Supreme Court Clarifies “Preparatory or Auxiliary” Activities under DTAA: Union of India vs. U.A.E. Exchange Centre (24 April 2020)

Introduction

Date of the Judgment: 24 April 2020
Citation: (2020) INSC 373
Judges: A.M. Khanwilkar, J., Ajay Rastogi, J.

Does the activity of a liaison office in India, which downloads remittance details and prints cheques for beneficiaries, constitute a “permanent establishment” (PE) of a foreign company, making it liable to tax in India? The Supreme Court of India addressed this question in a significant ruling concerning the interpretation of the Double Taxation Avoidance Agreement (DTAA) between India and the United Arab Emirates (UAE). The court examined whether the activities of a UAE-based exchange center’s liaison offices in India were “preparatory or auxiliary” in nature, thus exempting them from being considered a permanent establishment under the DTAA.

The Supreme Court bench, comprising Justices A.M. Khanwilkar and Ajay Rastogi, delivered the judgment. Justice A.M. Khanwilkar authored the opinion for the bench.

Case Background

U.A.E. Exchange Centre, a company based in the UAE, provides remittance services to Non-Resident Indians (NRIs). The company received permission from the Reserve Bank of India (RBI) in 1996 to open liaison offices in India. These offices were primarily intended to facilitate communication, handle reconciliation, and print Indian Rupee drafts. The company’s main business involves receiving funds from NRIs in the UAE and then transferring these funds to beneficiaries in India. This transfer occurs through two methods: direct bank transfers and physical cheques/drafts printed by the liaison offices in India.

The dispute arose concerning the second mode of remittance, where the liaison offices in India downloaded remittance details from the UAE server, printed cheques, and dispatched them to beneficiaries in India. The Income Tax Department argued that this activity constituted a “business connection” in India, making the company liable for taxes. The company, however, contended that its liaison offices only performed auxiliary functions, and therefore, no income accrued in India.

Timeline

Course of Proceedings

The Authority for Advance Rulings (AAR) ruled that the income of U.A.E. Exchange Centre was deemed to accrue in India because the liaison offices’ activities constituted a “business connection.” The AAR opined that the liaison offices were a “permanent establishment” (PE) under the DTAA, as their activities were not merely “preparatory or auxiliary.”

Aggrieved by the ruling of the AAR, the company approached the High Court of Delhi. The High Court overturned the AAR’s decision, holding that the liaison offices’ activities were indeed “preparatory or auxiliary” and thus, did not constitute a PE under the DTAA. The High Court emphasized that the DTAA overrides the provisions of the Income Tax Act, 1961, and that the activities of the liaison offices were only supportive of the main business conducted in the UAE.

Legal Framework

The case revolves around the interpretation of the following key legal provisions:

• Section 2(24) of the Income Tax Act, 1961: Defines “income.”
• Section 4 of the Income Tax Act, 1961: Deals with the charge of income tax.
• Section 5 of the Income Tax Act, 1961: Defines the scope of total income.
• Section 9(1)(i) of the Income Tax Act, 1961: Deems certain income to accrue or arise in India, including income from a “business connection” in India.

  The explanation to Section 9(1)(i) clarifies that for a business where all operations are not carried out in India, only the income attributable to operations in India is deemed to accrue there. Further, Explanation 2 defines “business connection” to include certain activities carried out by a person on behalf of a non-resident.

• Section 90 of the Income Tax Act, 1961: Empowers the Central Government to enter into agreements with foreign countries for the avoidance of double taxation.
• Article 5 of the DTAA between India and UAE: Defines “permanent establishment” (PE). It includes a fixed place of business through which the business of an enterprise is wholly or partly carried on. However, it excludes fixed places of business used solely for activities of a “preparatory or auxiliary character.”

  Specifically, Article 5(3)(e) states that the term “permanent establishment” shall be deemed not to include the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character.

• Article 7 of the DTAA between India and UAE: Deals with the taxation of “business profits.” It states that the profits of an enterprise of a contracting state shall be taxable only in that state unless the enterprise carries on business in the other state through a permanent establishment situated therein.

