Legally Bharat

Delhi High Court

Hyatt International Southwest Asia … vs Acit(International … on 19 September, 2024

Author: Yashwant Varma

Bench: Yashwant Varma, Sanjeev Narula, Purushaindra Kumar Kaurav

                   *       IN THE HIGH COURT OF DELHI AT NEW DELHI
                   %                                 Judgment reserved on: 05 July 2024
                                              Judgment pronounced on: 19 September 2024

                   +       ITA 216/2020
                           HYATT INTERNATIONAL SOUTHWEST
                           ASIA LTD                                 ..... Petitioner
                                        Through: Mr. S. Ganesh, Sr. Adv. with Mr.
                                                 U.A. Rana, Mr. Himanshu
                                                 Mehta, Advs.
                                                    versus
                           ADDITIONAL DIRECTOR OF INCOME TAX ...Respondent
                                        Through: Mr. Sanjay Kumar & Ms Easha,
                                                 Advs.
                   +       ITA 217/2020
                           HYATT INTERNATIONAL SOUTHWEST
                           ASIA LTD                                 ..... Petitioner
                                        Through: Mr. S. Ganesh, Sr. Adv. with Mr.
                                                 U.A. Rana, Mr. Himanshu
                                                 Mehta, Advs.
                                        versus
                           DEPUTY COMMISSIONER OF INCOME TAX ..Respondent
                                        Through: Mr. Sanjay Kumar & Ms Easha,
                                                 Advs.
                   +       ITA 218/2020
                           HYATT INTERNATIONAL SOUTHWEST
                           ASIA LTD                                 ..... Petitioner
                                        Through: Mr. S. Ganesh, Sr. Adv. with Mr.
                                                 U.A. Rana, Mr. Himanshu
                                                 Mehta, Advs.
                                        versus
                           ASSISTANT DIRECTOR OF INCOME TAX ...Respondent
                                         Through: Mr. Sanjay Kumar & Ms Easha,
                                                  Advs.
                   +       ITA 219/2020
                           HYATT INTERNATIONAL SOUTHWEST
                           ASIA LTD                                  ..... Petitioner
                                         Through: Mr. S. Ganesh, Sr. Adv. with Mr.
                                                  U.A. Rana, Mr. Himanshu
Signature Not Verified
Digitally Signed
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By:KAMLESH KUMAR
Signing Date:19.09.2024
16:08:04
                                                              Mehta, Advs.
                                                    versus
                           ADDITIONAL DIRECTOR OF INCOME TAX ...Respondent
                                        Through: Mr. Sanjay Kumar & Ms Easha,
                                                 Advs.
                   +       ITA 140/2021
                           HYATT INTERNATIONAL SOUTHWEST
                           ASIA LTD                                 ..... Petitioner
                                        Through: Mr. S. Ganesh, Sr. Adv. with Mr.
                                                 U.A. Rana, Mr. Himanshu
                                                 Mehta, Advs.
                                        versus
                           DEPUTY COMMISSIONER OF INCOME TAX ...Respondent
                                        Through: Mr. Sanjay Kumar & Ms Easha,
                                                 Advs.
                   +       ITA 36/2022
                           HYATT INTERNATIONAL SOUTHWEST
                           ASIA LTD                                 ..... Petitioner
                                        Through: Mr. S. Ganesh, Sr. Adv. with Mr.
                                                 U.A. Rana, Mr. Himanshu
                                                 Mehta, Advs.
                                        versus

                           ASSISTANT COMMISSIONER OF
                           INCOME TAX                                ...Respondent
                                        Through: Mr. Sanjay Kumar & Ms Easha,
                                                 Advs.
                   +       ITA 201/2023
                           HYATT INTERNATIONAL SOUTHWEST
                           ASIA LTD                          ..... Petitioner
                                        Through: Mr. S. Ganesh, Sr. Adv. with Mr.
                                                 U.A. Rana, Mr. Himanshu
                                                 Mehta, Advs.

                                                    versus

                           ACIT(INTERNATIONAL TAXATION)-2(1)(1),
                           NEW DELHI                        .....Respondent
                                        Through: Mr. Sanjay Kumar & Ms Easha,
                                                 Advs.
Signature Not Verified
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By:KAMLESH KUMAR
Signing Date:19.09.2024
16:08:04
                    +       ITA 215/2023
                           HYATT INTERNATIONAL SOUTHWEST
                           ASIA LTD                                 ..... Petitioner
                                        Through: Mr. S. Ganesh, Sr. Adv. with Mr.
                                                 U.A. Rana, Mr. Himanshu
                                                 Mehta, Advs.
                                        versus
                           ACIT (INTERNATIONAL TAXATION)-2(1)(1),
                           NEW DELHI                           .....Respondent
                                         Through: Mr. Sanjay Kumar & Ms Easha,
                                                  Advs.
                           CORAM:
                           HON'BLE MR. JUSTICE YASHWANT VARMA
                           HON'BLE MR. JUSTICE SANJEEV NARULA
                           HON'BLE MR. JUSTICE PURUSHAINDRA KUMAR
                           KAURAV
                                                    JUDGMENT

YASHWANT VARMA, J.

1. This Full Bench has been constituted as a consequence of a
Division Bench of the Court doubting the correctness of the view
expressed in Commissioner of Income-tax (international taxation)
vs. Nokia Solutions and Networks OY1. The Division Bench, while
referring the question for our consideration had doubted the view
expressed in Nokia Solutions that profit attribution to a Permanent
Establishment2 would be warranted only if the enterprise as a whole,
and the PE constituting merely a component thereof, had earned profits.

2. The appellants appear to have argued that in case the enterprise at
an entity level had suffered a loss in the relevant Assessment Year3, no
profit or income attribution would be warranted insofar as the PE is
concerned. When these batch of appeals were initially considered by

1
2022 SCC OnLine Del 5088
2
PE
3 AY

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the Court on 16 January 2023, the following order came to be passed:-

―1. One of the questions arising in the present petitions is whether
any taxable income can be attributed to the Permanent Establishment
(hereafter ―PE‖) in India if the overseas entity has incurred a loss in
the relevant assessment years.

2. Mr. S. Ganesh, learned Senior Counsel appearing for the
appellant, submits that Article 7 of the Double Taxation Avoidance
Agreement (hereafter ―DTAA‖) entered into between the
Government of United Arab Emirates and the Republic of India
applies only in cases where the assessee earns profit.

3. If it is accepted that Article 7 of the DTAA doesn’t apply; the
questions that would next follow are whether DTAA applies in the
context where there is a loss, and whether recourse to DTAA is
necessary for taxing the income of a permanent establishment in
India as an independent assessee.

4. According to the respondent, notwithstanding that an overseas
entity incurs a loss, if there is positive income attributable to the PE,
the same would be taxable notwithstanding Article 7(1) of the
DTAA.

5. Mr. Ganesh submits that the aforesaid questions are squarely
covered by the decision of the coordinate Bench of this Court
Commissioner of Income Tax (International Taxation)-2 v. M/s
Nokia Solutions And Networks OY; ITA 503 of 2022, decided on
02.12.2022. He has also drawn the attention of this Court to
Paragraph 11, 13 and 13.1 of the said decision, which read as under:

*** **** ***
―11. The Tribunal has returned a finding of fact, that the
respondent/assessee recorded a ―global net loss‖ in the
relevant assessment year, and therefore no profit been
attributed to it.

13. We may also note, that a plain reading of the Article 7 of
the Double Taxation Avoidance Agreement between India
and Finland also persuades us to take the same view as that
which is taken by the Tribunal.

13.1 A plain reading of the Article 7(1) would show, that the
issue of taxability would arise qua the respondent/assessee
only if profits accrue to the respondent/assessee, and that
too only to the extent they can be attributed to its PE in
India.‖

6. He submits that in view of the said decision, the question whether
any taxable income could be attributed to PE, would not arise in the
event, the assessee incurs a loss.

7. It is noted that although the observations made in the said decision

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appear to be squarely in favour of the appellant, it is also apparent
that various other contentions relevant for addressing the said
question have not been considered. This is also perhaps because the
Court had not framed any question regarding the applicability of
Article 7 of the DTAA.

8. Prima facie, this Court is of the view that if Article 7(1) of the
DTAA – which concerns with the attribution of profits of the
assessee – is not applicable in case the assesse incurs a loss, the
other provisions of the Income Tax Act, 1961, would be applicable
and any income arises or accrues within the territories of India
would be chargeable to tax.

9. Prima facie, if the establishment in India is generating profits, but
the other entities of the assessee overseas are incurring a loss, the
profits generated by the establishment, if otherwise chargeable under
the Income Tax Act, would be required to be assessed and taxed.

10. In this view, we are inclined to observe that the aforesaid issue
be referred to a larger Bench.

11. Mr. S. Ganesh submits that there are other questions which arise
in the present appeal and if those are decided in favour of the
assessee, the aforesaid issue may not be relevant.

12. He states that at the threshold, it is the assessee’s case that it has
no Permanent Establishment in India and if this issue is held in
favour of the assessee/ appellant, it may not be relevant to address
the issue as noted above.

13. Learned counsel for the respondent states that he is not prepared
to argue on the questions as framed earlier and requests for an
adjournment.

14. At his request, list on 13.02.2023.

15. The hearing fixed on 31.01.2023 stands cancelled.‖

3. The aspect of profit attribution to a PE again arose for
consideration as would be evident from a reading of the order dated 14
March 2023 and which is extracted hereinbelow: –

―1. On 05.07.2021, this Court had framed the following questions
for consideration in ITA 216/2020:

“(i) Has the Tribunal misconstrued the provisions of Article
7(1) of the DTAA entered into between the Government of
United Arab Emirates and the Government of the Republic
of India?

(ii) Whether the findings recorded by the Tribunal, in
paragraphs 56, 57 and 59 are perverse and contrary to the
terms of the Strategic Oversight Services Agreement
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(SOSA)?

(iii) Whether the Appellant has Permanent Establishment
in India within the meaning of Article 5(1) dehors the
parameters prescribed in Article 5(2) of the DTAA?

(iv) Whether, in the given facts and circumstances, the
provisions of Article 5(2) would prevail over the provisions
of Article 5(1) of the DTAA?

(v) Whether the Tribunal misdirected itself both in law and
on facts in holding that service charges received by the
Appellant under the various SOSA Agreements were taxable
as royalty?”

2. Similar questions were also raised in other connected appeals.

3. After hearing the parties, this Court is of the view that the
questions require to be slightly modified. The questions that arise for
consideration in these appeals are restated as under:

(i) Whether the Tribunal misdirected itself both in law
and on facts in holding that service charges received
by the Appellant under the various SOSA Agreements
were taxable as royalty?

(ii) Whether the Appellant has Permanent Establishment
in India within the meaning of the Double Taxation
Avoidance Agreement?

(iii) Whether the findings recorded by the Tribunal, in
paragraphs 56, 57 and 59 are perverse and contrary to
the terms of the Strategic Oversight Services
Agreement (SOSA)?

(iv) Is Article 7(1) of the DTAA at all applicable to the
Appellant, having regard to the fact that it has
incurred losses in the relevant financial years?

4. Insofar as the fourth question is concerned, this Court had, on
16.01.2023, expressed its view that the said question is required to
be considered by a larger Bench, considering this Court’s reservation
regarding the decision of the coordinate Bench of this Court in the
case of Commissioner of Income Tax (International Taxation)-2
vs. M/s Nokia Solutions and Networks OY; ITA 503 of 2022,
decided on 02.12.2022.

5. Mr. Ganesh, learned Senior Counsel appearing for the appellant
states that, at this stage, the appellant does not wish to press the
fourth question as stated above because the appellant’s appeals can
be decided on the basis of the first three questions.

6. He, however, reserves the right for pressing the said question at
an appropriate stage if the need so arises.

7. In view of the above, this Court considers it apposite to examine
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the first three questions as set out above in the first instance.

8. Learned Counsel for the parties agree that if the decision in any of
the three questions is in favour of the appellant, it would not be
necessary for this court to consider the fourth question and the same
will be taken as given up finally.

9. Arguments have been partly heard on the first three questions.

10. List for further proceedings on 20.04.2023‖.

4. It is on the aforesaid basis that the Court appears to have
proceeded to consider the challenge which stood raised and the issue of
applicability of Article 7 of the Double Taxation Avoidance
Agreement4 between India and the United Arab Emirates, in case
losses had been suffered at an entity level was reserved for further
consideration. The appeals were ultimately decided in terms of a final
judgment rendered on 22 December 2023. The Court had identified the
four principal questions which merited determination as being the
following:-

―(i) Whether the Tribunal misdirected itself both in law and on facts
in holding that service charges received by the Appellant under the
various SOSA Agreements were taxable as royalty?

(ii) Whether the Appellant has Permanent Establishment in India
within the meaning of the Double Taxation Avoidance Agreement?

(iii) Whether the findings recorded by the Tribunal, in paragraphs
56, 57 and 59 are perverse and contrary to the terms of the Strategic
Oversight Services Agreement (SOSA)?

(iv) Is Article 7(1) of the DTAA at all applicable to the Appellant,
having regard to the fact that it has incurred losses in the relevant
financial years?‖

5. As would be evident from the final decision rendered, Questions

(i) and (ii) came to be answered in the affirmative. The Court while
considering Question (iii) came to hold that the findings rendered by
the Income Tax Appellate Tribunal5 on payments being liable to be

4 DTAA
5 Tribunal

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viewed as royalty under Article 12 were unsustainable.

