Virtual Service PE Not Recognised Under India-UK DTAA: Delhi HC sets aside withholding Tax Order against Ernst & Young [Read Order]

In a recent decision, the Delhi High Court held that the Income Tax Department cannot rely on the idea of a “virtual service permanent establishment” under the India-UK tax treaty to demand withholding tax.

Ernst and Young LLP filed a writ petition challenging an order passed by the tax authorities. The tax department directed Ernst and Young LLP to deduct tax at the rate of 5.25% on payments to be made to Ernst & Young (EMEIA) Services Limited, a company based in the United Kingdom.

The department treated these payments as taxable business income in India.

The petitioner had applied under Section 195(2) of the Income Tax Act seeking a nil withholding tax certificate for payments of about Rs. 17.5 crore. They argued that the payments were not fees for technical services and that EMEIA did not have a permanent establishment in India under the India-UK Double Taxation Avoidance Agreement.

The tax authority rejected the application on the ground that EMEIA had a “virtual service permanent establishment” in India under Article 5(2)(k) of the tax treaty. Based on this, the authority concluded that the income was taxable in India and directed tax to be withheld.

The petitioner's counsel argued that the tax authority relied only on the concept of a virtual service permanent establishment, which is not recognised under the tax treaty. They pointed out that the Delhi High Court had already ruled in an earlier case, Clifford Chance, that a service permanent establishment requires physical presence of employees in India and that a virtual presence is not enough.

The revenue counsel argued that the writ petition should not be entertained because an alternate remedy was available. They also argued that the treaty provision does not require physical presence of employees in India.

The Division Bench comprising Justice V.Kameswar Rao and Justice Vinod Kumar observed that the words “within a Contracting State” in the tax treaty clearly mean that services must be performed physically in India.

The court explained that the treaty does not allow the concept of a virtual service permanent establishment and that courts cannot add new concepts that are not written into the treaty.

The court set aside the withholding tax order and sent the matter back to the assessing officer for fresh consideration in line with the law laid down by the court. The petition was disposed of.

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