Introduction: Understanding the concept of project offices and cross-charges in India
When a foreign company sets up a Project Office (PO) in India to execute a specific project, it often relies on its Head Office (HO) for support. It could be shared services like IT, HR, legal advice, or even project planning.
Cross-charges are the mechanism through which these costs are allocated from the HO to the PO or vice versa. This ensures the PO bears its fair share of expenses for services or resources provided by the HO. For example, if the HO provides $10,000 worth of IT support to the PO, it cross-charges this amount to reflect the cost in the PO’s financials. While this practice helps with accurate cost allocation, it brings a host of tax, legal, and compliance implications under Indian laws like the Foreign Exchange Management Act (FEMA), the Income Tax Act, 1962 (IT Act), the Companies Act, 2013, and GST laws.
This article aims to explore the conceptual understanding of a PO, how it’s formed, relevant Reserve Bank of India (RBI) compliances, as well as key tax implications.
What is a Project Office?
A Project Office (PO) is a temporary office established by a foreign company in India to carry out a specific project that the HO has been awarded. Unlike a permanent subsidiary/company, a PO has a limited lifespan tied to the project’s duration and must close once the project is complete.
What Is the Purpose of a PO?
Under FEMA regulations, a PO can only be set up to execute a specific project in India. The PO is not allowed to engage in unrelated business activities like trading or manufacturing. For example, a German company might establish a PO to build a wind farm in Gujarat, but that PO cannot start selling solar panels. The PO’s activities must strictly align with the project’s scope, and it must cease operations once the project ends.
How is a PO established in India?
The rules for setting up a PO are governed by the Foreign Exchange Management (Establishment in India of a Branch Office or a Liaison Office or a Project Office or Any Other Place of Business) Regulations, 2016 (FEMA Regulations) issued under the Foreign Exchange Management Act, 1999 (FEMA Act):
Automatic Route: A foreign company can establish a PO without prior RBI approval if the project meets one of these conditions:
- It’s funded directly by inward remittances from abroad (e.g., the HO transfers funds to India).
- It’s funded by a bilateral or multilateral agency.
- It has been cleared by an appropriate Indian authority, such as a government ministry.
- The Indian entity awarding the contract has a term loan from an Indian bank or public financial institution for the project.
Registration Requirements: Within 5 working days of establishing the PO, the foreign company must register it with the Registrar of Companies (ROC) and submit Form FC to an Authorised Dealer (AD) bank. The PO must also open a foreign currency account in India to receive project-related remittances.
Closure Process : Once the project is completed, the PO must close, and any surplus funds must be repatriated to the HO. The PO submits a closure report to the AD bank, which informs the RBI.
When Does a Project Office Need RBI Approval?
A PO can often be set up without prior RBI approval, thanks to automatic route under the FEMA Regulations. However, there are specific scenarios where approval is mandatory:
- Non-Qualifying Funding: If the project isn’t funded by inward remittances, a bilateral/multilateral agency, or an Indian bank loan, per Regulation 4, RBI approval is required. For example, if the project relies on domestic borrowings in India, the company must apply to the RBI.
- Entities from countries with common land border: Companies from countries sharing a land border with India (e.g., China, Pakistan,Nepal) need prior RBI approval. This rule was introduced to address national security concerns following geopolitical tensions.
- NGOs and FCRA-Covered Entities: If the foreign company is a Non-Government Organisation (NGO) or falls under the Foreign Contribution (Regulation) Act, 2010 (FCRA), it needs prior approval. Further, entities engaged in FCRA activities (e.g., receiving foreign contributions for social causes) must have FCRA registration and cannot seek FEMA approval for a PO.
Does a Project Office Create a Taxable Presence in India?
A PO qualifies as a Permanent Establishment (PE) for the foreign company (HO) in India under the IT Act, meaning that the HO must pay taxes on profits linked to the PO’s activities This reflects the treatment of the HO and PE as distinct enterprises. Here’s how it works.
Definition of a PE: Under Section 92F(iii) of the IT Act, a PE is defined as “a fixed place of business through which the business of the enterprise is wholly or partly carried on.”
