International Ruling — An Indian Perspective

Facts of the case

A US multinational corporation manufactured and sold computers, etc. In the Norwegian market, its products were sold through an indirectly owned subsidiary (Norway Co.), which acted as a commissionaire for the Irish group company (Ireland Co.).

Tax audit was carried out by Norwegian Tax Authorities on Norway Co. At the time of the audit, Ireland Co. had no employees, but procured all necessary services from another group company in Ireland.

Norway Co. had a margin of about 1% of the turnover in the years that were covered by the tax audit. All agreements with customers were concluded on standard terms and conditions set out by Ireland Co. Ireland Co., as the principal, prepared marketing strategies, had access to the products, was responsible for the freight and logistics, customer followup, technical assistance, administrative tasks, etc. Ireland Co. did not regard itself as taxable in Norway and therefore did not report any income to Norwegian tax authorities. After the tax audit of Norway Co.,

Ireland Co. was considered to have a permanent establishment (PE) in Norway.

A schematic representation of arrangement is as follows:

•  Whether the expression ‘authority to conclude contracts in the name of the enterprise’ in English version of tax convention between Ireland and Norway or the expression ‘authority to conclude contracts on behalf of the enterprise’ in the Norwegian version requires that the contract entered into by an agent is ‘legally binding’ on the principal or it is sufficient that the contract ‘in reality binds the agent’ to trigger Agency PE?

•  Whether Norway Co. was a dependent agent of Ireland Co.?

•  If there is an agency PE, what is the profit attributable to the PE? Relevant provisions in the Double Tax Avoidance Agreement (DTAA) The relevant Article of Ireland-Norway DTAA was based on OECD Model. Article 5(5) of the OECD Model reads as follows: “Notwithstanding the provisions of paragraphs 1 and 2, where a person — other than an agent of an independent status to whom paragraph 6 applies — is acting on behalf of an enterprise and has, and habitually exercises, in a Contracting State an authority to conclude contracts in the name of the enterprise, that enterprise shall be deemed to have a permanent establishment in that State in respect of any activities which that person undertakes for the enterprise, unless the activities of such person are limited to those mentioned in paragraph 4 which, if exercised through a fixed place of business, would not make this fixed place of business a permanent establishment under the provisions of that paragraph.”

The Norwegian version of DTAA uses the expression ‘authority to conclude contracts on behalf of the enterprise’ instead of ‘an authority to conclude contracts in the name of the enterprise’ as used in the English version. Main contentions of the taxpayer For the condition of Agency PE to be satisfied, the contract must be legally binding on the principal. If it is not legally binding, it cannot be regarded as concluded on behalf of or in the name of the principal. Under the civil law of the UK, an agent could legally bind the principal, regardless of the fact whether contract was entered in the name of principal or not.

To clarify that such agents were covered, a paragraph 32.1 was added in OECD Commentary to the effect that the paragraph applies equally to an agent who concludes contracts which are binding on the principal even if those contracts are not in the name of the principal. This supports the argument that the phrase ‘authority to conclude contracts in the name of the enterprise’ only means that it must be legally binding on the principal.

However, under Norwegian law, an agent cannot enter into contracts that are binding on the principal. This was also a term in the contract between Ireland Co. and Norway Co. that Ireland Co. is not bound towards Norway Co.’s customers and hence, conditions of agency PE are not satisfied. Since Ireland Co. is an empty company, it cannot instruct and control Norway Co.

Control as a result of group connection, board representation, daily management, and integrated accounting system is not relevant for determining dependency. The agency contract states that the agent is an ‘independent contractor’, neither party shall have the power to direct or control the daily activities of the other and that Norway Co. is free to involve itself in contracts with other parties. Norway Co. also sells additional products from other supplier/s.

Main contentions of tax authority

Under Vienna Convention of Law of Treaties, a purposive interpretation should be given to tax conventions.

