Tax challenges for German companies operating internationally

India is increasingly becoming a focal point for internationally active companies - not least against the backdrop of global trade conflicts, geopolitical tensions and the search for alternative markets to China. While major economies such as USA have been positioning themselves with protectionist measures since the beginning of the year, India is becoming a strategically important hub in Asia for export-orientated German SMEs.

For many companies, this not only raises the question of market potential and production locations, but also of the local tax framework - particularly with regard to the permanent establishments and withholding tax issues.

Permanent Establishment (“PE”) – PE or not PE?

Determination of PE in Indian jurisdiction, is governed by the provisions of bilateral tax treaties (‘Treaty‘, “DTA”) entered by India with respective countries. One such bilateral treaty has been en-tered with Germany as well. 

Article 5 of the India-Germany Treaty hinges on the presence of a PE by enumerating specific pa-rameters for Fixed Place PE and Agency PE. The presence of a PE in India acts as a taxable nexus, triggering source-based taxation and it acts as the demarcation line between non-taxable and taxable presence. Its determination is critical for characterizing income as business profits, consequential profit attribution and taxation in the source state (India).

Article 7 of the India Germany DTA states that: 

“The profits of an enterprise of a Contracting State shall be taxable only in that State unless the en-terprise carries on business in the other Contracting State through a permanent establishment situ-ated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment.”

Thus, establishing a PE in India can have far-reaching tax consequences. Particularly in the case of services or production support provided by German companies on site, a precise categorisation of activities is necessary.

India-Germany DTA provides for constitution of PE under the following aspects:

1. Fixed Place PE - typically arises when a foreign enterprise carries on business, wholly or partly, through a fixed location in India. Key conditions include the existence of a physical place of business, a sufficient degree of permanence or continuity in its use, and the right of the enterprise to exercise control over the premises for conducting its operations. Where these criteria are met, a Fixed Place PE is considered to be established in India.
2. Agency PE - typically constituted when a dependent agent habitually acts on behalf of a Germany enterprise - such as habitually concluding contracts, maintaining and delivering goods, or habitually securing orders predominantly for the enterprise or its group entities. To qualify as a depend-ent agent, the entity must exhibit legal and economic dependence on the foreign principal, including limited autonomy, binding authority, and lack of independent infrastructure or diverse clientele. Furthermore, such agent’s activities must primarily benefit the foreign enterprise and not repre-sent typical independent business operations in ordinary course. 

Preparatory or Auxiliary Activities 

Paragraph 3 of Article 5 of India-Germany Treaty contains a non-obstante clause that carves out specific exclusions from the ambit of PE which includes where the activities undertaken are of a ‘preparatory’ or ‘auxiliary’ nature. Such activities, by virtue of their functional significance are not deemed sufficient to constitute PE in India.

The terms “preparatory” or “auxiliary” are neither defined under the Income-tax Act, 1961 (‘ITA’) nor within the Treaty itself. However, interpretive guidance is available through international commentaries  as well as from Indian jurisprudence. 

Broadly, a preparatory activity is one which is carried on in contemplation of executing essential and significant activities of the enterprise as a whole. Similarly, an auxiliary activity is carried on to support, without being part of essential and significant activities of the enterprise as a whole. However, the characterization of activities as “preparatory” or “auxiliary” has to be examined on case-to-case basis depending on substance over form.

Judicial precedents  have held that preparatory and supporting activities are mere support functions which do not in isolation, result in carrying out of business of the foreign entity. Thus, can’t be construed as constitution of PE. 

This interpretation is in line with Art. 5 OECD Model Tax Convention and strengthens legal certainty for foreign companies operating in India through liaison offices or other representative offices, provided the activities actually fall under ancillary or support functions and no dependent business relationships are established.

The creation of a PE significantly also amplifies the compliance and tax risk exposure in India, including:

• Obligation to maintain books of accounts as per Indian GAAP;
• Getting books of accounts audited for corporate law and tax purposes;
• Filing of income tax returns under Section 139 of the Income-tax Act, 1961;
• Exposure to Indian transfer pricing regulations if transactions with associated enterprises exist;
• Advance tax and interest obligations;
• Risk of tax audits, reassessments, and prolonged litigation over profit attribution methodologies.

Withholding tax (‘WHT’) increase from April 2023 - significance for cross-border services

Another critical issue that can arise in the context of cross-border transactions during business expansion in India is w.r.t. WHT implications on the incomes earned by the German companies in case such income relates to royalty, technical services, dividends or interest. Effective from April 1st 2023, there has been substantial ramifications for the cost of doing business which significantly increased WHT rates   in India under the ITA notably raising the rates on royalties and technical services i.e. from 10%  to 20% . 

However, India recognises the precedence of double taxation agreements (DTAAs) over ITA. This reduces the WHT in treaty-protected cases, say, India-Germany DTAA provides for WHT rates for royalty and technical services should not exceed 10%. However, reduced rate is subject to availability of following documents:

• Tax registration in India (Permanent Account Number i.e. PAN)
• Submission of a German certificate of tax residence 
• Submission of Form 10F (mandatory online now)
• Filing of Indian income-tax return u/s 139 r.w.s. 115A(5) of ITA
• A Declaration of no PE in India. 

Contractual organisation and tax assumption

In cross border arrangements, another recurring key issue pertains to the allocation of the economic incidence of Indian WHT. In cases where the service recipient bears such incidence (commonly referred to as tax assumption clause), the taxable base undergoes grossing-up thereby increasing the overall transaction cost. 

For example, in a scenario involving payment of € 100 at a tax rate of 10% it can result in total burden of € 111.11, on which the WHT is payable which will ultimately result in increased tax burden just because of the assumption.

Moreover, the constitution of a PE in India fundamentally alters the tax profile of the foreign enter-prise, resulting in a substantially higher tax burden, increased compliance obligations, and increased exposure to long-term tax risks and tax & regulatory scrutiny.

Refund and Credit in Germany

Indian WHT can generally be credited in accordance with Section § 34c EStG , but only up to the rate recognised under India-Germany DTAA (10%). Tax deductions in excess of this cannot be generally allowed as credit in Germany and therefore represent a cost factor in economic terms. Offsetting against trade tax is still not guaranteed - despite individual rulings at tax court level (e.g. Hesse Tax Court of 26 August 2020 - 8 K 1860/16). Although the judgement of the Hesse tax court is legally binding, the BFH has rejected the tax office's appeal as inadmissible and has therefore not com-mented on the substantive issues.

Conclusion

Tax complexities in India have grown significantly in recent years driven by rising WHT rates and heightened scrutiny by Indian tax authorities concerning PE issues, 
German companies need to analyse their tax obligations in detail at an early stage in order to be well positioned. Such proactive planning not only helps ensure compliance but also minimizes the risk of unexpected tax liabilities and potential disputes, enabling businesses to operate more efficiently and confidently in the Indian market.
As a multidisciplinary tax law firm with a special focus on internationally operating medium-sized companies, Baker Tilly supports cross-border engagements to India in close cooperation with our colleagues from Baker Tilly India - professionally sound, practical and with many years of project experience in cross-border exchange.

Many thanks to our guest author  Sunil Arora, Tax Partner at Baker Tilly India.