6. Question (iv), in light of the earlier orders of 16 January 2023
and 14 March 2023, was reserved and referred for our consideration. It
however becomes pertinent to take note of the following observations
which appear in the final judgment insofar as the issue of attribution is
concerned. We deem it apposite to extract paragraphs 33 to 36 of the
final judgment hereinbelow: –

―Re: Question No. (iv)

33. One of the principal contentions advanced by the Assessee is that
even if it is assumed that the Assessee has a PE in India, there is no
question of attributing any amount as income chargeable to tax
under the Act to its PE, as it has incurred a loss on an entity level
(global basis). According to the Assessee, income chargeable to tax
under the Act could be attributed to its PE in India only if the
Assessee had made profit on an entity level. Concededly, the said
issue is covered in favour of the Assessee by a decision of the
Coordinate Bench of this Court in Commissioner of Income Tax
(International Taxation)-2 v. M/s Nokia Solutions and Networks
OY. However, we have some reservations regarding the said view.

34. The profits attributable to the Assessee’s PE in India are required
to be determined on the footing that the PE is an independent taxable
entity. It is, thus, possible that an Assessee makes a net loss at an
entity level on account of losses suffered in other jurisdictions,
which is partly offset by profits arising from India. In these
circumstances, if it is held that the Assessee has a PE in India, prima
facie the Assessee would be liable to pay tax on the income
attributable to its PE in India notwithstanding the losses suffered in
other jurisdictions. This aspect was not deliberated in the case of
Commissioner of Income Tax (International Taxation)-2 v. Nokia
Solutions and Networks OY.

35. This Court was of the view that the fourth question as raised by
the Assessee ought to be referred to a larger Bench. This was
recorded by this Court in an order dated 14.03.2023. However, the
learned senior counsel appearing for the Assessee had requested this
Court to consider the other questions and had asserted that the
Assessee would not press the fourth question, if the Assessee’s
appeals are disposed of in its favour on the basis of the other
questions as framed. The learned counsel for the parties had also
agreed that if the appellant succeeded before this Court in respect of
the first three questions, the Assessee would finally give-up the
fourth question without any recourse.

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36. In view of the above, this Court is confining further deliberations
to the first three questions as set out above.‖

7. As is apparent from the tentative observations entered by the
Division Bench, it found itself unable to concur with the submission
that income attribution would be impermissible if the enterprise had on
a global level suffered a loss. The Division Bench observed that the
issue of attribution of profits to a PE in India would have to be
determined on the basis of the latter being considered to be an
independent taxable entity. It thus opined, prima facie, that once it is
found that the assessee has a PE in India, it would be liable to pay tax
on such income in India notwithstanding the losses that the enterprise
as a whole may have suffered in other jurisdictions.

8. Nokia Solutions was considering a challenge to a decision
rendered by the Tribunal and which in turn had sought to draw
sustenance for holding that global profit or loss would constitute a
relevant factor for attributing income to a PE on the basis of a decision
rendered by a Special Bench of the Tribunal in Motorola Inc. Vs.
Deputy Commissioner of Income Tax, Non-Resident Circle New
Delhi (and vice-versa)6.

9. While noticing the aforesaid, the Court in Nokia Solutions had
held as follows:-

―10. We may note, that the impugned order passed by the Tribunal
has proceeded on the basis, albeit on a demurrer, that the
respondent-assessee has a permanent establishment (“PE”) in India,
and thereafter gone on to discuss, as to whether any profits could be
attributed to it.

11. The Tribunal has returned a finding of fact, that the respondent
assessee recorded a “global net loss” in the relevant assessment year,
and therefore no profit could have possibly been attributed to it.

6

2005 SCC OnLine ITAT 1
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11.1 A discussion on this aspect is set forth in the following
paragraphs of the impugned judgment passed by the Tribunal (page
88 of 97 ITR (Trib)) :

“The assessee emphatically denies that the appellant has
a permanent establishment in India. However, without any
prejudice to that basic contention, the assessee submitted
that even assuming without conceding that the assessee has
a permanent establishment in India, no profit or income can
at all be attributed to the permanent establishment as the net
profit of the assessee is loss and there are no taxable
attributable profits available. The Assessing Officer has
incorrectly determined the profits taking into gross profit
into consideration and if the net profit is taken into
consideration rightly, then the issue as to whether the
assessee has a permanent establishment in India would end
up as an academic issue.

The attribution of profits (net profit) stands covered in
favour of the appellant by the judgment of the Special
Bench in the case of Nokia Corporation for the assessment
year 1997-98 and 1998-99 (involving same business as
carried out by the appellant) as mentioned in the paper book
Volume C-page 936, at 949-950 (para 287). The Special
Bench held that the appellant-company’s world wide net
profit margins as per its audited accounts are to be applied
for determining the quantum of the income to be attributed
to the permanent establishment. The effect being if the
appellant-company is in net loss as per its audited accounts
or the calendar years 2009 and 2010, which relate to the
present assessment year 2010-11, there would be no profit
or income attributable to the permanent establishment.
There are losses in both years as per the audited accounts.
Paper book- Volume A of compilation page 164, at 169 and
page 180 at 185. The relevant portion of the said Special
Bench Judgment is quoted herein below (page 287 of
Volume C, at page 949-950) :

‘287 … Taking all these into consideration, we
consider it fair and reasonable to attribute 20 per cent.
of the net profit in respect of the Indian sales as the
income attributable to the permanent establishment.
The following steps are involved in computing the
income attributable to the permanent establishment :
First the global sales and the global net profit have to
be ascertained. From the accounts presented before us
as well as before the Income-tax authorities, the
global net profit rate has been ascertained at 10.8 per
cent. and 16.1 per cent. by the Commissioner of
Income- tax (Appeals), to which no objection has
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been taken by either side. This percentage has to be
applied to the Indian sales and by Indian sales, we
mean the total contract price for the equipment as a
whole and not the bifurcated price which the
Assessing Officer has referred to in the assessment
order. This will also be consistent with our view that
the software and the hardware constitute one
integrated equipment. The resultant figure would be
the net profit arising in respect of the Indian sales. Out
of this figure of net profit 20 per cent. shall be
attributed to the permanent establishment to cover the
three activities mentioned above. The Assessing
Officer is directed to compute the income of the
permanent establishment as directed above.’
The Revenue appealed before the hon’ble Delhi High Court
against the said Special Bench judgment and the only
ground raised by the Department was with regard to the rate
of net profit (20 per cent.) applied by the Special Bench and
not with regard to the method of taking the net profit rate of
the foreign enterprise. The Revenue Department has thus
accepted the finding of the Special Bench with regard to the
net profit margin method and has allowed that finding to
become final. The same method of attribution of profits to
the permanent establishment on the basis of the net profit
rate of the foreign enterprise has been applied by the
Revenue in the cases of three other assessees who were in
the same field of business as the appellant, viz., ZTE,
Huawei and Nortel. Each of these assessees was engaged in
the supply of telecom equipment to Indian telecom
operators. The Income-tax Appellate Tribunal order passed
in the case of Notel specifically records that in the cases of
each of these two assessees, the Revenue had adopted the
net profit rate of the foreign enterprise for determining the
amount of profit income which was attributable to each
enterprise’s respective permanent establishment. Hence,
applying the said Special Bench judgment to the facts of the
present case, as the appellant has global net loss as per its
audited accounts, no profit or income can be attributed to
the assessee in India.

To mention Special Bench ruling is in line with the
provisions of article 7(1) of the India Finland Double
Taxation Avoidance Agreement (DTAA), which is set out
at page 719, at 723 of Volume B of the compilation. For the
sake of convenience, article 7(1) is reproduced hereunder:

1. The profits of an enterprise of a Contracting State
shall be taxable only in that State unless the enterprise
carries on business in the other Contracting State
through a permanent establishment situated therein. If
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the enterprises carries on business as aforesaid, the
profits of the enterprise may be taxed in the other
State but only so much of them as is attributable to
that permanent establishment.’
Article 7( 1) thus provides as under :

‗(a) The profits of an enterprise can ordinarily be
taxed only by the country in which it is located.

(b) If however, the enterprise has a permanent
establishment located in another country (which is
also a signatory to the Double Taxation Avoidance
Agreement), through which it carries on its business,
then a portion of its profits, to the extent it is
attributable to the permanent establishment can be
taxed in the other country.’
On a plain reading of article 7 (1) of the Double Taxation
Avoidance Agreement, the question of attributing profits to
the permanent establishment arises only if the foreign
enterprise is making a profit. This is the condition
precedent. If it is making a loss then no question arises at all
of attributing any profit to the permanent establishment,
which would be taxable in India.

The Assessing Officer has taken gross profit margins of the
appellant-company for 2009 and 2010 as per its audited
accounts instead of the net profit margins. The gross profit
margins of the appellant-company for 2009 and 2010 were
positive, and that was how the Assessing Officer could
attribute profits to the permanent establishment. In so
adopting the gross profit margins of the appellant-company,
the Assessing Officer has acted in a manner which is
directly contrary to article 7(1) of the Double Taxation
Avoidance Agreement and also contrary to the said Special
Bench judgment. It is the net profit margins which are to be
considered as for attribution as per the Double Taxation
Avoidance Agreement.

The computation made by the Assessing Officer in his
assessment order is incorrect as the Assessing Officer has
not allowed the payments made by the appellant to NSN
India for the services rendered by NSN India as a deduction
from the profit attributable to the alleged permanent
establishment. If the said payments are allowed as a
deduction from the gross profit figures taken by the
Assessing Officer, then again the resultant figure would be
losses. Consequently, even if the method of attribution
adopted by the Assessing Officer is considered to be
correct, in any event, there would be no profit/income

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attributable to the permanent establishment. The
computation is as under :

xxxx xxxx xxxx

29. Consequently, even if the appellant has a permanent
establishment in India, no profit or income can in law at all
be attributed to permanent establishment which would be
taxable in India. Hence, we hold that, the adjudication on
issue of permanent establishment would be academic in
nature.

12. Having regard to the following finding of fact returned by the
Tribunal, we are of the view that the proposed questions of law, i. e.,
A and B would not arise for consideration.

13. We may also note, that a plain reading of the article 7 of the
Double Taxation Avoidance Agreement entered into between India
and Finland also persuades us to take the same view as that which is
taken by the Tribunal.

13.1 A plain reading of the article 7(1) would show, that the issue of
taxability would arise qua the respondent-assessee only if profits
accrue to the respondent-assessee, and that too only to the extent
they can be attributed to its permanent establishment in India.

14. Given this position, we are not inclined to entertain the appeal.‖

10. It becomes pertinent to note that the Tribunal while considering
the appeal preferred by Nokia Solutions had noticed the decision of the
Special Bench in the assessee’s own case and which formed part of a
batch of connected appeals including the one preferred by Motorola
Inc. in the following context. Apart from a host of other issues which
were raised for the consideration of the Special Bench of the Tribunal,
the penultimate question was with respect to attribution of income. This
becomes apparent from a reading of paragraphs 423 to 427 and which
read as follows: –

“423. We have considered the matter of attribution of income to the
PE carefully. For the assessment year 1997-98 the Assessing Officer
has first bifurcated the value of the total supply of equipment i.e.
both hardware and software into 70% for hardware and 30% for
software. 70% of the supply value comes to Rs. 102,63,12,952/-. He
has estimated the income at 40% thereof which comes to Rs.
41,05,25,180. From this figure he has deducted 5% as permissible
expenses u/s 44C of the Income-Tax Act which comes to Rs.

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2,05,26,259. The balance of Rs. 38,99,98,921 has been taken as the
taxable income from hardware and is taxes @ 55%. A similar
procedure has been adopted in the assessment year 1998-99, except
that tax has been charged @ 48%. The CIT (Appeals) in paragraph 7
of his order for the assessment year 1997-98 has reduced the income
to 5% of the sales to Indian parties. While doing so he has noted that
the profit and loss account relating to Indian operations of the
assessee is not substantiated with any documents and is, therefore,
not reliable for the purpose of computing the income from sale of
hardware. He has accordingly taken the assistance of Rule 10 of the
Income-tax Rules to compute the profits on the basis of assessee’s
global accounts. He has noted that the global accounts showed a net
profit of 10.8%. The net profit on Indian sales was, therefore, taken
at 10.8% but the CIT (Appeals) held that since the whole of this
profit cannot be attributed to the Indian operations as the activities
relating to manufacture and development of the products were
undertaken outside India, he has ultimately held that the profits
attributable to operations in India should be taken at 5% of the sales
to the Indian parties. For the assessment year 1998-99, he has taken
7.9% of the sale value considering the fact the net profit on Indian
sales was 16.1% as against 10.8% in the preceding year.

424. The Department in its appeals has taken the ground that the
CIT(Appeals) was not justified in reducing the income from 40% of
the value of the hardware to 5% of the sales to Indian parties.
Actually, for the assessment year 1998-99, the ground should be that
the CIT(Appeals) was not justified in reducing the income to 7.9%.
It appears to be a mistake in drafting the ground No. 1. On the other
hand the assessee in its appeals has taken up several contentions
including the contention that no income can be attributed to the PE at
all primarily because whatever expenses that are incurred by it are
compensated by the assessee on cost plus basis, that if the
expenditure incurred by the PE is taken into account then there will
be no income left to be assessed, that there are several activities
which do not lead to the existence of the PE and, therefore, they
cannot contribute to the revenues of the PE, that no income can be
attributed to the supervision because the supervision is only an
incident of the sale and does not constitute an operation by itself, that
the India specific accounts were wrongly rejected by the CIT
(Appeals) and that at any rate the adoption of 5% and 7.9% of the
sales to Indian parties is arbitrary and excessive.

425. We have carefully considered the argument raised by the
Department as well as the assessee. In the present case it cannot be
disputed that the research and development activities and the
manufacture of the GSM equipment took place wholly outside India.
W have also found, for reasons stated earlier, that the title and risk in
the equipment also passed wholly outside India. The only activities
which the assessee carried on in India through its PE were:

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a) Net work planning,

b) Negotiations in connection with the sale of equipment, and

c) The signing of the supply and installation contracts.

