Physical presence in India is a pre-requisite to establish Service PE and digitalization would not create a “Virtual PE” without altered treaty provisions

Hon’ble Delhi High Court (Delhi HC) in the case concerning a Singapore based law firm, i.e. the Assessee, engaged in providing legal advisory services to clients in India, addressed the issue of establishment of a Service Place PE triggered by the physical presence of Assessee’s employees in India beyond the threshold of 90 days enshrined in the Article 5 of the India Singapore Double Taxation Avoidance Agreement (‘Tax treaty’).

For the AYs under question, assessee had reported NIL income taking the position that no permanent establishment was created in India and thus its business income was not taxable in India based on the conjoint application of Article 5: Permanent Establishment and Article 7: Business Profits of the India–Singapore Tax treaty. Revenue, on the other hand, took the view that the presence of Assessee’s employee/personnel in India surpassed the prescribed 90-days threshold as outlined in Article 5(6) of the Tax treaty, thereby, establishing a service PE in India for the Assessee. Additionally, the Revenue attempted to club the actual presence in India with remote service provision by employees to Indian clients as falling under service PE, arguing for a concept of ‘virtual PE’ where physical presence is no longer necessary for virtual services.

Revenue claimed that technological advancements have enabled effortless cross-border service delivery, suggesting that the conventional need for physical presence should be reconsidered.

The Delhi HC taking into consideration the arguments put forth, placed reliance on the clear and unambiguous wording of the Tax treaty which state:

1. An enterprise shall be deemed to have a permanent establishment in a Contracting State if it furnishes services within a Contracting State through employees or other personnel.

2. Based on the words “within a Contracting State” and “through employees or other personnel”, what is essential is the rendition of services in India by the employees of the non-resident enterprise, while mandating a physical footprint within India.

3. The term ‘within’ signifies territorial connotation and thus in the absence of personnel physically performing services in India, there can be no furnishing of services ‘within’ India.

4. Rendition of services by employees present within the country would constitute a service permanent establishment.

The Delhi HC also relied on the reasoning in Supreme Court judgments in E‑Funds (ADIT v. E-Funds IT Solution Inc., [2017] 399 ITR 34 (SC)) and Morgan Stanley (DIT v. Morgan Stanley and Co., [2007] 292 ITR 416 (SC)), to endorse that constitution of a service PE requires actual performance of services in India through employees or other personnel physically present in India and thus days on which no services were furnished to clients in India are to be excluded while computing the threshold period of 90 days for the purposes of Article 5(6)(a) of the Tax treaty, i.e. vacation days, business development days.

Interestingly, the Delhi HC did acknowledge the alternative argument put forth by the Revenue, i.e. virtual service permanent establishment being established by virtue of services being virtually provided/performed from outside India, in light of increasingly open global virtual economy, and the diminishing requirement of physical presence of non-resident employees to furnish services.

The Delhi HC observed that Tax treaties which are carefully negotiated must be interpreted strictly; where a concept such as virtual service PE is absent, this should be viewed as an intentional omission, and courts must not introduce it through judicial interpretation.

However, the Delhi HC also noted that Article 5(6) contemplates only the rendering of services by employees actually present within the country, and that neither the Tax treaty nor the Income tax statue (ITA) explicitly acknowledges a concept of virtual service PE. Further, it was duly noted that India’s reservations/comments as recorded in the OECD Model Convention and Significant Economic Presence (SEP) concept introduced in ITA through the Finance Act, 2018, reflect a deliberate policy to capture digital or virtual economic participation outside the traditional permanent establishment framework. However, in the absence of administrative recognition by India and consequent changes to the Tax treaty, such unilateral developments do not alter the applicable beneficial Tax treaty which does not extend to virtual or digital services provided from abroad.

Conclusion:

The ruling reaffirmed that Indian tax exposure with respect to Service PE remains hinged on the physical presence in India and actual provision of services within India. The same also goes to emphasize the importance of robust underlying documentation for exclusion of non-active days for calculation of the threshold. Importantly, the Delhi HC did acknowledge but expressly declined to extend the concept of virtual service PE into the extant Tax treaty framework indicating that shift toward recognizing a virtual‑presence tax nexus would require revisiting the Indian Tax treaties.