WIRC: Seminar on Permanent Establishment, August 6, 2011 Attribution of Profits to PE & Force of Attraction Rule Presented by: Vishal J Shah Executive Director PricewaterhouseCoopers Pvt Ltd
Presentation Outline Profit Attribution Force of Attraction Slide 2
Non-resident taxation of Business Profits Trigger - Income Accrual (S. 5) or Business Connection (S.9) Domestic law - Permanent Establishment (Art. 5) Tax Treaty Computation Domestic Law Basic Provisions - S. 5 Income Accrual - Section 9(1)(i) r.w. Explanation 1 thereto Other Aides Rule 10 / CBDT Circulars Basic Provisions Tax Treaty - Art. 7 (1) Basic Rule - Art 7(2) & onwards Computation Methodology Other Aides Model Commentaries / OECD Reports Overriding Principle Limited Source-based Taxation Slide 3
Attribution Principles Domestic Law
Under the Act Section 5 (2)(b) brings to tax - Income Accruing or Arising in India For instance, Activities carried out or services rendered in India - Income Deemed to Accrue or arise in India (Section 9) Income accruing or arising, directly or indirectly, through or from, any business connection Taxing rights limited to an economic nexus in India Slide 5
Rule 10 Rule 10 Income determination for Section 9(1)(i) - Powers of the AO - % of India Revenues For instance Industry estimates - Circular 742 in the context of Foreign Telecasting Companies 10% deemed as income - Global Profitability Rate - applied to India revenues - Any other manner Slide 6
Where all operations are not carried out in India Attribution limited to activities carried out in India Explanation 1(a) to Section 9(1)(i) in the case of a business of which all the operations are not carried out in India, the income...shall be only such part of the income as is reasonably attributable to the operations carried out in India Slide 7
Other Methods Safe Harbours - CBDT Circulars Circular 742 Foreign Telecasting Companies Circular 5 of 2004 BPOs - Presumptive Basis taxation S. 44BB (Oil&Gas), S. 44BBA (aircraft operators), etc CBDT Circular no. 23 (1969) now withdrawn Judicial Precedents discussed later Slide 8
Some Exceptions Explanation 1 to Section 9(1) - Purchase of Goods in India for Exports - News Collection for transmission out of India - Shooting of Cinematograph films Fees for Technical Services or Royalty Income separate covered by S. 9(1)(vi) and (vii) even if part of normal Business activities - Unless S.44DA (attributable to PE) applies Slide 9
Attribution Principles Tax Treaty
Basic construct of India Tax Treaties Article Art 7(1) Basic Rule Art 7(2) Computation Hypothesis Income Attributable to PE Key Provisions Force of Attraction Rule (if any) or Indirect attribution As if PE is a distinct and independent enterprise engaged in same or similar activities under same or similar conditions Art 7(3) Expense Deduction Others (varies from Treaty to Treaty) Actual Expense incurred, incl. reasonable allocation of General & Admin Overheads Whether in source state or in HO state Subject to domestic law No deduction for HO payment (except reimbursement of actual expenses) Applying Apportionment method in case of difficulty (reasonable) Methodology applied consistently Y-on-Y Exception (Purchase activity) Slide 11
Attribution V/s. Computation Attribution is different from computation Expense attributed to PE may or may not be deductible Revenue attributed to PE may or may not be chargeable; or revenue may be exempted from tax Slide 12
OECD Update / Approach
Background work Alternative Approaches Relevant Business Activity Approach - Profit attribution cannot exceed profits of the enterprise as a whole from the activity in which PE has participation - Accordingly, loss created by other part of the enterprise would effectively reduce the profit that could be attributed to the PE Functionally Separate Entity Approach - Does not limit profit attribution to the profits of the enterprise as a whole - Article 7(1) does not affect the quantum of profit attributable to the PE - Profit attribution governed by Article 7(2) by presuming PE as a separate entity and applying the arm s length principle 2008 Report& consequent 2010 Model Update endorses the Functionally Separate Entity approach Slide 14
OECD Update 2008 Report Attribution of Profits to PE - Most Preferable Approach to attribution in modern-day multination trade and operation - Recognised some differences between Report & existing application of Art. 7 Leading to a new version of Art. 7 itself - Released as part of the OECD 2010 Model Update - With updated commentary on application of Art. 7 (in line with the 2008 Report) Adopts the arm s length principle Slide 15
Art. 7 New v/s Old Key Changes 1. Profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits that are attributable to the permanent establishment in accordance with the provisions of paragraph 2 may be taxed in that other State. 2. For the purposes of this Article and Article [23 A] [23B], the profits that are attributable in each Contracting State to the permanent establishment referred to in paragraph 1 are the profits it might be expected to make, in particular in its dealings 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 the other parts of the enterprise. Largely similar approach, more force to adopting the Arm s length principle Slide 16
