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INDIA | tax trap offshore supply taxation in construction projects

Uncertainties relating to the determination of the profits attributable to a construction/installation permanent establishment (PE) are a substantial tax-related project risk for companies within the plant construction sector. In the appeal proceedings of an Austrian plant engineering company, the Indian Court of Appeal ruled that an allocation of 35% of the supply profits to the Indian permanent establishment was correct despite the existence of a DTA. This decision, which deviates from international principles, has - in addition to the withholding tax deduction on technical services, which is unusual for Austrian DTAs - significant tax implications for Indian projects of foreign construction companies. 

To determine the profits of a PE, the OECD applies the two-stepped authorized OECD approach (AOA). In step 1, the functions and risks analysis attributes business functions and risks either to the head office or to the PE. Crucial factors for step 1 are the so-called “significant people functions” and the “risk follows function” principle. In step 2, an arm’s length profit of the PE will be determined based on transfer pricing principles. In short, step 2 deals with the following question: what would be the profit of a separate legal entity with the same functions and risks as the PE?

Whilst many jurisdictions follow these principles of the OECD (e.g. Saudi Arabia recently abolished the force of attraction principal if a double taxation agreement [DTA] in accordance with the OECD model tax convention is applicable), India frequently taxes income with regard to the PE which should be attributable to the head office according to the AOA. In doing so, Indian tax officers often refer to a decision from the Income Tax Appellate Tribunal in Delhi in 2020 regarding an Austrian plant construction company (AUT-Co). In the following, we sum up the most important findings of the said decision in bullet point form:

The common practice in international plant construction business to split the total project in an on and offshore contract was seen as an artificial split to avoid taxes in India. The Indian tax authority additionally argued that the services performed by the PE are crucial to fulfil the obligations of the offshore contract.

  • If the transfer of title, risk and peril takes place outside India, offshore supplies are generally not taxable in India. Even though it was agreed in the offshore contract that the transfer of title, risk and peril took place outside India, the Indian tax authority denied the non-taxability of the offshore supplies because AUT-Co was considered to owe a function al plant in India.
  • Following the famous Rolls-Royce decision, the Indian tax authority attributed 35% of the offshore contract to the Indian PE.
  • Based on a database analysis, a profit margin of 9.75% was applied to the offshore sup plies contract. The Indian corporate tax rate for non-residents amounts to approx. 40%.

In a more recent tax assessment, an Indian tax officer – referring to the above-cited decision – attributed 100% of the profits from offshore supplies to the Indian PE. Furthermore, an objection highlighting the detailed price breakdown in the contract and the AOA principals was rejected by the Indian tax office. The Indian taxation approach led to a significant mismatch between the assessment basis for the taxation in India and the assessment basis for the tax exemption in Austria. The resulting double taxation directly impacts the profit ability of the company/project.

How can a company deal with such a double taxation? Besides local Indian appeal proce dures, concerned taxpayers will regularly have to initiate a mutual agreement procedure (MAP) in the state of residency. However, many jurisdictions will only initiate an MAP if a domestic appeal has been filed in the project state. As appeal procedures are lengthy, it is important to monitor related deadlines (e.g. filing deadlines for initiating MAP procedures).

ven though the above-cited cases refer to Austrian residents, the Indian taxation approach and the differing interpretation of DTA provisions constitute a serious tax trap for all plant construction companies resident in jurisdictions that apply the AOA. Besides India, we experi enced an increasing number of jurisdictions around the globe trying to extend the taxation rights beyond the provisions in applicable DTAs. To avoid double taxation and lengthy tax disputes, it is advisable to have a tax safety check before signing international contracts.

This article has also been published in the WTS Global International Corporate Tax Newsletter #1/2022, where you will also find recent tax-related news from Argentina, Brazil, China, Germany, Indonesia, Italy, Netherlands, Pakistan, Poland, Singapore and Vietnam.

In case you need assistance with the tax treatment of your international construction project please do not hesitate to contact the authors. You will find more information about we have to offer for cross-border projects HERE.