The dogma of physical presence in the International Tax Treaties
**Lovish J Goyal
Introduction
The Delhi High Court’s (“DHC”) recent judgment in Commissioner of Income Tax v. Clifford Chance Pte Ltd (“Clifford Chance”) is a stark example of the widening gulf between twentieth-century laws and the realities of the modern economy, which is increasingly becoming digital. The DHC in Clifford Chance resorted to an interpretation of Article 5(6)(a) of the India-Singapore Double Taxation Avoidance Agreement (“DTAA”) to include a requirement of a physical presence of the personnel of the establishments to constitute a Service Permanent Establishment (“SPE”). The Court further relied on this added requirement to hold that the Assessee did not constitute an SPE in India.
The ruling is based on a misinterpretation of the existing treaty framework. It develops a jurisprudence which continues to rely on physical presence as the sole matrix of source-based taxation, undermining economic presence and the actual flow of economic value. This article argues that the position taken by the DHC prefers form over substance and by reducing taxability to be contingent on the physical presence of the human agent while providing services rather than the locus of the services, the judgment has arguably paved a roadmap for treaty misuse under the guise of tax planning in the services sector.
Background
The underlying dispute arose from the assessment of the Assessee, which is a non-resident firm originally belonging to Singapore, providing legal advisory services India. As per the DTAA, only the enterprises having a Permanent Establishment in India, would be liable to pay Income Tax. The Revenue contended that the Assessee constituted a virtual SPE in India for the Assessment Year (“AY”) 2021-22. The factual matrix attracted provisions of Article 5(6)(a) of the DTAA. This Article stipulates that an enterprise shall be deemed to have a permanent establishment if it furnishes services within a Contracting State through employees or other personnel for a period aggregating more than 90 days in a financial year.
For the AY 2021-22, the Assessee had shifted to a purely digital working mode. None of the employees visited India, yet the firm had an annual turnover of around ₹7.97 Crores in India. The Revenue argued that this constituted a virtual SPE. However, the Assessee argued that physical presence is mandatory to constitute an SPE and thus for the AY 2021-22, the Assessee cannot be said to have constituted an SPE. The core issue before the DHC inter alia was whether the Assessee constituted a virtual SPE in absence of a physical presence.
The DHC interpreted the term ‘within a contracting state’ mentioned in Article 5(6) of the DTAA to contain a strict territorial connotation, mandating the physical presence of personnel of the establishment in the contracting state. The Court further held that the concept of a virtual SPE does not even find a mention in the DTAA and thus cannot be applied. It reasoned that reading such a concept into the treaty would amount to judicial overreach, noting that absent a renegotiation of the treaty, the virtual provision of services remains outside the tax net.
Analysis
The DHC in Clifford Chance has interpreted the provisions of Article 5(6) of the DTAA in silos without taking into consideration contemporaneous market realities and the recent developments in tax jurisprudence which have upheld the principles of ‘substance over form’. DHC, in its ruling acknowledges that fact that supply of the service is an essential yardstick to determine the existence of an SPE. However, it moves forward to include an additional requirement of the physical presence of the personnel of the Assessee to attribute an SPE to it. Article 5(6) of the DTAA merely requires that an establishment has to provide service within a contracting state to constitute an SPE. This implies the condition of a presence within the country and consequently providing services within that country. However, it is nowhere stipulated that such a presence has to be physical in nature.
The Apex Court in the case of Hyatt International Southwest Asia Ltd. v. ADIT (“Hyatt International”) had held that business continuity should be the essential element to evaluate the existence of an SPE under the India-UAE Double Tax Avoidance Agreement (“India-UAE DTAA”). It is pertinent to note that the provisions for the constitution of an SPE under the India-UAE DTAA and the India-Singapore DTAA are identical. This had the effect of moving the interpretation of an SPE from a narrow focus to one that considers the economic and functional realities of business operations.
Rather than integrating the principles enunciated in Hyatt International, the DHC dismissed its application to Clifford Chance. The Court distinguished the cases on technical grounds, noting that Hyatt International dealt with the question of stay of particular employees which was not a question in Clifford Chance as the Revenue had already calculated the aggregate days of physical presence. This distinction is jurisprudentially shallow as it ignores the principles laid down by the Apex Court in Hyatt International, which acknowledges that an SPE requires business presence in the form of continuity of operations in the Contracting State. The DHC also rejected the observations of the Madras High Court in the decision of Verizon Communication Singapore Pte Ltd v. ITO (“Verizon”) on how physical presence has now been replaced by virtual presence on account of rapid digitalisation. The DHC failed to provide reasonable reasons to deny the said observations other than holding that the observations in Verizon were mere obiter dicta.