426. In the case of Ahmadbhai Umarbhar, 18 ITR 472, the Supreme
Court held that the income attributable to the manufacturing activity
should be more then the income attributable to the activity of sale. In
the case of Annamalia Timber Trust & Co. v. CIT, 41 ITR 781, the
Madras High Court approved the tribunal’s decision that 10% of the
income can be attributed to the signing of the contracts in India.
The
Calcutta High Court also approved the same percentage as income
attributable to the signing of the contracts in India in the case
of CIT v. Bertram Scott Ltd., 31 Taxman 444. We have kept the
principles laid down in these judgments in mind. In the present case,
as already noted, in addition to the signing of the contracts in India,
the preliminary negotiations for the contracts and the network
planning were carried out through the PE. We may clarify here that
the network planning activity is different from the activities which
are of the preparatory or auxiliary character. In respect of signing of
contracts, alone, the income attributed is 10% in the decisions cited
above. Two more activities have been carried out by the PE in India
and, therefore, we have to attribute a higher income than what was
attributed in the decided case. The negotiations which ultimately
lead to the signing of the contracts may involve more effort on the
part of the PE and the signing of the contracts is only the
fructification of those efforts. Obviously, therefore, the income
attributable to the negotiations part should be more and in addition
to the income attributable to the signing of the contracts. Some
income has to be attributed to the net work planning also. Taking all
these into consideration, we consider it fair and reasonable to
attributable 0% of the net profit in respect of the Indian sales as the
income attributable to the PE. The following steps are involved in
computing the income attributable to the PE.

427. First the global sales and the global net profit have to be
ascertained. From the accounts presented before us as well as before
the Income-tax authorities, the global net profit rate has been
ascertained at 10.8% and 6.1% by the CIT (Appeals) to which no
objection has been taken either side. This percentage has to be
applied to the Indian sales and by Indian sales, we means the total
contract price for the equipment as a whole and not the bifurcated
price which the Assessing officer has referred to in the assessment
order. This will also be consistent with our view that the software
and the hardware constitute one integrated equipment. The resultant
figure would be the net profit arising in respect of the Indian sales.
Out of this figure of net profit 20% shall be attributed to the PE to
cover the three activities mentioned above. The A.O. is directed to
compute the income of the PE as directed above.‖

11. As is evident from the aforesaid extracts of that decision, the
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reference to global sales and global net profit was made in the backdrop
of the parties having failed to produce adequate material which may
have independently established the profit margin of the PE in India. It
was in the aforesaid backdrop that the Special Bench of the Tribunal
ultimately appears to have held that a net profit of 20% should be
attributed to the PE.

12. By the time the issue again arose for consideration of the
Tribunal for AY 2010-11, it proceeded on the basis that the question of
attribution already stood answered in light of the judgment handed
down by the Special Bench pertaining to AYs’ 1997-98 and 1998-99. It
was on the aforesaid basis that the Tribunal observed that since the
Special Bench had already held that it would be Nokia’s worldwide net
profit margin which was to be applied for determining the quantum of
income attributable to the PE, the same principle should apply and
govern the issue for AY 2010-11. It thus held that since Nokia on a
global scale had suffered a net loss, no profit or income could be
attributed to its PEs’.

13. The Tribunal also appears to have borne in consideration the fact
that the Revenue while pursuing its appeal before this Court against the
judgment rendered by the Special Bench in Motorola Inc. had confined
it to the ultimate rate of net profit which had been applied. It thus took
the view that the Revenue would be deemed to have accepted the legal
position as propounded by the Special Bench, namely, of global profit
or loss being relevant and determinative.

14. Our Court while ultimately upholding the view taken by the
Tribunal in the case of Nokia Solutions dismissed the appeal of the
Revenue holding that the view expressed by the Tribunal did not merit

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consideration. However, while doing so, the Court also observed that a
plain reading of Article 7 persuades it to affirm the view that was taken
by the Tribunal. This was further reiterated with the Court observing
that the issue of taxability could arise only if profits had accrued to the
assessee and that too only to the extent attributable to its PE in India.

15. Appearing for the assessee, Mr. S. Ganesh, learned senior
counsel, at the outset contended that once the Revenue had accepted the
formulation of the legal position by the Special Bench of the Tribunal
in Motorola Inc. and had restricted its challenge only to the prescription
of a profit percentage, it would not be permissible for them to re-agitate
those questions.

16. Apart from the above, Mr. Ganesh commended for our
acceptance the view expressed by the Court in Nokia Solutions when it
had observed that the question of taxability would arise only if profits
had accrued to the assessee at a global level. According to learned
senior counsel, a plain and textual reading of Article 7 of the DTAA
would also lead us to the same conclusion.

17. According to Mr. Ganesh, on a reading of Article 7 of the DTAA,
it would be apparent that the profits of an enterprise based in UAE
would ordinarily be taxable only in that State and not in India. It was
his submission that if the enterprise based in the UAE were making a
loss, the question of taxability either in UAE or in India would not arise
at all. According to learned senior counsel, only if an enterprise were
making a profit, could a PE through which it carries on business be
subjected to tax and that too restricted to so much of the profit as is
attributable to that PE. Consequently, according to Mr. Ganesh, for a
foreign enterprise to be taxed in India, the following three conditions

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precedent would have to be conjunctively satisfied: –

A) The foreign enterprise must be making a profit;
B) The foreign enterprise has a PE in India; and
C) At least a part of the profit made by that enterprise is attributable
to its PE in India and that part alone being liable to be taxed.

Learned senior counsel thus submitted that if a foreign enterprise
like the appellant were making a loss, the question of attributing any
profit to its PE in India would not arise and consequently that enterprise
would have no tax liability in India.

18. Appearing for the Revenue, Mr. Kumar addressed the following
submissions for our consideration. Learned counsel at the outset,
submitted that the judgment of the Court in Nokia Solutions is clearly
being read out of context and is distinguishable on facts. It was
submitted that although the decision of the Special Bench of the
Tribunal was subjected to an appeal before this Court, the same came to
be dismissed with the Court refraining from even framing a question of
law. Mr. Kumar contended that the Court in Nokia Solutions had
refrained from rendering any definitive findings as would be apparent
from the operative parts of that decision. Learned counsel sought to
make good the aforesaid submission by inviting our attention to the
following observations as appearing in that order of dismissal: –

―12. Having regard to the following finding of fact returned by the
Tribunal, we are of the view that the proposed questions of law, i. e.,
A and B would not arise for consideration.

13. We may also note, that a plain reading of the article 7 of the
Double Taxation Avoidance Agreement entered into between India
and Finland also persuades us to take the same view as that which is
taken by the Tribunal.

13.1 A plain reading of the article 7(1) would show, that the issue of
taxability would arise qua the respondent-assessee only if profits

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accrue to the respondent-assessee, and that too only to the extent
they can be attributed to its permanent establishment in India.

14. Given this position, we are not inclined to entertain the appeal.‖

19. It was thus sought to be contended by Mr. Kumar that this Court
ultimately declined to entertain the appeal of the Revenue in light of the
findings of fact which had come to be rendered by the Tribunal.
According to learned counsel, the decision of this Court in Nokia
Solutions, and the correctness of which has been doubted by the Bench
while referring the matter for our consideration, came to be rendered
primarily influenced by the fact that the Revenue had failed to question
the method of attribution and the net profit rate as was adopted by the
Special Bench. According to learned counsel, the same must
consequently be read as confined to the peculiar facts which obtained
and that the said decision cannot possibly be read as an authority for the
proposition of a global profit being an aspect of import insofar as
attribution under Article 7 is concerned.

20. Proceeding then to the DTAA itself, it was Mr. Kumar’s
contention that the Convention clearly contemplates an exercise of
attribution being undertaken under Article 7 in light of the PE being
treated as a separate and distinct enterprise in itself. According to Mr.
Kumar, Article 7 mandates the attribution of profits to a PE
acknowledging it to be a distinct and separate enterprise and thus such
an exercise being undertaken independently.

21. According to learned counsel, the determination of business
profit as per Article 7 is mandated to be undertaken on the basis that the
PE is a separate enterprise and is operating independently of the
enterprise of which it may be a PE. According to learned counsel, a
reading of the provisions of the DTAA would lead one to the irresistible
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conclusion that the only relevant consideration for answering the
question of business profit is the activities undertaken by the PE at its
individual level and uninfluenced by the activities of the enterprise of
which it may be a part.

22. In view of the aforesaid, it was contended that the taxability of
the profit of the PE would have no connection with either the profit or
the loss which the assessee earns or suffers at a global level. In view of
the above, it was contended that the view expressed by the Court in its
judgment of 22 December 2023 should be affirmed and the tentative
view expressed therein confirmed as being representative of the correct
position in law.

23. Mr. Kumar also sought to draw support for the aforenoted
submissions from paragraphs 11 and 12 of the Commentary on Article
7 of the Model Tax Convention on Income and on Capital-
Condensed Version7 dated 17 July 2008 and which read as follows:-

―11. When referring to the part of the profits of an enterprise that is
attributable to a permanent establishment, the second sentence of
paragraph 1 refers directly to paragraph 2, which provides the
directive for determining what profits should be attributed to a
permanent establishment. As paragraph2 is part of the context in
which the sentence must be read, that sentence should not be
interpreted in a way that could contradict paragraph 2, e.g. by
interpreting it as restricting the amount of profits that can be
attributed to a permanent establishment to the amount of profits of
the enterprise as a whole. Thus, whilst paragraph 1 provides that a
Contracting State may only tax the profits of an enterprise of the
other Contracting to the extent that they are attributable to a
permanent establishment situated in the first State, it is paragraph 2
that determines the meaning of the phrase ―profits attributable to a
permanent establishment‖. In other words, the directive of paragraph
2 may result in profits being attributed to a permanent establishment
even though the enterprise as a whole has never made profits;

conversely, that directive may result in no profits being attributed to
a permanent establishment even though the enterprise as a whole has
made profits.

7

OECD Commentary 2008
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12. Clearly, however, the Contracting State of the enterprise has an
interest in the directive of paragraph 2 being correctly applied by the
State where the permanent establishment is located. Since that
directive applies to both Contracting States, the State of the
enterprise must, in accordance with Article 23, eliminate double
taxation on the profits properly attributable to the permanent
establishment. In other words, if the State where the permanent
establishment is located attempts to tax profits that are not
attributable to the permanent establishment under Article 7, this may
result in double taxation of profits that should properly be taxed only
in the State of the enterprise.‖

24. Having noticed the submissions which were addressed by
respective parties, it would be appropriate to deal with the submission
of Mr. Ganesh who had argued that once the Revenue had accepted the
decision of the Special Bench in Motorola Inc. it would not be
permissible for it to take a contrary stand or contend that the profit or
loss of an enterprise at a global level would be irrelevant.

25. We find ourselves unable to sustain that submission for the
following reasons. Firstly, and at the outset, it must be borne in mind
that this Full Bench is called upon to consider a question of law which
stands referred for its consideration. It is clearly not concerned with
whether the Revenue could have maintained an appeal or not as also
whether it was estopped from taking a particular position in law
notwithstanding the dismissal of its appeal preferred against Motorola
Inc. We thus find ourselves unable to recognise any impediment
restricting the Revenue from advocating the acceptance of a particular
position on a question of law.

26. More importantly, and in our considered opinion, the arguments
of the appellants based on the decision of the Special Bench in
Motorola Inc. are clearly misconceived and rest merely on a stray
observation which appears in that decision. The Tribunal while
deciding Nokia Solutions also appears to have similarly misconstrued
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those observations as would be evident from the discussion which
ensues.

27. As is apparent from a careful reading of paragraphs 423 and 424
of Motorola Inc., the Special Bench found that authorities had found
themselves unable to place any credence on the profit and loss account
of the Indian PE since it had not been substantiated. It then proceeded
to outline the steps that would be involved in computing the income
attributable to the PE. It was in the aforesaid context that it observed
that “First the global sales and the global net profit have to
ascertained.” It then proceeded to observe that the global net profit had
been identified to be 10% and 6.8% in the first appeal proceedings. It
thus held that it would be appropriate to set apart 20% of that figure as
the net profit of the PE.

28. It is therefore apparent that the observations appearing in
Motorola Inc. have clearly been misinterpreted and read wholly out of
context. The decision of the Special Bench cannot possibly be read as
being an authority for the proposition which is canvassed for our
consideration by the appellants in these proceedings. The Tribunal in
Nokia Solutions had ultimately held that ―….as the Appellant has global
net loss as per audited accounts, no profit or income can be attributed
to the PE.‖ The Tribunal too appears to have completely misconstrued
Motorola Inc. as purporting to enunciate a binding legal principle of
global loss being pertinent for the purposes of considering whether
income is allocable to the PE. We thus find ourselves to read or
construe the decision of the Special Bench as lending credence to the
contentions which were canvassed at the behest of the appellants in
these proceedings. The aspect of a failure on the part of the Revenue to
question or assail the observations entered by the Special Bench,
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consequently, pale into insignificance.

29. However, and this we do propose to clarify. The observations that
appear hereinabove are rendered solely in the context of our endevour
to enunciate the correct legal position which would obtain and are not
intended to shroud the ultimate judgment which the Court rendered and
would continue to bind parties.

30. Having put the preliminary submissions to rest, and before we
commence our discussion on the principal question that stands posited,
it would be appropriate to notice the salient provisions of the DTAA
Article 3(1)(g) defines the expressions ―enterprise of a contracting
state and enterprise of the other contracting State‖ as follows: –

―ARTICLE 3
GENERAL DEFINITIONS

1. In this Agreement, unless the context otherwise requires:

xxx xxx xxx

(g) the terms ―enterprise of a Contracting State‖ and ―enterprise of
the other Contracting State‖ mean respectively, an enterprise carried
on by a resident of a Contracting State and an enterprise carried only
a resident of the other Contracting State ;

31. A PE is defined by Article 5 in the following terms: –

―ARTICLE 5
PERMANENT ESTABLISHMENT

1. For the purposes of this Agreement, the term “permanent
establishment” means a fixed place of business through which the
business of an enterprise is wholly or partly carried on.

