India: Tribunal rules on agency permanent establishment and profit attribution
Recently, the Income Tax Appellate Tribunal gave an important judgement regarding the creation of and attribution of profits to an agency permanent establishment (Agency PE) – Daikin Industries v ACIT ('ITA No 1623 of 2015 [New Delhi Income Tax Appellate Tribunal, May 28 2018]').
The non-resident taxpayer (a Japanese company) sold air conditioners to its wholly-owned Indian subsidiary (which acted as a distributor) and also directly to customers in India. In respect of these direct sales to customers, the taxpayer entered into agreements with its Indian subsidiary under which the subsidiary would provide marketing support, i.e. forwarding customer requests and the taxpayer's proposals/quotations. The agreements expressly stated that the activities of identifying customers, negotiating and finalising prices were exclusively carried out by the non-resident itself. An arm's-length commission for such activities was also paid.
The tribunal held that the non-resident taxpayer had an agency PE in India under the India-Japan treaty. This conclusion was based on the following:
The tribunal noted that it was inconceivable for the taxpayer to directly sell to Indian customers on a large scale without active support from the subsidiary;
Inadequate correspondence between the taxpayer and the customers indicated that all communication related to negotiation and sales happened through the subsidiary; and
Actual conduct (through emails) suggested that the Indian subsidiary was involved at every step from early pitching to communication to negotiation.
The tribunal concluded on the basis of the above, that the Indian subsidiary was habitually exercising authority in India to conclude contracts on behalf of the taxpayer, even though such contracts were formally signed by the taxpayer in Japan.
On the issue of attribution, the taxpayer relied on the Supreme Court of India's decision in DIT (IT) v Morgan Stanley 2007 (292) ITR 416 (SC), where it was held that once a transfer pricing analysis is done, there is no further need to attribute profits to a PE, which is an associated enterprise compensated on an arm's-length basis, taking into account all the functions performed and risks assumed by the enterprise. The tribunal, however, held that this principle could not be applied to the present case since:
The commission paid was based on the Indian subsidiary performing only two functions, i.e. the forwarding of customer requests and the taxpayer's quotations/proposals. Since several other functions were actually performed by the India subsidiary, the commission paid did not take into account all functions performed; and
The non-resident taxpayer had neither undertaken a transfer pricing analysis, maintained documents nor reported its international transactions to the tax authorities. As such, the commission it paid could not be considered as arm's length.
As a result, the tribunal concluded that such payment did not extinguish the tax liability of the non-resident taxpayer in India.
This decision suggests that activities that lead to the conclusion of contracts have to be viewed in their entirety and not merely from the perspective of whether the Indian entity has the power to formalise them or not. It also highlights the importance of maintaining adequate supporting documents to substantiate the functions performed and risks assumed by a non-resident in its dealings with Indian affiliates.