A number of infrastructure and energy related projects are carried out by the foreign companies particularly because it requires highly sophisticated technology and expertise. In order to fulfil such projects, these foreign firms enter into EPC contracts (Engineering, Procurement and Construction Contract). More number of energy and infrastructure companies are willing to enter into EPC contracts because they clearly set out the duties and relationship of the project owner and contractor.
EPC contracts lay down the fixed time for completion of task, fixed price of the project, provides for single point of responsibility and mitigation of risk which gives certainty and clarity to the project owner. Under such a contract, the foreign company undertakes to design the project, procure the necessary goods and services and finally, construct the whole project. The foreign company may even sub-contract portions of this project. The project is handed over to the project owner just before its operation.
The complexity within these projects arises as the foreign companies may procure goods and services either from their country of which they are a resident or from the local lands of the project owner. This sort of division in procuring goods, supplies and services from different lands creates issue of taxation. For instance, foreign companies’ professionals might visit the source state to provide supervisory services to the persons working on the project. In such a case, issue of taxability may arise as these are offshore services which are being utilized in India. In most cases, the state can tax the global income of their resident states. Hence, the profits generated due to this service might be taxed by the resident state. However, if the non-resident foreign company establishes its permanent establishment in the source state, its income generated through offshore services may be taxed.
Permanent Establishment:
A permanent establishment(PE) implies a foreign company which brings itself under the taxable jurisdiction of the source state by its fixed and continuous presence in the source state. There are four kinds of PE: Construction, Service, Agency and Fixed Place PE. A foreign company that carries out construction or installation activities in source for a specific period of time establishes its construction PE. A service PE is set up when the foreign company’s professionals provide supervisory, technical or any other kind of services to the source company for a particular duration. Under an agency PE, the agent carries out tasks on behalf of the non-resident company in the source state.
The agent may even enter into contracts on behalf of the source state. A fixed place PE is formed if the non-resident company is carrying out business in the source state wholly or partially with some sort of permanence. Formation of PE depends on the tax treaty between the source state and resident state. The OECD Model tax treaty and the UN Model tax treaty provide different number of days for the establishment of construction, fixed place, service and agency PE in the source state. For example, under OECD Model a construction or installation activity carried out for more than 12 months in the source state would constitute establishment of a PE.
This tax treaty is also known as the Double Taxation Avoidance Agreement. As mentioned earlier, since the parties belong to two different countries, there might be areas which can be taxed by both the nations leading to the issue of double taxation. A DTA Agreement avoids this sort of ambiguity and declares the areas which the source state and resident state can tax. Article 5 of this DTA Agreement contains the conditions for setting a PE in the source state. Many foreign companies avoid the risk of establishment of PE in the source state as it might attract taxability from foreign enterprises’ offshore services and offshore supplies. Hence, the foreign companies must analyse the tax implications of their activities before carrying out any business operations in the source state by assessing and understanding the tax treaty.
Consequences of establishment of PE:
In case, a company establishes a PE in the source state, its ‘business income’ generated from those business activities in the source state will be taxed by the source state and not by the resident state. Article 7 envisages the scope of business income attributable with the PE which can be taxed in source state thereby, setting boundaries of fiscal jurisdiction between two countries. While the OECD Model clearly mentions that only those profits ‘directly attributed’ with the PE will be accounted for as ‘business income’, the UN Model envisages a wider rule for determining this business income.
Under the UN Model, profits that arise from ‘same or similar kind of activities conducted by the foreign enterprise with or without the involvement of PE would also be considered a ‘business income’ taxable in the source state. Hence, the UN Model taxes profits that are both ‘directly’ and ‘indirectly’ attributable with the PE. This is also why Article 7 of the UN Model is said to incorporate the limited Force of Attraction(FoA) rule.
