The challenges for foreign law firms in India seem unending. Late last year, the Mumbai High Court had ruled that foreign law firms are not allowed to practice in India on non-litigation areas. Though unrelated, recently the Mumbai tax tribunal in the case of Linklaters LLP has held that the UK law firm was taxable on the entire income from services rendered to its Indian clients, irrespective of the place where the services were rendered .
Amongst various issues, significant questions before the bench were – if the income of the firm should be characterized as independent professional services or business profits, if Linklaters had a Permanent Establishment (PE) and, what portion of income should be attributed to such PE.
Facts and arguments
It is an accepted norm that global professional services firms serve their clients from multiple locations and so was the case in Linklaters engagement terms with its client. The bone of contention was taxability of fees earned from clients (Indian companies and Multinationals) with Indian projects. Linklaters did not have an Indian office, though, its UK staff stayed in India over 90 days (threshold for determining service PE) in a financial year. Linklaters claimed that income arising from Indian project clients were not taxable as business profits since it did not have an office or a permanent establishment (PE) in India.
Linklaters appealed on the question whether rendering professional services would constitute a service PE; a question decided against the firm in first appeals. The Revenue in turn appealed for not attributing entire income including services rendered outside India to the Indian PE as it was held in first appeals that only income attributable to staff for India visit is taxable
Tribunal ruling throws fresh perspective
Unlike India, partnership firms in the UK are considered as fiscally transparent entities and instead of taxing the firm, partners are taxed; a concept akin to trust or mutual fund who are not taxed and instead beneficiaries or unit holders are. The tribunal comprehensively debated treaty relief to such transparent partnership entity in coming to a conclusion that Linklaters was entitled to relief. Though, in my view, the UK-India treaty is clear on entitlement of benefits to partnership firms, which arguably would include fiscally transparent partnerships. It makes me wonder why Linklaters held on to a position that it did not fall under independent professional services when other UK based law firms, particularly Clifford Chance was aligned to the treaty. The terms of UK-India treaty are clear and unambiguous with respect to legal professional service providers, whether as individuals or partnership firms, be taxed under ‘independent personal services’ article of the treaty.
Service PE and force of attraction rule will apply
The Tribunal did not encounter difficulty in holding that since the stay days of the firms staff exceeded 90 days, it constituted a service PE under the treaty. Linklaters argument that a PE could not be upheld in the absence of a fixed place of business was not accepted and tribunal views seems to be in line with the OECD view.
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On the question of income attribution to the PE, the Tribunal overturned the relief granted (to Linklaters) by the first appellate authority – it ruled that entire income from services rendered to clients was subject to tax in India, regardless of whether services were rendered in or outside India. It applied what is called the ‘force of attraction’ principle in the treaty which uses the term income ‘directly or indirectly attributable’.
Tribunal’s omnibus interpretation of the FOA rule taxing the entire income of the UK law firm is undoubtedly strictest form of source based rule interpretation and could potentially result in complex situations for cross border services. Also, I am circumspect about its practical application in the context of an international law firm rendering services to global clients by making use of resources from multiple jurisdictions spread across different entities. It could result in bizarre outcome and make economic double taxation difficult to resolve. Ordinarily, FOA rule should trigger only where the Indian PE or branch plays an active role in fulfilling contractual obligation of the parent. Even in that event, only a proportionate portion of profits from offshore activities would fall in the mischief of FOA rule and not the entire profits. Would the situation have been different if Linklaters, London office had performed major part of the client work or if the staff visiting India did not play an active role in fulfilling the contractual obligation of the UK firm? There were no findings to this effect.
FOA rule in tax treaties
The primary intent of FOA rule ( in treaty) is to prevent tax avoidance resorted due to artificial split in contracts or business arrangements, particularly between related entities resulting in tax leakages in the source country. In instances, the FOA rules also cover bona fide business transaction to widen the source state’s tax base.
Historically, tax treaties between developed nations contained a ‘pure’ or ‘full’ FOA rule to tax the entire income of the non-resident in the source state, whether or not such income is directly attributable to the PE. However, a ‘pure’ FOA rule has not been popular among developing nations and therefore, in 1979 a modified form of the FOA rule was adopted in the UN Model Convention (MC).
The MC rule is aimed to deal with imperfections of PE definition and inefficiencies of arm’s length principle of income attribution since Transfer Pricing regulations in developing countries have been a recent phenomenon. The FOA rule present in the Indian tax treaties ( largely modeled on UN ) is in line with the UN MC (Eg. Treaties with US, Finland, Canada etc). The UN FOA rule provides that in addition to income attributable directly to a PE in the source state (based on arm’s length principle), the source state shall have right to tax profits attributable to other business activities, which are similar to those of the PE. An example of applicability of such FOA rule is contained in the memorandum to India- Japan treaty and I had wished that the Tribunal has considered it.
Indian jurisprudence on FOA
Whilst the Indian jurisprudence is evolving, the Linklaters case has added an interesting dimension to income attribution principle under the treaty which is no longer restricted to domestic law provisions as in Vodafone’s case.
In Linklaters case, the Tribunal did not follow jurisdictional Mumbai High Court decision of Clifford Chance UK arguing that the decision has lost its relevance due to retrospective amendment in law. The Clifford decision was rendered in late 2008 pursuant to the Supreme Court decision in IHI’s case and prior to the 2009 retrospective amendment .The 2009 amendment, keeping in mind legislative intend said that a non-resident earning fees from technical services (FTS) is taxed in India even if the service provider does not have a business presence in India.
My reading is that the Clifford decision stands and has not lost its relevance since the reference to SC decision in IHI case was merely to explain the ‘territorial nexus’ theory. Also, the IHI decision is in the context of FTS, whereas, in the context of Clifford, there was no doubt that the income was in the nature of business income.Hence, Clifford did not entirely rely on IHI case.
Closing reflections
Indian jurisprudence on the FOA rule is nascent and its interpretation should be contextual i.e. applied in the context of taxability of an international law firm. If applied otherwise, the consequences would mean assuming extra territorial jurisdiction to tax income which ordinarily not be taxed under the domestic law – for illustration, in linklaters case, fees earned for work performed in the UK.
On FOA principle, it seems likely that the Mumbai ruling would be tested for higher adjudication in the Court.
However, Linklaters position that income arising from services rendered in India should not be taxed since it did not have a service PE ( in India) despite over 90 days stay of staff members appears ambitious. The DTC bill would add a fresh dimension to the debate with validation of ‘direct and indirect’ principle to tax offshore transactions. Nevertheless, it would be interesting to witness how Law firms fight it out in Courts!
(The author is a Partner with BMR Legal and views are entirely personal.)