5/2004 dated 28 09 2004 1
Circular No. 5/2004 was issued by the Central Board of Direct Taxes on 28 September 2004. Its subject is 5/2004 dated 28 09 2004 1.
Sets out how much of a foreign enterprise's profit is taxable in India when its business process outsourcing unit here is a permanent establishment. If a non-resident merely outsources services to a resident Indian entity and there is no business connection, the Indian entity is assessed on its own and the non-resident is not liable under the Act. Where there is a business connection and the Indian entity is the permanent establishment, Article 5 of the relevant double taxation avoidance agreement is engaged, whether through a branch or sales office or through an agent other than an independent agent who habitually concludes contracts, regularly delivers goods or habitually secures orders. Article 7 then taxes only so much of the profits as is attributable to the permanent establishment, computed as if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise, that is on the arm's length principle, with a deduction for expenses incurred for the purposes of the permanent establishment, including executive and general administrative expenses wherever incurred, determined on accepted accounting principles and the provisions of the Act.
India had seen a steady growth over a decade of business processes outsourced to information technology enabled entities here, ranging from procurement of orders and sales queries to software maintenance, debt collection, software development and card and mobile telephone services, and the extent of profit attributable to such a permanent establishment was under the Board's consideration.
CIRCULAR
INCOME-TAX ACT
Taxation of IT-enabled Business Process Outsourcing Units in India
CIRCULAR NO.5/2004, DATED 28-9-2004
1. A non-resident entity may outsource certain services to a resident Indian entity. If there is no business connection between the two, the resident entity may not be a Permanent Establishment of the non-resident entity, and the resident entity would have to be assessed to income-tax as a separate entity. In such a case, the non-resident entity will not be liable under the Income-tax Act, 1961.
2. However, it is possible that the non-resident entity may have a business connection with the resident Indian entity. In such a case, the resident Indian entity could be treated as the Permanent Establishment of the non-resident entity. The tax treatment of the Permanent Establishment in such a case is under consideration in this circular.
3. During the last decade or so, India has seen a steady growth of outsourcing of business processes by non-residents or foreign companies to IT-enabled entities in India. Such entities are either branches or associated enterprises of the foreign enterprise or an independent Indian enterprise. Their activities range from mere procurement of orders for sale of goods or provision of services and answering sales related queries to the provision of services itself like software maintenance service, debt collection service, software development service, credit card/mobile telephone related service, etc. The non-resident entity or the foreign company will be liable to tax in India only if the IT-enabled BPO unit in India constitutes its Permanent Establishment. The extent to which the profits of the non-resident enterprise is to be attributed to the activities of such Permanent Establishment in India has been under consideration of the Board.
4. A non-resident or a foreign company is treated as having a Permanent Establishment in India under Article 5 of the Double Taxation Avoidance Agreements entered into by India with different countries if the said non-resident or foreign company carries on business in India through a branch, sales office etc. or through an agent (other than an independent agent) who habitually exercises an authority to conclude contracts or regularly delivers goods or merchandise or habitually secures orders on behalf of the non-resident principal. In such a case, the profits of the non-resident or foreign company attributable to the business activities carried out in India by the Permanent Establishment becomes taxable in India under Article 7 of the Double Taxation Avoidance Agreements.
5. Paragraph 1 of Article 7 of Double Taxation Avoidance Agreements provides that if a foreign enterprise carries on business in another country through a Permanent Establishment situated therein, the profits of the enterprise may be taxed in the other country but only so much of them as is attributable to the Permanent Establishment. Paragraph 2 of the same Article provides that subject to the provisions of Paragraph 3, there shall in each contracting state be attributed to that Permanent Establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a Permanent Establishment. Paragraph 3 of the Article provides that in determining the profits of a Permanent Establishment there shall be allowed as deductions expenses which are incurred for the purposes of the Permanent Establishment including executive and general administrative expenses so incurred, whether in the State in which the Permanent Establishment is situated or elsewhere. What are the expenses that are deductible would have to be determined in accordance with the accepted principles of accountancy and the provisions of the Income-tax Act, 1961.
6. Paragraph 2 contains the central directive on which the allocation of profits to a Permanent Establishment is intended to be based. The paragraph incorporates the view that the profits to be attributed to a Permanent Establishment are those which that Permanent Establishment would have made if, instead of dealing with its Head Office, it had been dealing with an entirely separate enterprise under conditions and at prices prevailing in the ordinary market. This corresponds to the "arm’s length principle". Paragraph 3 only provides a rule applicable for the determination of the profits of the Permanent Establishment, while paragraph 2 requires that the profits so determined correspond to the profit that a separate and independent enterprise would have made. Hence, in determining the profits attributable to an IT-enabled BPO unit constituting a Permanent Establishment, it will be necessary to determine the price of the services rendered by the Permanent Establishment to the Head office or by the Head office to the Permanent Establishment on the basis of "arm’s length principle".
7. "Arm’s length price" would have the same meaning as in the definition in section 92F(iii) of the Income-tax Act. The arm’s length price would have to be determined in accordance with the provisions of sections 92 to 92F of the Act.
8. The CBDT Circular No. 1/2004, dated 2nd January, 2004 is hereby withdrawn with immediate effect.
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In a transfer pricing or permanent establishment assessment of an Indian outsourcing unit and its foreign principal, and in a section 195 question on remittances to the principal.
It mentions. Circular No. 1/2004, Circular No. 5/2004
Source: the Income Tax Department’s own published text — its page for this instrument.
