Attribution of Profits to Permanent Establishments: India and The OECD

Transcription

1 Attribution of Profits to Permanent Establishments: India and The OECD By, Kriti Chawla Khanna The author, Kriti Chawla Khanna, is a Chartered Accountant and a Company Secretary. She specialises in International Tax Laws with LLM from King s College London. She can be connected on: Cell: (+91) kriticjm@gmail.com LinkedIn: linkedin.com/in/kriti-chawla-18a Word Count: 8185 Disclaimer: Views and opinions expressed in this document are solely of the author, unless covered by references/ sources mentioned as footnotes. It is advised the document be used for reference purposes.

2 Introduction India s Prime Minister, Mr. Narendra Modi, referring to the theme, Creating a Shared Future in a Fractured World, at the World Economic Forum Annual Summit 2018, says The biggest reasons for fracture at the international level are: Control of Territories: Both Direct and Indirect; and Control of Transactions: including cross border trade and movement of people. In a conscious attempt to recover from the said fracture, Mr. Modi discussed 1 various factors promoting economic growth in India, including, move towards a less cash socitey, unified tax system in the form of GST, competitve federalism etc. Hence, as Mr. Modi stressed India offers you everything you seek 2 Likewise, #LondonisOpen is a major campaign to show that London is united and open for business, and to the world 3 The above recitals, though not exhaustive, while pointing towards globalisation of the world economies, give rise to multiple jurisdictional operations for Multi- National Enterprises ( MNEs ). Establishment of Permanent Establishments 4 of such MNEs in the host country is a direct consequence. Following source based taxation, the concept of PE is widely discussed in International Tax Laws. It is the taxable business presence of an enterprise in the host country, i.e. it divides taxation rights between the host and the resident country. This division of rights i.e. a correct and fair allocation of profits to the PE in the host country is imperative. This will ensure that the tax authorities, especially of a developing nation, are not apprehensive of erosion of their fair share of taxes. There is thorough guidance, including legal decisions on the criteria that defines when business activity reaches the level that triggers PE. However, the concept of resulting taxation i.e. estimation of attribution of profits to PE lacks clear rules. This debate is left open with the Indian tax authorities and Judiciary. While one will need to study the fine print there is a need to appreciate the interplay between attribution of income to PE and application of TP principles. It is relevant to note that as the economic activity of an enterprise gets more complex, the tax exposure from a PE perspective is minimized, but from a TP perspective increases. 5 1 Speech by Mr. Narendra Modi at the World Economic Forum Annual Summit 2018 in Davos 2 Excerpts from the speech by Mr. Narendra Modi at the World Economic Forum Annual Summit 2018 in Davos 3 as accessed on 27th September Hereby referred to as PE throughout the entire text 5 Samir Gandhi, Partner, Deloitte, Haskins & Sells in Mumbai as quoted in Ralph Cunningham, Morgan Stanley comes out on top, International Tax Review, July 12, 2007

3 This interplay between PE, attribution of profits to PE and the principles of transfer pricing ( TP ) is explained by way of this study. In addition to discussing the concept of attribution of profits to PE from the perspective of OECD 6 and India, a gamut of case laws on the subject are also discussed. Chapter one of this text discusses the concept of PE. This includes meaning adopted by the OECD, including amedements devised considering OECD BEPS 7 Action Plans; UN Model and India. The next two chapters set out guidance and principles laid by the OECD and India with regard to attribution of profits to PE. The author believes that the principles inferred on attribution, in the third chapter, are primary relevant fundamentals on the subject and hence have been substantiated with legal decisions on the issue in India. Futher, towards chapter four and five, a gamut of case laws have been analysed describing India s position on attribution of profits to PE involving application of specific provisions in the Income Tax Act, 1961 ( The Act ), arm s length principle ( ALP ), global formulary apportionment ( GFA ) etc. 6 Organisation for Economic Cooperation and Development 7 Base erosion and profit shifting (BEPS) refers to tax avoidance strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations. Under the inclusive framework, over 100 countries and jurisdictions are collaborating to implement the BEPS measures and tackle BEPS.

4 1. Permanent Establishment The concept of PE is found in the early model conventions including the 1928 model conventions of the League of Nations. 8 Also widely recognised in the UN Model 9 and the OECD Model 10, PE is the primary instrument that establishes taxing jurisdiction over the business of a foreign corporate entity. Accordingly, profits of an enterprise of one contracting state are taxable in the other state following the presence of PE in that other state. However, only that part of the profit would be taxable that would be attributable to such PE. The basis of taxation of PE is believed to work on the principle of equality; i.e. equality of treatment of foreigners by placing, in principle, branches of foreign enterprise on the same footing as similar establishments of domestic enterprise as regards the computation of receipts and expenses, which, once they have been allocated or apportioned by separate accounting, are to be treated in accordance with the tax laws of the country to which they have been attributed. 11 It is, however, worth mentioning that the residence state must allow for credit of the taxes paid in the host state under Article 23B 12 of the OECD Model. Place of Business Fixed Location Element of Permanence Right To Use Business Activity Figure1: Requisites for Establishment of a Permanent Establishment 8 United Nations Model Double Taxation Convention between Developed and Developing Countries 2017; Article 5, General Considerations; Paragraph 2 9 United Nations Model Double Taxation Convention between Developed and Developing Countries 10 OECD Model Tax Convention on Income and on Capital 11 International Taxation of Permanent Establishments: Principles and Policies; Michael Kobetsky, Page Article 23B of the OECD Model is called Credit Method

