TaxTMI 
TaxTMI 
Public Consultation on the proposal for amendment of Rules for Profit attribution to Permanent Establishment
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....s or deemed to accrue or arise in India. The incomes that shall be deemed to accrue or arise in India are specified in Section 9 of the Act which, inter alia, provides that 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. However, in cases where a DTAA is also applicable, taxes on business income of a non-resident can be levied to the extent the same is permissible under such agreement. Thus, business income of a non- resident can be taxed in India if it satisfies the requisite thresholds provided under the Act as well as the threshold provided in the applicable tax treaty, by a concept of Permanent Establishment (PE), which is defined in Article 5 of Model Tax Conventions and tax treaties. 2. Under Article 7 in the Indian treaties, profits are to be attributed to the PE as if it were a distinct and separate entity on the basis of the accounts of the PE and where such accounts are not available to enable determination of profits attributable to the PE, the profits attributable to the PE can be determined under the domestic laws. For the application of this method, the Ass....
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....ferent Standards of Article 7 in Model Tax Conventions& its Implications Section 4 Economic Basis for Allocation of Taxing Rights in respect of Income from Business Section 5 Different Approaches to Profit Attribution& International Practices Section 6 Views of Academicians & Experts on Profit Attribution Section 7 Position of India on Inadequacies of Revised Article 7, AOA & FAR based Profit Attribution Section 8 Court Decisions on Profit Attribution in India Section 9 Need for Clarity in India's Approach on PE Attribution: Various Options for a More Specific rules Section 10 Profit Attribution in Significant Economic Presence Nexus Section 11 Conclusions &Recommendations of the Committee 3 | Page Report on Profit Attribution to Permanent Establishments Section 1 Constitution and Mandate of the Committee 1.1 Introduction 1. Taxation of non residents in India is governed by the provisions of the Income-tax Act, 1961 (hereinafter referred to "the Act") and the provisions of the double taxation avoidance agreement(s) (hereinafter referred to as "agreement(s)"or "tax treat(ies)"), concluded or adopted by the Central government under the powers....
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....arrived by a process of negotiation by the Contracting States. 4 | Page Report on Profit Attribution to Permanent Establishments on one of the three standard versions2 of Article 7 in model tax conventions prepared by OECD and UN Committee of Experts. 3. During the Base Erosion and Profit Shifting (BEPS) project undertaken by the G-20 countries, including India and the OECD along with other participants, there has been a number of changes in the definition of PE as a result of the Final Report on Action 7 of the BEPS Action Plan aimed at preventing the artificial avoidance of PE status, which has since been incorporated in Article 5 of the OECD as well as the UN model tax conventions. As part of the follow up work on Action 7 Report, work was also attempted to bring greater clarity on how these changes will impact issues related to profit attribution consequent to the expanded definition of permanent establishment. Accordingly, follow up work was undertaken by the Working Party-1 and Working Party-6 of OECD and some draft papers were prepared by the OECD, proposing guidance as to how profit would be attributable as per the Authorized OECD Approach (AOA)3. The AOA is a g....
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.... India is provided in rule 10 of Income-tax Rules, 1962. 6. There have been some concerns regarding the uncertainty and unpredictability resulting from the application of rule 10. These arise from the lack of specificity and the availability of very broad discretion to the AO without any clear and specific guidance, leading at times to claims of excessive taxation in India. The same concerns also appear to be reflected in the comments of OECD seeking details and specific guidelines on how profits are attributable in India. These concerns have led to the recognition of the issue as to whether there is a need to provide more specific rules or clear guidance on profit attribution under Indian domestic laws, especially rule 10 of the Rules, in order to bring greater certainty, consistency and predictability to the process of profit attribution under this rule. 7. Concerns have also been arising globally on how profits should be attributed in respect of profits generated from digital businesses. The Final Report on Action 1 of BEPS has pointed out that the rise and growth of digital economy has made the concept of physical presence redundant as the revolutionary developments in th....
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....pply side factors in profit attribution. (iii) Recommend the changes needed in rule 10 of Income-tax Rules to provide specific rules on how profits are to be attributed to a non-resident person having PE in India. 7 | Page Report on Profit Attribution to Permanent Establishments 1.3 Work of the Committee 11. In accordance with the mandate given to it, meetings of the Committee were held from time to time to finalize the report. The Committee took into account the history and evolution of different standards of profit attribution rules that currently prevail in the model tax conventions, along with the formal Indian position adopted in respect of them as well as the decisions of the Indian courts in matters involving profit attribution. The Committee also analyzed their economic impact for different economies and in particular their impact for Indian economy and tax collections. The Committee also took into account the views and opinions of academicians and experts as also some of the international practices prevailing or proposed to be adopted across the world, which can have relevance for the work of the Committee. The issues taken into account by the Committee, the....
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....income of a resident7 in India is taxable in India. However, the taxability of income of a non-resident is limited to income that arises or accrues in India, is deemed to accrue or arise in India or is received or deemed to be received in India. Section 9 of the Act deals with income that is deemed to accrue or arise in India. As per clause (i) of sub-section (1) of the said section, "all income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situate in India" are deemed to accrue or arise in India, thereby elaborating upon the scope of income that would be taxable in India. 14. The concept of business connection is explained in Explanations 1 and 2 to clause (i) of sub-section (1) of section 9 of the Act, to which Explanation 2A8has recently been added by the Finance Act, 2018 to explicitly include significant economic presence within the scope of business connection. Clause (a) of Explanation 1 states that in the case of a business of which all the operations are not carried out in....
