Decoding The Nexus Of Economic Loyalty & Profit Attribution To Permanent Establishments

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This insight explores the intricate process of attributing profits to Permanent Establishments, a vital topic for multinational corporations in today's global economy.
India Tax
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This insight explores the intricate process of attributing profits to Permanent Establishments, a vital topic for multinational corporations in today's global economy. Originating from early 20th-century initiatives by the League of Nations, this practice has evolved into the Authorized OECD Approach. This approach rigorously aligns profit allocation with the actual economic activities of a Permanent Establishment using detailed functional and comparability analyses, adhering to the arm's length principle. It also touches on India's unique compliance with modern international guidelines, as seen through its tax treaties and judicial rulings. Furthermore, it critiques traditional methods for occasionally missing the dynamics of digital economies and suggests alternative methods for distributing profits more equitably worldwide.


In the age of globalization, the world has witnessed a technological revolution that has made geographical boundaries inconsequential to business operations. This expansion has enabled multinational enterprises ('MNEs') to extend their reach across borders, capitalizing on opportunities for growth and economies of scale. This global expansion has led to two distinct modes of cross-border transactions: conducting business witha country (without a physical presence) and conducting businesswithina country (with a physical presence).

In the first scenario, foreign entities engage in commercial transactions with residents of a country without establishing a physical presence. These transactions typically involve the sale of goods or provision of services, with ownership, risks, and rewards situated beyond the country's borders. The tax implications for these entities are relatively straightforward, as they are generally not liable for taxes in the country where their consumers are located due to the absence of an official presence within its jurisdiction.

In contrast, the second scenario involves a foreign entity establishing a tangible presence within another country to conduct business activities. This naturally attracts tax liabilities in that country. Such presence could be through the employment of personnel, engagement of agents, or the creation of fixed bases for operations. The tax implications arising from these engagements necessitate addressing two principal questions: which jurisdiction is entitled to tax the business profits earned by the foreign entity through its physical presence, and what methodology should be applied to determine the taxable portion of profits?

Tracing the Roots of Permanent Establishments (PEs)

The concept of profit attribution to PEs has seen significant evolution since its inception in the 1920s. This evolution traces its roots to the foundational work of the League of Nations and culminates in the modern approach encapsulated in the Authorized OECD1 Approach ('AOA'). The AOA, through a structured framework and methodical analysis, seeks to align profit attribution with the economic reality of a PE's contribution to an MNE's overall earnings.

The PE concept originated from the League of Nations' 1923 Report on Double Taxation, which emphasized the economic loyalty of a business to a taxing jurisdiction. This marked a transition that underscored the PE as an objective criterion, establishing a tangible connection, or nexus, that reasonably reflects the business's economic ties to a jurisdiction.

Fast forward to 2008, the OECD issued a comprehensive 263-pager report2 on attribution of profits to PEs which formulated the most preferred approach to attribution of profits to a PE under the existing a. 7 of the Model Tax Convention3 ('MTC'). Subsequently, the OECD amended its commentary on a. 7 of the MTC, to incorporate its guidelines of the 2008 version of the report in its 2010 report4 on attribution of profits to PEs, another 240-pager document. Thereafter, the OECD's response to base erosion and profit shifting ('BEPS') culminated in the issuance of BEPS Action Plan 7 in 2015. This initiative aimed to curb artificial avoidance of PE status by MNEs.

The Authorized OECD Approach (AOA)

The OECD has published various reports that provided guidelines on the attribution of profits in the case of PEs. However, the practices followed by both OECD and non-OECD countries, and these countries' interpretation of a. 7 of the OECD's MTC varied significantly.

To eliminate this uncertainty, the OECD introduced the AOA in the 2008 and 2010 reports. The AOA prescribed a framework wherein the PE is conceptually segregated from its parent enterprise and treated as an independent entity. Profits are then determined through a comparability analysis and on the basis of the functions performed by it, theassets it uses and the risks it assumes ('FAR analysis') which is aligned with the OECD's Transfer Pricing ('TP') Guidelines for Multinational Enterprises and Tax Administrations, by analogy using the arm's length principle ('ALP').