OECD Commentary is important for interpretation since Ireland-Norway DTAA is modelled on the lines of OECD. The expression ‘on behalf of’ in Norwegian text or the expression ‘to conclude contracts in the name of enterprise’ in the English text does not indicate that contract should be legally/statutorily binding on the principal. One should interpret the phrase having regard to its functional impact. Since agent draws the principal into the national economy of Norway, it should be taxed in Norway.

OECD Commentary also supports functional interpretation when it states in para 32 that agent must involve the principal to a particular degree in the country concerned for trigger of permanent establishment. The addition of paragraph in OECD Commentary should not be looked as a consequence of difference between common law and civil law of the UK.

The phrase ‘in the name of’ should not be interpreted strictly, but one must understand it as synonymous with ‘on behalf of’. A substance over form approach must be adopted. The decisive factor is whether the agent in reality binds the principal. An internal administrative circular by the Ministry of France also asserts that one has an agency structure where the agent in reality binds the principal.

The following factors show that Norway Co. was binding Ireland Co. in reality

•  All sales took place under the brand name of Ireland Co. without showing that Ireland Co. was not behind the sales.

•  A large number of contracts entered into took place on standard conditions within detailed limits where Ireland Co. could not refuse to meet its obligation.

•  Sales on conditions other than standard terms could be made only with prior approval of Ireland Co.

•  In practice, Ireland Co. did not review the contract entered into by Norway Co.

•  here was no instance demonstrated by Ireland Co. where sale undertaken by Norway Co. was not approved by Ireland Co. Norway Co. was a dependent agent of Ireland Co. on account of the following factors

•  Norway Co. was subject to Ireland Co.’s instruction and control.

•   Norway Co. could only sell allowed products on approved contract conditions and at fixed prices terms of which were fixed by Ireland Co.

•  There was an overlap of board members and management of Norway Co. and Ireland Co.

•  There was an integrated accounting system which gave Ireland Co. full insight into Norway Co.’s financial status.

•  Ireland Co. had access to Norway Co. premises under the agency contract.

•   Norway Co. acted only for one principal as an agent. Though, formally under the contract, Norway Co. was not prevented from entering into contract with outsiders, in reality it was so prevented.

•     Sale of third-party products was marginal.

High Court Ruling

On the question of PE

The wordings of the Norwegian and English texts are reasonably open and the wordings in itself do not provide a basis for concluding the matter.

Para 32.1 of the OECD Commentary reads as fol-lows:

“32.1 Also, 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. Lack of active involvement by an enterprise in transactions may be indicative of a grant of authority to an agent. For example, an agent may be considered to possess actual authority to conclude contracts where he solicits and receives (but does not formally finalise) orders which are sent directly to a warehouse from which goods are delivered and where the foreign enterprise routinely approves the transactions.”

While the latter part of the first sentence in the OECD Commentary reading ‘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’ in the OECD Commentary supports the appellant, the third sentence (namely, lack of active involvement of principal being indicative of agent’s authority) and the example following it reading ‘For example, an agent may be considered to possess actual authority to conclude contracts where he solicits and receives (but does not formally finalise) orders which are sent directly to a warehouse from which goods are delivered and where the foreign enterprise routinely approves the transactions’, support tax authority’s contention that it is sufficient that the contract is binding on the principal in reality. Commentaries by authors Avery Jones & Skaar also support this interpretation.

The purpose of the agency rule is to avoid eva-sion of tax obligation. The presence of a local representative within defined characteristics is at par with a business through permanent establishment. In order to realize this purpose one must look at the realities in the relationship between the agent and principal. It is sufficient that the agent effectively binds the principal.

Accordingly, the Court held that there is an agency PE and for this purpose, the Court noted as follows:

•     Norway Co. enters into contracts directly with the Norwegian customers and sells Dell Products to them.

•     The sales take place within clear guidelines for the activity and authority.

•     It is absolutely unthinkable that Ireland Co. would change a signed customer contract in Norway between Norway Co. and the customer, and factually, also this has not happened.