5 Reference in the OECD Model Article 5 of the OECD Model provides innitial reference on the definition of PE. It defines PE as a fixed place of business through which the business of an enterprise is wholly or partly carried on 13. Article 5(2) lists a few examples of PE that includes, branch, office, factory, workshop etc. Other examples include building site, construction or installation project only if they lasted for more than twelve months. Mulitnationals in the pre-beps era had been avoiding PE status by making use of Article 5(4) of the OECD Model 14. It stated that the term PE shall not include specific activities/ combination of activities that were mere preparatory or auxiliary in nature. However, the recent amendement made by OECD 15 to the definition of PE fails attempt of such multinationals. Hence, OECD, together with the G20 16 nations, in October 2015, released 15 Action Plans to tackle BEPS. Amongst the 15, Action 7 concerns Preventing the artificial avoidance of Permanent Establishment Status. It amends the definition of PE provided in Article 5 to prevent artificial circumvention eg, via the use of commissionaires structures 17 or the fragmentation rules. Following this amendement, anti-fragmentation rule is devised to ensure that the MNC does not avoid possible PE status through fragmentation of a cohesive operating business into several small operations 18 to argue that each part is merely engaged in perparatory or auxiliary activitity thus benefiting from the exception discussed above. It prevents paragraph 4 from providing an exception from PE status for activities that might be viewed in isolation as preparatory or auxiliary in nature but that constitute part of a larger set of business activities conducted in the source country by the enterprise (whether alone or with a closely related enterprise) if the combined activities constitute complementary functions that are part of a cohesive business operation 19 Reference in the UN Model Article 5 of the United Nations Model is based on Article 5 of OECD Model but contains several significant differences. 20 The following pointers attempt to highlight such differences between the UN Model 2017 and the post-beps OECD Model: 13 Article 5(1) of the OECD Model Tax Convention on Income and on Capital 14 Published 30 th October OECD as per the report titled Preventing the Artificial Avoidance of Permanent Establishment Status 16 Group of Twenty OECD BEPS Action 7: Additional Guidance on Attribution of profits to Permanent Establishments: Public Discussion Draft; Paragraph United Nations Model Double Tax Convention between Developed and Developing Countries 2017; Article 5, General Considerations

6 The threshold for a building or construction site constituing a PE is sixmonths as compared to twelve months provided in the OECD Model. UN Model well recognises the concept of service PE. Hence, furnishing of activities by an employee or other personnel of an enterprise could result in the creation of PE provided they exceed the threshold of 183 days in any twelve month period in the fiscal year concerned. UN Model also recognised delivery as an activity that might result in creation in PE. However, the same stands exempted as per Article 5(4) of the OECD Model. It is believed by the author that such provisions in the UN Model, lowering the threshold requisite for establishment of PE, are believed to be in sync with the functioning of developing economies. They might mean to serve mechanism to permit (developing nations) to preserve source taxation rights, in certain circumstances, with respect to the profit from such services. 21 Expanding the scope of above belief, When you have international economic activity between a developed and a developing country, the direction of flow of investment is almost always from Country R (being the developed country) into Country S (the developing country), whether you are talking about a business activity or a passive investment such as shares of stock or a debt instrument. So, the UN Model basically lowered the threshold of activity that can trigger taxation in the source country. 22 In turn, this widens the scope to trigger threshold for PE establishment. Reference in the Income Tax Act, 1961 In India, the concept of PE is similar to Business Connection as provided in the Act. This is evident from Section 9 of the Act stating, all income accruing or arising, whether directly or indirectly, through or from any business connection in India shall be deemed to accrue or arise in India. Following the path laid by the OECD Model, the term business connection relied heavily on physical presence. However, keepng abreast with growing digital business models and OECD BEPS, the Government of India expanded the definition of business connection vide Finance Act, 2018 to tax digital transactions. Significant Economic Presence ( SEP ) of a non-resident in India will also constitute business connection and hence, income attributable to such economic presence will be taxable in India. 21 C.A. Dunahoo & G.D. Sprague, 2008 OECD Model: Changes to the Commentary on Article 5 Regarding the Treatment of Services: More Choices, Less Clarity, 63 Bull. Intl. Taxn. 5 (2009), p. 193, Journals IBFD. 22 Developing Countries, Tax Treaties and the United Nations Model Tax Convention, Peter D. Byrne, Page 701

