Attribution of Profits to a Permanent Establishment

1. Attribution of Profits to a Permanent Establishment Narayan Mehta Sudit K Parekh & Co 27th January, 2006

2. Agenda • Attribution provisions under ITA • Attribution provisions under Treaty • Treatment of Head Office expenses • Taxation of royalties / FTS in a PE situation • OECD’s discussion draft on PE attribution, going forward

3. Fundamental Issues • Constitution of a business connection / PE (Article 5) • Attribution of Profits to the PE (Article 7)

4. ITA provisions - Explanation to section 9(1)(i) “ (a) 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 ”

5. Basic concepts • What is attributable to? • Not defined in ITA or DTAA • Means ‘assign’ or ‘refer to’ • Why attribute? • Profits of foreign enterprise taxable in India • However, taxing rights restricted to only profits that are relatable to Indian operations

6. Attribution of profits….a guesswork? An Illustration Hukumchand Mills Ltd (103 ITR 548) (SC) “ In the absence of some statutory or other fixed formula, any finding on the question of proportion involves some element of guesswork. The endeavor can only be to be approximate and there cannot in the very nature of things be great precision and exactness in the matter.”

7. Judicial thinking • Lower authorities – better placed to decide the issue • AAR may not entertain questions on attribution of profits • Matter of fact analysis • The courts avoid interfering unless attribution unreasonable or arbitrary • New Consolidated Fields (125 Taxman 959) (SC) • Mewar Textile Mills (60 ITR 423) (SC)

8. What are profits reasonably attributed to operations?

9. Business operations not requiring profit attribution • Courts have ruled that the profits cannot be attributed to the following activities • Performance of guarantee in India after sale of goods outside India (CIT vs Hindustan Shipyard Ltd - 109 ITR 158) • Buying operations (Rahim vs CIT - 17 ITR 256) • Isolated Purchases (CIT vs Jiyajeerao Cotton Mills Ltd - 118 ITR 72) • Conclusion of loan agreement in India ( C.G. Krishnaswami Naidu vs CIT – 62 ITR 686) • Formation of contact in India ( CIT vs Anamallais Timber Trust Limited 18 ITR 333) • Procurement of orders (without acceptance) on behalf of non-resident ( CIT vs R. D. Aggarwal – 56 ITR 20)

10. How to attribute profits to various business activities? • No prescribed methods • Fact sensitive • Methods to attribute profits to various business activities • Resources deployed as a basis of attribution • Salaries paid / costs incurred as basis of profits attribution • Others based on facts

11. Under what circumstances Rule 10 can be invoked? • Actual amount of income accruing or arising to a non-resident cannot be definitely ascertained • Rule 10 is the method of last resort

12. Methodsspecified underRule10 • The three methods specified are: • Presumptive Method • Proportionate Method • Discretionary Method • Rule 10 involves estimation and subjectivity • Litigious in nature

13. Presumptive Method under Rule 10 Illustration • X Inc, a US company is engaged in manufacture of engineering goods • Goods are to be sold in India • X Inc has a branch in India which does marketing and distribution of the goods in India • For y.e.2005, X Inc sold goods worth INR 1 million in India • The Indian branch claimed deductions for various expenses incurred outside India • AO was not in a position to determine profits subject to tax in India based on the books of accounts of the Indian branch • AO invokes Rule 10 and applies Presumptive Method • AO feels 10% is reasonable attribution to the activities of the Indian branch • Consequently, income subject to tax in India - Rs 1,00,000

14. Proportionate Method under Rule 10 Illustration • X Inc submits its world accounts to the AO • The following figures are available:

15. Proportionate Method under Rule 10 (contd.) • Under proportionate method, profits attributable to India will be calculated using the following formula • Profits subject to tax in India = Total taxable profits * Turnover in India ----------------------- Total Turnover I.e. 2,500,000 * 1,000,000 = Rs 250,000 --------------- 10,000,000 • World income means income from relevant business of the assessee • Relevant if the assessee is engaged in more than one business

16. Discretionary Method under Rule 10 • This is the residuary clause under Rule 10(iii) • This method allows the AO to compute income in some other manner as he deems fit • In case the above two methods are not suitable, ITA gives the tax payer discretion to formulate some new method to determine the income

17. Order of preference under Rule 10 • Rule 10 does not specify any order of preference to be followed • AO should first try the Proportionate Method • If global accounts are available • If that is not possible, then follow the Presumptive Method • Discretionary Method should be applied only if the above two methods cannot be applied • Useful inference – Iraqi Airways V/s IAC (23 ITD 115 Delhi Tribunal)