•     The formal organisation of the sale through an agency relationship where the agent may not be able to bind the principal formally (either according to an agency contract or according to the applicable Agency Act) cannot be the only decisive factor in evaluation of emergence of a permanent establishment.

On the question of independence

Independence is a fact-based exercise to be examined applying same criteria as applicable to unrelated parties. The fact that there is an overlap of board members and management is not in itself a decisive factor.

However, in the present facts, Norway Co. was financially and legally dependent on Ireland Co. in view of the following factors:

•    Norway Co. could not have existed without right to sell.

•    Norway Co. could only sell permitted products on standard terms and conditions and at fixed prices — all provided by Ireland Co. as the principal.

•    Norway Co. did not have an independent accounting system and the principal had full access to Norway Co. accounts.

•     In terms of the Commissionaire Agreement, Ireland Co. had access to Norway Co.’s premises.

•     Norway Co. acted as commissionaire for only one principal, namely, Ireland Co.

•     Third-party sale was marginal.

•     The provisions in the agency contract that the agent shall act as an independent party and that none of the parties shall be able to control one another, were self-proclaimed paper provisions which did not reflect reality of conduct between the parties.

On apportionment
The main rule for attribution of PE profit is the direct method indicated in Article 7(2). This entails that the permanent establishment shall be viewed as an entirely independent enterprise which carries out the same activity under the same conditions. Thereafter, on principle, each individual item of income and expense has to be evaluated and view needs to be taken to decide whether it can be attributed to PE.

However, Article 7(4) also allows use of indirect method (formulary approach) where total result of the enterprise between the head office and establishment is apportioned by adopting relevant allocation key (e.g., turnover, income, expenses, number of employees and capital structure).

When separate accounts are not kept for the Norwegian activity, it will not be possible to apply the direct method. The company’s function, business equipments and risk connected to the permanent establishment need to analysed. Nor-wegian tax authorities must then undertake an estimation based on these parameters, and decide a part of the profits that shall be attributed to the permanent establishment.

This estimation lies outside the Court’s authority for judicial review as long as the estimation is not unjustifiable or extremely unreasonable. The Court has no reason to see that this is the case.

The taxpayer’s argument that a large part of the value creation takes place outside Norway as Ire-land Co. undertakes market analysis, etc. is duly considered in apportionment of 60% of the profits to Norway and 40% to Ireland.

Since the main part of the income from sales of the products in Norway is generated in this country, and since the tax authorities have attributed to Ireland Co. (which does not even have employees) with 40% of the profits, apportionment method adopted by the lower authorities is irrefutable.

The Court is in agreement with the tax authority that there is no requirement for an evaluation to be undertaken of whether income from commission is market related — and in that case no further apportionment of the profits can be made to Norway.

Indian perspective
Substance over form

The High Court observed that in deciding whether there is an agency PE or not, one must look at the realities in the relationship between the agent and principal and it is sufficient that the agent effectively binds the principal. The Court also observed that the provision in the contract that the agent shall act as an independent party and that none of the parties shall be able to control one another was a pure paper provision which did not express reality between the parties.

The aforesaid observations are in line with the Indian judicial trend, a summary of which is given below:

?    ACIT v. DHL Operations BV (2005) 142 Taxman 1 (Mum.) (Mag) — The Tribunal observed that in determining agency relationship one has to consider the substance of the agreement between the parties rather than its form.

?    The verification of participation in the conclusion of contracts must not only be conducted from the formal standpoint, but also from a substantial standpoint [ABC, In re (2005) 274 ITR 501 (AAR) citing Ministry of Finance v. Phillip Morris GmbH 4 ITLR 903 (Supreme Court of Italy)].

?    An agency-principal relationship may be con-stituted notwithstanding

(a)    Denial of agency in the agreement [Morgan Stanley & Co., In re (2006) 284 ITR 260 (AAR); Galileo International Inc. v. DCIT, (2009) 116 ITD 1 (Del.) para 17.3].