7 For this purpose, SEP shall mean: transation in respect of goods, services or property, including provision of downloaded data or software, carried out by a non-resident in India; systematic and continuous soliciting of business activities including interaction with users through digital means. The above provisions are applicable irrespective whether the non-resident has a place of business in India. Hence, being a domestic law concept, tax treaties could override SEP provisions. The author concludes that the current scope of SEP provisions in India is currently a matter of debate. The concept of business connection was also discussed by the Supreme Court ( SC ) in CIT v. R.D. Aggarwal & Co 23 A business connection involves a relation between the business carried on by the non-resident which yields profits or gains and some activity in the taxable territories which contributes directly or indirectly to the earning of such profits or gains. It predicates an element of continuity between the business of the non-resident and the activity in the taxable territories. Much in tune with value creation, the concept of business connection in India, seems in sync with the guidelines laid by OECD BEPS on PE. Reference in Legal Decisions The concept of PE has been widely explained in varied decided case laws in India. In CIT v. Visakhapatnam Port Trust 24, Hon ble High Court of Andhra Pradesh, after an elabrate survey of the legal precedents available worldwide observed, the words PE postulate the existence of substantial element of enduring or permanent nature of a foreign enterprise in another country which can be attributed to a fixed place of business in that country. It should be of such nature that it would amount to a virtual projection of foreign enterprise of one country into the soil of another country. This excerpt from the judgement can be directly corelated with the underlying requisities laid by the OECD Model for PE, as explained in figure 1. Hon ble SC of India has been instrumental in well analysing the term in two landmark cases. In Morgan Stanley 25, a special leave petition was filed before the SC by Morgan Stanley and Company against the ruiling of the AAR 26. The AAR Ruling dealt with whether Morgan Stanley USA (MSCo) had a PE in India with respect to the back-office operations it had outsourced in India to Morgan Stanley Advantage Services (MSAS). The SC observed that MSCo was not carrying out any business activity in India. MSAS was rendering back-office services in India; such functions were considered as "preparatory or auxiliary" in nature under the Treaty. Thus, no fixed place of business existed to establish PE status in India. 23 (1965) 56 ITR [1983] 144 ITR DIT International Taxation, Mumbai vs. Morgan Stanley & Co. Inc (2007) 292 ITR Authority for Advance Rulings

8 The SC, in another case i.e. Formula One World Championship Ltd. v. CIT (International Taxation) 27 explained requisities for establishment of PE at length. The case concerned the taxability of a three day event in India involving a motor racing championship. The issue before the SC was whether the taxpayer, Formula One World Championship Limited ( FOWC ), a UK tax resident, had a PE in India. The SC held under the facts and circumstances that FOWC did consititute PE in India basing it s decision on the following: Presence of FOWC s business in India by way of holding exclusive commercial rights in relation to F1 Championship and exploiting the same in India. FOWC played a major role in conducting F1 Championship in India and hence, it was assessed that FOWC had the right to use and control over the circuit. It is pertinent to mention that time period was not a significant consideration in the present case. The SC held that the High Court ( HC ) rightly concluded that even though it was for limited three days, FOWC had full and exclusive access to the circuit for the entire duration of the event; thus, number of days for which the access was there would not make any difference, in coming to the conclusion that FOWC had the circuit to its disposal. Lastly, FOWC undertook business of exploitation of commercial rights in India through the F1 championship. To conclude, FOWC was taxable on receipts in India by means of establishment of PE in India. Basis above, there is systematic and defined guidance, on global and domestic front, on the issue of establishment of PE in the source country. However, same does not hold true for the subject of attribution of profits to PE. It is at this point, that TP has a crucial role in estimation of fair and logical attribution of profits to the residence and the source state. The following Chapters, throwing light on the guidance available in the OECD Model together with the Indian Taxation Laws, also discuss a range of cases on attribution of profits to PE. 27 [2017] 394 ITR 80/248 Taxman 192/80 taxmann.com 347 (SC)

9 2. Guidance by OECD on attribution of profits to Permanent Establishments The concept of attribution of profits to PE comes into existence with the establishment of PE in the host country, as stipulated in Article 5 of the OECD Model. Once proven presence, Article 7 of the OECD Model on Business Profits comes into picture. It stipulates, the profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in that other Contracting State through a permanent establisment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in that other state but only so much of them as is attributable to that permanent establishment. There have been two different approaches in terms of interpretation of Article 7 furnished above. They include the Relevant Business Activity Approach ( RBA ) and the Specific Entity Approach ( SEA ). The concept, application and relevance of these approaches have been discussed below: Relevant Business Activity Approach OECD Working Party 6 referred to the first interpretation of Article 7(1) of the OECD Model as the Relevant Business Activity Approach. Also called the single enterprise approach, it considered the entire business as a unified whole, of which PE is a part. Hence, profits of the enterprise are those of the business enterprise including the PE. Meaning, profits are included from both related and unrelated parties. The attribution is then basis an apportionment key as stipulated in the guidance. In other words, profits attributable are limited to the profits earned for the specific activity in consideration. Also, it infers that dealings within the enterprise i.e. with the PE are ignored for the purpose of calculation of profits for this approach. The approach now is not accepted. However, a slight variation of the same has been identified in Australia. Specific Entity Approach The present accepted approach adopted by the OECD is elaborated in the 2010 final report on attribution of profits to PE. For this reason, the specific entity approach is also referred to as the Authorised OECD Approach (AOA). The principle requires PE to be treated as a separate and distinct enterprise for the purpose of attribution of profits to PE. Hence, the profits to be attributed to a PE are such that the PE would have earmed as a separate and independent enterprise, taking into account functions performed, assets used and risks assumed ( FAR ) by the enterprise through the PE. Hence, FAR analysis forms an important part of this approach to profit attribution. Also in sync with BEPS Action Plan, this approach has been gloablly adopted as the new standard for attribution of profits to PE. It has also been adopted into the domestic law of many countries. It is also intune with the principle followed in India for attribution of profits to PE.