2. The term “permanent establishment” includes especially :

(a) a place of management ;

(b) a branch ;

(c) an office ;

(d) a factory ;

(e) a workshop ;

(f) a mine, an oil or gas well, a quarry or any other place of
extraction of natural resources ;

(g) a farm or plantation ;

(h) a building site or construction or assembly project or
supervisory activities in connection therewith, but only where
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such site, project or activity continues for a period of more than
9 months ;

(i) the furnishing of services including consultancy services by
an enterprise of a Contracting State through employees or other
personnel in the other Contracting State, provided that such
activities continue for the same project or connected project for
a period or periods aggregating more than 9months within any
twelve-month period.

3. Notwithstanding the preceding provisions of this Article, the term
“permanent establishment” shall be deemed not to include :

(a) the use of facilities solely for the purpose of storage, display
or delivery of goods or merchandise belonging to the enterprise ;

(b) the maintenance of a stock of goods or merchandise
belonging to the enterprise solely for the purpose of storage,
display or delivery ;

(c) the maintenance of a stock of goods or merchandise
belonging to the enterprise solely for the purpose of processing
by another enterprise ;

(d) the maintenance of a fixed place of business solely for the
purpose of purchasing goods or merchandise, or of collecting
information, for the enterprise ;

(e) the maintenance of a fixed place of business solely for the
purpose of carrying on, for the enterprise, any other activity of a
preparatory or auxiliary character.

4. Notwithstanding the provisions of paragraphs (1) and (3), where a
person – other than an agent of independent status to whom
paragraph (5) applies – is acting on behalf of an enterprise and has,
and habitually exercises in a Contracting State an authority to
conclude contracts on behalf 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 the purchase of
goods or merchandise for the enterprise.

5. An enterprise of a Contracting State shall not be deemed to have a
permanent establishment in the other Contracting State merely
because it carries on business in that other State through a broker,
general commission agent or any other agent of an independent
status, provided that such persons are acting in the ordinary course
of their business. However, when the activities of such an agent are
devoted wholly or almost wholly on behalf of that enterprise, he will
not be considered an agent of independent status within the meaning
of this paragraph.‖

32. The subject of business profits and its taxability is regulated by
Article 7 which reads as under: –

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―ARTICLE 7
BUSINESS PROFITS

1. The profits of an enterprise of a Contracting State shall be taxable
only in that State unless the enterprise carries on business in the
other Contracting State through a permanent establishment situated
therein. If the enterprise carries on business as aforesaid, the profits
of the enterprise may be taxed in the other State but only so much of
them as is attributable to that permanent establishment.

2. Subject to the provisions of paragraph (3), where an enterprise of
a Contracting State carries on business in the other Contracting State
through a permanent establishment situated therein, there shall in
each Contracting State be attributed to that permanent establishment
the profits which it might be expected to make if it were a distinct
and separate enterprise engaged in the same or similar activities
under the same or similar conditions and dealing wholly
independently with the enterprise of which it is a permanent
establishment.

[3. In determining the profits of a permanent establishment, there
shall be allowed as deductions expenses which are incurred for the
purposes of the business of the permanent establishment, including
executive and general administrative expenses so incurred, whether
in the State in which the permanent establishment is situated or
elsewhere, in accordance with the provisions of and subject to the
limitations of the tax laws of that State.]

4. Insofar as it has been customary in a Contracting State to
determine the profits to be attributed to a permanent establishment
on the basis of an apportionment of the total profits of the enterprise
to its various parts, nothing in paragraph (2) shall preclude that
Contracting State from determining the profits to be taxed by such
an apportionment as may be customary ; the methods of
apportionment adopted shall, however, be such that the result shall
be in accordance with the principles contained in this Article.

5. No profits shall be attributed to a permanent establishment by
reason of the mere purchase by the permanent establishment of
goods or merchandise for the enterprise.

6. For the purposes of preceding paragraphs, the profits to be
attributed to the permanent establishment shall be determined by the
same method year by year unless there is good and sufficient reason
to the contrary.

(7) Where profits include items of income which are dealt with
separately in other Articles of this Agreement, then the provisions of
those Articles shall not be affected by the provisions of this Article.‖

33. It becomes pertinent to note that Article 5 while defining the
expression ―PE‖ brings within its ambit a varied nature of
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establishments and which need not necessarily be those which have a
separate legal persona. As we view Article 5, it becomes apparent that
the nature of establishments which are included within the meaning of
the phrase ―PE‖ range from a place of management to a mine or a
building site and thus not being confined to a juridical entity as is
ordinarily understood in law.

34. The fact that a PE for the purposes of taxation is viewed as a
separate and distinct centre, was one which was noticed by us, albeit
briefly, in International Management Group (UK) Limited vs.
Commissioner of Income Tax-28 as would be evident from the
following extracts of that decision: –

“107. We also bear in mind the submission of Mr. Vohra who had
laid stress upon the memorandum of understanding and the services
agreement being an indivisible contract and constituting a singular
source of the income in question. Undisputedly, the income was
earned by and was liable to be remitted to IMG. The service
permanent establishment was undoubtedly not a separate legal entity
which could have been possibly called upon to satisfy the test of
economic ownership as suggested. While Conventions do accord an
independent identity upon a permanent establishment, they do so for
the purposes of taxation alone. A permanent establishment, however,
need not in all circumstances be a juridical entity as is recognised in
law. It is perhaps these and other limitations which constrained
Vogel to express the following reservations with respect to the test
of ―economic ownership‖ (page 893):

―The effectively connected rule is not based on the force of
attraction rule (No. 31 of OECD Model Convention 2014
Comm. on article 10; No. 24 of OECD Model Convention
2014 Comm. on article 11; No. 20 of OECD Model
Convention 2014 Comm. on article 12; No. 15 of UN
Model Convention 2011 Comm. on article 10). This means
that dividends, interest and royalties flowing to a resident of
a Contracting State from a source situated in the other State
must not, by a kind of legal presumption, or fiction even, be
related to a permanent establishment or a fixed base, as the
case may be, which that resident may have in the source
State, so that this State would not be obliged to limit its tax
jurisdiction in such a case. The shares, debt claims, rights
8
2024 SCC OnLine Del 4558
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or property must form part of the assets of the permanent
establishment respectively the fixed base or must be
otherwise effectively connected with that establishment or
base. This view is also put forward in Tech Mahindra
Ltd. v. Commissioner of Taxation [[2016] FCAFC 130;
2016 ATC 20-582; (2016) 103 ATR 813.] , where the
Australian Federal Court stated that profits which are made
liable to tax in the source State under the ‗force of
attraction’ notion are not attributable to a permanent
establishment and therefore not effectively connected with
it. The US Technical Explanation gives the example of
dividends derived by a dealer in shares or securities from
shares or securities that the dealer held for sale to
customers. However, in respect of debt claims, rights and
property, the UN Model Convention allows a limited force
of attraction under article 7(1)(c) : Business activities in the
source State of the same or similar kind as those effected
through the permanent establishment may also be taxed in
the source State. Consequently, interest received from debt
claims and royalties received from rights and property
effectively connected with such business activities may also
be taxed unrestrictedly in the source State (No. 20 of UN
Model Convention 2011 Comm. on article 11; No. 17 of
UN Model Convention 2011 Comm. on article 12). For
example, the proviso applies whenever both the permanent
establishment’s business activities and the head office’s
business activities carried out in the permanent
establishment State consist of managing or trading shares,
granting loans or licensing. However, it does not apply if
the head office’s or the permanent establishment’s activities
consist only of disposing of capital by buying shares or
depositing funds into bank accounts. Such activities are not
the business activities referred to in article 7(1)(c) of the
UN Model Convention.

The risk that the permanent establishment proviso may
be abused through the transfer of shares, debt claims, rights
or property to a permanent establishment set up solely to
benefit from privileged tax regimes in the permanent
establishment State may be remote (No. 32 of OECD
Model Convention 2014 Comm. on article 10; No. 25 of
OECD Model Convention 2014 Comm. on article 12; No.
21 of OECD Model Convention 2014 Comm. on article

12). First of all, a permanent establishment can only be
identified if a business is carried on therein. Secondly, the
condition that the shares, debt claims, rights or property
must be effectively connected to such a location requires
more than merely recording these assets in the books of the
permanent establishment for accounting purposes. Next to

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this, the OECD believes that domestic anti-abuse rules can
be an adequate weapon.

According to the OECD, shares, debt claims, rights or
property form part of the assets of a permanent
establishment if the ‗economic’ ownership of these is
allocated to that permanent establishment (No. 32.1-32.2 of
OECD Model Convention 2014 Comm. on article 10; No.
25.1-25.2 of OECD Model Convention 2014 Comm. on
article 12; No. 21.1-21.2 of OECD Model Convention 2014
Comm. on article 12). ‗Economic’ ownership means the
equivalent of ownership for Income-tax purposes by a
separate enterprise, with the attendant benefits and burdens,
such as the right to the dividends, interest or royalty
attributable to the ownership of a holding, debt claim, right
or property, as the case may be, and the potential exposure
to gains or losses from the appreciation or depreciation of
that holding, debt claim, right or property. In the opinion of
this author, the term ‗economic’ ownership is not
appropriate for the allocation of assets to a permanent
establishment. A permanent establishment itself can never
be owner of an asset because it is not a separate legal entity.
As a result, it can never be the ‗economic’ owner of an
asset as well. The term is therefore misleading. It also
guides away attention from what is actually relevant for
answering the question of what assets must be allocated to a
permanent establishment : The significant people’s
functions. The author believes that this is an activity test
and has nothing to do with an ownership test, and therefore
is of the opinion that the relevant test is, or should be,
whether the shares, debt claims, rights or property, as the
case may be, are managed and their exploitation is directed
and controlled by people active in or from a permanent
establishment. If so, the asset concerned is effectively
connected with that permanent establishment and the
income received from it (i.e., dividend, interest respectively
royalty must be attributed to that permanent establishment
(see supra m.No. 124)). Whether the economic strength of a
permanent establishment is enhanced is, as such, not a
relevant criterion. Assets cannot create economic activity
by themselves.‖

35. The separate treatment which is liable to be accorded to the
functioning of a PE is an aspect which also emerges from the following
observations rendered by the Supreme Court in DIT (International

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Taxation), Mumbai vs. Morgan Stanley & Co. Inc.9:-

―19. Under Article 7, the taxability is of MNE. What is to be taxed
under Article 7 is income of MNE attributable to the PE in India.
The income attributable to the said PE is the income attributable to
foreign company’s operations in India, which in turn implies the
income attributable to the activities carried on by MNE through its
PE in India. Therefore, there is a difference between the taxability of
PE in respect of its income earned by it in India which is in
accordance with the Income Tax Act, 1961 and which has nothing to
do with the taxability of MNE, which is also taxable in India under
Article 7, in respect of the profits attributable to its PE. Under
Article 7, the taxability is of MNE. What is taxable under Article 7 is
profits earned by MNE. Under the said IT Act, the taxable unit is the
foreign company, though the quantum of income taxable is income
attributable to PE of the said foreign company in India.‖

xxx xxx xxx

34. Article 7 of the UN Model Convention inter alia provides that
only that portion of business profits is taxable in the source country
which is attributable to PE. It specifies how such business profits
should be ascertained. Under the said article, a PE is treated as if it is
an independent enterprise (profit centre) dehors the head office and
which deals with the head office at arm’s length. Therefore, its
profits are determined on the basis as if it is an independent
enterprise. The profits of the PE are determined on the basis of what
an independent enterprise under similar circumstances might be
expected to derive on its own. Article 7(2) of the UN Model
Convention advocates the arm’s length approach for attribution of
profits to a PE.‖

36. Klaus Vogel on Double Taxation Conventions10 succinctly
explains the origins of the concept of a PE in the following words11:-

“A. General Issues

I. Overview and Main Features

Article 5 OECD and UN MC is the last but most elaborate of the
articles which contain general definition of terms relevant
throughout many different treaty articles (infra m.no. 4 et seq.). The
article determines the threshold that functions as the essential
demarcation line between short-term or ephemeral activities in the
source State and ‘permanent establishments’ (PEs) (i.e., solidified
sources of income which serve as a (primary or secondary) basis for

9
(2007) 7 SCC 1
10 Vol. I, Fifth Edition
11
Vol. I, Fifth Edition, page 389
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the taxpayer in a State other than his or her State of residence). To a
large extent, a PE does not only resemble the concept of residence in
appearance but may also trigger similar, though not identical legal
consequences.

Since the early 1920s, the PE threshold has been commonly used in
DTCs to determine whether a particular kind of income shall or shall
not be taxed in the country from which it originates Wherever
distributive rules use the PE concept (infra m.no. 4 et seq.). they
reconcile requirements of international justice (prerogative of
source-based taxation) and practical prudence (prerogative of
residence-based taxation). In connection with those rules, Article 5
OECD and UN MC serves to simplify and facilitate taxation of
cross-border activities. At the same time, it is in line with trends to
encourage liberalization of international trade. Thus, the PE
principle was adopted to accomplish three main objectives:

– assigning tax revenue to the source State

– maintaining practicability by establishing a minimum threshold
(i.e., by preventing pure and unconditional source-based taxation
where the contact of the taxpayer to the source State is only
occasional or peripheral (ef. no. 132 et seq. OECD MC Comm. on
Article 5)); and

– placing the PE on equal footing with a local (i.e., resident)
entrepreneur for the purposes of various articles, thus providing
neutrality between the different forms of a secondary establishment
available to foreign investors.‖

37. The working of an enterprise in a Contracting State through the
agency of a PE, the ―functional integration‖ between the two and the
import of the word ―through‖ as it appears in Article 5 was lucidly
explained in Vogel as under12:-

―7. ‘Through’: Functional Integration

134 Article 5(1) OECD MC (since 1977; see supra m. no. 45)
requires that the business of an enterprise (for these terms, see supra
m. no.27 et seq.) is carried on through the fixed POB. The
preposition ‗through’ specifies the functional relation between the
POB and the activities of the taxpayer. This relation can be
described best by the notion of a functional integration of the POB in
the enterprise of the taxpayer. Such functional integration contains
several aspects which need to be carefully distinguished from one
another. Their common denominator, however, is the type and
degree of proximity of the POB to, or even identification with, the

12
Vol. I, Fifth Edition, page 414 to 416.

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taxpayer’s paramount economic activity.