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.... profits are deemed to accrue or arise in India that is attributable to the business activities carried out in India. Under the Act, the income under the head "profits and gains of business or profession" is to be determined under the applicable provisions, and the taxpayers are required to maintain books of account and financial statements for this purpose. 17. However, where such books of account are either not maintained or it may not be possible to determine the actual profits from such books of account, the Assessing Officer can resort to secondary options prescribed in rule 10 of the Rules, which provides as under: 9 The revised Explanation 2 reads as under: Explanation 2 .- For the removal of doubts, it is hereby declared that "business connection" shall include any business activity carried out through a person who, acting on behalf of the non-resident,- (a) has and habitually exercises in India, an authority to conclude contracts on behalf of the non-resident or habitually concludes contracts or habitually plays the principal role leading to conclusion of contracts by that non-resident and the contracts are- (i) in the name of the non-resident; or (ii) fo....
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....ess of such person (such profits and gains being computed in accordance with the provisions of the Act), as the receipts so accruing or arising bear to the total receipts of the business, or (iii) in such other manner as the Assessing Officer may deem suitable." 18. As can be seen, in cases where the actual amount of business profits taxable in the hands of a non-resident having a business connection in India is not accurately ascertainable, the Assessing Officer can determine such profits by either of the three methods provided in rule 10. While the first two methods are relatively specific, the third method allows the Assessing Office to apply any variation of the first two methods or any other method that he considers applicable in that case. 2.2 Application of Tax Treaties to Business Profits of a Non Resident 19 Section 90 of the Act empowers the Central Government to enter into agreement(s) with other States or specified territories for the purpose of avoiding double taxation. Similarly, section 90A of the Act authorizes a specified association in India to enter into such an agreement with a specified association of a specified territory subject to adoption by way....
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.... has been included for the purpose of this Article. Once these changes come into effect in the applicable tax treaties, they can be expected to address the challenge of artificial avoidance of PE status, and thereby bring certain entities, which may have been able to artificially avoid taxation earlier, into the tax net. 10 22 Article 7 of the model tax conventions and the tax treaties provide that the business profits of an enterprise of a Contracting State shall be taxed in the other Contracting State only to the extent such profits are attributable to the PE existing in that state. However, there exists a major difference in the approach between the OECD and the UN model tax conventions in the form of 'force of attractions rules' that are provided in paragraph 1 of Article 7 in the UN model 10 These changes can be brought into effect either through the amendment of a tax treaty consequent to bilateral negotiations, or by application of Articles 12 to 15 of the Multilateral Instrument prepared under Action 15 of the BEPS project and already signed by several countries including India, provided that both Contracting States in a tax treaty opt for making such amendments th....
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....uated 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 (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." 12 Double Taxation Avoidance Agreements are commonly referred as "tax treaties". These bilateral treaties are derived from provisions from standard Model Tax Conventions prepared by the OECD and the UN Committee of Experts, and usually vary significantly from either convention, depending upon the preferences of the sovereign Contracting States. 13 Developed countries, being exporters of capital and technology, favour greater taxing rights for the country of residence, resulting in a bias favouring them. The UN Model Tax Convention was therefore developed for tax treaties between developed and developing countries, which reduces this tilt to some extent. 14 Article 12 of OECD model tax conv....
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....giance. The necessity of ensuring that taxing rights correspond with such economic allegiance was also emphasized in the BEPS project. The various recommendations made therein, including those in Action 7, are aimed at ensuring that the jurisdiction that has an economic allegiance with the business and thereby contributes to its profits should not be denied the right of taxing such profits by artificial arrangements. 2.3 Summary 27. To sum up, once it has been established that an enterprise satisfies the taxable threshold nexus of business connection under the Act as well as the taxable threshold nexus of PE under the applicable tax treaty, its profits become taxable in India. However, such profits are taxable only to the extent they are attributable under the relevant provisions of the Act as well 15 League of Nations Document E.F.S.73.F.19 Economic and Fiscal Commission, 'Report on Double Taxation' (1923). 16 John Huston & Lee Williams, Permanent Establishments: A planning primer (1993). 17 John Huston & Lee Williams, Permanent Establishments: A planning primer (1993). 14 | Page Report on Profit Attribution to Permanent Establishments as the tax treaty. Artic....
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....ons and dealing wholly independently with the enterprise of which it is a permanent establishment. 3. In the determination of the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purpose 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. 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 laid down in this article. 20The DTAA between India and Egypt was signed on 20.2.1969 and entered into force on 30.9.1969 16 | Page Report on Profit Attribution to Permanent Establishments 5. No profits shall be attributed to a permanent establishment by r....
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....r the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. 21Russo, Raffaele (ed.), The Attribution of Profits to Permanent Establishments: The Taxation of Intra-Company Dealings, Amsterdam (2005): IBFD 17 | Page Report on Profit Attribution to Permanent Establishments 3.In the determination of 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. 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 laid down in this Art....
