Introduction
The conventional idea of taxing the cross-border transactions of a multinational corporation is based on physical existence, known as ‘Permanent Establishment’ (‘PE’). The term ‘permanent establishment’ postulates the existence of a substantial element of an enduring or permanent nature of a foreign enterprise in another country, which can be attributed to a fixed place of business in that country.[1] If an enterprise is carrying out its operations through a PE in another country, then the profits of the enterprise which are attributable to the said PE are taxed in that other country itself.
However, as the global economy pivots towards a ‘borderless’ digital landscape, the traditional principles of international taxation are being stress-tested. For any assessee with a global business, few concepts are as contentious today as the ‘Virtual Service PE’.
Service PE in DTAAs
The taxability of a foreign enterprise in India is determined on the basis of the relevant double tax avoidance agreement (‘DTAA’), if the same is more beneficial than the Income-tax Act, 1961 (‘Act’)[2]. Article 7 of the DTAAs lays down rules for the taxability of business profits of the foreign enterprise. It provides that the business profits of the enterprise shall not be taxable in India unless it carries on business through a PE in India.
Article 5 of the DTAAs provide for the concept of PE and lays down the situations which shall lead to creation of a PE of the foreign enterprise in India. Certain DTAAs such as India-USA, India-Singapore, India-Australia, India-UAE, etc. provide for a ‘Service PE’. The conditions leading to the constitution of a Service PE may differ from country to country. Therefore, the provision of Service PE as contained in the United Nations Model Double Taxation Convention, 2021 (‘UN MTC’) is being referred to hereunder.
Article 5(3)(b) of the UN MTC states that the furnishing of services, including consultancy services, by a foreign enterprise through employees or other personnel engaged by it for such purpose shall constitute a PE (‘Service PE’), subject to certain conditions. The Supreme Court in the case of Assistant Director of Income-tax v. E-Funds IT Solution Inc.[3], held that a Service PE is constituted in India if the foreign enterprise furnishes service ‘within India’ through employees or other personnel. That is, the relevant test for a Service PE is the ‘presence of employees in India’ for furnishing of services.
It is pertinent to note that there is no Service PE concept in the OECD Model Tax Convention, 2017 read with the 2025 Update to the OECD Model Tax Convention (‘OECD MTC’). However, the Commentary on Article 5 includes an alternative provision on Service PE. The same provides that the taxation should not extend to services performed outside the territory of a State and the physical presence requirement is explicit in the definition of ‘Service PE’ provided therein.
Revenue’s gambit – Virtual Service PE
Recently, the Indian Tax Authorities have been taking a stand that where the services are rendered by the employees of a foreign enterprise remotely / virtually to the Indian resident, then a ‘virtual Service PE’ is constituted within the meaning of Article 5. The rationale often given by the tax authorities is that, if a non-resident provides continuous, high-value services to Indian residents via digital means (e.g., video conferencing, remote servers, or cloud-based collaboration), then it has a ‘functional’ presence equivalent to a physical presence in India. The Tax Authorities buttress their argument by relying on the OECD’s Tax Challenges arising from Digitalisation – Interim Report, 2018 (follow-up to BEPS Action Plan 1 on Addressing Tax Challenges of the Digital Economy) (‘OECD Interim Report’). It inter alia states that as per the minority view, the requirement of physical presence is no longer relevant for the application of the ‘Service PE’ definition in Article 5(3)(b) of the UN MTC. That the term ‘furnishing of services’ used in UN MTC refers to services ‘used’ or ‘consumed’ in the source jurisdiction, and as such can include services performed from a remote location.
Virtual Service PE – Interpretational oversights by the Tax Authorities?
The question now, in view of the stand being taken by the Tax Authorities, is – whether the rendition of services virtually can trigger a Service PE of the non-resident in India on account of changing technological landscape?
The alternative provision on Service PE in the OECD MTC Commentary categorically lays down the requirement of physical presence of the employees / personnel in the source state for the same to constitute a ‘Service PE’ of the non-resident employer in the source state. In relation to ‘Service PE’ under the UN MTC, the Supreme Court[4] has held the same. Significant to note that a new Article 12B was added to the UN MTC to allocate the taxing rights to the country of the payer in case of automated digital services[5]. The UN MTC acknowledges that the modern methods for the delivery of services allow foreign enterprises to render substantial services for customer in another country with little or no presence in that country. Therefore, Article 12B was introduced which did not require any particular threshold, such as a PE, fixed base, etc. in the other country. In other words, the services provided digitally to the residents of another country would not be taxable under UN MTC but for Article 12B. Corollary to this that the provisions pertaining to Service PE and Fees for Technical Services in the UN MTC otherwise could not have covered such services by the foreign enterprise.
