The concept of permanent establishment (PE) plays a pivotal role in international tax law in determining a taxpayer’s liability to have its business profits subjected to tax in the source state. As digitalisation continues to blur the lines of traditional business operations, the question of profit attribution becomes increasingly complex. One such challenge arises in a situation where a multinational entity’s (MNE’s) activities in a source state yield profit, while its overall performance at the group level results in losses. This scenario raises a critical legal question: whether profits generated by a PE in the source state can be attributed to the MNE in the event that the group has incurred losses.
A three-judge bench of the High Court of Delhi recently settled this controversy in the case of Hyatt International Southwest Asia Ltd. v Additional Director of Income Tax (Hyatt International), wherein the bench, inter alia, clarified that the profits attributable to a PE may be taxed in the hands of the MNE even though the group has incurred losses at a global level. This article delves into the impact of this judgment on MNEs with a business presence in India.
Analysis of the former position
The issue of whether profit attribution is warranted in the hands of a PE where an MNE is incurring losses at a group level has been subjected to significant judicial scrutiny time and time again. The issue traces its origin from the decision of a special bench of the Delhi Income Tax Appellate Tribunal (ITAT) in the case of Motorola Inc. v Deputy Commissioner of Income Tax (2005; Motorola), wherein the ITAT held that global profit or losses are a relevant and determinative factor for calculating if any profit is attributable to the PE.
The conclusions of the special bench were reaffirmed by the Delhi bench of the ITAT in the case of Nokia Solutions and Networks OY v Additional Commissioner of Income Tax (2022; Nokia Solutions), which, inter alia, held that the global profit margins should be applied to determine the income attributable to the PE in India. However, since the entity in this case was incurring losses at a global level, the ITAT held that no profit could be attributed to the PE in India. This decision was upheld by the High Court of Delhi in Commissioner of Income Tax v Nokia Solutions and Networks OY (2022).
Notably, the principle of hypothetical independence of a PE – which is fundamental to profit attribution, as outlined in Article 7 of India’s double taxation avoidance agreement (DTAA) with Finland – was not addressed in the case involving Nokia Solutions and Networks OY, which is headquartered in Finland.
Recently, a division bench of the High Court of Delhi, in Hyatt International Southwest Asia Ltd. v Additional Director of Income Tax (2023), expressed its reservations regarding the applicability of profit attribution principles set out in Nokia Solutions and referred the question for determination before a three-judge bench.
Analysis of the full bench’s Hyatt International ruling
With regard to the judgment dated September 19 2024, a full bench of the High Court of Delhi ruled that the income attributable to a PE must be assessed independently of the entity’s global profits or losses. Therefore, even if a foreign company has incurred losses at a global level, it may be required to pay taxes in India on the profits attributable to its PE in India. Some of the key observations of the bench in this regard were as follows:
The usage of the phrase “so much of them as is attributable to that permanent establishment” in Article 7 of the DTAA with the United Arab Emirates (with Hyatt International Southwest Asia Ltd. being headquartered in the United Arab Emirates) – read along with international commentaries, model tax conventions, etc. – mandates that a PE is a separate and an independent centre for the purpose of fiscal treatment and taxation.
Article 7 does not expand its reach to the overall operations or profitability of an enterprise. It is solely concerned with the profits or income attributable to the PE. The taxability of income earned by a PE is not even remotely linked to the overall operations of the enterprise of which it may be a part.
The bench in the Nokia Solutions case has misconstrued the rationale of the special bench in Motorola to hold that if the taxpayer has losses according to global accounts, no profit can be attributed to its PE in India.
If a taxpayer’s submissions were to be accepted, the tax authorities would have the power to tax a PE even when it has incurred losses and the MNE group has incurred profits. Since this interpretation is contrary to the intent of Article 7 of the DTAA with the United Arab Emirates, the argument of global accounts being relevant is untenable.
Final comments on the implications of the ruling
The ruling in Hyatt International marks a significant shift in the legal landscape in India concerning profit attribution to a PE. This is because, prior to this judgment, Indian judicial forums generally accepted that no profit attribution to a PE was warranted in cases where the MNE was incurring losses at a global level. In such cases, the judicial forum’s role was limited to testing the sanctity of the global financial statements and determining the enterprise’s profitability through alternative means if the financial statements were unacceptable (see the Delhi bench of the ITAT’s ruling in Nortel Networks India International Inc. v Assistant Director of Income Tax (2014) and Motorola).
However, pursuant to the Hyatt International ruling, MNEs with a PE in India can no longer escape the rigours of taxation in India merely because they are incurring losses at a global level. Thus, such MNEs must reassess their approach to taxation and compliance in India.