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....rofits from being diverted from one state to the other. 31. Paragraph 13 of the Commentary on Article 7 in the 1963 Draft Convention also expressly states that Paragraph 3 of Article 7 constitutes a mere clarification of the arm's length principle24 embodied in Paragraph 2 of Article 7. Paragraph 3 of Article 7 provides that general administrative expenses should be allocated to the different parts of an enterprise on the basis of an allocation factor. Here two things emerge -(i) the Commentary specifically refers to the 'arm's length principle' as being embodied in paragraph 2 of Article 725, and (ii) paragraph 3 immediately afterwards comes as a compromise and actual alteration of this principle in application to a PE. Paragraph 4 of Article 7 of the Convention recognizes apportionment of profits as per the customary practice. Paragraphs 22 to 25 of the Commentary on Article 7 further explains that a country may use the method of apportioning the total profits of the enterprise by reference to some formulae. It also gives the three categories of the criterion which can be used as the basis of such an apportionment. These three categories were the receipts of the enterprise, it....
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....s of the enterprise by reference to various formulae. Such a method differs from those envisaged in paragraph 2, since it contemplates not an attribution of profits on a separate enterprise footing, but an apportionment of total profits; and indeed it might produce a result in figures which would differ from that which would be arrived at by a computation based on separate accounts. Paragraph 4 makes it clear that such a method may continue to be employed by a Contracting State if it has been customary in that State to adopt it, even though the figure arrived at may at times differ to some extent from that which would be obtained from separate accounts, provided that the result can be fairly said to be in accordance with the principles contained in the Article. It is emphasized, however, that in general the profits to be attributed to a permanent establishment should be determined by reference to the establishment's accounts if these reflect the real facts. It is considered that a method of allocation which is based on apportioning total profits is generally not as appropriate as a method which has regard only to the activities of the permanent establishment and should be used only....
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....n of the total working capital of the enterprise allocated to each branch or part. It is not, of course, possible to say in vacua that any of these methods is intrinsically more accurate than the others; the appropriateness of any particular method will depend on the circumstances to which it is applied. In some enterprises, such as those providing services or producing proprietary articles with a high profit margin, net profits will depend very much on turnover. For insurance enterprises it may be appropriate to make an apportionment of total profits by reference to premiums received from policy holders in each of the countries concerned. In the case of an enterprise manufacturing goods with a high cost raw material or labour content, profits may be found to be related more closely to expenses. In the case of banking and financial concerns the proportion of total working capital may be the most relevant criterion. It is considered that the general aim of any method involving apportionment of total profits ought to be to produce figures of taxable profit that approximate as closely as possible to the figures that would have been produced on a separate accounts basis, and that it wo....
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.... capital, but also provided guidance on where one of them as the basis for apportionment could be considered preferable to another. 3.1.4 Revision of Article 7 by OECD in 2010 & the AOA 36. This OECD Commentary underwent few changes till Article 7 was modified in 2010 and new commentary was introduced. In 2008, OECD brought out a report on Attribution of Profits to Permanent Establishments. In this report, OECD provided for the 'Authorised OECD Approach' or the AOA as the approach preferred by OECD for attribution of profits to a PE under the new Article 7 in its model tax convention29. Another report on the Attribution of Profits to Permanent Establishments was published by OECD in 2010 which focused on the interpretation and application of the revised and updated Article 7 in the model tax convention and was an amended and revised version of the 2008 report. In both the reports, the AOA was based on the 'separate entity approach', under which a PE is considered hypothetically as being a separate and independent entity from its Head Office (HO), which performs the same or similar functions as that of an independent enterprise under same or similar conditions. However, unlike....
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....cted to make if it was a distinct and separate entity. This would normally be achieved by determining profits in accordance with the applicable principles of accounting, where separate accounts are maintained for the PE, provided the PE functions as a separate entity in a manner that would maximize its own profits as a supposedly separate entity. Commentators like Klaus Vogel have referred to such determination as "separate accounting" or "direct method". However, substantial differences exist between the pre-revised Article 7 as it existed in the OECD model tax convention and the UN model tax convention even in the application of this direct method for determination of taxable profits31. 3.2 Differences between Article 7 in the pre-2010 OECD Model Tax Convention and the UN Model Tax Convention 39. Article 7 in the UN Model Tax Convention is derived from the pre-2010 version of Article 7 in the OECD model tax convention, with consequent similarities. The differences, however, are also very significant, and consist primarily in the form of 'force of attraction32' rule in paragraph 1 of Article 7 and the 'limitation of deductible expenses' in paragraph 3 of the UN Model tax con....
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....profits are derived. It also highlights the basic difference between the nature and purpose of Article 5 and 7, of which the former provides an essential nexus threshold of PE that must be satisfied for taxing any profits of the enterprise of the other Contracting State, but once such threshold is achieved, then by application of force of attraction rules, profits attributable to the PE and taxable in the jurisdiction includes profits from the same or similar business even if such business activities were not carried out or effectively connected with the PE. 42. The other significant difference between Article 7 of UN model tax convention and the pre-2010 Article 7 of OECD model tax convention is in the restriction of certain deductible expenses laid down in paragraph 3. The UN model provision restricts the deductibility of expenses like royalties, fees, commission or interest, while also prohibiting the taxation of any receipts of the PE from the head office on their account. The restriction of the deductibility of these expenses is in line with the economic reality of the business, since these payments are not operational expenses and actually represent a sunk cost for assets ....
