Attribution of Profits

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
• OECDs 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?
Hukumchand Mills Ltd (103 ITR 548) (SC)
An Illustration
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
Methods specified under Rule 10

• 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
An Illustration

• CIT vs Shinwa Kalum Kaisha Ltd (Cal HC)
• (165 ITR 270)

• 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

Para 1

• 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.

21
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
Art 7(1)- variations in Indian treaties

• Use of words, directly or indirectly
  attributable to
• India-Vietnam Treaty
• India-Singapore Treaty
• India-UK Treaty

24
Article 7

Para 2

• 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.

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
Art 7(2)- variations in Indian treaties

• 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

27
Article 7

Para 3

• 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.
• .

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)

• Arms 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
Art 7(3)- variations in Indian treaties

• 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

35
Article 7

Para 4

• 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.
• .

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

Para 5

• 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.

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 _at_ 30
• Agreement made after May 31, 1997 tax rate _at_
  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 Arms Length
  Principle to the hypothetical enterprises in
  accordance with TP Guidelines, by analogy

44
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 FF
  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 Arms Length, home
  country to respect host countrys tax treatment
  (and give relief on that basis), even if
  inconsistent with home countrys treatment
• Where host country's treatment not Arms Length,
  home country can make adjustments
• In case of disagreement as regards Arms Length
  Principle, MAP available

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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 [phone] Mobile 91
9820544495 E-Mail narayan.mehta_at_skparekh.com