10 The table below summarises the differing pointers in the two approaches. Particulars Limit Profits Loss Relevant Business Activity Approach Imposes a limit on the profits that could be attributed The attributed profits cannot exceed the profits that the entire enterprise earns from relevant business activity Loss from other parts of the enterprise would reduce profits attributable to PE Separate Entity Approach/ AOA Does not impose any such limit. The attributed profits can exceed such limits Loss from other activities of the enterprise cannot reduce the profits attributable to PE. There are nations using either the RBA approach or the AOA. However, the current lack of consensus is unsatisfactory as it results in a real risk of double, or less than single, taxation, especially in cases where one jurisdiction uses the functionally separate entity approach and the other jurisdiction uses the relevant business activity approach. 28 The OECD explicitly states that from the perspective of consistency with ALP, administrability and wide support from public comments and consultations, separate entity approach is the preferred approach, and hence, given the name, Authorised OECD Approach. 28 OECD Report on the Attribution of Profits to Permanent Establishments Page 26

11 3. Guidance in India on Attribution of Profits to Permanent Establishments Reference to attribution of profits to PE in India is provided in Section 9(1)(i) Explanation 1(a) of the Act. In the case of a business of which all the operations are not carried out in India, the income of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India. Hence, profit attribution in India is restricted to the amount reasonably attributable to operations in India. The question of reasonable attribution can be linked to general provisions on determination of income of non-residents. In the absence of any specific rule, Rule 10 of the Income Tax Rules, 1962 ( the Rules ) is relied upon. If he Assessing Officer ( AO ) is of the opinion that the income accruing or arising to the nonresident, whether directly or indirectly, through or from any business connection in India cannot be definitely ascertained, the amount of such income may be calculated: - At such percentage of the turnover so accruing or arising as the AO may consider to be reasonable ( presumptive method ), or, - On any amount which bears the same proportion to the total profits or gains of the business of such person as the receipts so accruing or arising bear to the total receipts of the business (proportionate method), or, - In such other manner, as the AO may deem suitable (discretionary method) Rule 10 was drafted much earlier than the detailed TP laws in the Country. Hence, it is feared by the author that they may not be of much relevance or utility for attribution of profits to PE, considering the current complex business models. However, there have been and there still are various legal cases being decided considering Rule 10. They are subject matter of detailed discussion in the following chapter. Further, there are some specific sections ( special provisions ) in the Act for computing income of non-residents. In seldom cases, these have also been relied by the Tribunals/ Courts for attribution. Section under the Act pertaining to Attribution Specific Business Activity Presumptive Income as percentage of gross profit 44B Shipping 7.5% of Gross Revenue 44BB Exploration of Mineral Oils 10% of Gross Revenue 44BBA Aircrafts 5% of Gross Revenue 44BBB Turnkey Projects 10% of Gross Revenue These provisions, as tabulated above, attribute profits to the Indian operations of a PE i.e. non-residents on a presumptive basis. Though, not attribution in true

12 sense, there are widely available judicial precendents relying on these presumptive provisions for attribution. Based on rules and specific sections discussed above, following are established general principles that the author feels, largely guide attribution of profits to PE in India: PE s Participation in Economic Value Chain of the Host Country The primary basis of taxation of PE is on account of significant economic penetration of the PE in the host country. Economic ties lead to PE being treated at par with the domestic taxpayer for taxation purposes. This principle has been established in various Indian case laws namely, Rolls Royce Singapore Private Limited (Delhi High Court Judgment) 29, M/S IJM (India) Infrastructure Limited (Hyderabad Bench) 30, ZTE Corporation 31, Morgan Stanley 32 etc. In ZTE Corporation v. Additional Director of Income Tax, the Delhi Bench of the Income Tax Appellate Tribunal (ITAT) held that, the most important aspect to be kept in mind is the level of PE s participation in the economic life of the source country. It is primarily nexus between the source country and PE s activities which produce the taxable income to the taxpayer. Similarly, in DIT (International Taxation) v. Morgan Stanley & Company Inc. 33 the SC explained the above in the following manner: The object behind enactment of transfer pricing regulations is to prevent shifting of profits outside India. Under Article 7(2) not all profits of MSCO (taxpayer) would be taxable in India but only those which have economic nexus with PE in India.Lastly, it may be added that taxing corporate on the basis of the concept of economic nexus is an important feature of attributable profits (profits attributable to the PE). Quoting the reverse true, also the SC in the case of M/S Hyundai Heavy Industries Co. Ltd 34 held that payments made towards offshore supplies provided by the non-residents could not be attributable to the PE in the absence of economic nexus of such payments with the PE in India. The above judgment was preceded by the decision of the SC in Ishikawajma Harima Heavy Industries Ltd. v. DIT 35, wherein it was held that the concept of territorial nexus is fundamental in determining the taxability of any income in India. 29 [TS-515-HC-2011(DEL)] 30 TS-671-ITAT-2016(Hyd)-TP 31 ITA No.5870/Del/2012 Taxsutra.com 32 (2007) 292 ITR 416 (SC) 33 supra Appeal (civil) 2734 of ITR 408 SC