(b)    Description in the agreement as independent contractor [ABC, In re (2005) 274 ITR 501 (AAR), para 16].

(c)    Provision in the agreement that neither party has any authority to bind or to contract in the name of the other [ABC, In re (2005) 274 ITR 501 (AAR), para 16; Morgan Stanley & Co., In re (2006) 284 ITR 260 (AAR)].

(d)    Description in the agreement as independent consultant and not an employee of the com-pany [Sutron Corpn., In re (2004) 268 ITR 156 (AAR), para 13].

(e)    Specification in the agreement that services would be rendered on a principal-to-principal basis [ACIT v. DHL Operations B.V. (2005) 142 Taxman 1 (Mum.) (Mag), para 33].

•     The question (regarding agency PE) must be decided not only with reference to private law but must also take into consideration the actual behavior of the contracting parties. An approach relying solely on aspects of private law (the law of contracts) would make it easily possible to prevent an agent from being deemed a PE even where he is engaged most intensively in the enterprise’s business [Prof. Klaus Vogel in Treatise on Double Taxation Convention cited in Motorola Inc. v. DCIT, (2005) 95 ITD 269 (Del.) (SB), para 132].

•    There is an agency PE if despite specific terms of contract, agent habitually concludes contracts on behalf of the principal without any protest or dissent from the principal. If the agent habitually exceeds his authority and concludes contracts, such ‘illegal’ exercise should be regarded as an approval by the principal on account of its conduct and the agent should be deemed to have the authority [TVM Ltd., In re (1999) 237 ITR 230 (AAR), para 14, 16].

•    Amadeus Global Travel Distribution S.A. v. DCIT, (2008) 113 TTJ 767 (Del.) — The Tribunal held “The phrase ‘authority to conclude con-tracts on behalf of the enterprise’ does not confine to application of para 4 to an agent who enters into contract literally in the name of the enterprise. The para 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. Lack of activity involved by the enterprise in the transactions may suggest of an authority being granted to the agent.”

•    Jebon Corporation India Liaison Office v. CIT, (2010) 125 ITD 340 (Bang.) — In this case, based on peculiar facts, the Tribunal held that the activities carried on by the Liaison Office (LO) were not confined to liaison work, but LO was actually carrying on commercial activities of procuring purchase orders, identifying the buyers, negotiating with the buyers, agreeing to the price, thereafter requesting them to place a purchase order and to forward the same to HO. Material was then dispatched to cus-tomer and then LO followed up with customer regarding the payments and also offerred after sales service. Tribunal further held that “merely because the buyers place orders directly with the Head Office and make payment directly to the Head Office and it is the Head Office which directly sends goods to the buyers, would not be sufficient to hold that the work done by the liaison office is only liaison and it does not constitute a permanent establishment as defined in Article 5 of DTAA.”

The High Court, affirming the above decision of the Tribunal observed — “Once the material on record clearly established that the liaison office is undertaking an activity of trading and therefore entering into business contracts, fixing price for sale of goods and merely because the officials of the liaison office are not signing any written contract would not absolve them from liability.”

Dependent agent

One of the facts which influenced the Court in holding that Norway Co. was a dependent agent of Ireland Co. was that though, formally in terms of agency contract Norway Co. was not prevented from entering it to contract with outsiders, in reality it was so prevented and it acted as an agent for only one principal. Again, it could sell permitted products only on standard terms and conditions and at fixed prices, provided by Ireland Co.

Some of the Indian precedents which have consid-ered such features in connection with independent agent are as follows:

•    In Dassault Systems KK, In re 2010 TIOL 02 ARA-IT, in determining economic dependence, the AAR was influenced by the fact that the number of principals were more than one.

•     An agent could be dependent notwithstanding a resolution by the board of directors that the company can deal with third parties, when otherwise the company was legally and economically dependent only on one enterprise from whom it earned its entire revenue [Morgan Stanley & Co., In re (2006) 284 ITR 260 (AAR)].