135 The first function of the term ‗through’ is to make it clear
that the taxpayer has to control the PE (see supra m.no. 106 et seq.
for details).

136 Secondly, functional integration presupposes that the
taxpayer ‗wholly or partly carrie[s] on’ his business (Article 5(1)
OECD MC; the OECD MC Comm. uses the verb ‘carried out’
synonymously (no. 35 OECD MC Comm. on Article 5)). However,
like ‗business’ and ‗enterprise’ (cf. supra m no.27 et seq.), these
words do not function as a substantive filter either. While early draft
Model Conventions contained the condition that the fixed POB
should have ‘a productive character’, this requirement was never
adopted by the OECD Model (see no. 35 OECD MC Comm. on
Article 5). None of the current MCs provide a specific productivity
test. It follows that POBs may constitute a PE even if they perform
activities which have mainly or exclusively expenditures to show
for.

137 Likewise, the ‘carrying-on’ requirement does not imply an
activity in the sense of an active and visible work. It includes even
stand-by services and omissions. This gains significant relevance
where the omission is profitable (e.g., in the case of a POB earning
money in the source State simply by fulfilling, for whichever period
of time, a non-competition agreement relating to the territory of that
State).

138 However, a diffuse passivity which equals a (temporal or
lasting) suspension of the activities which the POB has been
designed for may indicate that the POB is not ‗permanent’. For
details, see supra m.no.87 et seq.

139 Thirdly, the phrase ‘through which’ indicates that the taxpayer
makes use of the POB in that he employs it as an instrument
(equalling or resembling an operating asset) for his entrepreneurial
activities. This third aspect of the functional integration is by far the
most disputed one.

140 Historically, the instrumental character of the POB for the
carrying-on of the enterprise could not be taken for granted.

Between 1963 and 1977, the OBEC/OECD MC did not employ this
term. Rather, it was sufficient that the taxpayer carried on his
business ‘in’ the POB (see supra m.no.45). Based on the old Model,
some older DCs use the words ‗in which’ still today. While some
authors have denied any divergence in substance , the 1977
amendment is a strong reason to assume a semantic shift indeed.
141 In a different context (viz., in Article 5(4.1) of the OECD and
UN MC, as amended in 2017), the OECD and UN have returned, in
one specific regard, to this old line by stating that an enterprise
should carry on business ‘at the same place’. However, the
simultaneous use of this language on the one hand and the terms
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‘used or maintained by an enterprise’ on the other, in one and the
same sentence in the initial phrase of Article 5(4.1) OECD and UN
MC, proves how careful and attentive the 2017 Models have been
drafted. This dualism is another good reason to stipulate a different
meaning of ‗through’, as opposed to ‗in’ or ‗at’. For all of these
reasons, we do see a substantial difference between both terms.
142 It follows that on the one hand, the activities mentioned in
Article 5(1) OECD and UN MC need no longer be carried on ‘in’ or
‘at’ the POB. In this respect, the 1977 change of Article 5(1) OECD
MC has enlarged the scope of the PE definition. Especially if one
thinks of an activity as a human behaviour, one can now (unlike
before 1977) easily subsume unmanned facilities under the PE
definition (see supra m.no. 45 and see, e.g., no. 127 OECD MC
Comm. on Article 5).

143 On the other hand, the requirement of an instrumental
character of the POB has become irrefutable. Even stronger than
the English amendment (‗through which’ instead of ‗in which’), the
corresponding modification of the French text (‘par l’intermédiaire
de laquelle’ instead of ‘où’) has stressed the functional integration of
the POB in the business.

144 The OECD MC Comm. has weakened the meaning of
‗through’ since 2003. The Commentary holds the view that the
requirement a functional integration is met as soon as the taxpayer
exercises the business in a fixed POB which is at his disposal (no.
20 OECD MC Comm. on Article 5 (added on 28 January 2003.))
This is the reason for the characterisation of the famous painter
example (i.e., the fictitious case of a painter who, for two years,
spends three days a week in the large office building of its main
client) as a service PE. In substance, the view of the OECD MC
Comm. limits the meaning of ‘through’ to the first two instead of all
three semantic aspects required by Article 5(1) OECD MC (supra
m.no. 135 et seq. and 139 et seq.).

145 This abridging interpretation of Article 5(1) OECD and UN
MC is not convincing, though. It sets the term ‗through’ as a
synonym of; in’ or ‗at’. It is certainly not harmful, under Article 5(1)
OECD and UN MC, if the taxpayer carries on his business also ‗in’
the POB. However, it is not sufficient. Given that the terms ‘in’ or ‘at’
have been used in a considerable number of bilateral DCs and, above
all, that the OECD Model has intentionally replaced the word ‘in’
by ‘through’ in 1977 (supra m.no.45), the deviation in the text of
the OECD MC is to be regarded as meaningful. The ordinary
meaning of ‘through’ and ‘par l’intermédiaire de’ is different from,
and goes beyond, the ordinary meaning of ‘in’ or ‘at’ (cf. Article 31(1)
VCLT). Before the background of the 1963 OECD MC, it is least
among OECD Member States that ‗through’ has been given a special
meaning as opposed to ‗in’ (cf. Article 31(4) VCLT). A
reconsideration might be reasonable and recommendable from a
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policy viewpoint. It can only be realized, however, by a modification
of the text of Article 5(1) OECD and the UN MC itself.
146 Given that the POB may be a complex and heterogeneous
object, the issue arises whether every single element or component
part needs to be used. This is not required. It is sufficient that the
POB as a whole is functionally integrated, in the aforementioned
sense, into the business of the taxpayer. It should be noted, however,
that a too narrow use might trigger the application of Article 5(4)
OECD and UN MC even if the POB as a whole would not have
fallen under Article S (4) OECD and UN MC by virtue of its
outward appearance.‖

38. The imperatives of viewing the PE as a separate and independent
centre for the purposes of fiscal treatment and taxation is necessitated
for reasons of attribution and recognition of income generated by it
independently. This becomes apparent from a reading of paragraph 24
of the Organisation for Economic Co-operation and Development13
Commentary on Article 7, which is reproduced hereinbelow: –

―24. Paragraph 2 refers specifically to the dealings between the
permanent establishment and other parts of the enterprise of which
the permanent establishment is a part in order to emphasise that the
separate and independent enterprise fiction of the paragraph requires
that these dealings be treated the same way as similar transactions
taking place between independent enterprises. That specific
reference to dealings between the permanent establishment and other
parts of the enterprise does not, however, restrict the scope of the
paragraph. Where a transaction that takes place between the
enterprise and an associated enterprise affects directly the
determination of the profits attributable to the permanent
establishment (e.g. the acquisition by the permanent establishment
from an associated enterprise of goods that will be sold through the
permanent establishment), paragraph 2 also requires that, for the
purpose of computing the profits attributable to the permanent
establishment, the conditions of the transaction be adjusted, if
necessary, to reflect the conditions of a similar transaction between
independent enterprises. Assume, for instance, that the permanent
establishment situated in State S of an enterprise of State R acquires
property from an associated enterprise of State T. If the price
provided for in the contract between the two associated enterprises
exceeds what would have been agreed to between independent
enterprises, paragraph 2 of Article 7 of the treaty between State R
and State S will authorise State S to adjust the profits attributable to

13 OECD Commentary on Model Tax Convention on Income and on Capital 2017

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the permanent establishment to reflect what a separate and
independent enterprise would have paid for that property. In such a
case, State R will also be able to adjust the profits of the enterprise
of State R under paragraph 1 of Article 9 of the treaty between State
R and State T, which will trigger the application of the
corresponding adjustment mechanism of paragraph 2 of Article 9 of
that treaty.‖

39. The OECD Commentary then proceeds to summarize the scope
and extent of paragraph 1 as under:

―Paragraph 1

10. Paragraph 1 incorporates the rules for the allocation of taxing
rights on the business profits of enterprises of each Contracting
State. First, it states that unless an enterprise of a Contracting State
has a permanent establishment situated in the other State, the
business profits of that enterprise may not be taxed by that other
State. Second, it provides that if such an enterprise carries on
business in the other State through a permanent establishment
situated therein, the profits that are attributable to the permanent
establishment, as determined in accordance with paragraph 2, may
be taxed by that other State. As explained below, however,
paragraph 4 restricts the application of these rules by providing that
Article 7 does not affect the application of other Articles of the
Convention that provide special rules for certain categories of profits
(e.g. those derived from the operation of ships and aircraft in
international traffic) or for certain categories of income that may also
constitute business profits (e.g. income derived by an enterprise in
respect of personal activities of an entertainer or sportsperson).

11. The first principle underlying paragraph 1, i.e. that the profits of
an enterprise of one Contracting State shall not be taxed in the other
State unless the enterprise carries on business in that other State
through a permanent establishment situated therein, has a long
history and reflects the international consensus that, as a general
rule, until an enterprise of one State has a permanent establishment
in another State, it should not properly be regarded as participating
in the economic life of that other State to such an extent that the
other State should have taxing rights on its profits.

12. The second principle, which is reflected in the second sentence
of the paragraph, is that the right to tax of the State where the
permanent establishment is situated does not extend to profits that
the enterprise may derive from that State but that are not attributable
to the permanent establishment. This is a question on which there
have historically been differences of view, a few countries having
some time ago pursued a principle of general ―force of attraction‖
according to which income such as other business profits, dividends,
interest and royalties arising from sources in their territory was fully
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taxable by them if the beneficiary had a permanent establishment
therein even though such income was clearly not attributable to that
permanent establishment. Whilst some bilateral tax conventions
include a limited anti-avoidance rule based on a restricted force of
attraction approach that only applies to business profits derived from
activities similar to those carried on by a permanent establishment,
the general force of attraction approach described above has now
been rejected in international tax treaty practice. The principle that is
now generally accepted in double taxation conventions is based on
the view that in taxing the profits that a foreign enterprise derives
from a particular country, the tax authorities of that country should
look at the separate sources of profit that the enterprise derives from
their country and should apply to each the permanent establishment
test, subject to the possible application of other Articles of the
Convention. This solution allows simpler and more efficient tax
administration and compliance, and is more closely adapted to the
way in which business is commonly carried on. The organisation of
modern business is highly complex. There are a considerable number
of companies each of which is engaged in a wide diversity of
activities and is carrying on business extensively in many countries.

A company may set up a permanent establishment in another country
through which it carries on manufacturing activities whilst a
different part of the same company sells different goods in that other
country through independent agents. That company may have
perfectly valid commercial reasons for doing so: these may be based,
for example, on the historical pattern of its business or on
commercial convenience. If the country in which the permanent
establishment is situated wished to go so far as to try to determine,
and tax, the profit element of each of the transactions carried on
through independent agents, with a view to aggregating that profit
with the profits of the permanent establishment, that approach would
interfere seriously with ordinary commercial activities and would be
contrary to the aims of the Convention.

13. As indicated in the second sentence of paragraph 1, the profits
that are attributable to the permanent establishment are determined in
accordance with the provisions of paragraph 2, which provides the
meaning of the phrase ―profits that are attributable to the permanent
establishment‖ found in paragraph 1. Since paragraph 1 grants taxing
rights to the State in which the permanent establishment is situated
only with respect to the profits that are attributable to that permanent
establishment, the paragraph therefore prevents that State, subject to
the application of other Articles of the Convention, from taxing the
enterprise of the other Contracting State on profits that are not
attributable to the permanent establishment.

14. The purpose of paragraph 1 is to limit the right of one
Contracting State to tax the business profits of enterprises of the
other Contracting State. As confirmed by paragraph 3 of Article 1,
the paragraph does not limit the right of a Contracting State to tax its
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own residents under controlled foreign companies provisions found
in its domestic law even though such tax imposed on these residents
may be computed by reference to the part of the profits of an
enterprise that is resident of the other Contracting State that is
attributable to these residents’ participation in that enterprise. Tax so
levied by a State on its own residents does not reduce the profits of
the enterprise of the other State and may not, therefore, be said to
have been levied on such profits (see also paragraph 81 of the
Commentary on Article 1).‖

40. The Commentary on the United Nations Model Double
Taxation Convention between Developed and Developing Countries
202114 while explaining the concept of a PE makes the following
pertinent observations: –

―7. It could perhaps be argued that in the general definition some
mention should also be made of the other characteristic of a
permanent establishment to which some importance has sometimes
been attached in the past, namely that the establishment must have a
productive character, i.e. contribute to the profits of the enterprise. In
the present definition this course has not been taken. Within the
framework of a well-run business organisation it is surely axiomatic
to assume that each part contributes to the productivity of the whole.
It does not, of course, follow in every case that because in the wider
context of the whole organisation a particular establishment has a
―productive character‖ it is consequently a permanent establishment
to which profits can properly be attributed for the purpose of tax in a
particular territory (see Commentary on paragraph 4).‖

41. The concept of a PE is more lucidly explained in the commentary
as follows: –

―41. Also, a permanent establishment may exist if the business of the
enterprise is carried on mainly through automatic equipment, the
activities of the personnel being restricted to setting up, operating,
controlling and maintaining such equipment. Whether or not gaming
and vending machines and the like set up by an enterprise of a State
in the other State constitute a permanent establishment thus depends
on whether or not the enterprise carries on a business activity
besides the initial setting up of the machines. A permanent
establishment does not exist if the enterprise merely sets up the
machines and then leases the machines to other enterprises. A
permanent establishment may exist, however, if the enterprise which

14
UN Model Convention 2021
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sets up the machines also operates and maintains them for its own
account. This also applies if the machines are operated and
maintained by an agent dependent on the enterprise.