Further, a useful reference may again be made to the OECD Interim Report. Therein, while referring to the provisions relating to Significant Economic Presence[6] (‘SEP’) introduced by India in its domestic law, it has been specifically stated that the SEP provisions, shall only apply to the situations not covered by DTAAs until the DTAAs concluded by India are amended in a similar manner. Indian Legislature has also recognised that the SEP amendments made in the domestic law will serve as a guide for India to renegotiate its DTAAs.[7] Meaning thereby that until the corresponding amendments are made in the DTAAs, the taxation of business income shall be governed by the existing interpretative rules and rules of a virtual PE cannot be read into it.
Judicial interpretation
While Tax Authorities consistently push for nexus based on value creation and digital reach, the judiciary continues to anchor its interpretation in the letter of the law. The recent decision of the Delhi High Court in CIT v. Clifford Chance Pte Ltd.[8] serves as a landmark moment in this debate[9], reaffirming that ‘virtual’ presence cannot be judicially conjured where the DTAA demands physical reality.
In Clifford Chance (supra), the Tax Authorities argued that Clifford Chance had a Service PE in India under Article 5 of the India-Singapore DTAA. It was argued that even without a physical presence, a ‘Virtual Service PE’ was created. Persistent reliance was placed by the Authorities on the OECD Interim Report to bridge the gap between physical and digital presence.
The Delhi High Court emphatically rejected the ‘Virtual PE’ theory. The Court held that Article 5 of the India-Singapore DTAA specifically requires the services to be ‘furnished within’ the contracting state through employees ‘present’ in that state. The Court noted that ‘Virtual Service PE’ finds no mention in the DTAA and hence, the judiciary cannot read new concepts into a treaty to bridge gaps caused by technological shifts.
Reaffirming the physical presence as a sine qua non for a Service PE, the High Court observed that the OECD Interim Report itself concedes that the ‘virtual’ nexus is a proposal under discussion, and not a consensus-based recommendation. Therefore, in the absence of specific amendments to the text of DTAAs, the concept of a ‘Virtual Service PE’ remains legally vulnerable to challenges.
Conclusion
The decision of the Delhi High Court reinforces a clear principle: while business delivery models are evolving toward virtual platforms, the legal framework for Service PE remains grounded in physical presence. For non-residents, this ruling provides strong judicial support for offshore-only delivery models without creating a PE in India, provided personnel do not physically enter India.
However, the judgment does not eliminate all risks. India’s domestic Significant Economic Presence provisions and global trends, such as 2025 Update to the OECD Model Tax Convention and potential DTAA renegotiations, signal an eventual shift toward digital nexus rules. Until such changes are implemented, businesses can confidently rely on current treaty interpretations that require actual physical presence for Service PE, while simultaneously planning for SEP compliance and monitoring future developments in international tax policy.
[The authors are Partner, Associate Partner and Senior Associate, respectively, in Direct Tax practice at Lakshmikumaran & Sridharan Attorneys]
[1] CIT v. Visakhapatnam Port Trust [[1983] 144 ITR 146 (Andhra Pradesh High Court)]; Approved by the Supreme Court in [2003] 263 ITR 706 (SC).
[2] Section 90(2) of the Act.
[3] [2017] 399 ITR 34 (SC).
[4] E-Funds IT Solution Inc. (supra).
[5] Defines to mean services provided on the Internet or digital or other electronic network requiring minimal human involvement from the service provider.
[6] Expands the Indian domestic definition of nexus for business income.
[7] Memorandum explaining the provision in the Finance Bill, 2018.
[8] [2025] 181 taxmann.com 254 (Delhi).
[9] Earlier decisions being Clifford Chance Pte Ltd. v. ACIT [[2024] 160 taxmann.com 424 (Delhi-Trib)]; ABB FZ-LLC v. Dy. CIT [[2017] 166 ITD 329 (Bengaluru-Trib)].