Tax Implications: As a PE, the HO is liable for tax on profits attributable to the PO under Section 9(1)(i) of the IT Act. This section taxes income deemed to accrue or arise in India through a “business connection,” which includes a PE. The HO must also comply with transfer pricing rules under Section 92 to ensure transactions with the PO are at arm’s length.
Are Cross-Charges Taxable in India?
Cross-charges occur when the HO allocates costs to the PO for services or resources, such as IT support, HR services, or legal fees. The deductibility of these are typically governed by Section 44C of the IT Act. The taxability of these charges depends on whether they include a profit element.
Cost-Based Cross-Charges: If the cross-charge is on a cost basis (no profit markup), it’s generally not taxable under the IT Act.
Charges with Markup: If the HO adds a profit markup (e.g., $11,000 for a $10,000 cost), the profit ($1,000) may be taxable as FTS under Section 9(1)(vii) depending on the nature of the service and the applicable Double Taxation Avoidance Agreement. Where a mark-up is added the deduction available may be limited to the actual cost incurred, in accordance with the limits prescribed under Section 44C of the IT Act. However, such recharges, particularly where they include a profit element, may be characterised as Fees for Technical Services (FTS) and subjected to tax on a gross basis.
From a common law perspective, transactions between an HO and its PO should be regarded as intra-entity transactions. Given the principle that one cannot enter into a contract with oneself, these transactions ordinarily do not give rise to a taxable event. However, given the application of transfer pricing provisions, under which the HO and the PO as a PE are treated as separate taxable units, can result in tax implications. Such transactions would require a detailed assessment to determine its appropriate tax treatment.
Transfer Pricing: Even cost-based cross-charges must comply with Section 92 of the IT Act, which requires all related party transactions to be at arm’s length. This means the charge should reflect what an independent party would pay for the same service in India. Non-compliance of this provision can lead to adjustments by tax authorities.
Addressing Common Concerns About Cross-Charges
As businesses often have transactions which require cross-charges between a HO of a foreign company and a PO in India, several practical questions arise. This section will attempt to address some of these concerns tailored to the context where a PE is assumed to have been established due to the PO’s operational presence.
Treatment of Pre-Incorporation Expenses
An area of ambiguity under the FEMA framework pertains to the permissibility of pre-establishment expenses incurred for setting up a PO in India. These expenses may include legal and consultancy fees, document processing charges, and incidental administrative costs incurred by the HO in the course of establishing the PO.
While the RBI has issued specific guidance on pre-operative expenses for wholly owned subsidiaries (WOSs). There is no corresponding clarification for how PO’s shall treat pre-operative expenses.
Under the FEMA Regulations, as stated in this Article, PO’s may be established under the automatic route for executing specific contracts, and all funding must come through inward remittances from the HO. As the PO is not a separate legal entity in this sense, therefore it does not have a balance sheet prior to establishment, and all liabilities, including those incurred during pre-establishment, are inherently those of the HO.
Based on the above, certain AD banks may/may not permit the reimbursement of pre-establishment expenses on a cost basis from the PO account after establishment. As the treatment of pre-operative expenses is not formally clarified under the existing FEMA regulations, nor has the RBI issued circulars or FAQs expressly permitting or disallowing such treatment. Moreover, the Annual Activity Certificate (AAC) to be submitted by the PO does not specify whether such costs can be reported as part of the PO’s legitimate business expenditure.
Accordingly, the permissibility of pre-establishment expenses for POs remains a grey area, with no express regulatory guidance from the RBI. In view of the constantly evolving regulatory environment, and given the absence of a specific clarification for POs akin to the one issued for WOSs, any such expenditure should ideally be discussed in advance with the AD bank or brought to the attention of the RBI for confirmation on a case-specific basis.
Reporting Requirements for Cross-Charges
FEMA regulations mandates AAC to be submitted annually to the RBI through an Authorised Dealer (AD) bank and to the Director General of Income Tax (international transactions), to detail all transactions. Other reporting under tax would be carried out as a domestic entity.