The DTAA, entered into under Section 90 of the Income Tax Act, 1961, aims to avoid double taxation and prevent fiscal evasion. The Supreme Court has consistently held that the provisions of a DTAA override the provisions of the Income Tax Act, 1961, to the extent of any inconsistency.

Arguments

Arguments of the Union of India (Appellants):

• The Income Tax Department argued that the activities of the liaison offices in India constituted a “business connection” under Section 9(1)(i) of the Income Tax Act, 1961.
• The department contended that the liaison offices were not merely performing “preparatory or auxiliary” activities, but were an integral part of the remittance process.
• They relied on the ruling of the Authority for Advance Rulings (AAR), which held that the activities of the liaison offices constituted a permanent establishment (PE) in India.
• The appellants argued that the activities of the liaison office in India were essential for the completion of the remittance contract, and thus, could not be considered auxiliary.
• The department attempted to distinguish the judgment in DIT (International Taxation), Mumbai vs. Morgan Stanley & Co. Inc. [2007] 7 SCC 1, arguing that the present case did not deal with service PE.

Arguments of U.A.E. Exchange Centre (Respondents):

• The company argued that its liaison offices in India only performed “preparatory or auxiliary” activities, as defined under Article 5(3)(e) of the DTAA between India and UAE.
• The company emphasized that its main business was in the UAE, and the liaison offices in India merely facilitated the delivery of remittances to beneficiaries.
• The respondent contended that the DTAA overrides the provisions of the Income Tax Act, 1961, and that the activities of the liaison offices did not constitute a PE.
• The respondent relied on the judgment of the Delhi High Court, which held that the liaison offices’ activities were indeed “preparatory or auxiliary” in nature.
• The respondent argued that the activities of the liaison office were circumscribed by the permission given by the RBI and were in the nature of preparatory or auxiliary character.

The main point of contention was the interpretation of the term “preparatory or auxiliary character” under Article 5(3)(e) of the DTAA, and whether the activities of the liaison offices fell within this exclusion.

Submissions Table

Issues Framed by the Supreme Court

The core issue before the Supreme Court was:

1. Whether the stated activities of the respondent-assessee would qualify the expression “of preparatory or auxiliary character”?

Treatment of the Issue by the Court

Authorities

The Supreme Court considered the following authorities:

Cases:

• Commissioner of Income Tax, Punjab vs. R.D. Aggarwal & Company [AIR 1965 SC 1526]: Discussed the essential features of “business connection.”

  The court noted that a real and intimate relation must exist between the trading activities by a non-resident carried on outside India and the activities within India, and that the relation contributes directly or indirectly to the earning of income by the non-resident.

• Union of India & Anr. vs. Azadi Bachao Andolan & Anr. [(2004) 10 SCC 1]: Established that DTAA overrides the provisions of the Income Tax Act, 1961.

  The Court reiterated that Section 90 of the Income Tax Act, 1961, empowers the Central Government to issue a notification for the implementation of the terms of a Double Taxation Avoidance Agreement, which would override the provisions of the Act to the extent of any inconsistency.

• Commissioner of Income Tax, AP-I vs. Vishakhapatnam Port Trust [(1983) 144 ITR 146 (AP)]: Related to the implementation of DTAA.
• Commissioner of Income Tax vs. Davy Ashmore India Ltd. [(1991) 190 ITR 626 (Cal)]: Related to the implementation of DTAA.
• Leonhardt Andra Und Partner, GmbH vs. Commissioner of Income Tax [(2001) 249 ITR 418 (Cal)]: Related to the implementation of DTAA.
• Commissioner of Income Tax vs. R.M. Muthaiah [(1993) 202 ITR 508 (Kant)]: Related to the implementation of DTAA.
• Arabian Express Line Ltd. of United Kingdom & Ors. vs. Union of India [(1995) 212 ITR 31 (Guj)]: Related to the implementation of DTAA.
• DIT (International Taxation), Mumbai vs. Morgan Stanley & Co. Inc. [(2007) 7 SCC 1]: Discussed the concept of “permanent establishment” and “preparatory or auxiliary” activities in the context of back office operations.

