The issue of attribution of income to a taxable presence of an entity in another State, or Permanent Establishment (PE), has been the subject of considerable controversy over the last several years. The business connection/PE concept as it is understood in international tax law sets the basic threshold limit beyond which a multinational enterprise ought to be taxed in the country of source of business activity.
Tax treaties, which provide for avoidance of double taxation and related matters are normally negotiated on the basis of the OECD model, the UN model, and the US model.
The UN model was developed mainly to counter-balance the OECD model, which was considered to be tilted in favour of residence based taxation since OECD mainly comprises of developed countries. UN Model seeks to reflect and voice the concerns of developing nations, which sought to establish source-based taxation on the basis that developing countries were importers of equipment and technology were, thus, the source of the income of developed nations.
Although similar to the OECD model, the UN model uses a lower PE threshold and includes additional situations in which a PE can be created, for example, Service PE, i.e. on account of services of employees in the source state. Similarly, UN Model contains force of attraction clause for attribution of profits, thus, seeking to attribute profits arising from not only operations of the PE but also from sale or supply of similar goods and services in the source State, even though PE may not be directly involved in such supply.
2. Need for attribution
The concept of attribution of profits is closely linked to the concept of PEs. Typically PEs are hypothesised as entities separate from their parent in economic terms, though not necessarily legally. For example, an agent or a branch office may constitute a PE of a foreign enterprise, though the agent may have any legal form other than that of the foreign enterprise and the branch is legally the same legal entity as the head office of the overseas enterprise. The need for appropriate attribution of profits arises in order to allow the source state to eliminate subjectivity and mitigate the effect of external and internal influencing factors in taxing the economic activity carried on by the foreign enterprise on its soil.
3. Principles under domestic law
The Income tax Act, 1961 ('the Act') contains basic framework for attribution of profits to a 'business connection' or 'Permanent Establishment'. Section 9(1)(i) of the Act read with the relevant Explanation provides that income from a 'business connection' in India shall be taxable in India but only to the extent as is reasonably attributable to operations carried out in India.
Further, Rule 10 of the Income Tax Rules ('the Rules') provides that if the Tax officer is of the opinion that income arising to a non-resident cannot be properly ascertained, the amount of such income may be calculated at (i) percentage of turnover, as may be considered appropriate; or (ii) an amount which bears the same proportion to the total profits of business of such person as the receipts accruing or arising bear to the total receipts of business.
In other words, the domestic law provides for applying a profit rate to the India-specific turnover of the foreign company for ascertaining the profits attributable to the operations carried out in India. Applying a global profit rate on India specific turnover would result in estimation of total profits from Indian turnover, though the entire activities giving rise to such profits, e.g. research and development, manufacturing, marketing and selling may not have been carried out in India. For example, in some cases, certain marketing activities as well as negotiation and conclusion of sale contracts may have been carried out in India, but all other activities, e.g. research and development, manufacturing, technical services etc. may have been carried out outside India.
In such cases, the Courts have, in the past, used an ad hoc basis for estimating the profits attributable to India specific activities, based on facts of each case.
In the case of Anglo French Textile Company Ltd. v. CIT: 25 ITR 27, the Supreme Court returned a finding that in the facts of the case, 10% of profits were to be attributed to operations carried out in India.
Again, in Hukum Chand Mills Ltd. v. CIT: 103 ITR 548, the Supreme Court found that attribution of 15% of profits was reasonable in the facts of that case. More recently, in case of Motorola Inc: 95 ITD 269, the Special Bench of the Income Tax Appellate Tribunal, ('ITAT') held that attribution of 20% of profits was sufficient for role played by the PE in negotiation and conclusion of contracts and supply of equipment in India by the PE of the taxpayer. Similarly, in case of Galileo International Inc. 114 TTJ 289, 15% of total revenues were considered to be attributable to the Indian PE on the basis that the PE played a role in negotiating contracts.
While the Courts have in the past followed an ad hoc approach in determining profits attributable to PE, more recently, it is seen that the judicial view is veering towards more scientific and systematic way of attribution of profits, by relying on FAR analysis, using transfer pricing principles.
The Central Board of Direct Taxes ('CBDT'), vide circular no. 5 dated September 28, 2004, provided, inter alia, that profits to be attributed to a PE should be those which the PE would have made if, instead of dealing with the head office, it had been dealing with a separate enterprise under prevailing market conditions, thus bringing in the arm's length concept in profit attribution.
The Supreme Court, in Morgan Stanley & Co. v DIT: 292 ITR 416, categorically stated that profits attributable to a PE shall have to be determined based on FAR analysis, i.e. functions performed, assets employed and risks assumed, based on arm's length principles. This view has been upheld in a number of decisions.1
4. OECD and position under Treaties
While the profit attribution based on domestic law has been rather ad hoc and presents obvious challenges, the attribution under the Treaties itself is not free from issues. Article 7(2) of most treaties concluded by India provides for basis of attribution of profits, i.e. profits attributable to the PE shall be profits that the PE would be expected to make if it were a distinct enterprise carrying on business under uncontrolled conditions.
