Placement of computer equipments like servers and routers in India by a foreign entity
does/ does not amount to Permanent Establishment of the foreign entity in India
Countries negotiate bilateral tax treaties to govern the tax treatment of cross-border transactions. Under most tax treaties, a company that sells goods and services to foreign markets can have its profits taxed by the foreign tax authority only if the company maintains a "permanent establishment (PE)" within the foreign jurisdiction (the "source country") and profits are attributable to this permanent establishment.
In the absence of any permanent establishment, the source country is not permitted to levy its income tax on any profits arising from the international transaction and the country where the business is based (the "residence country") will generally tax all of the profits.
According to the definition given by the OECD model tax convention Article 5 a "Permanent Establishment" means a fixed place of business through which the business of an enterprise is wholly or partly carried on.
The term "permanent establishment" typically includes:
a) A place of management;
b) A branch;
c) An office
d) A factory
e) A workshop, and
f) A mine, an oil or gas well, a quarry or any other place of extraction of natural resources
A non-resident or a foreign company is treated as having a Permanent Establishment in India under Article 5 of the Double Taxation Avoidance Agreements, entered into by India with different countries, if the said non-resident or foreign company carries on business in India through a branch, sales office etc. or through an agent (other than an independent agent) who habitually exercises an authority to conclude contracts or regularly delivers goods or merchandise or habitually secures orders on behalf of the non-resident principal.
Some primary characteristics of a permanent establishment are as follows:
· A place where the business of the employer is carried out
· Activities occur with a certain degree of regularity either daily, weekly or monthly
· There is a degree of permanence & continuity even when it is only for a specific period
· There is a person who has authority to authorize contracts or make decisions respecting the operations
Taken as a whole, the definitions of permanent establishment suggest the need for some geographic and temporal permanence that enables foreign businesses to conduct significant business activities within source countries. In other words, the permanent establishment must have some tangible physical presence that is not temporary in nature.
Now, the threshold question of whether or not “the placement of computer equipments like servers and routers in India by a foreign entity does/ does not amount to Permanent Establishment of the foreign entity in India” can be discussed in context of e-commerce.
E-Commerce is a subset of e-business. It is a commerce of conducting transactions using network of computers and telecommunication i.e. internet.
The rationale for the permanent establishment concept has historically rested on two main grounds. Firstly, the permanent establishment concept was reasonably easy to administrate for tax authorities. Secondly, the permanent establishment principle arguably represented a balanced rule from an international equity perspective. This sharing of tax revenues additionally made sense from an efficiency perspective because residence countries and source countries were now given an incentive to cooperate in reducing the chance for international double taxation, hence promoting international trade.
The emergence of e-commerce, however, upset this balance because physical locations are no longer required in foreign markets in order to engage in significant commercial activities. The issue whether computer equipments at a given location constitute a permanent establishment firstly depends on whether it meets the requirement of being “fixed”.
As such a distinction needs to be made between computer equipment, which may be set up at a location so as to constitute a PE, and the data that is used by or stored on that equipment. For instance, an Internet website which is a combination of software and electronic data, does not in itself constitute a tangible property and neither does it have a “place of business” as such it cannot constitute a PE.
On the other hand, the Server (tangible machines that are set up within the source country) are computers networked to the Internet having a physical location and such location may thus constitute a “fixed place of business” of the enterprise that operates the server.
Thus if the enterprise carrying on business through a website has the server at its own disposal for example owns or leases and operates the server, the place where that server is stored could constitute a PE. However such server cannot be a PE if merely hosting arrangements exist
To constitute a fixed place of business the server needs to be located there for a sufficient period of time to be treated fixed. However some countries have argued that the e-tailor’s business is carried on not through servers but enterprise offices warehouses etc. where its income generating activities take place yet the requirement that an e-tailor must have affixed place of business is not met by a server.
Preparatory or auxiliary activities can constitute a PE where such activities provide a communication link hence a router that acts as a gateway between 2 or more network junctions and buffers and transfers data among them (for example: the local network is connected to the Internet, and vice versa.) can constitute a PE provided that such functions are a core part of the enterprise and the equipment is fixed in the place of business.
Number of commentators and delegates of the OECD Model Tax Convention adopted by the Committee on Fiscal Affairs on 22 December 2000 have noted, it is unlikely that much tax revenues depend on the issue of whether or not computer equipment at a given location constitutes a permanent establishment.
In many cases, the ability to relocate computer equipment reduces the risks that taxpayers in e-commerce operations have found to have in permanent establishments, where they did not intend to. It is crucial, however, that taxpayers and tax authorities know where the borderlines are and that taxpayers not be put in a position to have a permanent establishment in a country without knowing that they have a business presence in that country (a result that is avoided by the conclusion that a web site cannot, in itself, constitute a permanent establishment).
Thus a server seems, at first glance, to fall within the traditional definition of permanent establishments. E-commerce importing nations will be tempted to assert that the server should constitute a permanent establishment under traditional international tax principles in order to protect their ability to tax the cross-border transactions.
These changes will result in the removal of physical intermediaries or dependent agents from foreign markets. These business model shifts will lead to the erosion of source country income tax revenues as long as international tax rules emphasize the need for a physical presence within source countries
With the development of the Internet, online retailers can now accomplish much of their sales and advertising strategies via a website that transfers transaction costs to customers, including activities such as product selection.
The Internet also permits businesses to gather information in foreign markets without having a physical presence in those markets and enables a number of administrative tasks to be performed remotely.
Still, a server operated by an e-commerce business that performs most or all of a business transaction would likely be considered to perform activities that, taken collectively, form an essential and significant part of the commercial transaction and therefore will be characterized as a permanent establishment under the OECD Proposal.
Further, it is suggested that the nature of this type of server-permanent establishment, especially its lack of personnel, is likely to mean that tasks performed by the server would likely be conducted under a “contract service provider” arrangement that would leave all substantial assets and risks with the head office and attribute to the permanent establishment the profits associated with the physical operation of the computer server.
Given the need for the permanent establishment to recognize, in computing profit, the arm’s length value of the tangible and intangible property that it uses and that were contributed to it by other parts of the enterprise, the conclusion would be.
The author can be reached at: email@example.com