13 PE to be treated as a Separate Legal Entity It is a globally accepted fact that profits are attributed treating PE as a separate and distinct legal entitty. This view was reiterated in M/S Seagate Singapore International Headquarters Private Limited 36 : For the purpose of computation of profits of the PE, it should be treated as a separate and distinct enterprise wholly independent of the enterprise of which it is a PE. In this context, the Hyderabad bench of the ITAT, in the case of M/S IJM (India) Infrastructure Limited 37 had held that PE of a foreign enterprise was to be treated as a separate enterprise for the purpose of transfer pricing. Extending this concept further, the ITAT held that any transaction entered into by an Indian company with such PE was outside the purview of international transaction as per Section 92B of the Income Tax Act. Such conclusion was based on the fact that there was no tax base erosion in such case. This view is also well accepted globally. Article 7(2) of the OECD Model lays, there shall in each contracting state be attributable to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. Hence, this pinciple is in sync with OECD AOA too. Profit Attribution to PE as per the Arm s Length Principle ALP is the international consensus on transfer pricing. 38 Indian TP regulations also stand in approbation of the ALP for profit attribution. In this respect, CBDT 39 Circular No. 5/2004 clarifies, profits to be attributed to a PE are those that PE would have made if, instead of dealing with its Head Office, it had been dealing with an entirely separate enterprise under conditions and at prices prevailing in the ordinary market. This corresponds to the arm s length principle. The concept of attribution as per ALP would be incomplete without discussing the landmark SC judgment in DIT (International Taxation), Mumbai v. Morgan Stanley and Company Inc 40. Though the case has been disucssed at length in the next chapter, the primary principle states: The impugned ruling is correct in principle insofar as the associated enterprise, that also constitutes a PE, has been remunerated on an arm s length basis taking into account all the risk-taking 36 AAR no. 831/ TS-671-ITAT-2016(Hyd)-TP Central Board of Direct Taxes 40 (2007) 292 ITR 416 (SC)

14 functions of the enterprise. In such cases, nothing further would be left to be attributed to the PE. In India, transition could be observed on the approach followed for attribution of profits. Apart from relying on ad-hoc basis involving Rule 10, there have been various occassions where detailed FAR Analysis has been considered. These include Rolls Royce Singapore Private Limited 41, Arrow Electronics 42, Hyundai Rotem Company 43 etc. Further, Tribunals in India, have also resorted to GFA. Is it an approach worth considering? What formula is used for such attribution? These questions have been extensively catered to in the following two chapters. 41 [TS-515-HC-2011(DEL)] 42 Arrow Electronics India Ltd v. ADIT [I.T (TP).A Nos.209 & 210/Bang/2011] - AY & AY and ADIT v. Arrow Electronics India Ltd [I.T (TP).A Nos.617 to 619/Bang/2011 & 31-33/Bang/2011 AY , & ] 43 [TS-609-ITAT-2016(DEL)-TP]

15 4. Legal Decisions in India on Attribution of Profits to Permanent Establishments More than 1 lakh cases are pending across all benches of ITAT in India 44 With about 3500 disputes, India has the third largest number of pending cases related to transfer pricing in the world, says global consultancy EY 45 With substantial number of cases available in India on TP, including, attribution of profits, without clear guidelines, the approach followed on the subject varies. Hence, legal decisions have been observed to form a transition. The legal decisions range from ancient decided precedents where attribution was based on activities in British India, to reliance on Rule 10 and specific provisions in the Act. Each of these are of importance owing to differences in facts and circumstances of each case. Further, legal decisions with reliance on FAR analysis and GFA are also discussed in the next chapter. The figure below shows the transition observed in India with respect to attribution of profits to PE. CIT, Bomaby v. Ahmedbhai Umarbhai & Company 46 is one of the early rulings on attribution by the SC dating back to the 4 th of May The company, resident in British India, owned oil mills within British India while carried on manufacturing facilities at a mill in Raichur, Hyderabad. This manufacturing was 44 Curbing tax litigation is vital India tax insights-eighth edition, Rajan Vora, tax partner in a member firm of EY Global 45 India has the 3 rd largest number of transfer pricing cases: EY updated December 20,2014, FirstPost 46 (1950) 18 ITR 472 (SC)