The AOA recommends a two-step approach for the determination of profits attributable to a PE:

Step 1: The AOA kickstarts with an exhaustive functional and factual analysis aligned with the FAR analysis. This involves an in-depth examination of the PE's operations, the functions it performs, the assets it utilizes, and the risks it shoulders.

Step 2: Following the functional review is the comparability analysis. This involves identifying transactions within the PE and across the MNE, as well as with independent entities. The objective is to establish conditions mirroring those that would occur between independent parties in similar transactions under comparable circumstances.

Rooted in the ALP, which is central to TP regulations, this analysis often presents challenges due to the distinctive characteristics of PEs and the lack of directly comparable data. To mitigate this, the AOA allows for various TP methodologies, such as the Comparable Uncontrolled Price ('CUP') method, Resale Price Method ('RPM'), Cost Plus Method ('CPM'), Transactional Net Margin Method ('TNMM'), and the Profit Split Method ('PSM'). The selection of a method depends on data availability, the nature of the PE's operations, and the comparability of the transactions.

India's Taxation Treaties & the Concept of PE

India has consistently aligned its taxation treaties with a. 7 of the United Nations MTC, which advocates for equitable rights in source-based taxation. This includes the recognition of the PE concept as per a. 5 of the double taxation avoidance agreements ('DTAAs')5. Domestically, the Income-tax Act, 1961 ('IT Act') governs this through the 'business connection' defined in s. 9 and the PE definition in s. 92F(iiia)6 of the IT Act.

India's DTAAs generally align with the taxation of a PE till the time the OECD MTC was amended in 2010. Earlier, in 2008, OECD had amended its Commentary (while not amending the MTC) to introduce a FAR based approach to profit attribution. It is interesting to note that India uniquely reserved its right in 2010 to adhere exclusively to this updated version of a. 7 and any associated Commentary or subsequent amendments. This unique stance by India has been detailed under 'Positions of Non-OECD Economies' since then.

Despite the absence of specific guidance from tax authorities on how profit attribution preferences differ between India's methods and those suggested by the OECD AOA, various Indian judicial decisions demonstrate adherence to the ALP as recommended by OECD principles.

The concept of PE in India, as outlined by the combined reading of ss. 5 and 9 of the IT Act, shapes the tax base for the purpose of profit attribution to PEs. S. 5 of the IT Act provides the tax base in this regard, stating that a foreign entity needs to pay taxes in India on income received or deemed to have been received in India, or on income that accrues or is deemed to accrue or arise through a 'business connection' in India. Further, s. 9 of the IT Act provides an inclusive definition of 'business connection' to include activities conducted by a person on behalf of a foreign entity, including contract negotiation, stock maintenance with regular delivery, and securing orders for the foreign entity in India.

In a landmark judgment in CIT v. R. D. Aggarwal & Co.7, the Supreme Court explained the criteria for the establishment of a 'business connection' of a foreign entity in India. It stipulated that such a connection necessitates the demonstration of ongoing business operations and a substantive correlation between the foreign entity's commercial activities and its engagements within India. This includes ancillary functions such as back-office operations and support services that may not per se constitute a PE within the jurisdiction.

In Formula One World Championship Ltd. v. CIT, IT8, the Supreme Court held that a foreign entity could constitute a PE even if its activities in India are undertaken only for three days. This decision was based on the reasoning that if a business is conducted in India by a foreign entity for a limited number of days, during which it has complete control over and access to it, it would be sufficient for it to constitute a PE in India.

In alignment with international tax commentaries, the Indian judiciary has stated that for a place of business to be at the disposal of a foreign entity in India, it is essential for such a company to have a certain degree of control over the premise or space in the country. This means that it has unrestricted access to it and can use it, based on its requirements, to undertake its business activities in India.9

Attributing Profits to PEs in India

Upon establishing a foreign entity's PE in India, profit attribution is permissible solely on that portion of income which can be 'reasonably attributed' to its operations within the country. For this purpose, r. 10 of the Income-tax Rules, 1962 ('IT Rules') provides a methodology that parallels the Global Formulary Apportionment ('GFA') approach10. This method recommends allocating global profits across various countries based on financial parameters like turnover and asset bases, contrasting with the transaction-based pricing allocation.