  The Court held that back office operations supporting the main office functions fall under Article 5(3)(e) of the DTAA, and do not constitute a permanent establishment.

• Assistant Director of Income Tax -1, New Delhi vs. E-Funds IT Solution Inc. [(2018) 13 SCC 294]: Dealt with the issue of service PE and the concept of “support services.”

  The Court observed that outsourcing of work to India would not give rise to a fixed place PE if the Indian company only renders support services.

• Anglo-French Textile Co. Ltd., by Agents, M/s. Best & Company Ltd., Madras vs. Commissioner of Income Tax, Madras [AIR 1953 SC 105]: Discussed the concept of business connection.

  The Court noted that a non-resident entity could be taxed only if there was a business connection between the business carried on by a non-resident and some activity in the taxable territory which contributes directly or indirectly to the earning of those profits or gains.

Legal Provisions:

• Section 2(13) of the Income Tax Act, 1961: Defines “business.”
• Section 2(24) of the Income Tax Act, 1961: Defines “income.”
• Section 4 of the Income Tax Act, 1961: Deals with the charge of income tax.
• Section 5 of the Income Tax Act, 1961: Defines the scope of total income.
• Section 9(1)(i) of the Income Tax Act, 1961: Deems certain income to accrue or arise in India.
• Section 90 of the Income Tax Act, 1961: Empowers the Central Government to enter into agreements with foreign countries for the avoidance of double taxation.
• Section 29(1)(a) of the Foreign Exchange Regulation Act, 1973: Deals with restrictions on foreign companies operating in India.
• Article 5 of the DTAA between India and UAE: Defines “permanent establishment” (PE).
• Article 7 of the DTAA between India and UAE: Deals with the taxation of “business profits.”

Judgment

How each submission made by the Parties was treated by the Court?

How each authority was viewed by the Court?

• Commissioner of Income Tax, Punjab vs. R.D. Aggarwal & Company [AIR 1965 SC 1526]: The Court acknowledged this case in defining the essential features of “business connection,” but ultimately found it not applicable in the context of the DTAA.
• Union of India & Anr. vs. Azadi Bachao Andolan & Anr. [(2004) 10 SCC 1]: The Court relied heavily on this case to reiterate that the DTAA overrides the provisions of the Income Tax Act, 1961.
• DIT (International Taxation), Mumbai vs. Morgan Stanley & Co. Inc. [(2007) 7 SCC 1]: The Court found this case directly applicable, as it dealt with the concept of “preparatory or auxiliary” activities in the context of back office operations. The Court applied the principle that back office functions do not constitute a PE under Article 5(3)(e) of the DTAA.
• Assistant Director of Income Tax -1, New Delhi vs. E-Funds IT Solution Inc. [(2018) 13 SCC 294]: The Court referred to this case to support the view that support services do not give rise to a fixed place PE.
• Anglo-French Textile Co. Ltd., by Agents, M/s. Best & Company Ltd., Madras vs. Commissioner of Income Tax, Madras [AIR 1953 SC 105]: The Court distinguished this case, noting that the facts were different from the present case.

What weighed in the mind of the Court?

The Supreme Court’s decision was primarily influenced by the following factors:

• The DTAA’s Overriding Effect: The Court emphasized that the DTAA between India and UAE overrides the provisions of the Income Tax Act, 1961. This principle, established in the Azadi Bachao Andolan case, was crucial in determining the tax liability of the respondent.
• Interpretation of “Preparatory or Auxiliary”: The Court interpreted the term “preparatory or auxiliary” in Article 5(3)(e) of the DTAA broadly, holding that the activities of the liaison offices fell within this exclusion. This interpretation was influenced by the Morgan Stanley case, which dealt with the similar issue of back office operations.
• Limited Scope of RBI Permission: The Court took note of the limited permission granted by the RBI to the respondent, which did not allow the liaison offices to engage in any primary business activity. This reinforced the view that the activities were of a preparatory or auxiliary nature.
• Nature of Activities: The Court found that the activities of the liaison offices were limited to downloading remittance details, printing cheques, and dispatching them to beneficiaries. These activities were deemed to be supportive of the main business conducted in the UAE, and not an integral part of it.