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....of the markets and the demand side factors to profitability of a foreign enterprise. By attributing profits only on the basis of FAR, representing supply side factors, and excluding sales from the equation, the contribution of market jurisdictions to the profits derived by an enterprise from that jurisdiction stand completely ignored. 46. The other extremely significant change introduced by this revision was to omit the option of determining attributable profits by way of apportionment, as may be permissible under the domestic laws. This option, which existed in the paragraph 4 of the Article 7 of the model tax conventions till then, was omitted from the revised Article 7 of the OECD model tax convention. The practical significance of this change was that even in cases where accounts were not available or where they were not accurate, the determination of attributable profits was to be done by taking into account function, assets and risks, and more importantly, without taking sales into account.33 33 Unlike statement of accounts, which begins by taking sales or receipts into account, determination of attributable profits in the absence of any accounts by relying only on func....
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.... or 'corporate tax', the tax base consists of profits of the enterprise, which are determined by following the applicable laws and prevailing accounting standards. In economic theory there are two types of profits - economic profits and financial or accounting profits. Almost invariably, it is the financial profits, as determined from the accounts of the business that are subjected to tax under the tax laws governing taxation of income. Accounting profit is calculated according to the generally accepted accounting principles or accounting standards. In simple terms, such profit is a company's total revenue or sales receipts reduced by the explicit costs of producing goods or providing services. These explicit costs involve direct monetary movement and include expenses such as the cost of raw materials, employee wages, transportation, rent and interest on capital. Usually, accounting profit is limited to a particular time period, such as a fiscal quarter or year. Accounting profit computations are undertaken for the purpose of reviewing the financial outcomes of business and determination of profits, not only for the purpose of taxation, but also for the purpose of determining accum....
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....e report of four economists whose report to the League of Nations is considered as the conceptual basis for international taxation regime till date: "The oranges upon the trees in California are not acquired wealth until they are picked, and not even at that stage until they are packed, and not even at that stage until they are transported to the place where demand exists and until they are put where the consumer can use them. These stages, up to the point where wealth reaches fruition, may be shared in by different territorial authorities."35 This famous example only elaborates a simple principle that is always recognized by all businessmen, that it is the market and the demand for consumption that dictates production and not vice versa. In other words, profits are created by sales and not by inventories. Since it goes without saying, production is an equally essential element to business and no profits can be generated without production36, it becomes clear that both production and sales are essential for the generation of profits. It also means that neither can be ignored for the purpose of determining the profits that would be taxable in a jurisdiction. 4.2 The Concept....
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....valuation of the good or service, and the marginal production cost. If the average consumer's willingness to pay, reflecting the true value of the good or service, exceeds the market price, there is profit and welfare increases. So supply without demand cannot produce 'value'. The significance of demand in the determination can also be understood by the fact that when the consumers have a greater ability to pay, consequent to the rise of disposable resources available with them, they are willing to pay more for the same good, and this willingness or the ability to pay more for the same goods increases the value of that good in the market, as objectively measured in terms of price. Thus, we can observe similar goods having different prices (denoting different values) in different economies - a phenomenon that is captured economically in the form of differences in "Purchasing Power Parity".37 55. As far as the intrinsic theory of value is concerned, it may be useful to take into account that the price volatility of goods, which is often observed in case of changes in supply shocks, does not allow such intrinsic value to be equated with price. The price can never exceed this suppos....
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....sumers, as reflected by their per capita income. The income of the consumers is in turn dependent upon the general state of economy and its maintenance by the overall resources of the economy, including those financed by public funds. Any rise in demand leads to a rise in both price as well as quantum of sales, and thereby contributes to an increase in profits of businesses. The same is also true in respect of a non resident enterprise that is participating in that economy and earning sales revenue therein. 58. Value addition is an essential ingredient for production and supply, since no consumer will ever be willing to pay anything for a good unless it is supplied to him. The cost of adding value is important, since a reduction in costs leads to higher profits for the enterprise. Where the demand is taken as given for a quality of product, the addition of higher value within the supply chain for the same cost is equivalent to a fall in costs of value addition. Such improvements in supply amount to a reduction in marginal costs and result in the downward shifting of supply curve in a partial equilibrium model. In a perfectly competitive market, this would have the effect of fall....
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....ular country is allowed to tax the profits of an enterprise, it is necessary to have rules for the determination of the relevant share of the profits that will be subjected to taxation. Profit attribution rules perform this function. The different approaches to profit attribution can be considered to be a spectrum with the supply side approach being at one end and the demand side approach being at the other end. However, it is important to note that the tax treaties prescribe only certain broad methodologies within which it is open for a Contracting State to apply its domestic laws, such as those relating to accounting standards, deductible expenses, deduction for sunk costs like depreciation as well as rules for apportionment, wherever permissible under the treaties. 5.2 Approaches for Profit Attribution 62. The Article 7 of the OECD Model Tax Convention and the AOA recommended by OECD is based on a purely supply side approach towards profit attribution38, which attempts to completely neglect the role of demand in contributing to profits. The OECD approach seeks to allocate taxing rights to the origin jurisdiction as income is equated with the product of the employed product....
