Over the last many years, India has been on the radar of several foreign companies. However, overseas firms looking to venture into the Indian market could be at an initial stage of examining the market in terms of size, customer preferences, growth potential, etc. As it may not be feasible to establish a full-fledged business presence at such a preparatory stage, overseas firms can establish a liaison office (LO) in India.
An LO is in the nature of a representative office—set up primarily to explore and understand the business, establish contacts, gather market intelligence to promote the products or services of the overseas parent company.
The activities of an LO do not usually trigger taxability for the head office. However, there have been cases where they have attracted taxes, or at least the tax department has sought to so contend. A 30 April decision of the Bangalore Income Tax Appellate Tribunal, in the case of Jebon Corp., has held on facts that the activities of its LO trigger tax liability in India.
To open an LO in India, a foreign firm is required to obtain prior approval from the Reserve Bank of India (RBI). An LO is not permitted to undertake any commercial, trading or industrial activity—directly or indirectly. Generally, an LO is permitted to undertake the following:
—Represent the parent company/group in India
—Promote export/import from/to India
—Promote technical/financial collaborations between the parent and companies in India
—Act as a communication channel between the parent company and Indian firms
RBI’s master circular dated 1 July 2008, dealing with “Foreign Investments in India”, has expressly mentioned that an LO is not allowed to undertake any business activity in India and cannot earn any income in the country.
Though an LO is a fixed place of the foreign enterprise in India, under most tax treaties entered into by India, it per se should not constitute a permanent?establishment?(PE), as most of the tax treaties specifically exclude from the definition of a PE a fixed place of business set up solely for the purpose of advertisement, supply of information or other activities that are preparatory or auxiliary in nature.
Under India’s tax treaties with developed countries, such as the US, UK, Japan and Germany, activities such as concluding contracts or securing orders for a principal would result in constituting an agency PE in India, triggering tax liability. In the case of tax treaties with several other countries, including the Netherlands and South Korea, the activity of securing orders for foreign enterprise, per se, is excluded from the definition of PE; that is, the agency PE definition is somewhat narrower, restricted to “concluding contracts”.
Though an LO would have obtained approval from RBI to undertake permitted activities, the tax authorities could independently examine these activities to ascertain if these constitute a taxable business presence/PE in India.
There have been various decisions wherein it has been held by the courts that if the activities of an LO are of a preparatory or auxiliary character, the LO should not be taxable in India.
The decision of the Delhi tribunal in Western Union Financial Services Inc. v. Additional Director of Income Tax, dated 10 March 2006, is relevant in this context.
Western Union had, with RBI approval, set up an LO in India to act as a communication link between the money transfer agents and its head office, to visit agents and offer training and refresher courses in connection with the operations of the assessee and accounting procedures, etc. The LO had also provided management software (VOYAGER) to agents, free of cost. Based on the facts of the case, the tribunal had observed that the LO had not undertaken any activity that was not in accordance with what had been approved by RBI. Accordingly, the LO could not be considered to be a fixed place PE.
In the case of Jebon, the South Korea-headquartered firm that trades in semiconductor components manufactured by various companies outside India had set up an LO with RBI approval. As per the approval, the Jebon LO was not to undertake any activity of a trading, commercial or industrial nature, nor enter into any business contracts in its own name without taking prior permission from RBI. It was also prohibited from charging any commission or fees for the business activities or services rendered by it.
However, the employees of the LO were generating enquiries by way of telephone calls and cold calls, were involved in negotiations for each enquiry and, in some cases, even closed orders to the satisfaction of the customer and the head office. Further, the employees had the freedom to decide the margin or selling price, provided the company did not incur a loss. However, the LO had to revert to the head office in case a customer asked for a price lower than a set price band.
Based on this, the assessing officer held that the employees of the LO were acting on behalf of the head office, and had the authority to conclude contracts on its behalf. Accordingly, the officer held that Jebon had a business connection/PE in India under the Income-tax Act/India-South Korea tax treaty, and estimated the profits attributable to the LO in India. The matter was challenged before the Bangalore tribunal.
The revenue authorities contended that the LO constituted a PE of the South Korean company in India. The RBI approval should not be seen as any certification of non-prosecution of actual business as understood under the provisions of the Act. The LO enjoyed complete freedom in deciding the sales margin, and the head office had no role to play in this regard. The LO was not merely performing communication work, but was playing a vital role in the decision-making process in relation to product pricing. The presence of the LO for marketing and selling its products was inevitable if Jebon was to run its business in India.
The South Korean company contended that the LO did not constitute its PE in India as it did not directly make any sales to customers, either in India or abroad, nor did it make any purchases from suppliers. The unit price, along with the band of margin offered to customers, was provided by the head office. The LO’s activities were restricted within the terms of the RBI approval and were preparatory and auxiliary in charter and, hence, outside the ambit of the PE definition.
The tribunal held that trading activity includes identifying customers, negotiating purchase price, sales price and procuring orders from customers. In the given case, part of the trading activity in respect of supplies made to Indian customers was done by the LO and was in continuation of the trading activity of the South Korean company. Accordingly, there was a business connection in India, and income attributable to the operations carried out here will be taxable in hands of the assessee under the Act.
The decision of the Bangalore tribunal serves as a reminder to companies to examine the activities and functions performed by their LOs in India. Functions such as securing orders, fixing prices, negotiations and authority to conclude contracts could attract the taxman’s scrutiny. Approval from RBI is not conclusive evidence that the activities of an LO are of a preparatory and auxiliary nature and the LO is not the PE of foreign enterprise.
It is important to ring-fence the functions and activities of the LO and educate its employees as to the functions which can be performed and which cannot be performed— both from a regulatory and a tax standpoint.
Ketan Dalal is executive director and Manish Desai is associate director, PricewaterhouseCoopers. Your comments and feedback are welcome at firstname.lastname@example.org