21 May 2013 Global Tax Alert News and views from Transfer Pricing Delhi Tribunal rules on attribution of profits to an Indian permanent establishment of a US company Executive summary This tax Alert summarizes a recent ruling of the Delhi Income Tax Appellate Tribunal (Tribunal) in the case of Convergys Customer Management Group Inc. (Taxpayer) 1 on the issue of attribution of profits to a permanent establishment (PE) in India under the India US Double Taxation Avoidance Agreement (DTAA). The Taxpayer, who is engaged in providing customer management services, outsourced the provision of some of the services to its subsidiary in India (IndCo). Under the facts of the case, after holding that the Taxpayer has a fixed place PE in India, the Tribunal had to decide on the extent of profits to be attributed to the PE. As a general principle, the Tribunal recognized that attribution of profits to the PE is a transfer pricing issue and no further profits can be attributed to a PE once an arm s length price has been determined for IndCo, if the transfer pricing analysis subsumes the risk profile of the PE. The Tribunal also observed that in the facts of the case the risk of service delivery resides outside India and cannot therefore be attributed to the PE. The Tribunal however ruled that some part of the residual profits earned by the Taxpayer from the contracts that were outsourced to IndCo should be attributed to the PE. Accordingly, the Tribunal held that an attribution of 15% of the residual profits, determined by applying the global operating income percentage to the revenues from contracts outsourced to IndCo, as
reduced by the operating profit of IndCo, would be a reasonable basis for attributing profits under the facts of the case. Background and facts The Taxpayer, a tax resident of the United States, provides customer management services by utilizing advanced information system capabilities, human resource management skills and industry experience. The Taxpayer has a subsidiary in India, IndCo. The Taxpayer procures services from IndCo on a principal-to-principal basis for providing services to its customers. IndCo functions a limited risk service provider to the Taxpayer. During the course of audit proceedings the Tax Authority alleged that the Taxpayer has a PE under the provisions of Article 5 of the DTAA. The Tax Authority, for the purpose of attributing profits to the PE, allocated global revenue and expenses (excluding direct expenses) in proportion to the number of employees considering all employees to be delivering the same value to the revenue of the Taxpayer. The Taxpayer filed an appeal before the Commissioner of Income-tax (Appeals), which is the first appellate authority, against the assertion of PE and the approach adopted for attribution of profits. The First Appellate Authority upheld the Tax Authority s position that the Taxpayer has a PE in India. With regard to profit attribution to the PE, The Appellate Authority held that no further profits can be attributed to the Taxpayer s PE to the extent that the transfer pricing analysis of IndCo has already captured such functions, assets and risks. However, further profit was required to be attributed on account of: Certain assets of the Taxpayer being deployed in India. Entrepreneurial services to manage risk related to the service delivery are performed by the Taxpayer in India. In computing the profits to be attributed, the First Appellate Authority considered total revenue of Taxpayer pertaining to contracts/ projects in respect of services were procured from IndCo. However, while computing profits, the First Appellate Authority did not allow deduction for expenses such as research and development, depreciation, amortization etc. The Appellate Authority also considered only 50% of selling, general and administrative expenses and limited the quantum of deduction for head office expenses to the ceiling prescribed under domestic tax law. The Taxpayer filed an appeal against the order of the First Appellate Authority before the Income-tax Appellate Tribunal regarding the PE determination as well as the approach to attribution of profits to the PE. The Tax Authority also filed an appeal before the Tribunal against the First Appellate Authority s order for changing the Tax Authority s approach to profit attribution. Before the Tribunal, in addition to advocating a number of arguments to support its position of not having a PE as well on the inappropriateness of the profit attribution methodology adopted by the Tax and Appellate Authority, the Taxpayer also pointed out that while on one hand additional profits have been attributed to the alleged PE of the Taxpayer in India, on the other hand a transfer pricing adjustment has also been made in the hands of IndCo. Thus, the same income attributable to India has been taxed twice, once in the hands of the Taxpayer, as a PE and then in the hands of IndCo as a transfer pricing adjustment. Tribunal s ruling The Taxpayer s employees frequently visited the premises of IndCo and some of its seconded employees worked in key positions such as Country Head, Managing Director etc. of IndCo. Accordingly, as such employees have a fixed place at their disposal and IndCo as a practical matter was the projection of the Taxpayer s business in India, the Taxpayer had a fixed place PE in India. The methodology adopted by the Tax Authority and the First Appellate Authority for attribution of profits to a PE cannot be accepted as they have considered 2