18. Practical application of Rule 10 CIT vs Indian Textile Eng Pvt. Ltd. & another (Bombay HC) (141 ITR 69) An Illustration • Indian Textile Engg, an Indian company was assessed as agent of PB Ltd • PB Ltd was incorporated in UK and was a subsidiary of another UK company • There was a group policy that if a group company makes losses then such losses shall be made good by other group companies as per direction of Parent company • Such agreement was allowed under UK laws • During the year, PB Ltd made provision for doubtful debts towards amount receivable from certain parties • As per group policy, PB Ltd received payments towards losses incurred by it • Under UK law, such a receipt was treated as trading receipt. Also deduction was allowed towards doubtful debts in the UK • Under Indian law, the payment received was taken as part of taxable profit but no deduction was allowed for provision for doubtful debts • The High Court stated that if a particular type of payment is not allowed as business expenditure, receipt of similar nature should not be taxed

19. Practical application of Rule 10 CIT vs Shinwa Kalum Kaisha Ltd (Cal HC) (165 ITR 270) An Illustration • The assessee was a company incorporated in Japan and was engaged in shipping business • The income subject to tax in India was computed under Proportionate Method with the following formula • Profits attributable to India = Total profit from the business * Freight receipts in India / Total freight receipts • The assessee received certain amounts such as foreign currency adjustments, interest earned on discount, etc. • These receipts were incidental to the shipping business • The AO did not include such incidental receipts in the denominator I.e. Total freight receipts on the premise that such receipts were not connected to India • The HC held in favour of the assessee stating that the Proportionate Method requires total receipts of business carried out inside and outside India • The figure ‘Total profits’ was inclusive of such incidental receipts and hence for consistency, it is imperative to include the same in the denominator

20. Article 7 “ The 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 of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment. Para 1 ”

21. The implication! • PE can be also taxed for business directly conducted by HO! Force of Attraction • FOA enlarges the scope of PE country taxation • The PE country to tax profits as is attributable to: • The PE • Sales of goods or merchandise of the same or similar kind as those sold through that PE • Other business activities carried on through that PE • FOA- present only in the UN Model & not OECD Model • No FOA rule under ITA! • However receipt basis of taxation under ITA

22. Force of attraction rule- an illustration US HO Profits taxable in India due to force of attraction rule Indian Branch (trading in goods) End clients Higher of 41.82% corp tax, or 8.415% MAT

23. Use of words, ‘directly or indirectly attributable to’ India-Vietnam Treaty India-Singapore Treaty India-UK Treaty Art 7(1)- variations in Indian treaties

24. Article 7 “ Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it where 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. Para 2 ”

25. Art 7(2) • Indian IRS cannot ignore Branch accounts • Symmetrically prepared accounts should be considered • Appropriate adjustments to be made when required to compute ALP • Asset transfers from PE to HO should be treated as transaction resulting in profit • Organization as a whole realizes profit or not is not a relevant consideration

26. Dealing wholly independently with either the HO enterprise or with other enterprises India-Australia Treaty India-Bangladesh Treaty India-US Treaty Determination of profits on reasonable basis India France Treaty India Italy Treaty Art 7(2)- variations in Indian treaties

27. Article 7 “ In determining the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the permanent establishment, including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere. . Para 3 ”

28. Art 7(3) • No deduction for amount paid by PE to HO or other offices, by way of FTS, royalties etc. • Actual reimbursements allowed • Banking enterprise - deduction for interest allowed • Amounts paid by the HO or other branches to the PE – similar treatment • Deductions subject to domestic law of the country in which PE situated? • Section 44C head office expenses allowable

29. Art 7(3) • Arm’s length pricing when goods / services provided in normal course of business. • No profit to be charged if the expense incurred is to rationalize overall cost of the organization or increase its sales in a general way • When goods are not given to PE for resale but for general use then only related cost should be shared • Eg: depreciation on machinery based on usage

30. Art 7(3) - intangibles • Allocating the ownership of intangibles – a difficult proposition • Cost incurred for creation of intangibles • May be attributable to all the parts of the organization which makes use of it • Such costs should be allocated without any mark up to the PE.

31. Art 7(3) – services & interest Services • Mark up needs to be charged when: • The enterprise provides such services on commercial terms, or • The enterprise is in the business of providing such services • General management activity - no mark up to be charged to the PE • Eg: training provided to the employees of various parts of the enterprise Interest • No interest to be charged between the enterprise and the PE • Interest may be charged in the case of financial enterprise (e.g. bank)

32. An illustration

33. An illustration

34. No reference to the limitation of the domestic tax laws India-Israel Treaty India-Japan Treaty India-Kenya Treaty Deduction for reasonable expenses India Syria Treaty Restrictions only for executive and general exp India Switzerland Treaty Art 7(3)- variations in Indian treaties

