PE definition by way of commissionaire arrangements or fragmentation of business activities.   

In order to tackle such tax avoidance, the BEPS Action plan 7 recommended modifications to paragraph (5) of Article 5 to provide that an agent would include not only a person who habitually concludes contracts on behalf of the non-resident, but also a person who habitually plays a principal role leading to the conclusion of contracts.

Presently activities such as maintenance of stocks of goods for storage, display, delivery or processing, purchasing of goods or merchandise, collection of information is excluded from PE trigger when these are preparatory or auxiliary in nature.   

The Action Plan 7 recommends introduction of anti-fragmentation rule so as to prevent the tax payer from resorting to fragmentation of functions which are otherwise a whole activity.

The BEPS Action Plan 7 have now been included in Article 12 of the MLI.  Consequently these provisions will automatically modify India’s bilateral tax treaties covered by MLI< where the treaty partner has also opted for the said Article 12.  

Consequently the tax treaties will have a wider scope for PE or business presence while the domestic tax laws could have a narrower scope.  Hence the amendment to the domestic tax laws to align them with the tax treaties so as to the make the tax treaties effective.  

Proposed amendment

The first clause in the Business Connection definition dealing with agency is proposed to be replaced such that a Business Connection is triggered to include any business activities carried through a dependent agent of a non-resident who habitually concludes contracts or habitually plays the principal role leading to conclusion of contracts by the non-resident, where the contracts are:

1. in the name of the non-resident; or

2. for the transfer of the ownership of, or for the granting of the right to use, property owned by the non-resident or for which the non-resident has a right to use; or

3. for provision of services by that non-resident.

This amendment will take effect from 1 April 2019 i.e. from assessment year 2019-20 onwards.

Observations on the proposed amendment

 a. Will sourcing activities get covered by the new amendment?

The income deeming regulations clearly exclude income from operations which are confined to the purchase of goods in India for the purpose of export.  There is no change to this regulations. 

Activities comprising of purchase of goods for a non-resident other than for export will be hit by the proposed regulations.   

b. Impact of sales and marketing activities done by a Indian subsidiary for its overseas parent

It is common for an Indian subsidiary or branch to undertake marketing and / sales activities in connection with tangible goods and intangibles (software) etc and for the Indian customer to enter into a contract directly with the non-resident parent. 

These activities are likely to now attract the business presence test under domestic tax laws as well and would require careful evaluation for mitigation/attribution.

c. Can treaty still protect the taxpayer?

The domestic tax regulations or the tax treaty provisions whichever is more beneficial will prevail.  Post the amendment the domestic tax regulations are sought to be made at par with the wider scope of the MLI. However for those countries who have not signed up for Article 12 of the MLI the earlier tax treaty would hold good.  Even here one will have to interpret the PE clauses in line with the OECD commentary which lays emphasis on substance rather than form.  

Conclusion

Tightening the business presence test has been one of the action plans under BEPS. India is proactive in adopting the action plans as can be seen from the various amendments incorporating them.

It is imperative that the non-resident taxpayer has a clear review of all activities by an agent in India for possible business presence trigger and take appropriate steps thereafter.