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....the 'remote seller' and the 'e-tailer' would be taxed solely in the countries where they sell their goods and the location of production is neglected for tax allocation purposes. 66. Conceptually, to discover the destination of income, for nexus establishment purposes, reference is essentially made only to the location of the customer under the demand approach, which, for instance, is essentially the case under sales only formulary apportionment mechanisms41. This approach has recently become popular in the United States, where many States have increased the attribution of sales in a three factor formula to 90% or even 100%. 42 The original approach taken by the US States takes into account the demand based approach along with contribution of assets and manpower, representing supply, in a 3 factor formulary apportionment. 5.3 The Common Approaches in International Practices 67 Goods and services do not only need to be produced but they should be sold as well. Conversely, in order to be able to sell goods and services, they need to be produced first. Income generation requires both the supply and the sales. No income or profit can be generated when either supply or demand i....
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....etermined fixed formula reflecting both supply-side factors (payroll, assets) and demand-side factors (sales at destination). Formulary systems typically seek to divide tax entitlements between both the origin and the destination states by attributing parts of the profit to both the jurisdictions of production and utility. The allocation keys adopted for this purpose aim at approximating the geographic location of income by reference to some apportionment factors. Typically, these factors are payroll and assets at origin to reflect the 43 Michael P. Devereux, 'Taxation of outbound direct investment: economic principles and tax policy considerations', Oxford Review of Economic Policy 698 (2008), Ana Agundez-Garcia, 'Taxation Papers; The Delineation and Apportionment of an EU Consolidated Tax Base For Multi-Jurisdictional Corporate Income Taxation: A Review of Issues and Options', European Commission Directorate-General Taxation & Customs Union Working Paper 2006 44 Peggy B. Musgrave, 'Principles for Dividing the State Corporate Tax Base', in Charles E. McLure, Jr. (ed.), The State Corporation Income Tax: Issues in Worldwide Unitary Combination (1984) 45 The traditional 'Mas....
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....120-121 (1920)] addressing the propriety of the formulary apportionment method of income attribution, the Court approved the method in broad terms. Initially the formula employed was a single-factor property formula, but States gradually abandoned it for a three- factor formula that averaged the ratios of property, payroll and sales within the state to the totals throughout the business. This produced an equitable and workable division of the corporate net income among the states and by 1978, forty-three of the forty-five states (as well as the District of Columbia) that imposed corporate income taxes were using this equally 47Maarten Floris de Wilde, 'Sharing the Pie'; Taxing Multinationals in a Global Market (2015). 48G.T. Altman & F.M. Keesling, Allocation of Income in State Taxation (2d ed. 1950), 38. 49 J.R. Hellerstein, W. Hellerstein and J.A. Swain, State Taxation (2017 rev.), paras. 8.03 - 8.06, which describes the historical development of the USA states' taxation of corporate income in detail. 35 | Page Report on Profit Attribution to Permanent Establishments weighted three-factor formula.50 However, this underwent a change when in 1978, the US Supreme C....
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.... Minnesota Sales 24 Mississippi Sales/Other 25 Missouri 3 factor 26 Montana 3 factor 27 Nebraska Sales 28 Nevada No state income tax 29 New Hampshire Double weightedsales 30 New Jersey Sales 31 New Mexico 80% sales, 10% prop/payroll 32 New York Sales 33 North Carolina Quadruple weighted sales 34 North Dakota 3 factor 35 Ohio No state income tax 36 Oklahoma 3 factor 37 Oregon Sales 38 Pennsylvania Sales 39 Rhode Island Sales 40 South Carolina Sales 41 South Dakota No state income tax 42 Tennessee Triple weighted sales 43 Texas Sales 44 Utah Sales 45 Vermont Double weighted sales 46 Virginia Double weighted sales/Sales 47 Washington No state income tax 48 West Virginia Double weighted sales 37 | Page Report on Profit Attribution to Permanent Establishments 49 Wisconsin Sales 50 Wyoming No state income tax 51 District of Columbia Sales From this, it can be observed that US domestic laws accepts sales, even in the absence of any other function, asset or risk, as sufficient factor for attributing at least 33.3% of the profits derived from those sales, and also permits US States to attribute a hi....
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....es. The proceeds of trade tax are apportioned among the municipalities, which derive their taxing rights from higher levels of government. 5.5 The European Proposal for CCCTB 77. The European Commission with its Action Plan for a Fairer and Efficient Corporate Tax System,55relaunched its 2011 idea of a Common Consolidated Corporate Tax Base (CCCTB) in a two-step approach, with the publication on 25 October 2016 of two new interconnected proposals, for a common corporate tax base (CCTB), and for a common consolidated corporate tax base (CCCTB). The CCCTB promises a harmonized set of rules to determine the tax base, the consolidation of taxable profits at the EU level and formula-based apportionment. A comprehensive proposal has been placed before the European Council for issuing a Directive in which the profits derived from within Europe are attributed to different tax jurisdictions within EU on the basis of a simple formula, wherein one third profits are attributed on the basis of sales, one third on the basis of manpower and wages (one sixth on the basis of wages, and one sixth on the basis of number of personnel), and one third on the basis of the assets. 78. The rationa....