42. It follows from the definition of ―enterprise of a Contracting
State‖ in Article 3 that this term, as used in Article 7, and the term
―enterprise‖ used in Article 5, refer to any form of enterprise carried
on by a resident of a Contracting State, whether this enterprise is
legally set up as a company, partnership, sole proprietorship or other
legal form. Different enterprises may collaborate on the same project
and the question of whether their collaboration constitutes a separate
enterprise (e.g. in the form of a partnership) is a question that
depends on the facts and the domestic law of each State. Clearly, if
two persons each carrying on a separate enterprise decide to form a
company in which these persons are shareholders, the company
constitutes a legal person that will carry on what becomes another
separate enterprise. It will often be the case, however, that different
enterprises will simply agree to each carry on a separate part of the
same project and that these enterprises will not jointly carry on
business activities, will not share the profits thereof and will not be
liable for each other’s activities related to that project even though
they may share the overall output from the project or the
remuneration for the activities that will be carried on in the context
of that project. In such a case, it would be difficult to consider that a
separate enterprise has been set up. Although such an arrangement
would be referred to as a ―joint venture‖ in many countries, the
meaning of ―joint venture‖ depends on domestic law and it is
therefore possible that, in some countries, the term ―joint venture‖
would refer to a distinct enterprise.

43. In the case of an enterprise that takes the form of a fiscally
transparent partnership, the enterprise is carried on by each partner
and, as regards the partners’ respective shares of the profits, is
therefore an enterprise of each Contracting State of which a partner
is a resident. If such a partnership has a permanent establishment in
a Contracting State, each partner’s share of the profits attributable to
the permanent establishment will therefore constitute, for the
purposes of Article 7, profits derived by an enterprise of the
Contracting State of which that partner is a resident (see also
paragraph 56 [of the Commentary on Article 5 of the 2017 OECD
Model Tax Convention] below).

44. A permanent establishment begins to exist as soon as the
enterprise commences to carry on its business through a fixed place
of business. This is the case once the enterprise prepares, at the place
of business, the activity for which the place of business is to serve
permanently. The period of time during which the fixed place of
business itself is being set up by the enterprise should not be
counted, provided that this activity differs substantially from the
activity for which the place of business is to serve permanently. The
permanent establishment ceases to exist with the disposal of the
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fixed place of business or with the cessation of any activity through
it, that is when all acts and measures connected with the former
activities of the permanent establishment are terminated (winding up
current business transactions, maintenance and repair of facilities). A
temporary interruption of operations, however, cannot be regarded as
a closure. If the fixed place of business is leased to another
enterprise, it will normally only serve the activities of that enterprise
instead of the lessor’s; in general, the lessor’s permanent
establishment ceases to exist, except where he continues carrying on
a business activity of his own through the fixed place of business‖.

42. The concept of a PE is based upon the undertaking of economic
activity in a particular State irrespective of the residence of an
enterprise and the same being understood to be in the nature of a
conglomerate or an entity which may have many arms or independent
functional units situate in various fiscal jurisdictions. Any
entrepreneurial activity which gives rise to income or profit thus
becomes liable to be taxed at source irrespective of the ultimate
recipient or owner of that income. Source here would mean the location
which gives rise to the accrual of profits or income or which is the
location where the same arises. The PE principle thus enables the
assignment of tax to the State which constitutes the source. The PE
concept thus creates a functional relationship and connect between the
principal entity and the place of business whose activities give rise to
the income or profit. It is this fictional creation of an independent
economic center in a Contracting State which informs the allocation of
taxing rights. Once the DTAA confers an independent identity upon the
PE, it would be wholly erroneous to answer the question of taxability
basis either the activities or profitability of the parent or the entity
which seeds and sustains the PE.

43. The Contracting State in which this imagined entity is domiciled
and undertakes business thus becomes identified as an independent
profit or revenue earning center which is liable to be taxed. Once such
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an entity is found to exist in one of the Contracting State, it is viewed as
a unit which contributes to the economic life of that State and thus be
liable to tax. It is these basic precepts which convince us to debunk the
theory of taxation in the source State being dependent upon a global
profit or taxation being subject to income or profit having been earned
at an entity level.

44. The identity which attaches to a PE for the purposes of
ascertainment of a taxing liability cannot possibly be doubted bearing
in mind the succinct observations of the Supreme Court in Morgan
Stanley and where their Lordships without a degree of equivocation
acknowledged the distinction that is liable to be drawn between a PE
with respect to income earned in the Contracting State where it is
domiciled or deemed to exist and the global enterprise of which it may
be a part. Vogel explains the PE concept as constituting the threshold
and the ―essential demarcation line‖ in the source State which sanctions
the imposition of a tax in a fiscal jurisdiction other than the State of
residence. This would clearly appeal to logical since the right of
taxation which inheres in the source State is connected to the
―economic life‖ of that transnational enterprise which is moored and
berthed by virtue of the existence of a PE which may be found to exist.
Regard must also be had to the fact that right of the source State to tax
does not extend to profits which are not allocable to the PE. All of the
above, thus clearly leads us to hold that the existence and identity of the
PE is separate and distinct and subject to tax to the extent of activities
that it may undertake in a State distinct from that of its principal.

45. It would also be pertinent to note that a cross-border entity may
structure its operations in a manner where it operates in more than one
taxing jurisdiction. If it be open for such an entity to assert that its
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global profits and income are not liable to be taxed on the basis of the
source principle, it would be wholly impermissible for it to contend that
the income which accrues or arises in the Contracting State is also
exempt from tax. In any case, the usage of the phrase “…so much of
them as is attributable to the permanent establishment.” is a clear
indicator of the DTAA warranting the PE being liable to be viewed as
an independent center of revenue.

46. The identifiable parts of Article 7 not only restrict the right of
one of the Contracting States to tax, it also provisions for the extent to
which a tax may be imposed by that State. This becomes evident from
it freeing a trans-border entity from the specter of a tax liability if it
does not have a PE in the introductory part of that covenant. It then
proceeds to restrict the impost by adopting the principle of attribution.
It thus constructs an objective criterion for identification of a PE and
when a foreign enterprise with sufficient economic presence would
become subject to tax. All of the above, convinces us to hold against
the argument of a PE not being taxable on an independent evaluation
being misconceived.

47. On a jurisprudential plane, the sovereignty concept is based on a
State’s power over a territory and a set of subjects which accept its
authority. It was these aspects which governed and regulated the right
of a State to levy a tax. However, as trade and commerce transcended
boundaries and borders, nations were confronted with profits and
incomes being shifted and claimed as exempt. It is the aforenoted
factors which appear to have moved the League of Nations in the early
1920s’ to constitute a group of economists to study the issue of double
taxation. That group is stated to have identified the fundamental factors
worthy of consideration to be (a) the origin of wealth or income, (b) the
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situs of income, (c) enforcement of rights connected with the above and

(d) domicile of the person vested with the power to use or dispose of
that income or wealth. It was the factor pertaining to ―origin‖ of income
which led to the enunciation of the source rule bearing in mind the need
to identify the primary source of creation of income and the residence
of its owner. It is these fundamental precepts which led to the
formulation of measures to determine the economic presence of an
entity in a given State and the functional integration of such an entity in
the economic activity undertaken in that State.

48. Vogel while speaking on taxing rights of nations makes the
following pertinent observations15:-

―Paragraph 1

10. [Taxing rights on business profits] Paragraph I incorporates the
rules for the allocation of taxing rights on the business profits of
enterprises of each Contracting State. First, it states that unless an
enterprise of a Contracting State has a permanent establishment
situated in the other State, the business profits of that enterprise may
not be taxed by that other State. Second, it provides that if such an
enterprise carries on business in the other State through a permanent
establishment situated therein, the profits that are attributable to the
permanent establishment, as determined in accordance with
paragraph 2, may be taxed by that other State. As explained below,
however, paragraph 4 restricts the application of these rules by
providing that Article 7 does not affect the application of other
Articles of the Convention that provide special rules for certain
categories of profits (e.g. those derived from the operation of ships
and aircraft in international traffic) or for certain categories of
income that may also constitute business profits (e.g. income derived
by an enterprise in respect of personal activities of an entertainer or
sportsman).

11. [Requirement of a PE] The first principle underlying
paragraph 1, i.e., that the profits of an enterprise of one Contracting
State shall not be taxed in the other State unless the enterprise carries
on business in that other State through a permanent establishment
situated therein, has a long history and reflects the international
consensus that, as a general rule, until an enterprise of one State has
a permanent establishment in another State, it should not properly be

15
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regarded as participating in the economic life of that other State to
such an extent that the other State should have taxing rights on its
profits.

12. [Threshold of attribution] The second principle, which is
reflected in the second sentence of the paragraph, is that the right to
tax of the State where the permanent establishment is situated does
not extend to profits that the enterprise may derive from that State
but that are not attributable to the permanent establishment. This is a
question on which there have historically been differences of view, a
few countries having some time ago pursued a principle of general
‘force of attraction’ according to which income such as other
business profits, dividends, interest and royalties arising from
sources in their territory was fully taxable by them if the beneficiary
had a permanent establishment therein even though such income was
clearly not attributable to that permanent establishment. Whilst some
bilateral tax conventions include a limited anti-avoidance rule based
on a restricted force of attraction approach that only applies to
business profits derived from activities similar to those carried on by
a permanent establishment, the general force of attraction approach
described above has now been rejected in international tax treaty
practice. The principle that is now generally accepted in double
taxation conventions is based on the view that in taxing the profits
that a foreign enterprise derives from a particular country, the tax
authorities of that country should look at the separate sources of
profit that the enterprise derives from their country and should apply
to each the permanent establishment test, subject to the possible
application of other Articles of the Convention. This solution allows
simpler and more efficient tax administration and compliance, and is
more closely adapted to the way in which business is commonly
carried on. The organisation of modern business is highly complex.

There are a considerable number of companies each of which is
engaged in a wide diversity of activities and is carrying on business
extensively in many countries. A company may set up a permanent
establishment in another country through which it carries on
manufacturing activities whilst a different part of the same company
sells different goods in that other country through independent
agents. That company may have perfectly valid commercial reasons
for doing so: these may be based, for example, on the historical
pattern of its business or on commercial convenience. If the country
in which the permanent establishment is situated wished to go so far
as to try to determine, and tax, the profit element of each of the
transactions carried on through independent agents, with a view to
aggregating that profit with that the profits of the permanent
establishment, that approach would interfere seriously with ordinary
commercial activities and would be contrary to the aims of the
Convention.

13. [Reference to paragraph 2] As indicated in the second sentence
of paragraph 1, the profits that are attributable to the permanent
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establishment are determined in accordance with the provisions of
paragraph 2, which provides the meaning of the phrase ‘profits that
are attributable to the permanent establishment’ found in paragraph

1. Since paragraph 1 grants taxing rights to the State in which the
permanent establishment is situated only with respect to the profits
that are attributable to that permanent establishment, the paragraph
therefore prevents that State, subject to the application of other
Articles of the Convention, from taxing the enterprise of the other
Contracting State on profits that are not attributable to the permanent
establishment.

14. [Scope of Paragraph 1] The purpose of paragraph 1 is to limit
the right of one Contracting State to tax the business profits of
enterprises of the other Contracting State. As confirmed by
paragraph 3 of Article 1, the paragraph does not limit the right of a
Contracting State to tax its own residents under controlled foreign
companies provisions found in its domestic law even though such
tax imposed on these residents may be computed by reference to the
part of the profits of an enterprise that is resident of the other
Contracting State that is attributable to these residents’ participation
in that enterprise. Tax so levied by a State on its own residents does
not reduce the profits of the enterprise of the other State and may
not, therefore, be said to have been levied on such profits (see also
paragraph 81 of the Commentary on Article 1.

Paragraph 2

15. [Determination of attributable profits] Paragraph 2 provides
the basic rule for the determination of the profits that are attributable
to a permanent establishment. According to the paragraph, these
profits are the profits that the permanent establishment might be
expected to make if it were a separate and independent enterprise
engaged in the same or similar activities under the same and similar
conditions, taking into account the functions performed, assets used
and risks assumed through the permanent establishment and through
other parts of the enterprise. In addition, the paragraph clarifies that
the rule applies with respect to the dealings between the permanent
establishment and the other parts of the enterprise.

16. [Fiction of independence: arm’s length principle] The basic
approach incorporated in the paragraph for the purposes of
determining what are the profits that are attributable to the
permanent establishment is therefore to require the determination of
the profits under the fiction that the permanent establishment is a
separate enterprise and that such an enterprise is independent from
the rest of the enterprise of which it is a part as well as from any
other person. The second part of that fiction corresponds to the arm’s
length principle which is also applicable, under the provisions of
Article 9, for the purpose of adjusting the profits of associated
enterprises (see paragraph 1 of the Commentary on Article 9).

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17. [Separability of PE profits] Paragraph 2 does not seek to
allocate the overall profits of the whole enterprise to the permanent
establishment and its other parts but, instead requires that the profits
attributable to a permanent establishment be determined as if it a
separate enterprise. Profits may therefore be attributed to a
permanent establishment even though the enterprise as a whole has
never made profits. Conversely, paragraph 2 may rest in no profits
being attributed to a permanent establishment even though the
enterprise as whole has made profits.

18. [Double taxation difficulties] Clearly, however, where an
enterprise of a Contracting State has a permanent establishment in
the other Contracting State, the first State has an interest in the
directive of paragraph 2 being correctly applied by the State where
the permanent establishment is located. Since that directive applies
to both Contracting States, the State of the enterprise must, in
accordance with either Article 23A or 23B, eliminate double taxation
on the profits properly attributable to the permanent establishment
(see paragraph 27 below). In other words, if the State where the
permanent establishment is located attempts to tax profit that are not
attributable to the permanent establishment under Article 7, this may
result in double taxation of profits that should properly be taxed only
in the State of the enterprise.