revenue of the Taxpayer as the starting point for arriving at the profits attributable to the PE of the Taxpayer in India. The revenue of the Taxpayer cannot be considered as the revenue of the PE. The attribution of profits to the PE should be based on transfer pricing principles as held by the Supreme Court of India in the case of Morgan Stanley Inc. 2 The view espoused by the First Appellate Authority that further profit is to be attributed on account of entrepreneurial services to manage risk by the Taxpayer in India is not appropriate since IndCo is remunerated on a cost plus basis irrespective of the service delivery. Therefore, this risk resides outside India. Even otherwise, the charge for the seconded employees/ employees visiting India to provide technical services is subsumed in the TP analysis of the IndCo. An overall attribution of profits to the PE is a transfer pricing issue and no further profits can be attributed once an arm s length price has been determined for IndCo, as the transfer pricing analysis subsumes the risk profile of the PE. Thus, there can be further attribution only on account of providing free of cost assets and software. The correct approach to arrive at the profits attributable to the PE is as under: Step 1: Compute global operating income/profit percentage of a particular line of business as per annual report of the Taxpayer. Step 2: This percentage should be applied to the end customer revenues with regard to contracts/projects where services are procured from IndCo. The amount arrived at is the operating income/profits from Indian operations. Step 3: Operating income/ profits from India operations is to be reduced by the profit before tax of IndCo. This residual profit, which represents income of the Taxpayer is to be apportioned between US (Head Office) and India (PE). Step 4: Profit attributable to the PE should be estimated on residual profits. In providing the above approach, the Tribunal observed as follows: The Tax Authority s estimation involves an unrealistic method of counting the worldwide number of employees and dividing it with the Taxpayer s global revenue without considering the relevant aspects. The finer and material aspects about the status and capacity of the employees are overlooked and the results become very vague and distorted. Therefore, the method adopted by the Tax authority cannot be relied on as the most appropriate method. Though the First Appellate Authority accepted the proposition that there cannot be notional addition to India revenue, however, his method also does not become rational as deduction for various expenditures incurred by Taxpayer such as research and development, depreciation, amortization, 50% of selling, general and administrative expenses have been ignored along with other expenses incurred by the Taxpayer outside India for earning the revenue from end customers. For the purpose of attribution of residual profits to the PE, reliance was placed on two Supreme Court rulings that dealt with profit attribution under domestic tax law. In the case of Anglo French Textile Co, 3 10% attribution was held reasonable and in Hukum Chand Mills Ltd, 4 15% attribution was held reasonable. Having regard to the two rulings, the Tribunal concluded that adoption of the higher figure of 15% for attribution of the Taxpayer s PE will meet the ends of justice. Comments When the existence of a PE is confirmed, Article 7 of the DTAA provides for tax-sharing rights over the profits earned by a US enterprise that carries on business through a PE in India. Article 7(2) deals with ascertainment and allocation of such profits by means of application of the transfer pricing principles based on the arm s length standard. Consistent with a number of other rulings in India, including that of the Supreme Court, this Tribunal ruling re-affirms that attribution of profits to a PE should be based on transfer pricing principles. The ruling also reiterates the general principle that no further profits can be attributed to a PE if the transfer pricing analysis of the affiliate subsumes the risk profile of the PE. 3
Despite the recognition of arm s length principles for profit attribution, while concluding on the extent of profits attributable to the PE, the Tribunal appears to have adopted a formulary apportionment approach. Further, the rationale for attributing a part of the residual profits to the PE does not appear to be very clear from the facts of the case. Under general transfer pricing principles, residual profits are typically allocated to an enterprise that owns valuable intangible property or makes other non-routine contributions. The ruling also does not seem to have explicitly addressed the economic double taxation argument of the Taxpayer in a situation where the residual profit that is attributed to the PE is also taxed in the hands of IndCo by way of a transfer pricing adjustment. In light of the ruling, it is important for multinational enterprises doing business in India to review their PE and related profit attribution risk periodically. The ruling also emphasizes the importance of a robust transfer pricing analysis as a tool managing PE profit attribution risk. Endnotes 1. ITA Nos. 1443/Del/2012 & 5243/Del/2011. While the ruling deals with a number of other issues such as existence of PE, characterization of payments as royalty etc, this alert covers the aspects relating to profit attribution to a PE. 2. [292 ITR 416]. 3. [23 ITR 101]. 4. [103 ITR 548]. 4
For additional information with respect to this Alert, please contact the following: Ernst & Young LLP (India) Vijay Iyer, New Delhi +91 11 6623 3240 vijay.iyer@in.ey.com Rajendra Nayak, Bangalore +91 80 4027 5454 rajendra.nayak@in.ey.com Ernst & Young Assurance Tax Transactions Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 167,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit www.ey.com. Ernst & Young LLP (India) is a member firm serving clients in India. About Transfer Pricing/TESCM We bring you a global perspective on transfer pricing and tax effective supply chain management (TESCM), based on our long-standing experience of what really works. We help you configure your supply chain effectively and design and implement sustainable transfer pricing policies. Our multi-skilled teams support you in implementing proactive, pragmatic and integrated strategies that address tax risks and help your business achieve its potential. It s how Ernst & Young makes a difference. www.ey.com 2013 EYGM Limited. All Rights Reserved. EYG no. CM3453 This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor. 5