Permanent Establishment in India – Relevance and Meaning of “Preparatory and Auxiliary”

Bijal Doshi, Partner and Tamanna Parekh, Associate examine the Indian perspective on the exclusion clause of Article on Permanent Establishment under a tax treaty i.e. activities are of “preparatory and auxiliary” character

Background:

Foreign companies often establish an office/Company in India (a liaison office (LO), branch, subsidiary or have consultants who primarily work for the foreign Company) to conduct activities such as gathering market intelligence, coordination with parent, their clients, etc, providing backend support and other similar assisting activities. 

Such activities, depending on the functions and degree of involvement in India, can lead to a Permanent Establishment (PE) in India under the Double Taxation Avoidance Agreement (“DTAA”). It is, however, important to understand the exact nature of activities and whether the same can be regarded as “preparatory and auxiliary”, thereby not having a PE in India.

Analysis of PE: 

Most Indian tax treaties are based on the United Nations Model Tax Convention (UN Model). While this model serves as a foundation for our analysis, the specific provisions of the relevant Double Taxation DTAA will prevail and dictate the taxability. 

Article 5(1) and 5(2) of the UN Model- Fixed Place of Business (similar in most DTAAs)

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

1. The term “permanent establishment” includes especially:
   a) A place of management; 
   b) A branch;
   c) An office;
   d) A factory
   e) …….”

While a fixed place of business may exist in India for a foreign Company, this alone does not establish the existence of a PE under Article 5 of the UN Model; though a branch is regarded as a PE. In order to be regarded as having a PE in India, the fixed place must carry on the core business activities of the foreign Company. The assessment of whether such a fixed place constitutes a PE requires a thorough examination of the Foreign Company’s actual activities.

Article 5 (4) (e) of the UN Model- Preparatory and Auxiliary Services (similar wordings in DTAAs signed by India)

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

(e) the maintenance of a fixed place of business solely for the purpose of carrying on any activity for the enterprise, provided that such activity is of a preparatory or auxiliary character….”

The terms ‘preparatory’ and ‘auxiliary’ are not explicitly defined under the Indian Income tax Act, 1961 or under any DTAA. There are, however, various commentaries and case laws on the same.

According to the UN Commentary, activities of a preparatory or auxiliary nature are those which do not form an essential and significant part of the enterprise’s business. A preparatory activity is one carried out in anticipation of the enterprise’s core operations, typically preceding the main revenue-generating activities. An auxiliary activity supports the business but does not contribute directly to profit generation.

Further, the UN Commentary highlights that even if an activity continues for a substantial period, as long as it remains purely preparatory or auxiliary, it does not establish a PE.

As per the Organisation for Economic Cooperation and Development commentary, the decisive criterion is whether or not the activity of the fixed place of business in itself forms an essential and significant part of the activity of the enterprise as a whole. It states that, as a general rule, an activity that has a preparatory character is one that is carried on in contemplation of what constitutes the essential and significant part of the activity of the enterprise as a whole. An activity that has an auxiliary character generally corresponds to an activity that is carried on to support, without being part of the essential and significant part of the activity of the enterprise as a whole.

The issue of whether the activities are of “preparatory and auxiliary” in nature, has been examined in many cases by various Courts in India.

In the case of UAE Exchange Centre v Union of India (2020), the Honorable Supreme Court of India analysed the meaning of the terms ‘preparatory’ and ‘auxiliary’.  It mentioned that the dictionary meaning of the expression ‘preparatory’ can be traced to the term ‘preparatory work’. Further, for the meaning of “auxiliary”, it mentioned that as per the Concise Oxford English Dictionary (12th edition), it would mean “as providing additional help or support” and in Black’s Law Dictionary (11th edition), the term ‘auxiliary’ is defined as “1. Aiding or supporting, 2. Subsidiary. 3. Supplementary”. In the instant case, the UAE Exchange Centre, a Company based in the UAE, operated a LO in India to facilitate its remittance services for non-resident Indians. The Supreme Court emphasized that this LO merely supported the primary business operations conducted in the UAE. Activities performed by the LO, such as downloading information and processing cheques, were deemed auxiliary to the main business activities of the Company and hence did not constitute a PE in India.

The Court referred to DIT (International Taxation), Mumbai v. Morgan Stanley & Co. Inc.(2007) (“MS & Co.”), where the Honorable Supreme Court of India addressed the tax implications of Morgan Stanley Advantage Services Private Limited (“MSAS”), a wholly owned subsidiary established to provide back-office support functions for its parent Company, MS & Co. The activities of MSAS primarily involved IT services, account reconciliation, and research support, which were deemed preparatory and auxiliary in nature. The Honorable Supreme Court held that these functions did not create a PE for MS & Co. in India. 

In the case of GE Energy Parts Inc. v CIT (International Taxation), Delhi-I (2018) the Honorable Delhi High Court ruled that the activities carried out by GE Energy Parts through its LO in India constituted a PE under Indian tax law. The Court emphasized that the complex nature of sales and marketing activities, which involved technical specifications, commercial terms, and financial negotiations, necessitated the involvement of qualified employees. This substantial role of the Indian LO indicated that its activities were integral to GE’s core business operations and the Court held that it had a PE in India. 

Another relevant case is Progress Rail Locomotive Inc. v. DCIT (2024), where the Delhi High Court held that the Indian subsidiary of the U.S.-based company, which provided specific business functions such as monitoring tenders, providing technical support, and conducting back-office operations, were preparatory and auxiliary services under Article 5(3) of the India-USA DTAA and did not constitute a PE. The Court clarified that, for a fixed place PE to exist, the foreign entity must effectively conduct its primary business operations through the subsidiary in India. 

In the case of Master Card Asia Pacific Pte. Ltd.  (2018 ) the Company operated a card interface processor in India, responsible for critical functions in transaction processing. These activities included not only preliminary verification of transactions but also the encryption of data through a network of transmission towers, which were integral to ensuring secure payment processing. The Authority for Advance Ruling held that these operations were significant enough to exceed the threshold of ‘preparatory and auxiliary’ activities, thereby constituting a PE in India for the foreign entity. 

Conclusion: 

In summary, the mere existence of a fixed place of business in India does not automatically result in the establishment of a PE. A detailed examination of the specific business activities conducted from that place is essential to determine if they are the core operations of the foreign Company and generate revenue. Thus, a thorough analysis of each case’s unique circumstances is crucial to ascertain PE existence under Indian tax law, highlighting the need for professional guidance in navigating the complexities of cross-border operations and their tax implications.

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