19. [Guidance feature of 2010 Report] As indicated in paragraphs
8 and 9 above, Article 7, as currently worded, reflects the approach
developed in the Report adopted by the Committee on Fiscal Affairs
in 2010. The Report dealt primarily with the application of the
separate and independent enterprise fiction that underlies paragraph
2 and the main purpose the changes made to that paragraph
following the adoption of the Report was to ensure that the
determination of the profits attributable to a permanent
establishment followed the approach put forward in that Report. The
Report therefore provides a detailed guide as to how the profits
attributable to a permanent establishment should be determined
under the provisions of paragraph 2.

20. [Two-step determination] As explained in the Report, the
attribution of profits to a permanent establishment under paragraph 2
will follow from the calculation of the profits (or losses) from all its
activities, including transactions with independent enterprises,
transactions with associated enterprises (with direct application of
the OECD Transfer Pricing Guidelines) and dealings with other
parts of the enterprise. This analysis involves two steps which are
described below. The order of the listing of items within each of
these two steps is not meant to be prescriptive, as the various items
may be interrelated (e.g. risk is initially attributed to a permanent
establishment as it performs the significant people functions relevant
to the assumption of that risk but the recognition and
characterisation of a subsequent dealing between the permanent
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establishment and another part of the enterprise that manages the
risk may lead to a transfer of the risk and supporting capital to the
other part of the enterprise).

21. [First step: analysis] Under the first step, a functional and
factual analysis is undertaken which will lead to:

– the attribution to the permanent establishment, as appropriate, of
the rights and obligations arising out of transactions between the
enterprise of which the permanent establishment is a part and
separate enterprises;

– the identification of significant people functions relevant to the
attribution of economic ownership of assets, and the attribution
of economic ownership of assets to the permanent
establishment;

– the identification of significant people functions relevant to the
assumption of risks, and the attribution of risks to the permanent
establishment;

– the identification of other functions of the permanent
establishment;

– the recognition and determination of the nature of those dealings
between the permanent establishment and other parts of the
same enterprise that can appropriately be recognised, having
passed the threshold test referred to in paragraph 26; and

– the attribution of capital based on the assets and risks attributed
to the permanent establishment.‖

49. Of equal significance are the following observations as appearing
in the judgment of the Supreme Court in Ishikawajma-Harima Heavy
Industries Ltd. vs. Director of Income Tax, Mumbai16:-

―37. Section 9 raises a legal fiction, but having regard to the
contextual interpretation and furthermore in view of the fact that we
are dealing with a taxation statute the legal fiction must be construed
having regard to the object it seeks to achieve. The legal fiction
created under Section 9 of the Act must also be read having regard
to the other provisions thereof. (See Maruti Udyog Ltd. v. Ram
Lal [(2005) 2 SCC 638 : 2005 SCC (L&S) 308] .)

38. For our benefit we may notice the provisions of Section 42 of the
Income Tax Act, 1922. It provided that only such part of income as
was attributable to the operations carried out in India would be
taxable in India.

39. Territorial nexus doctrine, thus, plays an important part in
assessment of tax. Tax is levied on one transaction where the
operations which may give rise to income may take place partly in
one territory and partly in another. The question which would fall for

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our consideration is as to whether the income that arises out of the
said transaction would be required to be proportioned to each of the
territories or not.

40. Income arising out of operation in more than one jurisdiction
would have territorial nexus with each of the jurisdiction on actual
basis. If that be so, it may not be correct to contend that the entire
income ―accrues or arises‖ in each of the jurisdiction. The Authority
has proceeded on the basis that supplies in question had taken place
offshore. It, however, has rendered its opinion on the premise that
offshore supplies or offshore services were intimately connected
with the turnkey project.

xxx xxx xxx

82. In Klaus Vogel on Double Taxation Conventions, it is stated:

―(g) No force of attraction principle.–The second sentence of
Article 7(1) allows the State of the permanent establishment to
tax business profits, ‗but only so much of them as is
attributable to that permanent establishment’. The MC has thus
decided against adopting the so-called ‗force of attraction of
the permanent establishment’ i.e. against the principle that,
where there is a permanent establishment, the State of the
permanent establishment should be allowed to tax all income
derived by the enterprise from sources in that State
irrespective of whether or not such income is economically
connected with the permanent establishment. In line with the
domestic law then prevailing in the USA, such a ‗force of
attraction’ was, for instance, incorporated in Germany’s 1954
DTC with USA [second sentence of Article III(I)]. In contrast,
the second sentence of Article 7(1) MC allows the State of the
permanent establishment to tax only those profits which are
economically attributable to the permanent establishment i.e.
those which result from the permanent establishment’s
activities, which arise economically from the business carried
on by the permanent establishment (cf. also para 5, MC
Comm. Article 7, supra m 10). As regards the profits made by
the enterprise in the State of the permanent establishment, a
distinction must always be made between those profits which
result from the permanent establishment’s activities and those
made, without any interposition of the permanent
establishment, by the head office or any other part of the
enterprise (also for mere assembly permanent establishment:

BFH 37 RIW 258 (1991). It is only when there is a connection
with the permanent establishment that the State of the
permanent establishment is entitled to impose tax. Conversely,
losses incurred in connection with direct transactions may not
be set off against a permanent establishment’s profits. Since a
DTC may not increase tax liability, the USA, it is true,
imposes tax at the lower amount that would ensue if the
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permanent establishment’s business and direct transactions
were combined and treated as if no DTC existed (of course,
the taxpayer may, in such event, not only set off the result of
individual direct transactions, which amounted to a loss
against the permanent establishment’s positive operating
result: I.R.S. Rev. Rul. 84-17, 1984-I Cum Bull 308).
According to that ruling, the taxpayer is in such cases entitled
to elect taxation which discounts the DTC (see supra Article I,
at m 44).‖
xxx xxx xxx

88. Therefore, in our opinion, the concepts of profits of business
connection and permanent establishment should not be mixed up.

Whereas business connection is relevant for the purpose of
application of Section 9; the concept of permanent establishment is
relevant for assessing the income of a non-resident under DTAA.
There, however, may be a case where there can be overlapping of
income; but we are not concerned with such a situation. The entire
transaction having been completed on the high seas, the profits on
sale did not arise in India, as has been contended by the appellant.
Thus, having been excluded from the scope of taxation under the
Act, the application of the Double Taxation Treaty would not arise.
The Double Taxation Treaty, however, was taken recourse to by the
appellant only by way of an alternate submission on income from
services and not in relation to the tax of offshore supply of goods.

xxx xxx xxx

92. Global income of a resident although is subjected to tax, global
income of a non-resident may not be. The answer to the question
would depend upon the nature of the contract and the provisions of
DTAA.

93. What is relevant is receipt or accrual of income, as would be
evident from a plain reading of Section 5(2) of the Act. The legal
fiction created although in a given case may be held to be of wide
import, but it is trite that the terms of a contract are required to be
construed having regard to the international covenants and
conventions. In a case of this nature, interpretation with reference to
the nexus to tax territories will also assume significance. Territorial
nexus for the purpose of determining the tax liability is an
internationally accepted principle. An endeavour should, thus, be
made to construe the taxability of a non-resident in respect of
income derived by it. Having regard to the internationally accepted
principle and DTAA, it may not be possible to give an extended
meaning to the words ―income deemed to accrue or arise in India‖ as
expressed in Section 9 of the Act. Section 9 incorporated various
heads of income on which tax is sought to be levied by the Republic
of India. Whatever is payable by a resident to a non-resident by way
of fees for technical services, thus, would not always come within
the purview of Section 9(1)(vii) of the Act. It must have sufficient
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territorial nexus with India so as to furnish a basis for imposition of
tax. Whereas a resident would come within the purview of Section
9(1)(vii) of the Act, a non-resident would not, as services of a non-
resident to a resident utilised in India may not have much relevance
in determining whether the income of the non-resident accrues or
arises in India. It must have a direct live link between the services
rendered in India, when such a link is established, the same may
again be subjected to any relief under DTAA. A distinction may also
be made between rendition of services and utilisation thereof.‖

50. In International Management Group, we had an occasion to
notice some of the salient principles with respect to source state
taxation as propounded in GVK Industries Limited and Another vs.
Income Tax Officer and Another17. This becomes evident from a
reading of paragraph 118 of our decision and which is reproduced
hereinbelow: –

“118. The territorial nexus which must imbue the issue of taxability
was duly recognized by the Supreme Court in GVK Industries,
where it held as follows:

―23. At this juncture, it is demonstrable that NRC is a non-
resident company and it does not have a place of business in
India. The Revenue has not advanced a case that the income had
actually arisen or received by NRC in India. The High Court has
recorded the payment or receipt paid by the appellant to NRC as
success fee would not be taxable under section 9(1)(i) of the Act
as the transaction/activity did not have any business connection.
The conclusion of the High Court in this regard is absolutely
defensible in view of the principles stated in CIT v. R.D.
Aggarwal and Co. [(1965) 56 ITR 20 (SC); 1964 SCC OnLine
SC 214.]
, CIT v. T.I. and M. Sales Ltd. [(1987) 166 ITR 93 (SC);
(1987) 3 SCC 132; 1987 SCC (Tax) 240.]
and Barendra Prasad
Ray v. ITO [(1981) 129 ITR 295 (SC); (1981) 2 SCC 693; 1981
SCC (Tax) 149.] . That being the position, the singular question
that remains to be answered is whether the payment or receipt
paid by the appellant to NRC as success fee would be deemed to
be taxable in India under section 9(1)(vii) of the Act ? As the
factual matrix would show, the appellant has not invoked Double
Taxation Avoidance Agreement between India and Switzerland.

That being not there, we are only concerned whether the ‘success
fee’ as termed by the assessee is ‗fee for technical service’ as
enjoined under section 9(1)(vii) of the Act. The said provision
reads as follows:

17

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xxx xxx xxx

25. The principal provision is clause (b) of section 9(1)(vii) of
the Act. The said provision carves out an exception. The
exception carved out in the latter part of clause (b) applies to a
situation when fee is payable in respect of services utilised for
business or profession carried out by an Indian payer outside
India or for the purpose of making or earning of income by the
Indian assessee, i.e., the payer, for the purpose of making or
earning any income from a source outside India. On a studied
scrutiny of the said clause, it becomes clear that it lays down the
principle what is basically known as the ‘source rule’, that is,
income of the recipient to be charged or chargeable in the country
where the source of payment is located, to clarify, where the
payer is located. The clause further mandates and requires that the
services should be utilised in India.

26. Having stated about the ‘source rule’, it is necessary to
appropriately appreciate how the concept has developed. At the
time of formation of ‗League of Nations’ at the end of 1920, it
comprised of only 27 countries dominated by the European States
and the United States of America. The United Nations that was
formed after the Second World War, initially had 51 members.

Presently, it has 193 members. With the efflux of time, there has
been birth of nation States which enjoy political independence
and that has led to cross-border and international trade. The State
trade eventually has culminated in formulation of principles
pertaining to international taxation jurisdiction. It needs no
special emphasis to state that the said taxation principles are
premised to promote international trade and to allocate taxation
between the States. These rules help and further endeavour to
curtail possibility of double taxation, tax discrimination and also
to adjudicate resort to abusive tax avoidance or tax evasion
practices. The nation States, in certain situations, resort to
principle of ‗tax mitigation’ and in order to protect their citizens,
grant benefit of tax abroad under the domestic legislation under
the bilateral agreements.

27. The two principles, namely, ‘situs of residence’ and ‘situs of
source of income’ have witnessed divergence and difference in
the field of international taxation. The principle ‗residence State
taxation’ gives primacy to the country of the residency of the
assessee. This principle postulates taxation of worldwide income
and worldwide capital in the country of residence of the natural or
juridical person. The ―source State taxation‖ rule confers primacy
to right to tax to a particular income or transaction to the
State/nation where the source of the said income is located. The
second rule, as is understood, is transaction specific. To elaborate,
the source State seeks to tax the transaction or capital within its
territory even when the income benefits belongs to a non-resident
person, that is, a person resident in another country. The aforesaid
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principle sometimes is given a different name, that is, the
territorial principle. It is apt to state here that the residence based
taxation is perceived as benefiting the developed or capital
exporting countries whereas the source based taxation protects
and is regarded as more beneficial to capital importing countries,
that is, developing nations. Here comes the principle of nexus, for
the nexus of the right to tax is in the source rule. It is founded on
the right of a country to tax the income earned from a source
located in the said State, irrespective of the country of the
residence of the recipient. It is well settled that the source based
taxation is accepted and applied in international taxation law.

28. The two principles that we have mentioned hereinabove,
are also applied in domestic law in various countries. The source
rule is in consonance with the nexus theory and does not fall foul
of the said doctrine on the ground of extra-territorial operation.
The doctrine of source rule has been explained as a country where
the income or wealth is physically or economically produced.
(See League of Nations, Report on Double Taxation by Bruins,
Einaudi, Saligman and Sir Josiah Stan (1923)). Appreciated on
the aforesaid principle, it would apply where business activity is
wholly or partly performed is a source State, as a logical
corollary, the State concept would also justifiably include the
country where the commercial need for the product originated,
that is, for example, where the consultancy is utilised.