Art. 7 New v/s Old Other Changes Actual cost v/s Mark-up on cross charges Apportionment method discarded Y-o-Y consistency condition removed Mere Purchase exception done away Slide 17
FSE Approach How it Works? Basic Principle - Fiction that PE is a separate enterprise & deals independent from the rest of the enterprise Other person (related or not) - Applying the Arm s length principle Two Step- Approach - Functional and Factual Analysis- Determining Attribution of Functions, Assets & Risk to the PE Based on economically sustainable documentation, identify dealings btw PE and Other parts of the enterprise Attribution of Capital - Transaction with Related party & other parts of the enterprise priced in accordance with the Transfer Pricing Guidelines (use of Methods) Comparability analysis and determing ALP Slide 18
FSE Approach Other Attributes Recognise transactions with other part of the enterprise Documentation Challenge - Consistency with economic substance & not just legal form No corresponding taxation of notional income in the hands of the HO Deductibility of expenses in accordance with the domestic law - Should not violate Art. 7(2) - Actual payment not necessary - Non-discrimination clause to apply Corresponding Correlative Adjustments in case of adjustments Needs to be tested vis-à-vis Specific Indian treaties Slide 19
FSE Approach Key Practical Challenges Recognition of Dealings Attribution of free capital Use of intangibles Use of capital assets and changes in asset allocation Internal support services Head office expense allocation Valuation of transactions with Head Office - Comparability & Benchmarking analysis Slide 20
Key India specific comments
Expense Deduction Most Treaties restrict expense deduction based on domestic law requirement - S. 44C General & Admin Overheads - S. 40(a) - TDS requirements Specific Treaty language matters - HO transactions ignored in most treaties Allowable Executive and General administrative expenses Actual reimbursement of expenses Interest payment in case of a banking enterprise Disallowable Royalty paid/ received for use of patents or other rights Commission paid/ receivable for management services Interest on money lent / borrowed Conflict with arm s length principle? Slide 22
Expense Deduction - Variations in Tax Treaties (Some Examples) No reference to limitation under domestic laws - Israel, Italy, Japan, Kenya, Malaysia, Mauritius, Philippines, Russia, Thailand, UAE and UAR reasonable expenses - Syria Tax treaties restricting deduction for expenses if disallowed to PE - Bangladesh, Switzerland, Tanzania and Zambia for the purpose of business - Kenya, New Zealand, Oman, Philippines, Singapore, Tanzania, Thailand, Turkey, Vietnam, Zambia Slide 23
Recognising Notional Transactions Expense Deduction to HO - Circular No. 649 Technical Fees - Circular No. 740 Interest - ABN Amro Bank (280 ITR 117) (Calcutta HC) Corresponding taxation of notional income? TDS? Absolute hypothetical independence vs. Restricted Independence - Linklaters LLP (132 TTJ 20) (Mumbai Tribunal) Relevant Business Activity Approach v/s FSE Approach restricted to Actual profits? Arm s length principle application restricted to HO / AE transactions; Not to actual transactions with independent enterprises Brand value of HO ignored (difference of India rates v/s taxpayer s rates)? Slide 24
Some Special situations Head office expenses (Section 44C) restriction v/s Non- Discrimination clause - Metchem Canada (284 ITR A.T. 196) Presumptive Taxation Deemed deduction for all eligible purposes - Lloyds Helicopters (249 ITR 162) MAT applicable - P.No.14 of 1997 (100 Taxman 1) Slide 25
Old Article 7(4) and Article 7(5) of OECD Model Article 7(4) - Apportionment (alternative) Method Attribution based on % of profits method to be adopted if customary under domestic law - Provided result is in accordance with independent enterprise benchmark Relaxation in the application of Apportionment Method only when arm s length method is difficult to apply Article 7(5) Purchase Exclusion Whether purchases for other enterprise included? Whether purchases of capital assets included? Prevalent in most Indian treaties Slide 26
Some Judicial Precedents Case Nature of PE Profit Attribution Ahmedbhai Umerbhai Sales in India 50% of the Profits Balance 50% (mfg) o/s India Rolls Royce Fixed Place & Agency PE Profits per Global Profitability rate 35% of Profits for the marketing activities Balance 65% (50% - mfg & 15% - R&D) attributed outside India Galileo Agency PE 15% of Revenues (less expenses) Amadeus Agency PE & Equipment PE 15% of Revenues (less expenses) Linmark International Hongkong Business Connection substantial activities in India 50% of Revenues (less expenses) Thumb Rule Approach v/s FAR Analysis Slide 27
Arm s Length Payment whether extinguishes tax liability
Agency PE Concept Agency PE Foreign Principal Agent Customers Arm s length compensation Dependent Agent Test Agent habitually concludes contracts on behalf of the Principal or secures orders from customers in India Agent works wholly or almost wholly for the Principal Hence is treated as a Dependent Agent Taxation Principle Taxation of the Agent per se Taxation of the Foreign Principal due to Agency PE Agency PE is a separate notional taxable entity independent of the Agent per se Whether Arm s length payment to Agent extinguishes further liability of the principal (Agency PE) Slide 29