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....total costs and expenses / (1-deemed profit rate) x deemed profit rate Expenditure Plus Method Where the taxpayer can accurately calculate its total expenditure but cannot accurately calculate its total revenue or costs Taxable income = total expenses / (1-deemed profit rate - business tax rate) x deemed profit rate Deemed profit rates Business Deemed Profit Rate Provision of engineering work, design and consulting services 15% - 30% Provision of management services 30% - 50% Provision of other services or business activities other than services No less than 15% If the tax authorities have evidence to support the case that a Non-TRE's actual profit rate is obviously higher than the above, a deemed profit rate higher than the high end of the range can be used to calculate the taxable income of the Non-TRE. 80. The deemed profit method can be considered as an exercise where an enterprise is deemed to generate certain profits for the purpose of taxation and is taxed on them, either on the basis of revenue or on the basis of costs, depending on which can be more objectively determined. In practice, it seems likely that enterprises that are only selling in China ....
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....experts on the issue of profit attribution. While some plainly take the OECD guidance for granted without putting it to any critical analysis, there are other experts and academicians who have been critical of the OECD approach of applying transfer pricing methods for profit attribution. Further, some highly renowned academicians and experts have endorsed the view that demand side factors, as represented by sales, are a valid basis for attribution of profits. 6.1 Views expressed by Prof. Klaus Vogel on Relevance of Sales 84. Klaus Vogel, who is considered an authority on international taxation, explains that sales are a valid basis for attributing profits. According to Vogel, it "cannot convincingly be denied that providing a market contributes to the sales income at least to same extent as providing the goods does. There is no valid objection, therefore, against a claim of the sale state to tax part of the sales income."57 This view of Klaus Vogel is frequently quoted by various academicians and authors and does not appear to have been rebutted in literature. It indicates that profit attribution on the basis of sales (as practiced in US and proposed in EU) is accepted as jus....
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....ain inter-nation equity.60 87. Richard and Peggy Musgrave, have suggested taxation of "residual profits" (profits that are derived from the synergies created by units of the same multinational group of enterprises in different jurisdictions) in both the source as well as the resident country, and not in the resident country alone, on the ground of greater inter-nation equity. As pointed out by them and others, the principle of inter-nation equity demands "common source rules employing consistent methods of unitary combination and uniform formulary apportionment."61 6.3 Views of Prof. Joseph Stiglitz & Other Contemporary Experts 88. Prof Joseph Stiglitz, a Nobel Laureate, who has also been the Economic Advisor to the US President and a Senior Advisor in World Bank, also endorses apportionment of profits on the basis of demand and supply side factors, as being preferable to the OECD approach of attributing profits on the basis of supply side factors (FAR) alone. 59Peggy B. Musgrave, 'Principles for Dividing the State Corporate Tax Base', in Charles E. McLure, Jr. (ed.), The State Corporation Income Tax: Issues in Worldwide Unitary Combination (1984) 60 Peggy B. Musgrav....
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....pling of profits from investment locations and linking profits to points of sale will be a solution to the problem of tax competition and promote global tax neutrality. 91. Several authors, in particular those affiliated to Tax Justice Network have repeatedly and consistently advocated adoption of global formulary apportionment system for attributing profits on the basis of both demand and supply side factors. Stjepan Gadžo from University of Rijeka, Faculty of Law in his doctoral thesis on Nexus Requirements for Taxation for Non- Residents66 has argued that strongest support for link of income source with the market state 62Reuven S.Avi-Yonah, Between Formulary Apportionment and the OECD Guidelines: A Proposal for Reconciliation; Law & Economics Working Papers, 2009, University of Michigan Law School 63 Reuven S.Avi-Yonah, "Formulary Apportionment and International Tax Rules." In Taxing Multinational Enterprises as Unitary Firms, edited by S. Picciotto, 67-74. Brighton, UK: Institute of Development Studies, 2017. 64 Bausch & Lomb Inc. v. C.I.R., 933 F.2d 1084. B and L developed an unpatented technology that enabled it to manufacture contact lenses at a cost of $2.50....
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....t to price. He gives the example of the production of the movie Star Wars: The Force Awakens to make his point. The movie used intellectual property (IP) located in the United States; actors from the United Kingdom and the United States; special effects developed in San Francisco, Singapore, London, and Vancouver; was shot in the UAE, the U.K., Iceland, and Ireland; and tickets for the movie were sold throughout the world. The question is: how much profit is to be attributed to each jurisdiction? If the traditional concept of the profit attribution to PE is applied in the above example, many countries may not get its share from the ticket sales even if the movie had record-breaking ticket sales in those countries. He advocates a destination based tax system because its base would be much easier to define than our current corporate tax base. Another key argument against the use of FAR for profit attribution in International tax literature is that it would be inappropriate for allocating business profits to PEs, particularly to PEs of highly integrated international enterprises since it does not reflect business reality, i.e. it does not recognize an international enterprise as an un....