The DHC reads in an additional requirement that the presence needs to be physical in nature to constitute an SPE as per Rule 5(6) of the DTAA. However, it bears no nexus with the determination of the taxable event as the same service is being provided in exchange for value and only the mode of delivery of the service is getting changed. This distinction between virtual and physical provision is increasingly problematic in the face of increased virtual avenues to conduct business and supply services. In the area of legal or management consultancy, the medium of delivery rarely alters the nature, quality, or consumption of the service. A legal opinion drafted in Singapore and transmitted to Delhi via secure server is functionally indistinguishable from one drafted by a lawyer sitting in a hotel room in Delhi. Neither can any distinction between physical and virtual service can be created in such cases from an economical lens. The Court still proceeded to interpret ‘within’ to imply a physical territorial existence. The Court in Clifford Chance preserves a boundary that has been rendered a mere technicality by the advancement of technology. Even the Organisation for Economic Cooperation and Development (“OECD”) in its BEPS Final Report of 2015 had also acknowledged the fact that virtual presence performs similar economic functions to physical presence and owing to rapid digitalisation, the necessity of physical presence in the source country has been replaced significantly by virtual presence.
Furthermore, the Court’s dismissal of the virtual SPE argument also ignores the interpretive aid provided by India’s domestic law. While DTAA overrides the Income Tax Act, Article 3(2) of the DTAA provides that when a treaty term is ambiguous in its meaning, courts should refer to the domestic policy context to discern the meaning of such term. Ambiguity in the meaning of the term ‘furnishing services within the contracting state’ warrants application of Article 3(2). The Apex Court in the case of Engineering Analysis Centre of Excellence Pvt. Ltd. v. CIT had also held that if the terms under the DTAA are not defined and are ambiguous, reliance can be placed on the Income Tax Act to ascertain their meaning. Therefore, it was imperative for the DHC to resort to the domestic context to interpret Rule 5(6) of the DTAA. The concept of significant economic presence under Explanation 2A to Section 9(1)(i) of the Income Tax Act, 1961, reflects India’s recognition of the possibility of economic presence beyond mere physical presence. Furthermore, Article 13 of the Multilateral Convention to Implement Tax Treaty related measures to prevent BEPS deals with the avoidance of PE through technicalities like the fragmentation of core business activities into exempt preparatory functions. This convention has been ratified by India. Although Article 13 does not deal with a virtual SPE, the underlying principle of Article 13 remains that treaty abuse shall not be allowed merely on the basis of technicalities. By strictly adhering to a physical presence technicality for Service PE, the Delhi High Court’s ruling diametrically opposes this international consensus on taxing economic substance. Furthermore, reliance should also have been placed on various documents of OECD (here, here, here and here) that have been consistently advocating for inclusion of virtual SPE within the definition of a PE and have been devising policies for the same. The said documents have been concerned about the Double Tax Avoidance Agreements which merely contain provisions of an FPPE or agent-based PE and explicitly require a physical presence in the contracting state. However, the India-Singapore DTAA contains a service PE clause that does not explicitly warrant a physical presence. Such ambiguity should have been settled taking into account the OECD proposals in this regard.
The practical implications of the decision in Clifford Chance are vast and profound. It effectively paves the way for treaty abuse under the guise of tax avoidance. It has the effect of establishing the 90-day cap not as a threshold for substantial presence, but as a safe harbour for tax evasion. Enterprises can now conveniently maintain a prima facie physical presence for relationship management or other elements that predominantly require a physical presence for less than 90 days, while shifting the bulk of substantive, billable execution to the digital realm. This digital service can be provided from a lower tax jurisdiction to a higher tax jurisdiction without submitting to the tax laws of the higher tax jurisdiction. As long as the days of physical presence are kept under 90, the enterprise can enjoy full access to the Indian market without any tax liability.
Conclusion
Ultimately, the Clifford Chance judgment highlights a gaping loophole where identical services attract diametrically opposite tax treatments based solely on the mode of delivery. The DHC’s observations that it cannot rewrite the DTAA to insert a virtual SPE clause seems to be problematic. The judiciary plays a crucial role in interpreting text in a dynamic world. By reading the physical presence requirement in the DTAA, the DHC has failed to undertake the role of bridging the gap between the law and the increased digitalisation of the market.
Until the Supreme Court steps in to harmonise the interpretation of Article 5(6) of the DTAA to the contemporary market realities, such rulings will continue to render multinational enterprises invisible to the taxman, even as they operate deeply within the domestic economy. The judgment serves as a call for the government to expedite the renegotiation of tax treaties, to incorporate provisions that capture the value created by the virtual service economy.
**Lovish J Goyal is a 3 rd Year law student at NALSAR University of Law, Hyderabad
Disclaimer: The views expressed in this blog do not necessarily align with the views of the Vidhi Centre for Legal Policy.