Morgan Stanley Ruling Captive Service Provider in India (I-Co) Deputation of people to Indian service Provider by Foreign co (F- Co) resulting in Service PE I-Co compensated on Cost-plus mark-up basis SC held As regards attribution of further profits to the PE of MSCo where the transaction between the two are held to be at arm s length, we hold the ruling is correct in principle provided that an associate enterprise (that also constitutes a PE) is remunerated on arm s length basis taking into account all the risktaking functions of the multinational enterprise. In such a case nothing further would be left to attribute to the PE. The situation would d be different if the transfer pricing analysis does not adequately reflect the functions performed and the risks assumed by the enterprise. Taxation of the Service PE separately? Slide 30
Other Rulings (in the context of Agency PE) Sony (Bom HC) overruled Sony (Mum ITAT) ruling Galileo (116 ITD 1) (Del HC) BBC Worldwide (Del ITAT) Star Cruise (Mum ITAT) specific reference that will not be a precedent Basic Approach: 1. Determine Income (Revenue) Attributable to Agency PE 2. Payments made to the Indian Agent 3. Since 2 > 3 no further taxation of the foreign principal Slide 31
OECD (2008 Report) Approach Independent taxation of the Agent and the Agency PE (as a separate notional taxable entity) Arm s length payment to agent does not always extinguish taxation of Principal Agent merely receives compensation for his services as an agent Based on the FAR analysis of the Agent Foreign Principal (resulting Agency PE) could be attributed additional risk based on the functions of the agent (carried out on behalf of the principal) Especially where such functions are in the nature of Significant People Functions eg. Inventory management, Debtors management Additional risk thereon - attribution to Agency PE - if such risk is not passed onto the Agent (and is, thus, not compensated in respect thereof) Purely factual analysis Slide 32
Agency PE.. Applying the OECD 2008 Report Agency PE Foreign Principal Agent Arm s length compensation Customers Scenario 1 Let us say Agent under takes Customer credit evaluation and debtors management function Related bad debt risk not being borne by the Agent; hence, arguably not compensated for Attributed to the Agency PE? Scenario 2 Credit evaluation & Debtors management undertaken by Principal HO personnel o/s India Related bad debt risk attributed to Principal HO or Agency PE? But, are the Indian rulings deviating at all? Slide 33
Force of Attraction Rule in PE Attribution
Objective Objective to curb misuse of routing transactions directly Hence extension of taxation to activities not necessarily carried out through the PE in some circumstances Achieved generally by way of an express Force of Attraction Clause Direct or Indirect Attribution Implied FOA? Is the scope wider than Section 9 of the Act? Slide 35
Express Force of Attraction Clause Article 7 Para 1 of the UN Model Convention The profits of an enterprise of a Contracting State shall be taxable only in that State unless the.. may be taxed in the other State but only so much of them as is attributable to (a) that permanent establishment; (b) sales in that other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment; or (c) other business activities carried on in that other State of the same or similar kind as those effected through that permanent establishment. Found in several India tax treaties Slide 36
Key Conditions Existence of a PE Roxon OY (103 TTJ 891) (Mum ITAT) Vis-à-vis Sale of goods Same or Similar Vis-à-vis Services / Other business activities Same or similar Activities carried out in state of PE (source state) Qua the Business activity and not Qua the Taxpayer Slide 37
Example Company A Supplies garments directly US PE of A Ltd Agency selling garments on behalf of Head Office to several Indian customers India Branch of Company A Customers in India Slide 38
Principles of Attribution Indian Tax Treaties Practical instances Following tax treaties contain FOA clause - Australia, Belarus, Canada, Cyprus, Czechoslovakia, Denmark, Finland, Indonesia, Italy, Kenya, Mongolia, New Zealand, Poland, Romania, Sri Lanka, Spain, Thailand, USA Types of FOA clauses in the tax treaties: Specific FOA Need of role to be played by PE Business reasons for not routing the direct business of HO through PE Tax avoidance motive need to be established Eg: Cyprus, Sri Lanka Normal FOA Automatically attributable if activities are same/similar No specific requirement of role to be played by PE Eg: Treaties other than Cyprus and Sri-Lanka containing FOA Slide 39
Direct or indirect attribution In some of the tax treaties the phrase directly or indirectly attributable to PE is used - Bulgaria, China, Malta, Oman, Singapore, Switzerland, UK, Uzbekistan, Ukraine, Vietnam - Singapore, Vietnam, Uzbekistan, Ukraine, Malta and UK tax treaties defines the term directly and indirectly - Does it widen the scope of Article 7? As per India-Vietnam tax treaty, directly or indirectly means where a PE has active role in negotiation of the contracts Does it mean implied Force of Attraction? - Linklaters LLP decision(132 TTJ 20) (Mumbai Tribunal) (UK Treaty) - UK treaty infact defines indirect attribution Slide 40
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