Force of Attraction Principle
The FoA principle attracts those business incomes also under the fiscal jurisdiction of the source state which arise from activities that are conducted by the foreign enterprise directly in the source state and without the participation of the PE. One of the judgements of Indian Court in the case Linklaters LLP Vs. Income Tax Officertalked about the limited force of attraction rule included in the India-UK DTAA. It held that a project that has been carried out from outside India can also be taxed by India if some activities of ‘same or similar kind’ were conducted in India by the foreign enterprise. Hence, the global income generated from the project would be taxed in India. After this case, other cases such as Shanghai Electric Group Co. Ltd. Vs. DCIT and Deputy Commissioner Of Income Tax vs Roxon Oy also mentioned the presence of FoA clauses under Article 7 of India-China and India-Finland treaties and reiterated the same principle as under Linklaters.
The phrase ‘same or similar kind of activities’ under Article 7 was subject to interpretation under these cases. Court had to examine if the activities that were conducted by the PE were being directly conducted by the foreign enterprise in India to evade taxation. Therefore, the two conditions laid down for operation of FoA clause was that the foreign enterprise must have a PE in India and it must carry out same or similar kind of activities as the PE in the source state. Establishment of PE being a pre-requisite for the application of FoA rule. Rule of FoA is particularly important to fill the loopholes in taxation laws. Hence, the UN Model tax treaty provides an option to protect tax leakages through FoA.
Lately, many countries such as Norway and Australia have omitted the FoA clauses from their DTAAs with India. This implies that the efforts are driven towards increasing the scope of taxability for the resident state and decreasing the areas of taxability for the source state. One advantage of omitting this FoA clause is that it might encourage foreign investments in India thereby bolstering the infrastructure, energy and power related sectors in India. Infact, even if the FoA clause is being utilized under some treaties by India, it is restrictive in nature and does not invite huge tax liability with it. Hence, the investors are not discouraged with the presence of FoA clauses but, they might avoid a PE risk in India.
Domestic Law
The domestic laws are pretty much in consonance with the rules under the treaty. Section 5 and section 9 of Income Tax Act encapsulate that the income which arises in India or which is deemed to arise in India will be taxed in India. This means that if a foreign non-resident company establishes a PE in India, then, activities conducted by the PE would fall automatically under the taxable jurisdiction of the source state. In the Ishikawajima case, court held that after the establishment of PE, a clear ‘business connection’ must exist between the activities carried out by the company in the resident state and in the source state. Any such income arising out of this business connection would be taxable at the hands of source state. However, even without establishment of PE, firms may successfully earn income which arises from activities in India, this would cause tax leakages. In order to avoid such leakages, court held in the case of Hyundai Heavy Industries Ltd that India can tax a foreign non-resident entity if income arises out of its business connection between the activities conducted in resident state and activities carried out in the source state.
It can be culled out that there exists a distinction between PE and establishment of a ‘business connection’ as per section 9 of Income Tax Act. Business connection may exist even without the existence of a PE. Additionally, the ‘FoA clause’ under DTAA and ‘business connection’ under section 9 produce similar sort of result. Both of them attract those areas of business under taxability which might not be covered by the ordinary provisions leading to tax evasion. However, the distinction between the two is that enforcement of FoA rule requires establishment of PE however, establishment of a PE is not a necessity for proving a ‘business connection’ under section 9.
The tax areas of different contracting state depends upon the DTAAs between the two states. Each case has to be analysed based on the DTAAs and the facts of that case. Since the taxability of offshore services and supplies have been highly controversial and so, before commencing a business in a source state, foreign enterprises must understand the tax liabilities which may be attracted due to their business activities.
Conclusion
The complexity under DTAA poses many taxation issues. The courts and tribunals have indicated towards splitting these contracts to understand the offshore and onshore elements and charge taxes accordingly. Authorities are also working towards avoiding tax leakages through the DTAA. Due efforts and cooperation between all the authorities and continuous exchange of information with the other contracting state may help to avoid tax evasion and will establish a fair and just system for international taxation. EPC Contractors must also deliberate upon the tax liabilities which may arise through their activities and accordingly plan their business operations.
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