Para 2 of Article 7 of the OECD Model Convention provides that profits to be attributed to a PE are, "the profits it might be expected to make, in particular, in its dealing with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through other parts of the enterprise."
OECD has done considerable work in recognizing and addressing issues in profit attribution. Broadly, the authorized OECD approach to attribution of profits suggests hypothesizing PE as a separate and distinct enterprise, dealing with its head office or parent enterprise on arm's length basis. The authorized OECD approach can be said to involve two broad steps. As first step, a functional and factual analysis would be applied to the PE to:
- Attribute to the PE, rights and obligations arising out of transactions between the enterprise of which the PE is a part and separate enterprises;
- Determine the functions of the hypothesised separate and independent enterprise and the economically relevant characteristics (both ―internal and ―external conditions) relating to the performance of those functions;
- Attribute risks among the different parts of an enterprise, based on the identification of significant people functions relevant to the assumption of risks;
- Attribute economic ownership of assets among the different parts of the single enterprise, based on the identification of the significant people functions relevant to the attribution of economic ownership of assets;
- Recognise and determine the nature of those dealings between the PE and other parts of the same enterprise that can appropriately be recognised; and
- Attribute capital based on the assets and risks attributed to the PE.
Under the second step, the authorized OECD approach provides that dealings of the hypothesised separate enterprise will be compared to transactions of independent enterprises performing the same or similar functions, using the same or similar assets, assuming the same or similar risks, and possessing the same or similar economically relevant characteristics.
Effectively, OECD approach hypothesizes the PE as a separate entity, attributing assets (tangible and intangible), ascertaining risks, attributing capital, identifying functions performed by PE for its own business and business of other parts of the enterprise, and functions performed by other parts of the enterprise for the PE, comparing the transactions of PE to transactions by unrelated parties, and arriving at arm's length remuneration for such transactions on the basis of the aforesaid analysis.
The authorized OECD approach itself presents several issues- e.g., in case of e-commerce operation where the server itself could be considered as a PE, there may not be any personnel on the ground to perform any functions. Thus, in the absence of any specific functions performed and risks assumed by the PE, it may perhaps be considered that profit attribution needs to be minimal.
Another challenge is that various treaties entered into by India are not identically worded. As a result, attribution in cases falling under treaties having a force of attraction clause needs to follow a slightly different approach. An example of force of attraction clause could be found in the UN Model Convention which provides for attribution of profits to the PE which include profits pertaining to the activities carried out by the PE as well as sale of same or similar goods or services in the relevant State, as those sold through the PE. In addition, under the UN Model also provides for attribution of other business activities carried out in another state of the same or similar kind as those effected through the PE. In cases where the Treaties contains 'force of attraction clause', an issue arises as to whether entire profits of same or similar goods need to be attributed to the PE, even though PE may not have played any part in the conclusion of contract or supply of goods and/or services, profits from which are sought to be attributed to the PE. The Special Bench of ITAT, in case of DIT v Clifford Chance: 143 ITD 1, read down the provisions of force of attraction clause by stating that profits indirectly attributable to the PE should be only those profits in respect of which PE has played some part. Nevertheless, the force of attraction clause seems to go beyond the mandate of section 9(1)(i) of the Act, wherein under the principle of apportionment, attribution of profits is to be restricted to the profits from the activities carried out in India by the PE2 and not otherwise. The applicability of this clause, thus, may be doubtful since a Treaty is not generally considered to provide for taxation of items of income, which are not taxable under the domestic law, in terms of section 90 of the Act.
Another common issue is use of intangibles owned by the parent entity by the PE. The primary issue is allocation of intangibles owned by an enterprise as a whole to the PE. Next issue is that separate entity approach would consider that payments for use of such intangibles must be allowed to be deducted in computing profits of the PE, considering that PE is not the economic owner of such intangibles. Existence of intangibles generated by the enterprise itself further complicates the matter. Also, even if actual payments are not made, a PE should ordinarily be entitled to a deduction for use of intangibles in its business. However, most treaties disallow payment of royalties by a PE to the head office in determining the profits attributable to the PE. This militates against the concept of hypothesizing PE as an enterprise distinct from its parent entity.
Authorized OECD approach also seeks to allocate a part of enterprise's 'free capital', i.e. equity or owners' contribution, to the PE, rather than hypothesizing that the entire funds of the PE are debt funds. In cases where the enterprise itself is thinly capitalized, it becomes difficult to arrive at a fair amount of free capital, in the absence of which, the amount of profits may be distorted, e.g. by heavy interest cost allocated to the PE, which may not be the case in uncontrolled conditions.