16 sold partly in Hyderabad and partly in Bombay. The SC attributed profits between the state of sale and manufacturing stating, Though profits may not be realised until manufactured article is sold, profits are not wholly made by the act of sale and do not necessarily accrue at the place of sale and to the extent profits are attributable to the manufacturing operations, profits accrue at the place where the operations are carried on. In the same case, value creation, in the most preliminary form, was emphasized by the SC laying, where raw material is worked up into it new product by process of manufacture, it obviously increases in value and this increase in value represents the income or profit which is the result of the manufacture, and as this profit accrues by reason of the manufacture it cannot but be located at the place where the manufacturing process is gone through. Another ancient judgment by the SC involved Anglo-French Textile Co. Ltd. v. CIT 47. The appellant was incorporated in the UK and owned spinning and weaning mills at Pondicheery in French India. In 1939, no sales of yarn or cloth were effected in British India. However, all purchases of raw material were made in British India by Messrs Best and Co. Ltd., Madras, working as agents of the appelant. The issue was whether allocation based on business operation was required. SC stated, there should be allocation of income between various business operations of the assessee demarcating the income arising in the taxable territories (British India) in the particular year from the income arising without the taxable territories in that year. Accordingly, figure of 10 percent on British Indian sales was considered reasonable for attribution of profits on the basis of extent of operations carried out in British India. Again, in Hukum Chand Mills Limited v. CIT 48, on the basis of facts of the case, 15 percent allocation was considered reasonable for the operations relating to contracts undertaken in British India. In arriving at the figure of 15 per cent, emphasis was laid on then Rule 33 of the Income Tax Rules, Rule 33 has now been replicated as Rule 10 of the Rules that has been explained above. Excerpts from the judgment stated, The question as to what proportion of the profits of the sales arose or accrued in British India is essentially one of fact depending upon the circumstances of the case. In the absence of some statutory or other fixed formula, any finding on the question of proportion involves some element of guess work. The endeavour can only be to be approximate and there cannot in the very nature of things be great precision and exactness in the matter. As discussed, the then Rule 33, applied as Rule 10 by the Tribunal and the Court, is believed to be the last resort for attribution of profits. Priority attribution ideally should be based on ALP taking accurate FAR 49 analysis into account since it is the basis on which TP is eventually based and accepted globally SCR 454: (1953) 23 ITR 101: AIR 1953SC ITA No.671/Del/ Functions performed, Assets used and Risks assumed

17 Application of Rule 10 in attribution of profits to PE As discussed, Rule 10 is the method of last resort. This was well established in Hyundai Rotem Company, Korea 50. Rule 10 can be applied in cases where the income of the PE cannot be definitely ascertained, and the AO has to demonstrate this. AO cannot simply proceed to apply Rule 10 without rejecting the TP study undertaken by the taxpayer. For rejecting the TP study, the AO must provide reasons and evidence. Following the above mentioned principle, in Nortel Networks India International Inc 51, since the acconts of the assessee had no sanctity and were not audited, Rule 10 was resorted to. Accordingly, attribution of 50% of profits to the operations in India was considered reasonable. Consulting Engineers Corporation 52 had a branch in India that was engaged in providing various services to taxpayer viz. engineering, calculations and drawing of various architectural designs. 95 qualified employees were working in the Indian branch for the associated enterprises based in the US. For profit attribution, Commissioner of Income Tax ( CIT ) observed, Given the set up activities allocation between the head office and the PE, it is seen that even though marketing, sale promotion and quality checks are being carried out by the Head Office, the Indian branch does the entire drawing and design work which also includes assuming the risks of drawing and design. It is thus true that the Indian branch also takes some risk as the important drawing, designing and calculations are carried out by the Indian company. Looking to the totality of situation, it is seen that 50% of the profits determined by the AO after applying Rule 10 are attributable to the operations carried out by the PE in India. Hence, risk assumption became the undelying factor in attributing profits together with reliance on Rule 10. These cases, collectively, are subsumed as a phase where profit atribution was based on functions performed by the PE in India. These include GE Energy Parts Inc 53 where 26% profits were attributable to marketing activities in India and Rolls Royce 54 where the Delhi HC affirmed 35% of 10% of total profits attributable to marketing activies. In ZTE Corporation 55, the Delhi Bench of the ITAT found that almost the entire sales function including marketing, banking, and after sales were carried on by the PE in India and so relied on a gamut of case laws 56 to rule that it would meet the ends of justice if 35% of net global profits as per published accounts out of 50 [TS-609-ITAT-2016(DEL)-TP] 51 (2014) TS-355 / TII-71 (Del ITAT) 52 Consulting Engineering Corporation v. JDIT (I.T.A.No.1597/Del/2009; Assessment Year : ), (I.T.A. No. 1598/ Del/ 2009 AY ) and ADIT v. Consulting Engineers Corporation (I.T.A.No.1275/Del/2009 AY ), (I.T.A. No /Del/2009; Assessment Year : ) Taxsutra.com 53 ITA No. 3605/De/ [TS-515-HC-2011(DEL)] 55 ITA 5870/Del/12 & ors 56 Rolls Royce, Nortel Networks India International Inc.