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....onomy, leading to greater profits for the enterprises, thereby putting in place a virtuous cycle that leads to a win-win situation for all stakeholders. 94. In case of a cross-border enterprise, where demand and supply are spread across two different jurisdictions, this virtuous cycle can be maintained only by a just and fair allocation of taxing rights to both states in a manner that does not lead to double tax burden. Tax paid in the jurisdiction where supply chain is located facilitate reduction of costs and make supply more efficient, whereas tax paid in the jurisdiction which contributes the demand would facilitate in promoting economic development there and consequential rise in demand, thereby leading to a virtuous cycle wherein all stakeholders continue to gain. 7.2 How Pure Supply Approach may Impact the Virtuous Cycle 95. In case of a cross-border enterprise, where demand and supply are spread across two different jurisdictions, if the taxing rights are restricted only to the country where the supply chain is located (as advocated by OECD approach), the market country would lose tax revenue, and will need to recover it from the local enterprises, thereby putting ....
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....f developing countries (source countries), and hence, has not been accepted. 98. India has a consistent policy of adopting Article 7 on profit attribution in its tax treaties on the basis of the UN Model, which provides for balanced rights for source based taxation. India had made reservations against the pre-2010 Article 7 of OECD Model Tax Convention regarding the deduction of expenses only in accordance with its domestic laws, which have been documented in OECD Model in the section on 'Positions of Non-OECD Economies' since 2008. 99. India has made even stronger reservations against the revised Article 7, which have also been documented in the same section since 2010, as under: 1.1 India reserves the right to use the previous version of Article 7, i.e. the version that was included in the Model Tax Convention immediately before the 2010 update, subject to its positions on that previous version (see annex below). It does not agree with the approach to the attribution of profits to permanent establishments in general that is reflected in the revised Article, in its Commentary and in 69 C. Guti'errez Puente, Chapter 12: The UN Model and the BRICS Countries - Another Vie....
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....mic Co-operation and Development (OECD) was formed in 1960 by way of a 'Convention on the Organisation for Economic Co-operation and Development'. This Convention entered into force in 1961 after being signed by twenty states in 1960. 71 Article 1 of OECD Convention 1960 is as under: Article 1 The aims of the Organisation for Economic Co-operation and Development (hereinafter called the "Organisation") shall be to promote policies designed: (a) to achieve the highest sustainable economic growth and employment and a rising standard of living in Member countries, while maintaining financial stability, and thus to contribute to the development of the world economy; (b) to contribute to sound economic expansion in Member as well as non-member countries in the process of economic development; and (c) to contribute to the expansion of world trade on a multilateral, non-discriminatory basis in accordance with international obligations. 72The VCLT is a treaty concerning the international law on treaties between states. It was adopted on 23 May 1969 and opened for signature on 23 May 1969. The Convention entered into force on 27 January 1980. India is not a signatory to this ....
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....rom this equation that affect profits, 'costs' are completely dependent on supply side factors, but 'price' and 'quantity of sales' result from the 73 Para 45 of the Report states that "It should be noted that many tax treaties contain a version of Article 7 that does not require the use of the AOA. In cases governed by those treaties, the method of attributing profits to a PE for the purpose of Article 7 of the applicable treaty might differ significantly from the AOA. This might be a function of the interrelation between the treaty and the domestic law of the jurisdiction where the PE is located (e.g., if the treaty expressly permitted the use of a customary domestic law apportionment approach, and domestic law contained such an approach). In other cases, the treaty might expressly prohibit the recognition of notional dealings between the PE and the non-resident enterprise of which it is a part (e.g., treaties with a version of Article 7 based on the United Nations Model Double Taxation Convention between Developed and Developing Countries). Therefore, the examples below should not be understood as representing the only appropriate approach to attributing profits to a PE" 5....
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....n is also independent from marketing functions, which only modify preferences without contributing in any way to the disposable income or the ability of consumers to pay for the goods. Thus, the 74In a Transfer Pricing, profits as well as the consumer demand contributing to it are assumed as given since the issue at hand is limited to apportioning value addition among different parts of the supply chain. In such an exercise, the profits and demand can be assumed to be static under a ceteris paribus assumption required for the limited purpose of dividing value addition within the different parts of the supply chain. However, in an exercise aimed at attribution of profits, profit is a variable, as are the factors contributing to it like demand and supply. Thus, relying exclusively on FAR in an exercise for the purpose of profit attribution changes this underlying assumption of a given demand under the ceteris paribus assumption to a radical presumption that demand is not relevant for generation of profits. Given the fact that profit is a difference between price and cost and price depends upon demand, a presumption that demand is not relevant for profits would be little more than ....