An issue sometimes arises in profit attribution in case of dependent agent PEs (DAPE), since DAPE typically pre-supposes taxation of the agent as well as of the overseas enterprise which constitutes the PE. There are thus, two taxable entities, the DA and the DAPE, i.e the overseas enterprise. The issue remains as to whether any further attribution is required if the DA is compensated on arm's length basis.
Here, it may be useful to refer to certain observations of the Mumbai Bench of the ITAT, in case of Set Satellite Singapore Pte Ltd: 106 ITD 175. The ITAT observed that DAPE itself is hypothetical because there is no establishment - permanent or transient-of the GE in the PE state. The hypothetical PE, therefore, must be visualized on the basis of presence of the General Establishment (GE) as projected through the PE, which in turn depends on functions performed, assets used and risks assumed by the GE in respect of the business carried on through the PE.
The DAPE and the DA have to be, therefore, treated as two distinct taxable units. The former is a hypothetical establishment, taxability of which is on the basis of revenues of the activities of the GE attributable to the PE, in turn based on the FAR analysis of the DAPE, minus the payments attributable in respect of such activities.
In other words, whatever are the revenues generated on account of functional analysis of the DAPE, should be taken into account as hypothetical income of the said DAPE, and deduction is to be provided in respect of all the expenses incurred by the GE to earn such revenues, including, of course, the remuneration paid to the DA.
The ITAT further observed that it could be open to the foreign enterprise to claim appropriate adjustment for the foreign enterprise's overheads and even a reasonable charge, on account of activities of the foreign enterprise carried on outside the host country, by treating the foreign enterprise as a fictionally separate entity.
The ITAT further went on to hold that tax liability of a foreign enterprise, in respect of its DAPE, is not extinguished by making an arms' length payment to the DA.
Though this decision of the ITAT was later overruled by the Bombay High Court, it points out an interesting conundrum in attribution of profits to PEs, which are constituted by separate legal entities, viz. external agent or subsidiary.
5. Recent trends in attribution of profits
Recently, the ITAT, in case of e-funds Corporation v ADIT: 42 SOT 165, held that the proper method for estimating the profits attributable to the PE shall be worked out in the following manner:
- Determination of proportion of Indian assets to global assets, including assets of eFunds India.
- Aggregation of global profits of the group (inclusive of eFunds India profits).
- Working of total profits attributable to India out of global profits in same proportion as above
- Aggregation of India attributable profits of group (X)
- Less: eFunds India profits (Y)
- Profits attributable to PE of Taxpayers (Z = X – Y)
In case of Convergys Customer Management Group Inc. vs. Assistant Director of Income-tax  34 taxmann.com 24, the ITAT proceeded to lay down a step by step methodology for attribution of profits to a PE as under:
- Global operating income percentage as per the annual report was to be computed;
- Operating income from Indian operations was to be arrived at by applying this percentage to end-customer revenue in regard to projects where services were acquired from the Indian entity;
- The operating income was to be reduced by the profit before tax of the Indian entity and the balance would be considered the profit attributable to the Indian PE.
- As determined above, the profit attributable to the PE should be estimated on residual profits.
Thus, profit of Indian PE = Operating income from Indian operations - Operating income of Indian subsidiary.
As evident from the above, the ITAT, in effect has upheld the principle that a PE may be hypothesized as an entity different from the agent or subsidiary constituting it. Accordingly, taxation of the agent or subsidiary would not extinguish the liability of the foreign principal or parent in so far as the activities of Indian PE are concerned, following the premise that the PE is performing certain activities separate from the agent or the subsidiary, for which such agent or subsidiary has not been remunerated adequately. It would be interesting to see whether such a treatment is consistent with the principle laid down by the Supreme Court in Morgan Stanley (supra), where, based on FAR analysis of the Indian subsidiary, the remuneration to the subsidiary was found to be at arm's length and it was categorically held that in view thereof, no further attribution could be made in the hands of the overseas parent.
The attribution of profits to PEs is a continuing conundrum which has no easy solutions. While the principle of arm's length attribution has been laid down in unequivocal terms by the Supreme Court, it would, perhaps, be relevant to analyse if the overseas entity assumes any risks or performs any functions in addition to the normal functions performed by the agent/subsidiary/PE, in which case, an attribution over and above arm's length remuneration to such agent etc. may be justified. With the recent judicial trend of placing reliance on FAR analysis in attributing profits to a PE, it is becoming increasingly important for multi-national enterprises to have a robust transfer pricing documentation in place in case a PE is held to exist and attribution of profits is challenged.
*Gautam Chopra, Partner, Seth Dua & Associates
1 Rolls Royce Singapore Pvt Ltd: ITA no. 1278/2010
Heavy Industries Ltd: 291 ITR 482 (SC)
2 See Ishikawajima–Harima Heavy Industries Ltd. v CIT: 288 ITR 492(SC) (in the context of offshore supply)
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