•     Brokers and bankers in India through whom an FII, a non-resident, carried on transactions on stock exchanges in India were agents of independent status vis-à-vis the FII [Morgan Stanley & Co. International Ltd., In re (2005) 272 ITR 416 (AAR), para 11].

•     A custodian in India, which was providing custodial services to an FII, a non-resident and also a number of other local and international companies on a routine basis was an independent agent, both legally and economically vis-à-vis the FII [Fidelity Advisor Services VIII, In re (2004) 271 ITR 1 (AAR), para 23 ].

•     K, an Indian company, was engaged in pro-moting professional examinations/certification programmes of foreign institutes, societies, professional bodies, etc. of international repute. K signed or was in the process of signing agreements with US non-profit-making bodies (foreign entities) for conducting certification programmes. K was to collect registration forms and fees from individuals in India, who wished to register themselves for the examinations; and pass them on to the foreign entity after deducting its administrative cost and commission. The foreign entity would conduct examinations either through K or through other entities in India. The evaluation of answer sheets and award of certificates was to be done by foreign entities who would also send certificates to K for local distribution to the successful candidates. The Authority observed that there was no financial, managerial or any other type of participation between K and foreign entities. K carried on a variety of is activities besides promoting examinations of foreign entities. It had engaged itself into business relationship with foreign entity and was in the process of forging such relationship with other foreign entities it was open for K have such relationship with other foreign entities. He was not subject to any control of foreign entity with regard to the manner in which it will carry out its activities with regard to promotion of the examinations. On these facts, the Authority held that K was enjoying an independent status [KnoWerX Education (India) (P) Ltd., In re (2008) 301 ITR 207 (AAR)].

Profit attributable to the PE

The High Court observed that direct method of apportionment cannot be applied since no separate accounts are kept by Ireland Co. in respect of Norwegian activity. Therefore, apportionment of profits should be based on an indirect method. The Court also observed that there is no requirement for an evaluation to be undertaken on whether income from commission is market related and in that case no further apportionment of profits can be made to Norway. However, unfortunately, the Court did not provide any reasoning behind this observation.

It is pertinent that the Court rejected application of direct method of apportionment since no separate accounts were maintained, and it was not possible to conduct FAR analysis (functions performed, assets used and risks assumed), which the Court held was an essential requirement for application of direct method of apportionment. Likewise, for evaluation as to whether commission is market related, it is necessary to conduct FAR analysis, which perhaps, the Court felt that was not possible. Hence, it may perhaps be on account of the feature that the aforesaid observations relevant evaluation of commission were made and not as a general proposition of law.

However, if the observations are read to mean that the Court held that payment of commission at ALP to agent would not exhaust further apportionment of profit, then it deviates to that extent from the Indian position. In DIT v. Morgan Stanley & Co., (2007) 292 ITR 416 (SC), it was observed that if a PE is remunerated on arm’s-length basis (ALP) taking into account all the risk-taking functions of the enterprise, then there is no further requirement to attribute profit. The Supreme Court further observed that if transfer pricing analysis does not adequately reflect the functions performed and risks assumed by the enterprise, then in such situation, there would be a need to attribute further profits to PE.

The Supreme Court decision was explained in eFunds Corporation v. ADIT, (2010) 42 SOT 165 (Del.) and Rolls Royce Plc v. DDIT, (2009) 34 SOT 508 (Del.). The Tribunal, after taking note of the Supreme Court observations, stated that the as-sessment of PE gets extinguished only if the following two conditions are cumulatively met:

(i)    The associate enterprise has been remunerated on arm’s-length basis and

(ii)    Having regard to FAR analysis, nothing more can be attributed to PE.

Both the decisions of Tribunal observe, if remuneration to the agent does not take into account all the risk taking functions of the non-resident enterprise, then in such case there would be a need to attribute profits to the PE for those functions/risks of principals which are not covered by the agent’s remuneration.