18 transactions of assessee with India are attributed to PE in India in respect of both hardware and software supplied by assessee to Indian customers. An important principle resulted from the above mentioned cases which was also the principle affirmed by the Delhi Bench of the ITAT in DDIT, New Delhi vs Nipro Asia Pte. Ltd 57. It was held, There can be no hard and fast rule of attribution of profit to marketing activities carried out in India at a particular level. In fact, attribution of profits to PE in India is fact based, depending upon the role played by the PE in the overall generation of income. Such activities carried out by a PE in India resulting in generation of income, may vary from case to case. Attribution of income has to be in line with the extent of activities of PE in India. Attribution based on Specific Provisions in the Act There are also specific sections based on presumptive profit figures that are used for attribution in India. One such important judgment includes Nipro Asia Pte Limited 58. The taxpayer is a Singapore-based company having branch in India, engaged in the business of trading of medical equipment to and from India. The Indian branch apart from providing marketing, sales warehousing, after sales services on behalf of the HO also marketed Nipro brands in India. The AO computed the gross profit margin of Nipro Corporation (Ultimate parent company) and its consolidated subsidiaries from its website and applied the same to sales made by the taxpayer in India. 40 percent of such determined profit was attributed to sales activity in India through PE. However, the approach of the AO was rejected on account of figures were taken from the website which was termed as a casual source with not much reliability being placed on the same. Further, drawing strength from prescription under Section 44B and Section 44BBB of the Act, together with relying on Rule 10, attribution of income has to be in line with the extent of activities of PE in India. Taking all the relevant facts into consideration and on a holistic approach, we direct to apply profit attribution at 10%. Discussion on attribution cannot be complete without bringing FAR analysis into account. Chapter four talks about FAR analysis together with discussion on the antonym approach known as GFA. 57 ITA No.4078/Del/ ITA No.4078/Del/2013

19 5. Functions, Assets and Risk Analysis v. Global Formulary Apportionment FAR Analysis is the foundation for TP that assists in comparability analysis to determine the most appropriate method justifying the transaction at hand. GFA, on the other hand, seeks to allocate the profits of a multinational on the basis of a pre-defined formula based on sales, payroll, capital base etc. This chapter discusses both the methods, including decided case laws, to analyse how attribution takes place in light of each of these approaches. It is pertinent to mention that India does not follow GFA for profit attribution. However, there are case laws where a proportionate percentage method is used for such attribution. The Delhi Bench of the ITAT laid down a multi factored formula for attribution of profits to PE in Convergys Customer Management Group Inc. v ADIT 59. The assessee, Convergys Customer Management Group Inc., USA having a subsidiary in India, Convergys India Services Private Limited (CIS), provided procurement services in the nature of IT enabled call center/back-office support to the Assessee on a principal to principal basis. As per Article 5(1) of the Indo-USA treaty, the Indian Subsidiary was held to be the fixed place PE for the assessee. AO adopted head count as basis for allocating revenue and expenses. However, the tribunal rejected the approach of the AO and used end customer revenue as base to which a global operating income percentage was applied to arrive at 59 [2013] 212 Taxman 613 (Delhi)

20 profits attributable to the Indian operations. The residual profits were than apportioned between the US (Head Office) and the Indian PE. Further, to allocate residual profits, the Delhi Tribunal relied on decision in Anglo French Textile Company Limited 60 and Hukum Chand Mills Limited 61 discussed previously. The higher figure of 15 percent was applied to the instant case to meet the ends of justice. In yet another case, E-Funds Corporation v. ADIT 62, ITAT worked out the following manner for attribution of profits to PE: 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) Initially, the Tribunal, on many occassions, relied on ALP for apt attribution of profits. However, a deviation was noticed with the usage of formulary apportionmnt. A pre-determined formula for determination of profits attributable to PE (GFA) disregarded FAR Analysis. This concern has also been acknowledged in OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations ( OECD TP ) stating: predetermine formulae are arbitrary and disregard market conditions, management s own allocation of resources, thus producing an allocation of profits that may bear no sound relationship to the specific facts surrounding the transaction. A formula based on a combination of costs, assets, payroll and sales implicitly imputes a fixed rate of profit per currency unit, regardless of differences in functions, assets, risks and efficiencies among members of the MNE group. Hence, GFA is not acceptable worldwide owing to practical difficulties. In India, formulary apportinonment appers to be akin to Rule 10 of the Rules. This creates ambiguity in the minds of the PE investments in India as to the approach to be followed for attribution of profits to PE in the country. Attribution as per FAR Analysis Discussion on attribution considering the principles of TP is incomplete without mentioning the landmark judgment in the case of Morgan Stanley 63. Under the impugned ruling delivered by AAR, remuneration to MSAS was justified by a TP SCR 454: (1953) 23 ITR 101: AIR 1953SC ITA No.671/Del/ SOT AAR No. 661 of 2005

