A luxury smart watch company based in Switzerland (“Company”) decides to establish a dedicated warehouse in India through a third party logistics provider (“3PLP”). The Company only develops high end applications to run the product, while the manufacturing is outsourced to an unrelated manufacturer in China.

The Company sources polished diamonds used in manufacture, from India, and has a liaison office (“LO”) for this purpose. Assuming that the Company has no other presence in India, and sales are undertaken only through online transactions, with 3PLPs delivering goods, would the Company have tax implications in India?

We will examine potential permanent establishment (“PE”) exposure for the Company, under the extant legal interpretations in India, and the proposed revised Commentary to the OECD Model Tax Convention under Action 7 of the BEPS[1] Final Report (“Report”).

Warehouse:

Many of India’s tax treaties include warehouses in their positive list of fixed place of business PE. Typically, such warehouses are intended to constitute PE where a foreign enterprise is in the business of letting out storage space or other facilities to third parties[2]. This is based on the premise that mere storage of one’s own goods could not result in any business earnings. In India, courts have examined the question of warehouses constituting PE and various precedents have emerged. In one case, where the subsidiary of a foreign company was engaged exclusively in the activity of storage for third parties as per instructions received from its foreign parent, the Indian subsidiary was held to be a PE[3].

In another case, a Singaporean resident company had engaged a third party warehouse to store and deliver goods. The fact that the foreign company personnel could enter the warehouse for inspection, inventory and related purposes, was construed as the space being ‘at the disposal’ of the foreign company, thereby constituting a PE[4]. However, another ruling held that where a foreign company had placed its goods in the warehouse belonging to its customer so that the goods were in the possession and at the disposal of the customer, the customer’s warehouse could not be construed as a fixed place PE of the foreign enterprise[5]. The Seagate ruling has been subject to extensive criticism and may not be sacrosanct in cases of warehouses constituting PE.

LO in India:

Often, foreign companies establish LOs to source goods for export from India. To allow benefits to non-resident exporters who purchase goods in India, the Income Tax Act (ITA) clarifies that no income shall be deemed to accrue or arise in India through or from operations, which are confined to the purchase of goods in India for export. India’s tax treaties too provide a PE exception where the foreign entity is exclusively engaged in purchase activities.

However, the Indian revenue authorities have, in a plethora of cases involving LOs engaged in sourcing of goods, tried to impute PE and sought to tax ostensible incomes arising in India. Over the course of the last few years, many LOs have received relief at the higher tax forums, which have recognized that sourcing activities do not per se qualify as a business activity and would fall within the exception for collection of information/purchase of goods for export, provided under tax treaties [6].

Online sales:

Income derived from sale of goods is typically in the nature of business income and therefore, only if a foreign company has a business connection/PE in India can such income be taxed in India. So, if the Company does not have a PE, online sale of watches may not be liable to tax in India.

Impact of the Report

Broadly, the Report seeks to prevent artificial avoidance of PE using certain common tax avoidance strategies. It has been recognised that activities which were previously regarded as preparatory or auxiliary could nowadays correspond to core business activities.

In this regard, in a far reaching change, the Report proposes to allow specific activity exemptions from PE to be made available only in cases where the activity is preparatory or auxiliary. Importantly, storage of goods for purpose of delivery or processing would be exempt only where the activity is preparatory or auxiliary in character.

This means that if the activity is an essential and important part of the core business of the foreign entity, there may be potential PE exposure. Similarly, in relation to 3PLP warehouses, a PE may exist if the foreign company has ‘unlimited access’ to such place of storage for the purpose of inspection and maintenance of goods, with the activity itself not being preparatory or auxiliary.

The Report’s focus on preparatory or auxiliary characteristics is intended to deny PE exclusions in cases where the activity represents an important part of the supply chain. Pertinently, the Report also recognizes that in ecommerce transactions specifically, the delivery of goods exception may be subject to abuse since delivery in such cases are actually value added services.

The Report also clarifies that where a fixed place of business is used only for the purchase of goods, and such purchase activity forms the core function of the enterprise, such activity will not qualify as preparatory or auxiliary, thus resulting in a PE.

In our example, the Company may have to first examine whether storage and delivery forms its core business. The Company may argue that its core business is the development of smart watch apps; but given that it follows an online sales model, where shortest delivery time is a prerequisite, the storage of goods in 3PLP warehouse may be construed as more than a mere auxiliary function.

Further, access to inventory and maintenance is a commercial requirement and unfortunately, the meaning of ‘unlimited access’ itself has not been clarified. This may potentially give rise to litigation, with Indian Revenue authorities trying to use Seagate principles.

As far as purchase exemption is concerned, since sourcing of polished diamonds is not the Company’s core business, it can be argued that the activity is auxiliary. Hence, the purchase exemption under both ITA and treaty may continue to be available. However, in case of entities whose core business is sourcing of goods, the Report denies PE exemption, though ITA may continue to do so.

How will the Report be adopted in India? India is likely to ratify the Multilateral Instrument as envisaged by the OECD’s BEPS Action Plan 15, thereby amending bilateral tax treaties, and plugging loopholes.