29. From the aforesaid, it is quite vivid that the concept of income
source is multifaceted and has the potentiality to take different
forms (See Klans Vogel, World-wide v. Source Taxation of
Income-Review and Revision of Arguments (1988)). The said rule
has been justified by Arvid A. Skaar in Permanent Establishment;
Erosion of Tax Treaty Principle on the ground that profits of
business enterprise are mainly the yield of an activity, for capital
is profitable to the extent that it is actively utilised in a profitable
manner. To this extent, neither the activity of business enterprise
nor the capital made, depends on residence.‖

51. Vogel while explaining the circumstances in which issues
relating to double taxation arise makes the following pertinent
remarks18: –

“A. Double Taxation and Its Avoidance

I. Circumstances Giving Rise to ‘Double Taxation’

18
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2 International juridical double taxation mainly arises today
because the vast majority of States, in addition to levying taxes on
domestic assets and domestic economic transaction, levy taxes on
capital situated and transactions carried out in other countries to the
extent that they benefit resident taxpayers. For example, the foreign
income or foreign capital of a resident natural or juridical person is
often subject to taxation based on the ‘principle of residence’
(taxation of worldwide income or worldwide capital). At the same
time, however, no State waives its taxation of transactions or capital
within its own territory even if they benefit, or belong to, non-
resident persons (principle of source; the term ‘territoriality
principle’ is avoided here because a variety of different meanings
have been attributed to it).” As a consequence, tax claims of different
States necessarily overlap.

3 Secondly, double taxation may also arise when a person is
deemed a resident simultaneously by two (or more) States or
because source rules overlap (i.e., because two (or more) States treat
the same economic transaction or item of capital as having occurred
or being situated in their territory). Thirdly, double taxation may
arise because certain States tax the worldwide income of their
citizens even when they are residents of another State (in particular
the US and Eritrea; Bulgaria, Mexico, Myanmar, the Philippines and
Vietnam gave up their earlier citizenship-based taxation).
4 By contrast, the term ‘economic double taxation’ is used to
describe the situation that arises when the same economic
transaction, item of income or capital is taxed in two or more States
during the same period, but in the hands of different taxpayers (so-
called ‗lack of subject identity’). Economic double taxation will
occur if assets are attributed to different persons by the domestic law
of the States involved, as, for example, when the tax law of one State
attributes an item of capital to its legal owner whereas the tax law of
the other State attributes the item of capital to the person in
possession or economic control. Economic double taxation may also
arise if, for example, alimony paid by a husband to his wife is
considered income and taxed in her hands while not being allowed to
be deducted as an expense by the husband in his residence State or if
one State taxes a legal entity at its place of residence whereas
another State disregards the legal entity and taxes its income or
capital by attributing it to a resident shareholder. Furthermore,
economic double taxation can result from conflicting rules regarding
the inclusion or deduction of positive and negative elements of
income and capital as, for example, in cases of transfer pricing.
Occasionally, the term ‗economic double taxation’ is also used to
describe the taxation of a corporation’s income that is taxed initially
at the corporate level and subsequently at the shareholder level (the
so-called ‗classical system of corporate taxation’).
5 The concept of ‗double taxation’, its prerequisites and its
limitations, have been subject to much academic controversy.

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Application of tax treaties, however, is merely a matter of
interpretation of the respective treaty. What conceptually is- and
what is not- ‗double taxation’ is therefore of no importance for the
treaty’s application.

6 The law of double taxation is a branch of what is commonly
called ‘international tax law’. Traditionally, this term has been
used to refer to all international as well as domestic tax provisions
relating specifically to situations involving the territory of more than
one State, so called ‗cross-border situations’.‖

52. Article 7 of the DTAA postulates that the profits of an enterprise
shall be taxable only in that State. It thus, and as a matter of first
principle, restricts the taxation of profits of an enterprise only to and in
the State of which it may be a resident. However, it then proceeds to
expand the scope of taxability by taking into consideration the activities
that may be undertaken by such an enterprise in the other Contracting
State through a PE situate therein. This is further explained with Article
7(1) prescribing that if the enterprise were carrying on business through
a PE situate in the other Contracting State, its profits would become
liable to be taxed in the other State, restricted however, to the extent
that those profits are attributable to that PE.

53. On a plain reading of Article 7(1), it becomes apparent that while
the profits of an enterprise of a Contracting State are ordained to be
taxed only in that State, if that enterprise were to carry on business in
the other Contracting State through a PE, the profits earned from
activities undertaken by such an establishment would become subject to
tax in the other State coupled with the rider of the same being confined
to the extent to which those profits are attributable to such an
establishment.

54. As we read Article 7, it becomes evident that Paragraph (1)
clearly envisages the profits of a PE being liable to be independently
taxed notwithstanding that PE being a constituent of a larger enterprise
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which may be domiciled in the other Contracting State. The exemption
from taxation which stands accorded to an enterprise of a contracting
State would cease to be applicable by virtue of the use of the word
―unless‖ which precedes the Article taking into consideration the
existence of a PE of that enterprise in the other Contracting State.
Article 7(1) proceeds to clarify that if the enterprise were carrying on
business through a PE in the other Contracting State, its profits to the
extent attributable to that PE would become subject to tax in the other
State.

55. Article 7(1) thus in clear and unequivocal terms constructs a
dichotomy between the profits that may be earned by an enterprise on a
global scale and those which are attributable to a PE situate in the
Contracting State. This becomes further evident from a reading of
Paragraph (2) of Article 7 and which stipulates that where an enterprise
carries on business through a PE in the other Contracting State, profits
would be liable to be attributed to that PE as if it were a distinct and
separate enterprise engaged in similar activities and independent of the
enterprise of which it may be a part.

56. This aspect is further amplified when we bear in consideration
Article 7(2) employing the phrase ―dealing wholly independently with
the enterprise of which it is a permanent establishment‖. Article 7(2)
thus clearly bids us to view the PE as a distinct and separate entity
engaged in undertaking business activity in its own right in a
Contracting State. It would consequently and on a fundamental plane be
incorrect to fuse the incomes generated by an enterprise as a whole with
the income that may be earned by a PE in one of the Contracting States.

57. It would also be incorrect to interpret Article 7 as requiring us to

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ignore the income that may be generated pursuant to activities
undertaken by a PE in one of the Contracting States and making the
exercise of attribution dependent upon the profits or the income that the
enterprise may otherwise earn at an entity level. In fact, Article 7(1)
itself excludes the profits of an enterprise from being subjected to tax
till such time as such an entity carries on no business in the other
Contracting State through a PE.

58. Consequently, even though a PE may be merely a part of the
larger entity, the profits generated from its activities undertaken in the
other State becomes subject to taxation. Article 7(1) further requires us
to undertake an exercise of identifying the extent of profits as are
attributable to the PE. It is to that extent alone that the profits of the
enterprise ultimately come to be taxed.

59. The view that we have taken above also finds support from the
OECD Commentary on Article 7 and relevant parts whereof have been
extracted in paragraph 39 of this judgment. As the Commentary
succinctly explains, the taxation right of the source State is dependent
upon the existence of a PE. That since such an establishment
participates in economic activity within the territory of the source State.
It is in the aforesaid context that the Commentary refers to it as
constituting a “separate source of profit”. Of equal significance are the
observations in the Commentary and which bids us to bear in
consideration the possibility of profits being attributed to the PE even
though the entity as a whole had never earned the same.

60. Proceeding further to explain the ambit of Paragraph 2 of Article
7, the OECD Commentary observes: –

―Paragraph 2

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15. Paragraph 2 provides the basic rule for the determination of the
profits that are attributable to a permanent establishment. According
to the paragraph, these profits are the profits that the permanent
establishment might be expected to make if it were a separate and
independent enterprise engaged in the same or similar activities
under the same or similar conditions, taking into account the
functions performed, assets used and risks assumed through the
permanent establishment and through other parts of the enterprise. In
addition, the paragraph clarifies that this rule applies with respect to
the dealings between the permanent establishment and the other parts
of the enterprise.

16. The basic approach incorporated in the paragraph for the
purposes of determining what are the profits that are attributable to
the permanent establishment is therefore to require the determination
of the profits under the fiction that the permanent establishment is a
separate enterprise and that such an enterprise is independent from
the rest of the enterprise of which it is a part as well as from any
other person. The second part of that fiction corresponds to the arm’s
length principle which is also applicable, under the provisions of
Article 9, for the purpose of adjusting the profits of associated
enterprises (see paragraph 1 of the Commentary on Article 9).

17. Paragraph 2 does not seek to allocate the overall profits of the
whole enterprise to the permanent establishment and its other parts
but, instead, requires that the profits attributable to a permanent
establishment be determined as if it were a separate enterprise.

Profits may therefore be attributed to a permanent establishment
even though the enterprise as a whole has never made profits.
Conversely, paragraph 2 may result in no profits being attributed to a
permanent establishment even though the enterprise as a whole has
made profits.

18. Clearly, however, where an enterprise of a Contracting State has
a permanent establishment in the other Contracting State, the first
State has an interest in the directive of paragraph 2 being correctly
applied by the State where the permanent establishment is located.
Since that directive applies to both Contracting States, the State of
the enterprise must, in accordance with either Article 23 A or 23 B,
eliminate double taxation on the profits properly attributable to the
permanent establishment (see paragraph 27 below). In other words,
if the State where the permanent establishment is located attempts to
tax profits that are not attributable to the permanent establishment
under Article 7, this may result in double taxation of profits that
should properly be taxed only in the State of the enterprise.‖

61. Global income, as a fundamental precept, has always been
invoked in respect of residents of a Contracting State. Most Nations
have ultimately reverted to the source rule for purposes of taxation. We
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are thus called upon to deal with a regimen which concerns itself with
the source from which income accrues or arises. This precept also
stands mirrored in Section 5 of the Income Tax Act, 196119 and which
jettisons the principle of territoriality only in respect of income earned
by a resident. Thus, taxation based on worldwide income stands
confined to natural residents. However, no Nation avowes or waives its
right to tax capital or transactions which are anchored to its own
territory. It is this basic precept of source which continues to bind.

62. The distinction which needs to be borne in mind with regard to
the income of a non-resident as opposed to an entity domiciled and
stationed in one of the Contracting States stands duly acknowledged in
Section 5 of our Act and which subjects the global income of a resident
alone to taxation. For non-residents, it is the principles of income
accruing or arising which are decreed to govern. It is these broadly
accepted and well recognised principles which imbue the DTAA also.

63. As was noticed hereinabove, the profits of an enterprise do not
become subject to taxation unless it be found that it functions in the
other Contracting State through a PE. Article 7 further postulates that it
is only such income which is attributable to the PE which would be
subjected to tax in the source State. As is pertinently noted in the
OECD and UN Commentaries, it would be wholly incorrect to found
taxation on the basis of the overall activities or profitability of an
enterprise. The source State is ultimately concerned with the income or
profit which arises or accrues within its territorial boundaries and the
activities undertaken therein. As those commentaries pertinently
observe, the profits attributable to a PE are not liable to be ignored on
the basis of the performance of the entity as a whole. This position also
19 Act

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finds resonance in the decisions of the Supreme Court in Morgan
Stanley and Ishikawajama and relevant parts whereof have been
extracted above.

64. If the submission of the appellants were to be accepted, the
Revenue would be recognised to have the power to tax even in a
situation where although the entity be profitable, the PE may have
incurred a loss. If the aforesaid logic were to be applied, in a converse
situation, the Contracting State would be countenanced to have the right
to tax only if the assessee at a global level were found to have earned
profit. That is clearly not the import of Article 7 of the DTAA. While
protecting the right of an enterprise to be subject to tax in the State
where it be resident, Article 7 places a negative stipulation in respect of
cases where a PE is found to exist coupled with an attribution exercise
being undertaken in respect of the domestic enterprise. The contention
of the respondents essentially requires us to confer a judicial
imprimatur upon the principle that the domiciled entity, namely a PE,
would be liable to be taxed only if the global enterprise were profitable.
This even though the income of that entity, by virtue of Article 7, stands
restricted to the extent of income being attributable to the PE. In fact,
Article 7 itself restricts the taxability of the enterprise to the extent of
income or profit attributable to the PE. We are thus of the firm opinion
that the argument of global income or profit being relevant or
determinative is totally unmerited and misconceived. The submission is
clearly contrary to the weight of authority which has been noticed
hereinabove.

65. Regard must also be had to the fact that Article 7 does not
expand its gaze or reach to the overall operations or profitability of a
transnational enterprise. It is concerned solely with the profits or
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income attributable to the PE. The taxability of income earned by a PE
existing in a Contracting State is not even remotely linked or coupled to
the overall operations of the enterprise of which it may be a part. The
argument of world-wide income is thus rendered wholly untenable.

66. On an overall consideration of the above, we come to the firm
conclusion that the submission of global income being determinative of
the question which stood referred, is wholly unsustainable. The
activities of a PE are liable to be independently evaluated and
ascertained in light of the plain language in which Article 7 stands
couched. The fact that a PE is conceived to be an independent taxable
entity cannot possibly be doubted or questioned. The wealth of
authority referred to hereinabove clearly negates the contention to the
contrary and which was commended for our consideration by the
appellants. Bearing in mind the well-established rule of source which
applies and informs the underlying theory of taxation, we find ourselves
unable to countenance the submission of the source State being
deprived of its right to tax a PE or that right being dependent upon the
overall and global financials of an entity. The Division Bench in these
appeals rightly doubted the correctness of taxation being dependent
upon profits or income being earned at the ―entity level‖. The decision
of the Special Bench in Motorola Inc. has clearly been misconstrued
and it, in any case, cannot be viewed to be an authority for the
proposition which was canvassed on behalf of the appellants. Article 7
cannot possibly be viewed as restricting the right of the source State to
allocate or attribute income to the PE based on the global income or
loss that may have been earned or incurred by a cross border entity.

67. We would thus answer the Reference by holding that the
tentative view expressed by the Division Bench in these set of appeals
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as well as the doubt expressed with respect to the findings rendered in
Nokia Solutions was well founded and correct. The Reference stands
answered in terms of our conclusions set forth in paragraph 66 above.

68. The papers of these appeals may now be placed before the
appropriate Roster Bench for disposal in light of our conclusions
recorded hereinabove.

YASHWANT VARMA, J.

SANJEEV NARULA, J.

PURUSHAINDRA KUMAR KAURAV, J.

SEPTEMBER 19, 2024/neha

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