Contract Manufacturing in India: Structuring Agreements Without Creating PE

Why Contract Manufacturing Creates PE Risk

India's manufacturing sector has become the preferred destination for companies executing China-plus-one strategies. With 100% FDI permitted through the automatic route in manufacturing, and incentive programmes like PLI covering 14 sectors, foreign companies are rapidly scaling production in India. Many choose contract manufacturing — engaging an Indian manufacturer to produce goods on their behalf — rather than setting up their own factory.

The tax risk lies in how "on their behalf" is interpreted. Under Article 5 of India's Double Taxation Avoidance Agreements (DTAAs), a permanent establishment (PE) is defined as a fixed place of business through which the business of a foreign enterprise is wholly or partly carried on. If the Indian contract manufacturer is treated as an extension of the foreign company — rather than an independent business — the foreign company may be deemed to have a PE in India, subjecting its global profits attributable to Indian operations to India's corporate tax rate of 35% (for foreign companies, including surcharge and cess).

The Three Types of PE Risk in Contract Manufacturing

1. Fixed Place PE (Article 5(1))

A fixed place PE arises when a foreign enterprise has a fixed physical location in India — an office, factory, warehouse, or workshop — at its disposal. In a contract manufacturing arrangement, this risk materialises when:

• The foreign company leases factory space or warehouse space in India, even if the contract manufacturer operates from that space
• Equipment owned by the foreign company is installed at the manufacturer's facility on a permanent or semi-permanent basis
• Foreign company employees are stationed at the manufacturer's facility to oversee production

Under current interpretations, consignment of machinery to an Indian contract manufacturer may create a PE if the machinery remains under the foreign company's control. A leading smartphone contract manufacturer invested approximately USD 250 million in machinery between FY2020 and FY2024, with up to 40% of this cost potentially avoidable if consignment models were clearly permitted under Indian tax law.

2. Dependent Agent PE (Article 5(5))

A dependent agent PE arises when a person in India habitually acts on behalf of the foreign enterprise and has the authority to conclude contracts in the name of that enterprise. In contract manufacturing, this risk emerges when:

• The Indian manufacturer negotiates and concludes sales contracts on behalf of the foreign company
• The manufacturer habitually secures orders or delivers goods on the foreign company's behalf
• The manufacturer works exclusively or almost exclusively for one foreign principal

The exclusivity factor is critical. If an Indian manufacturer derives 90% or more of its revenue from a single foreign principal, tax authorities are likely to argue dependency, regardless of the contractual language describing the relationship as principal-to-principal.

3. Service PE (Article 5(2)(l) — India-specific)

Many of India's DTAAs include a service PE clause that has no equivalent in the OECD Model Convention. Under this clause, a PE exists if a foreign enterprise furnishes services in India through employees or other personnel for a period exceeding a specified number of days (typically 90 or 183 days) in any 12-month period. In contract manufacturing, service PE risk arises from:

• Quality control inspectors visiting the manufacturer's facility regularly
• Technical personnel providing ongoing production support
• Training teams spending extended periods at the Indian facility

The Supreme Court Hyatt Ruling: A 2025 Wake-Up Call

On 24 July 2025, the Supreme Court of India delivered a landmark ruling in the Hyatt International case that significantly expanded the scope of PE determination. The Court held that Hyatt International (Southwest Asia) Ltd., a UAE-based company, had a taxable PE in India despite having no fixed physical office in the country.

Key Findings

The Court found that Hyatt's "sustained and substantive operational control" — including branding, managing bank accounts, staff supervision, training, and operational monitoring — extended well beyond an advisory role and reflected substantive involvement in Indian operations. The judgment established that:

• Economic substance overrides legal form in PE determination
• Repeated presence and operational control exercised through local employees or representatives can create a PE
• Profits attributable to Indian operations can be taxed even if the global entity reports net losses
• The absence of a fixed physical office does not preclude a PE finding

Implications for Contract Manufacturing

The Hyatt ruling means that foreign companies cannot rely solely on contractual labels ("independent contractor," "principal-to-principal") to avoid PE. If the actual conduct of the relationship demonstrates substantive control over the Indian manufacturer's operations — production schedules, quality standards, pricing, employee management — the tax authorities may successfully argue a PE exists.