21 analysis and, therefore, no further income could be attributed to the PE (MSAS). In other words, the said ruling equates an arm's length analysis with attribution of profits. It holds that once TP analysis is undertaken, there is no further need to attribute profits to a PE. The impugned ruling is correct in principle insofar as an associated enterprise, that also constitutes a PE, has been remunerated on an arm's length basis taking into account all the risk-taking functions of the enterprise. In such cases nothing further would be left to be attributed to PE. The situation would be different if transfer pricing analysis does not adequately reflect the functions performed and the risks assumed by the enterprise. In such a situation, there would be a need to attribute profits to PE for those functions/risks that have not been considered. Therefore, in each case, data placed by the taxpayer has to be examined as to whether TP analysis placed by the taxpayer is exhaustive of attribution of profits and that would depend on the functional and factual analysis to be undertaken in each case. Lastly, it may be added that taxing corporates on the basis of the concept of economic nexus is an important feature of attributable profits (profits attributable to PE). Delhi HC in the case of BBC Worldwide Ltd 64, under similar facts, held that if the correct ALP is applied and paid to the Indian agent, nothing further would be left to be taxed in the hands of the foreign enterprise following the principle laid down by the Hon ble SC in Morgan Stanley and Company Inc 65. Further, to justify pripority approach, following case law is an interesting example on how the Tribunal disregarded Rule 10 over TP methodology adopted by the taxpayer and accepted by the revenue from year to year. The taxpayer, a project office of Hyundai Rotem Company, Korea 66 (the taxpayer), provided liaison, co-ordination, and administrative support services to its head office, in connection with a contract being executed in India. The income of the project office was computed on a cost-plus 9% basis, and this was supported by a TP study. The Transfer Pricing Officer ( TPO ) did not accept the cost-plus methodology adopted by the taxpayer and instead determined the income by applying Rule 10. The TPO adopted a GFA in order to determine the income attributable to the project office. Aggrieved, the taxpayer appealed to the CIT(A) who upheld the TPO s approach. Aggrieved, the taxpayer appealed before the Tribunal. In given case, Rule 10 can be applied. But before that AO has to demonstrate that income of non-resident accruing or arising from any business connection in Indian cannot be definitely ascertained from the accounts or from the material available on the record. For the present assessee, the department itself has accepted the method of assessee in a number of years. Article 7 of the DTAA between India and South Korea provides that profits attributable to PE shall be determined by the same method year by year unless there is good and sufficient reason to the contrary. No reasons are assigned by the AO for adopting different 64 DIT v. BBC Worldwide Ltd. [2011] 203 Taxman 554 (Del) 65 supra TS-609-ITAT-2016(DEL)-TP

22 method from same source of income, in different years. He simply jumped to apply Rule 10 which is not a right course in this case. In view of the above discussion, we hold that income of the assessee be computed as declared by it, and accepted in subsequent year from the same contract. In Rolls Royce 67, it was held, In the present case, owing to the absence of a transfer pricing study, the HC could not apply transfer pricing principles and had to accept the arbitrary approach for attribution. Surely, the relevance and significance of a transfer pricing study when attributing profits to a PE cannot be made more evident than this. Therefore, a properly undertaken transfer pricing study is the only key to resolving a profit attribution dispute, the onus of which lies on the taxpayer. In the absence of a transfer pricing study the risk of arbitrary attribution is likely as Revenue officers and also Tribunals as well as Courts may be compelled to rely upon the formulatory approach provided in Rule 10 of the Income-tax Rules, unless they specifically direct for a TP study to be undertaken. In a recent decision in case of Arrow Electronics India Limited 68 - Arrow Asia Pac Ltd., Hong Kong had set up a company in Singapore, Arrow Electronics India Limited. This Singapore based company had opened a liaison office ( LO ) in Bangalore after obtaining relevant approvals from the Reserve Bank of India. However, Arrow Group, in December 2002 incorporated a fully owned subsidiary in the name of M/S Arrow Electronics India Private Limited. The LO was established to be the Indian PE. To attribute profits, AO placed considerable reliance on FAR analysis. It was held, there is no mathematical formula for working out profits of Indian operations and that of Singapore operations. Functions, Assets and Risk analysis is the best way to arrive at profits. The allocation of weights was in terms of different functions performed by the LO. The final quantification upheld by the Tribunal was attributable as 40:60 to the LO and the HO on the basis of following methodology. OECD BEPS, advocating value creation, holds that profits are taxed where economic revenue generating activities are performed. From the above cases, it is clear that attribution of profits is well in line with value creation. 67 ITA 1278/2010,ITA 1280/ I.T (TP).A Nos.209 & 210/Bang/2011 Cross Objection Nos.31 to 33/Bang/2011 I.T (TP).A Nos.617 to 619/Bang/2011

23 Conclusion and Way Forward Indian tax authorities and Judiciary have kept abreast with the changing business conditions and scenario in India. They have matured as they recognised constitution of PE through digital presence in India. Similarly, updated international tax principles have been seen inscribe relevant importance by the SC in legal disputes, including, Formula One World Championship Limited 69. This proves that the rules in India with respect to establishment of PE and well guided and laid. With establishment of PE, estimation of attribution of profits to PE comes into existence. A matter of continuos debate before the tax authorities and judiciary in India, the estimation is largely dependant on the facts and circumstances of each case. However, looking at legal precedents discussed in the chapters above, to avoid such legal disputes, documentation compliance becomes imperative for multinationals having PE presence in the Country. This requires necessary compliance under the Act including filing of Accountant s Report in Form 3CEB and maintenance of supporting documentation as required under the Act. In some cases, it would be advisable for the foreign enterprise to seek preliminary ruiling from the Authority of Advance Ruling for the transaction under consideration. 69 [2017] 394 ITR 80/248 Taxman 192/80 taxmann.com 347 (SC)