The taxability of income earned by foreign companies through their liaison/branch/representative offices is always a complex treatment. Foreign companies in India are only taxed on the income that arises or accrues through ‘business connections’ in India. Further, the double taxation treaties entered into between Indian and the domiciled jurisdiction of the foreign company will also influence the tax treatment of the incomes.
Generally, double tax treatment agreements will state that the whole income earned by foreign offices in India will only be taxable as business income under the Income Tax Act, if such incomes are earned through permanent establishments and business connections in India. In the event that the incomes earned are only in the vein of technical fees, royalty or interest, then such incomes will not be taxed as ‘business income’.
At the end of 2020, the Income tax Appellate Tribunal of Mumbai looked into this matter in the case of DZ Bank wherein the assessing officers alleged that all incomes earned by the foreign representative office in India (including interest incomes and commitment fees), would be taxable in India.
How are Foreign Offices Taxed in India:
In international taxation, the taxability of the income of a foreign company in a domestic jurisdiction is dependent on whether the activities of the company are conducted through a permanent establishment (‘PE’). A PE is defined in Indian law, as “a fixed place of business through which the business of a foreign enterprise is carried on wholly or in part.”
A PE provides a mechanism to determine the taxation of companies that might be widely established across different countries. India taxes the business income of a non-resident company that arises or accrues either directly or indirectly through (or from) its PE in India.
Hence, whether or not PEs have been established in a country, becomes a very important question for companies.
Once a PE of a foreign company is determined in India, then the business income (royalty fees, technical service fees, etc.) derived from the PE, which is attributable to India, will be subject to taxation under the IT Act. I.e. the facts and circumstances will have to be considered to determine which of the income can be attributed to the PE operations in India. This is done by doing an analysis of the functions performed, assets utilized and risks assumed (FAR analysis). Only the income attributed to India will be taxed in India. If the foreign entities have permanent establishments then their income earned in India will be taxed as business income taxable at 40% (rate charged for non-resident companies in India).
If they do not have a permanent establishment, foreign companies are still liable to pay tax on any income earned by way of interest, technical fees, or royalties. If they are considered to be only foreign entities (without a PE in India) then only such income that arises or accrues through India will be taxable in India.
DZ Bank (Representative Office vs. DCIT)
Facts of the Case:
- DZ Bank AG is a foreign bank incorporated in Germany which was working through a representative office in India. According to the Reserve Bank of India’s rules, the representative or liaison offices of foreign companies are not allowed to carry on any commercial businesses. Hence DZ Bank AG’s representative office in India was not engaged in carrying on any banking business.
- The DZ Bank argued that foreign companies (under section 115A of the Income Tax Act), are exempt from filing income returns if they only earn income by way of interest on foreign currency loans. They also deducted the required tax at source on the interest payable by Indian customers.
- The tax authorities contended by arguing that the representative office in India was a permanent establishment and all income earned in India should be taxed at 40%.
- The tax authorities argued that as DZ Bank had an established PE in India, all incomes by way of interest or commitment fees would be taxable as they were earned through the permanent establishment.
Holding of the Tribunal:
The Indo-German tax treaty has stated that the business income of a foreign unit in India will be taxable only if it arises through a permanent establishment. Else only the interest, technical fees, royalty or other such income will be liable under the taxable rates in India. However, such interest income can be taxed as business income under the treaty if it satisfies two conditions:
- That the foreign unit was carrying on business in the source jurisdiction, and
- That the debt on which interest is paid is effectively connected with the permanent establishment.
The tribunal held that the representative office in India was not in the nature of a permanent establishment, and the income arising by way of the interests paid by Indian customers on the foreign currency loans could not be taxed as business income. Representative offices have limited functioning in India and are not allowed to conduct commercial activities, although they do sometimes carry out economic activities. Further, even if the representative office was in the nature of a permanent establishment, the authorities had to prove that there was an effective connection between the permanent establishment and the debt to tax the interest as business income. No such connection existed in the case at hand.
The tribunal also clarified that when a foreign entity is taxed in India it is always the foreign company that is taxable and not the Indian office. i.e. DZ Bank AG is taxable and not the Indian office of the foreign bank.
Important Highlights:
- The tribunal held that the same amounts/incomes could not be taxed twice under different provisions of a double taxation treaty.
- The tribunal also held that the specific provisions of a double taxation treaty will be applicable over and above the general provisions.
- Under the Indo-German treaty, the income earned by way of interest cannot be taxed as business income unless the conditions therein are satisfied.
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