Structuring Agreements to Avoid PE: A Practical Framework

Based on the current legal landscape, DTAA provisions, and post-Hyatt jurisprudence, the following framework minimises PE risk in contract manufacturing arrangements:

1. Maintain Principal-to-Principal Relationship

The contract must clearly establish that the Indian manufacturer is an independent business, not an agent or extension of the foreign company. Key contract clauses:

• Independent contractor clause: Explicitly state that the manufacturer acts in its own name and for its own account
• No authority to bind: The manufacturer cannot conclude contracts, make representations, or bind the foreign company in any way
• Multiple clients: The manufacturer should ideally serve multiple foreign principals. An exclusivity arrangement dramatically increases dependent agent PE risk
• Own risk and reward: The manufacturer bears production risk, quality risk, and liability for defective goods

2. Limit Operational Control

The foreign company should provide specifications and quality standards but should not control the how of manufacturing. Practical guidelines:

• Specifications, not supervision: Provide product specifications, quality parameters, and testing protocols. Do not station employees at the facility to direct day-to-day operations
• Periodic audits, not continuous monitoring: Conduct quality audits quarterly or semi-annually, not through continuous on-site presence
• No employee secondment: Do not second employees to the manufacturer's facility. If technical support is needed, limit visits to the service PE threshold (typically 90 days in any 12-month period under most DTAAs)

3. Avoid Asset Placement

Placing assets — machinery, moulds, specialised equipment — at the manufacturer's facility creates fixed place PE risk. Alternatives include:

• Sale of equipment: Sell the equipment to the manufacturer and build the cost into the per-unit manufacturing price
• Licensing of IP: License manufacturing know-how and charge royalties under withholding tax provisions (typically 10-15% under most DTAAs) rather than providing equipment
• Lease through Indian entity: If you have an Indian subsidiary, the subsidiary can own the equipment and lease it to the contract manufacturer

4. Structure Payment Terms Carefully

The payment structure should reflect a genuine arm's length transaction, not a cost-plus arrangement that resembles an employment relationship:

• Per-unit pricing: Pay a fixed price per unit manufactured, not cost-plus-margin, which resembles a captive service arrangement
• Invoice on delivery: The manufacturer invoices upon delivery of finished goods, not upon incurring costs
• No guaranteed volumes: Avoid minimum purchase commitments that make the manufacturer economically dependent on the foreign company

5. Manage Transfer Pricing Proactively

Even if a PE is not established, the pricing between the foreign company and the Indian manufacturer must comply with India's transfer pricing regulations. Since March 2025, the CBDT has amended the safe harbour rules with the following key changes:

• Transaction value threshold increased from INR 2 billion to INR 3 billion (approximately USD 33 million)
• For contract manufacturing of auto components, the definition of "core auto components" has been expanded to include lithium-ion batteries for EVs
• Budget 2026 introduced a 2% minimum margin safe harbour for component warehousing in customs bonded areas
• The Finance Act 2025 introduced a repeat-transaction mechanism allowing the arm's length price determined for one year to apply to similar transactions for two subsequent years, effective from Assessment Year 2026-27

The Component Warehousing Safe Harbour: A 2026 Development

The Union Budget 2026 introduced a specific safe harbour for component warehousing — directly addressing one of the most common PE triggers in contract manufacturing. Under the new framework:

• Non-resident companies that store components in a warehouse located in a customs bonded area and supply those components to an Indian contract manufacturer can elect the safe harbour
• The minimum profit margin required is 2% of invoice value
• Tax authorities will refrain from initiating transfer pricing adjustments for covered activities when the prescribed margin is maintained

This is a significant development for foreign companies that previously had to choose between supply chain efficiency (storing components close to the manufacturer) and PE risk (maintaining inventory in India). The safe harbour effectively permits component warehousing without triggering a PE, provided the 2% margin threshold is met.

