-Business Connection- A New Look!
Article By: CA. Harsh Mathur
Business connection has always been an ambiguous term for the judiciary as well as tax payers!
Section 9(1)(i) of the Indian Income Tax Act 1961, tax any income earned by a Non Resident from a business connection in India. The term business connection has not been expressly defined in the act per se. The term has been the subject matter of various interpretations of judicial pronouncements
The finance act has widened the scope of the term business connection in line with BEPS action plan 7 by making an amendment in clause a of section 9 in explanation 2
This Action Plan proposes measure to curb the practice of multi-national companies of artificially avoiding the PE in source state through commissionaire arrangements.
The background of the loophole
The explanatory notes to finance bill 2018 released by CBDT dated 26.12.2018 states the problem before the amendment as below:
“Before amendment by the Act, the provisions of Explanation 2 to clause (i) of sub section (1) of section 9 of the Income-tax Act specified that "business connection" includes business activities carried on by non-resident through dependent agents. The scope of "business connection" under the Income-tax Act is similar to the provisions relating to Dependent Agent Permanent Establishment (DAPE) in India's Double Taxation Avoidance Agreements (DTAAs). In terms of the DAPE rules in tax treaties, if any person acting on behalf of the non-resident is habitually authorised to conclude contracts for the non-resident, then such agent would constitute a Permanent Establishment (PE) in the source country. However, in many cases, with a view to avoid establishing a PE under paragraph 5 of Article 5 of the DTAA, the person acting on the behalf of the non-resident, negotiates the contract but does not conclude the contract.
As clearly mentioned in the para above, many agents took benefit of this loophole and entered into a 'commissionaire arrangements' in a given State in its own name instead of its actual owner which eventually erodes the taxable base of the State where sale takes place.
What is Commissionaire Arrangements?
Commissionaire Arrangements: A 'Commissionaire Arrangement' is defined as an arrangement through which a person sells products in a given State in its own name but on behalf of a foreign enterprise who is the owner of the products. Through such an arrangement, a foreign enterprise is able to sell its products in a State without having a PE to which such sales may be attributed for tax purposes. Since the person that concludes the sales does not own the products, he cannot be taxed on the profits derived from such sales and may only be taxed on the remuneration that he receives for the services (usually a commission).
For example- A representative of a pharmaceutical enterprise actively promotes drugs produced by that enterprise by contacting doctors who subsequently prescribe these drugs.
Analysis- Though the marketing activity of the representative increases sales it does not directly result in the conclusion of contracts between the doctors and the enterprise and hence no deemed PE. The agents
work on commission basis and as they are selling products on their own name, they dodge the four-corners of concluding contracts on behalf of Non-resident principal.
BEPS recommendation to address the above loophole:
The OECD under BEPS Action Plan 7 reviewed the definition of 'PE' with a view to prevent the avoidance of payment of .The BEPS Action plan 7 recommended modifications to para (5) of Article 5 to provide that an agent would include not only a person who habitually concludes contracts on behalf of the non-resident, but also a person who habitually plays a principal role leading to the conclusion of contracts:
(i) In the name of the enterprise; or
(ii) For the transfer of the ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use; or
(iii) For the provision of services by that enterprise
The principal role test will now play a major role in determining the extent to which authorities can include the transactional arrangement in the business purpose scope.
Whether or not a person habitually concludes contracts or habitually plays a principal role as above, should be determined on the basis of the commercial expediency of the situation.
The amended definition brings within agency PE not only the contracts that create rights and obligations that are legally enforceable between the enterprise on behalf of which the person is acting and the third parties with which these contracts are concluded but also to contracts that create obligations that will effectively be performed by such enterprise rather than by the person contractually obligated to do so.
While mere promotion and marketing, limited risk distribution and activities that do not directly result in conclusion of contract gets excluded from agency PE; it is significantly expanded when it brings within agency PE any person, who has no authority to conclude contracts but plays a principal role leading to conclusion of contracts by enterprise routinely
d) India's action on BEPS recommendations: The recommendations under BEPS Action Plan 7 have been included in Article 12 of Multilateral Convention to Implement Tax Treaty Related Measures (herein referred to as 'MLI'), to which India is also a signatory. Consequently, these provisions will automatically modify India's bilateral tax treaties covered by MLI, where treaty partner has also opted for Article 12.
As a result, the Article 5(5) i.e. DAPE ( Dependent agent Permanent Establishment) of India's tax treaties, as modified by MLI, shall become wider in scope than the current provisions in Explanation 2 to Section 9(1)(i) of the Income-tax Act.
Need for amendment in Section 9
Since, in the current situations, the provisions of the domestic law being narrower in scope are more beneficial than the provisions in the DTAAs. Section 9 of the Act was amended so as to align them with the provisions in the DTAA as modified by MLI so as to make effective the provisions of treaties.
Question and Answer
Q1. Is the term principal role defined in Income Tax Act, 1961?
Ans. No, the term Principal Role is not defined in the Act. However OECD model commentaries have managed to give a comprehensive understanding of the term.
Q2. If the agent of a Non resident cannot on its own change or modify the terms of the contract, will it still be considered in the ambit of principal role?
Ans. Yes, the fact that the agent cannot on its own change or modify the terms of the contract does not mean that the conclusion of the contract is not the direct result of the activity he performed on behalf of the Non-resident.
Q3. This amendment is applicable from which date?
Ans. This amendment is applicable from AY 2019-20 i.e. from 1st April 2019.
Q4. Why this amendment has been brought through Multilateral Convention to Implement Tax Treaty Related Measures ('MLI')?
Ans. India is a signatory to MLI and to make the process faster and convenient amendment has been done in article 12 of MLI which will automatically modify India's Bilateral agreements covered by MLI where its treaty partner has also opted for article 12.
Q5. Does this amendment withdraws the DAPE provisions in para 5 of article 5 of India's DTAA?
Ans. No, it further widens the scope of application of the article.
REF: OECD Commentary, Explanatory notes to Finance Bill 2018.