Sentiment Analysis of Reasons Given by the Supreme Court:

Fact:Law Ratio:

Logical Reasoning:

The Court considered alternative interpretations but rejected them, emphasizing that the DTAA must be given a wider and liberal play, and that the activities of the liaison offices were clearly in aid or support of the main activity.

The Court’s reasoning was that the activities of the liaison offices were not an essential part of the main business of the respondent, but rather supportive activities. The Court also emphasized that the DTAA must be interpreted in a way that avoids double taxation.

The Supreme Court held that the activities of the liaison offices were of a “preparatory or auxiliary character,” and thus, did not constitute a permanent establishment (PE) under the DTAA. The Court also held that no tax can be levied or collected from the liaison office of the respondent in India in respect of the primary business activities consummated by the respondent in UAE.

The Court’s decision was unanimous, with both Justices A.M. Khanwilkar and Ajay Rastogi agreeing on the judgment.

“The expression “preparatory” is not defined in the 1961 Act or the DTAA.”

“The crucial activities in the present case are of downloading particulars of remittances through electronic media and then printing cheques/drafts drawn on the banks in India , which, in turn, are couriered or dispatched to the beneficiaries in India, in accordance with the instructions of the NRI remitter.”

“Having said thus, it must follow that the respondent was not carrying on any business activity in India as such, but only dispensing with the remittances by downloading information from the main server of respondent in UAE and printing cheques/drafts drawn on the banks in India as per the instructions given by the NRI remitters in UAE .”

Key Takeaways

The Supreme Court’s judgment has the following practical implications:

• Liaison offices of foreign companies in India, whose activities are limited to “preparatory or auxiliary” functions, are not considered a “permanent establishment” (PE) under the DTAA.
• Such liaison offices are not liable to pay tax in India on the business profits of the foreign company, to the extent that the profits are not attributable to a PE in India.
• The judgment clarifies the interpretation of “preparatory or auxiliary” activities under Article 5(3)(e) of the DTAA, providing guidance for businesses with liaison offices in India.
• The DTAA overrides the provisions of the Income Tax Act, 1961, to the extent of any inconsistency, which is a crucial point for tax planning.
• The ruling provides clarity to foreign companies operating in India through liaison offices, ensuring that they are not unduly taxed for activities that are merely supportive of their main business.

Specific Directions

The Supreme Court did not issue any specific directions in this case, other than dismissing the appeal of the Income Tax Department. The Court upheld the decision of the Delhi High Court, which had ruled in favor of the U.A.E. Exchange Centre. The Court’s judgment effectively clarified the law regarding the interpretation of “preparatory or auxiliary” activities under the DTAA, and provided guidance for future cases involving similar issues.

Final Decision

The Supreme Court dismissed the appeal filed by the Union of India and upheld the decision of the Delhi High Court. The Court held that the activities of the liaison offices of U.A.E. Exchange Centre in India were of a “preparatory or auxiliary character” and did not constitute a permanent establishment (PE) under the DTAA between India and UAE. Therefore, the company was not liable to pay tax in India on the business profits earned by its main office in the UAE.

Conclusion

The Supreme Court’s ruling in the case of Union of India vs. U.A.E. Exchange Centre is a significant judgment that clarifies the interpretation of “preparatory or auxiliary” activities under the Double Taxation Avoidance Agreement (DTAA). The Court emphasized that the DTAA overrides the provisions of the Income Tax Act, 1961, and that the activities of the liaison offices of foreign companies, which are merely supportive of the main business, do not constitute a permanent establishment (PE). This judgment provides clarity and guidance for businesses operating in India through liaison offices, ensuring that they are not unduly taxed for activities that are not part of their core business operations. The ruling is a landmark decision in the realm of international taxation and will have far-reaching implications for businesses operating across borders.