Nevertheless, the OECD has opted for the ALP, founded on global TP principles, over GFA. Indian courts and tribunals have consistently supported the adoption of ALP when attributing profits to PEs.

R. 10 of the IT Rules stipulates how to compute income for a non-resident entity when it is challenging to precisely determine actual business income from activities, property, assets, or other sources in India. The computation may involve:

  • R. 10(i) of the IT Rules involves calculating a reasonable percentage of the turnover accruing to the PE. Such a percentage may vary based on what is considered reasonable and serves as a test of reasonableness, thus permitting the application of the ALP.

  • R. 10(ii) prescribes profits to be split in a proportionate manner. Assuming the tax base to be 'x', x is to the total profit of the parent entity as the total receipts of the PE are to the total receipts of the parent entity. This limits attribution to a purely mathematical assessment.

  • R. 10(iii) of the IT Rules allows for flexibility by permitting the use of any other suitable method deemed appropriate. This provision is so broadly worded that it allows for a lot of subjectivity.

It is clear from the wording of r. 10 of the IT Rules that before invoking this provision, it must be demonstrated that the tax base cannot be ascertained from the books of accounts of the PE or in case the PE does not maintain any books of accounts. Hence, the three aforementioned methods cannot be applied straightaway in the presence of books of accounts of the PE.

In the case of Morgan Stanley11, the Supreme Court held that no generalization was possible for the attribution of profits to PEs. It was stated that there is a need to depend upon functional and factual analysis and the data placed by the taxpayer to be examined in each case. At the same time, considering whether once the TP analysis is undertaken, no further need to attribute profits to a PE arises, the Court noted that the object behind the enactment of TP regulations was to prevent the shifting of profits outside India and that taxing corporates on the basis of the concept of economic nexus was an important feature of profits attributable to PEs.

The Supreme Court held that payments at ALP extinguish any further attribution of profits to the headquarters if the arm's length analysis is exhaustive of functions, assets, and risks. However, it was also stated that the situation would be different if the TP analysis does not adequately reflect the functions performed and the risks assumed by the entity, and hence, further attribution of profits would be required. In this case, no further attribution was done beyond the ALP calculated, given the sufficiency of the TP compliance.

Exploring Alternative Approaches to Profit Attribution

The AOA has faced scrutiny for its complexity, exhaustiveness and reliance on traditional TP methods, which some argue may not adequately capture the value created by PEs. Critics contend that the AOA's primary focus is on functional analysis and the separate entity approach only focuses on the supply-side factors. Additionally, concerns have also been raised regarding the subjectivity involved in determining the arm's length pricing of intra-group transactions, potentially resulting in disputes between taxpayers and the tax authorities. In this background, there are some alternative approaches for attributing profits to PEs that deserve some consideration.

  • Formulary Apportionment Method: This method proposes the allocation of profits based on a predetermined formula, rather than on an analysis of individual transactions. The formula typically takes into account factors such as sales, payroll, and assets, which are used as proxies for the PE's contribution to the MNE's overall profits. This approach aims to distribute profits among jurisdictions according to their relative contributions to the generation of income and is seen as a way to simplify the profit attribution process, reducing the administrative burden associated with the AOA.

  • Fractional Apportionment Method: Similar to formulary apportionment, the fractional apportionment method requires the division of profits between a PE and its head office based on a predetermined ratio reflecting their respective contributions to the generation of revenue. However, it employs a more refined set of factors, potentially including measures of economic activity such as market size or capital investment. This method aims to provide a more nuanced and tailored approach to profit attribution that better reflects the economic realities of different industries and markets.

  • Profit Split Method: This method involves dividing the combined profits of an MNE between its various entities, including PEs, based on their relative contributions to value creation. This approach is particularly useful in cases where transactions are highly integrated or where intangible assets play a significant role in value creation. However, implementing this method requires extensive data and analysis that poses practical challenges for tax administrations and taxpayers.