35. Article 7 “ Insofar as it has been customary in a Contracting State to determine the profits to be attributed to a permanent establishment on the basis of an apportionment of the total profits of the enterprise to its various parts, nothing in paragraph 2 shall preclude that Contracting State from determining the profits to be taxed by such an apportionment as may be customary; the method of apportionment adopted shall, however, be such that the result shall be in accordance with the principles contained in this Article. . Para 4 ”

36. Art 7(4) • Customary proportionate method followed by the PE country may be followed for the purpose of determination of profits attributable to the PE. • The method should give the same results as per the article • OECD Discussion Draft on PE Attribution – Art 7(4) not required

37. Article 7 “ No profits shall be attributed to a permanent establishment by reason of the mere purchase by that permanent establishment of goods or merchandise for the enterprise. Para 5 ”

38. Art 7(5) • Same method should be followed every year unless sufficient reasons to the contrary • OECD Discussion Draft on PE Attribution – Art 7(5) not required

39. Head Office Expenses – Section 44 C • HO expenses include executive and general administrative expenses • CBDT Circular dated July 5th, 1976 suggests that the section applies only to non-residents having a branch in India • Applicability in case of a PE other than a branch? • Circular 643 requires that branch deducst TDS from payments to HO • The section presupposes carrying on of part of business outside India • Rupenjuli Tea Co. Ltd vs CIT) (Calcutta HC) (186 ITR 301) • Applicability in respect of expenses incurred by any other group offices other than head office outside India? • There is no legal requirement to debit HO expenses to Indian books for deduction of the expenditure • Whether Sec. 44C applies in case Art 7(3) does not prescribe restriction as per domestic tax laws?

40. Taxation of Royalties / FTS in a PE situation • If no PE in India- FTS Royalties taxable on gross basis u/s 11A / Tax Treaty • Agreement made on or before May 31, 1997 – tax rate @ 30% • Agreement made after May 31, 1997 – tax rate @ 20% • Agreement made on or after June 1 2005 • If PE exists in India – FTS / Royalties taxable on net basis u/s 44DA • Salient features of Sec. 44DA • Royalty / FTS received from Govt. or Indian concern • Section 44DA applies to any non-resident and not only to foreign companies • Agreement is made after 31-03-2003 • Business is carried out in India through a PE or professional services are provided from the fixed place of profession • For the purpose of this Section, definition of ‘PE’ is borrowed from S. 92F(iiia) • Restrictive definition under S. 92F(iiia) • Right, property or contract for which Royalty / FTS arises is effectively connected with the PE or fixed place of profession • Deduction under section 44C would continue to be available • Non-resident claiming benefit of S 44DA are required to maintain and get their accounts audited

41. OECD Discussion Draft - Approaches • The “Relevant Business Activity” (RBA) Approach The “Functionally Separate Entity” (FSE) Approach • Other approaches not supported by Article 7 • Total Net Profits • Total Gross Profits

42. Authorized OECD Approach – FSE • Simplicity (No limitation on profits) • Administrability (No need to determine worldwide profits) • Consistency (PE akin to legally distinct and separate enterprise)

43. Interpretation of Article 7 para 2 • Attribution of Profits to PE – Two step Analysis • Step I: Functional and Factual Analysis to hypothesise the PE and reminder of the enterprise as “Associated Enterprises” • Step II: Application of the “Arm’s Length Principle” to the hypothetical enterprises in accordance with TP Guidelines, by analogy

44. Functions • Assets • Risks • Capital Step I: Functional and Factual Analysis

45. Step II: Determination of Profits • Recognition of Dealings between various parts of the enterprise – Certain practical issues • PE not same as subsidiary • No legal consequences for the enterprise on the whole • Onus on taxpayer • Accounting records starting point but F&F analysis determinative • Absence of “Contractual Terms” • Actual conduct, correspondences and other documentation important • Tax officials should not disregard actual dealings or substitute other dealings for them

46. Documentation Requirements • TP Guidelines to apply by analogy • Documentation must be consistent with actual behaviour of parties • Information on profit attribution should be available to both – home and host countries • Documentation practically difficult as PE is part of the same enterprise, unlike AE

47. “Symmetrical Application” of the Authorized OECD Approach • Prime objective of discussion draft is to prevent double taxation • As long as results are at Arm’s Length, home country to respect host country’s tax treatment (and give relief on that basis), even if inconsistent with home country’s treatment • Where host country's treatment not Arm’s Length, home country can make adjustments • In case of disagreement as regards Arm’s Length Principle, MAP available

48. Concluding remarks • Attribution of profits – facts sensitive! • Relevant treaty interpretations also relevant • Upfront planning desirable • For instance, could the PE incidence itself be avoided based on suitable planning?! • Choice of entry strategy also critical • Suitable documentation desirable! • Seeing the larger picture helps in some cases!

49. Thank You ? Queries Narayan Mehta Tel: +91 22 22821141 Mobile: +91 9820544495 E-Mail: narayan.mehta@skparekh.com