Applicability of Transfer Pricing Regulations
A frequent inquiry among businesses pertains to whether cross-charges between a HO and its PO in India are subject to transfer pricing regulations. Since these transactions fall within the scope of Section 92 of the IT Act, they attract transfer pricing regulations. HO and PO are recognized as associated enterprises due to their affiliation within the same corporate structure.
In this regard, the decision of the Special Bench of the Income Tax Appellate Tribunal (ITAT), Ahmedabad in the case of TBEA Shenyang Transformer Group Company Limited rendered on November 11, 2024 is instructive. The judgement determined that cross-charges from a non-resident HO to its Indian PO constitute international transactions, requiring adherence to arm’s length pricing principles as outlined in Section 92C(1) of the Act.
Such transactions must be evaluated against comparable market standards to ensure fairness in pricing. In cases of non-compliance, tax authorities may exercise its authority under Section 92CA(3) to make necessary adjustments, while failure to maintain adequate documentation could result in penal implications under the IT Act.
Impact of cross charge on Permanent Establishment Status
Cross-charges do not create a PE status. PE is defined under Section 92F(iii) of IT Act. It is defined as a fixed place of business. The cross-charges are financial allocations, not a physical presence, so the PE status arises from the PO’s activities, not the charges themselves.
GST Liability and Reverse Charge Mechanism
One important thing businesses need to know is whether they have to pay GST on cross-charges from a HO situated outside India to a PO in India. These cross-charges are considered taxable supplies under Section 7(1) of the CGST Act because the HO and PO are recognised as separate entities under Section 25 of the CGST Act. This is despite the fact that essentially, they are the same entity. The PO, being set up in India, is seen as its own taxable unit, so services like consultancy or administrative charges (unless they are in the nature of reimbursements) from the HO are subject to GST. However, one may examine if such transfers from HO to the PO could qualify as an export of services, depending on the nature of the services being supplied.
In case the PO transfers funds to the HO, then such transfers would be considered to be services provided by the HO to the PO. In such cases, the transaction may qualify as an import of services. In such cases, reverse charge mechanism (RCM), outlined in Section 9(3) of the CGST Act would be applicable. Under RCM, the PO, as the one receiving the service, takes on the responsibility of paying the GST. If the PO is registered under Section 24 of the CGST Act, it can also claim a tax credit under Section 16(1) to offset some of the GST paid, subject to conditions.
Retrospective action by Authorities for non-compliance
A concern for businesses is whether cross-charges between a HO and PO can lead to retrospective compliance risks.
Per Section 149 of the IT Act, it permits the authorities to reassesses if income has escaped assessment, allowing a notice to be issued within Five years and Three months from the end of the relevant assessment year when the escaped income, including such cases where cross-charges are not at arm’s length. If found guilty penal implications may apply.
Under the CGST Act, for periods up to Financial Year 2023–24, recovery of tax not paid or short-paid is governed by:
- Section 73 (non-fraud cases): This Section permits the authorities to issue a notice within three years from the due date of the annual return.
- Section 74 (fraud/suppression cases/wilful misstatement):This Section permits the authorities to issue a notice within a five-years from the due date of filing the annual return
However, from Financial Year 2024–25 onwards, a new section was introduced. The newly added Section 74A, consolidates the recovery provisions under Sections 73 and 74 into a unified framework. Section 74A applies a uniform limitation period of 42 months (i.e., 3.5 years) from the due date of the annual return or from the date of an erroneous refund, irrespective of whether fraud is involved.
Section 13 (1) of the FEMA Act- This Section imposes penalties up to three times the sum involved if quantifiable or INR 2,00,000/- if it is not quantifiable, for contravention of various provisions of the FEMA Act/ Regulations/ Orders/Directions. However, these penalties can be compounded.
These provisions underscore the potential for retrospective scrutiny and penalties if cross-charges fail to comply with applicable regulations.
Conclusion
Navigating cross-charges between an HO and PO in India requires a thorough understanding of FEMA, GST, IT Act and the Companies Act, 2013. By addressing these common concerns with legal backing and practical examples, businesses can ensure compliance and mitigate risks.
Contributed by Nishant Kantawala, with key inputs from Yatin Sharma and Abhishek Dutta.
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