  • Supply-Demand Approach: This approach considers both the supply-side contributions i.e. the FAR analysis, and the demand-side factors such as market conditions, customer base, etc. in attributing profits. This method acknowledges that profits are generated not only by the production of goods or services but also by the markets in which they are sold. This method is said to be in alignment with economic realities that foster a fair distribution of tax liabilities.

  • Destination-Based Cash Flow Taxation: This is a concept that taxes profits where sales occur, rather than where production takes place. This approach is particularly relevant in the digital economy, where the location of consumers can be more significant than the location of production. It seeks to align the taxation of profits with the location of economic activity and value creation.


The traditional concept of profit attribution to PEs is a highly fact-intensive exercise and is typically based on the well-established ALP. However, the discourse on profit attribution has gained momentum in the era of digital business. The traditional ALP, despite undergoing numerous revisions over the past two decades, appears to fall short of providing a comprehensive solution. This included the 2017 revision to the OECD TP guidance, which extensively dealt with value creation and the subsequent guidance concerning hard-to-value intangibles. One of the reasons for this shortfall is that while ALP analysis takes into account the FAR analysis, it does not consider variables that cannot be attributed to the parties involved, such as the existence of a market itself.12


It can, thus, be seen that the attribution of profits to PEs is a complex and evolving area of international tax law. While the traditional methods have their merits, the emergence of digital economies and the increasing complexity of multinational operations necessitate the exploration of alternative approaches. These alternatives, while not without their challenges, offer the potential for a more equitable and realistic allocation of taxing rights among jurisdictions.


1. OECD – Organization for Economic Co-operation and Development – The OECD is a group od 37 member countries that discuss and develop economic and social policy. Its members are typically democratic countries that support free-market operations.

2. Report on the Attribution of Profits to Permanent Establishments, dated 17.07.2008, issued by the OECD,

3. Model Tax Conventions are standardized frameworks developed by international organizations (such as the OECD or the UN) to guide the negotiation and interpretation of bilateral tax treaties between countries. These conventions provide rules for allocating taxing rights, preventing double taxation, and addressing cross-border tax issues.

4. 2010 Report on the Attribution of Profits to Permanent Establishments, dated 22.07.2010, issued by the OECD,

5. Double Taxation Avoidance Agreements (DTAAs) are bilateral agreements between two countries to prevent double taxation of income. These agreements allocate taxing rights, provide mechanisms for resolving disputes, and promote economic co-operation between the signatory nations.

6. Income-tax Act, 1961; Section 92F. In Sections 92, 92A, 92B, 92C, 92D and 92E, unless the context otherwise requires,-

(iiia) "permanent establishment", referred to in clause (iii), includes a fixed place of business through which the business of the enterprise is wholly or partly carried on.

7. Commissioner of Income Tax, Punjab v. R. D. Aggarwal & Co. & Anr., (1965) 56 ITR 20

8. Formula One World Championship Limited v. Commissioner of Income Tax, International Taxation-3, Delhi & Anr., (2017) 15 SCC 602

9. Formula One World Championship Limited (supra); Rolls Royce PLC v. Director of Income Tax, International Taxation [2011] 339 ITR 147 (Delhi); GE Energy Parts Inc. v. Additional Director of Income Tax, [2017] 56 ITR (Trib) 51 (Delhi)

10. Global Formulary Apportionment (GFA) is a tax allocation method where MNEs allocate their profits among countries based on a formula that considers factors like sales, assets, and payroll. Unlike the ALP, GFA aims to distribute profits fairly across jurisdictions without relying on inter-company pricing.

11. DIT (International Taxation) v. Morgan Stanley & Co. Inc., [2007] 292 ITR 416 (SC)

12. Bhutani, M. (2021), Transfer Pricing - The Indian Landscape | Two Decades On, 'Chapter 12 - Profit Attribution', in. LexisNexis, pp. 516–517.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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