Sector-Specific Considerations

Pharmaceuticals and Medical Devices

Contract manufacturing of pharmaceuticals in India requires additional regulatory approvals from the Central Drugs Standard Control Organisation (CDSCO). The contract manufacturer must hold its own manufacturing licence. The foreign company's involvement in quality control — which is mandated by regulatory requirements — should be carefully documented as regulatory compliance rather than operational control, to avoid PE arguments.

Electronics and Smartphones

India's PLI scheme for electronics manufacturing has created a wave of contract manufacturing arrangements. The consignment of specialised SMT (Surface Mount Technology) equipment is common but creates PE risk. Consider having the contract manufacturer finance and own the equipment, with the foreign company providing a technology licence for the manufacturing process.

Automotive Components

The expanded safe harbour rules for auto components (including EV batteries) provide a clear framework. Foreign automotive OEMs should ensure their contract manufacturers meet the INR 3 billion transaction threshold and apply the safe harbour margins to secure certainty.

Documentation Checklist for PE-Safe Contract Manufacturing

Maintain the following documentation to defend against PE assertions by Indian tax authorities:

1. Master Manufacturing Agreement: Principal-to-principal terms, independent contractor language, no authority to bind
2. Functions, Assets, and Risks (FAR) Analysis: Document that the Indian manufacturer performs all production functions, uses its own assets, and bears manufacturing risks
3. Transfer Pricing Documentation: Benchmarking study demonstrating arm's length pricing. File annual transfer pricing documentation with the Indian entity's tax return
4. Employee Travel Log: Track all visits by foreign company personnel to the Indian manufacturer. Ensure cumulative days do not exceed the DTAA service PE threshold
5. Correspondence Record: Maintain records showing that the manufacturer exercises independent judgment in production decisions
6. Multiple Client Evidence: If the manufacturer serves other clients, document revenue diversification to counter exclusivity arguments
7. Equipment Ownership: Clear documentation that all manufacturing equipment is owned by the Indian manufacturer, not the foreign company

When a PE May Be Unavoidable — and How to Manage It

In some cases, the level of control required by the foreign company over the manufacturing process makes PE avoidance impractical. This is common in:

• Defence manufacturing under offset obligations (where the foreign OEM must maintain quality oversight)
• Pharmaceutical manufacturing where global regulatory bodies (FDA, EMA) require continuous manufacturing oversight
• Semiconductor fabrication where process control is integral to the product

In these scenarios, the strategy shifts from PE avoidance to PE management. This involves:

• Establishing the PE formally and filing Indian tax returns
• Minimising profits attributable to the PE through proper FAR analysis
• Claiming branch office or project office status for the PE to access DTAA benefits
• Applying for an Advance Pricing Agreement (APA) with the CBDT to fix the profit attribution methodology for 5 years, providing certainty

Key Takeaways

• Contract manufacturing in India creates three types of PE risk: fixed place PE (from owned/leased premises or equipment), dependent agent PE (from exclusivity and contract authority), and service PE (from employee presence exceeding DTAA thresholds).
• The 2025 Supreme Court Hyatt ruling established that economic substance overrides legal form — contractual labels alone cannot prevent a PE finding if actual conduct demonstrates operational control.
• Structure agreements on a principal-to-principal basis with no authority to bind, limit operational control to specifications rather than supervision, and avoid placing assets at the manufacturer's facility.
• The 2026 Budget's component warehousing safe harbour (2% minimum margin) addresses a major PE trigger by permitting inventory storage in customs bonded areas without PE consequences.
• Maintain comprehensive documentation — FAR analysis, transfer pricing study, employee travel logs, and correspondence records — to defend against PE assertions during tax audits.