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....red as separate and distinct entity, it is to be expected that such an independent entity will seek a share in additional profits or synergy rents. Synergy rents are not captured in the FAR analysis, which erroneously assigns all residual 75 "Among the different views, some countries specifically consider that corporate profits represent the excess of sales revenue (price multiplied by quantum of sales) over the costs of their supply and are a function of both demand and supply. Therefore, according to these countries, value created within the supply chain, representing the contribution of supply side, must be taken into account with the contribution of the demand for determining corporate profits attributable in a tax jurisdiction." 52 | Page Report on Profit Attribution to Permanent Establishments profits76 to the resident country where MNE is situated, and thereby denies the market jurisdiction their fair share of taxes on those profits. 107. In the context of taxation of digital economy, there is a discussion going on that these residual profits can be allocated to reward the user created value to solve the problem of profit allocation to user jurisdictions. In i....
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....urn. 77HM Treasury 2018, Corporate tax and the digital economy: position paper update available at https://www.gov.uk/government/consultations/corporate-tax-and-the-digital-economy-position-paper. 78 Australian Government Treasury Discussion Paper 2018, The Digital economy and Australia's corporate tax system, M Herzfeld 2018, 'News Analysis: Digital Optimism', Tax Analysts, 16 July 2018, p 5, referring to P Oosterhuis and A Parsons, 'Destination-Based Income Taxation: Neither Principled Nor Practical?', Tax Law Review (forthcoming). 53 | Page Report on Profit Attribution to Permanent Establishments the economic theory, its application for determination of profits does not appear to be based on any logical economic principle. 7.5 Committee's Observations 109. The Committee observes that the AOA approach restricts the taxing rights of the jurisdiction that contributes to business profits by facilitating demand, and thereby has the potential to break the virtuous cycle of taxation that benefits all stakeholders in the global economy. Instead, it can set a vicious cycle in place that is destined to lead to losses for all stakeholders. Thus, while AOA approach may be ....
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....able and on a rational basis. The Courts have also held that any finding on the question of profit attribution will involve some guesswork and the endeavour can only be to approximate and there cannot be great precision and exactness. The profit attribution has ranged from 0% in the case of SET Satellite to 75% in the case of Ansaldo Energia SPA involving EPC contract. Some of the cases are discussed for illustrative purposes to highlight the different approaches adopted under different cases. 8.2 Earliest Case laws prior to Pre-Independence Era 113. One of the earliest decision of the Supreme Court related to profit attribution was in the case of Anglo French Textile Company Limited v. CIT [23 ITR 101 (SC)] dating to the year 1952. It was a non-resident company manufacturing textile in India and as part of its business, bought cotton from, and sold textiles in British India (being the taxable territory) and partly outside British India. The entire profits from outside of British India were being received in British India. The issue before the court was whether income received in British India could be said to wholly arise in India and whether allocation based on business ope....
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....ount of sales made by the taxpayer whether made directly or through a branch in India. 116. In Nortel Networks India International Inc. [TS-355-ITAT-2014(DEL)] the Tribunal held the non-resident entity having a fixed PE and a DAPE as the hardware supplied by the non- resident was installed by the Indian subsidiary and contracts were pre-negotiated by it. The Tribunal upheld the profit attribution of 50% of profits of activities of the PE in India by applying rule 10 in view of the non-availability of India centric accounts. 117. In GE Energy Parts Inc. Vs ADIT [TS-34-ITAT-2017(DEL)]the Tribunal upheld AO's calculation for determination of total profit from the sales made by GE overseas entities in India at 10% of sales applying rule 10(iii). For marketing activities, it restricted attribution to 26% as against 35% considered by AO. The Delhi High Court has also upheld the findings and the approach of the Tribunal regarding the attributability of income. 118. In the case of ZTE Corporation vs ADIT [(2016) 159 ITD 696 (Del)] the Tribunal held that almost entire sales function, including marketing, banking, after sales, were carried out by the PE in India and therefore 35% of....
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.... income accruing/arising in India and further, Galileo US may deduct remuneration paid to distributors. The same attribution ratio was followed in the cases of Amadeus Global Travel Distribution SA and Abacus International Pvt. Ltd, Singapore. It was held that though no guidelines were available as to how much should be income reasonably attributable to the operations carried out in India, the same had to be determined on the factual situation prevailing in each case and for that one has to look into the factors like functions performed, assets owned and risk undertaken by the PE in India vis-a-vis the taxpayer. 121. In CIT v Hyundai Heavy Industries Co Ltd [(2007) 291 ITR 482 (SC)] the apex court held that revenue and costs attributable to the installation activities of a PE in India have to be determined based on generally acceptable principles of accountancy. In this case the PE did not maintain books of accounts; and the foreign enterprise itself pleaded during assessment that Section 44BB of the IT Act read with CBDT Instruction 1767 should be applied while determining profits of PE, Therefore, Court held that the profit attributable to installation, commissioning activitie....
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....ia by the Tribunal. It also approved the reasoning given by the Tribunal that the profit attributed to manufacturing activity and R&D activities i. e. 50 per cent and 15 per cent respectively which were carried out outside India were not to be taxed in India. 125. In Linmark International (Hong Kong) Ltd v DDIT (2011) [TS-5853-ITAT-2010(DELHI)- O]the non-resident was a company incorporated in and a resident of Hong Kong and under service agreement with Linmark Development (BVI) Ltd. (BVI Co), a company incorporated in the British Virgin Islands was engaged to provide facilitation services in connection with buying of goods from various countries in Asia. It had set up LOs in India which acted as a coordinating agency. BVI Co received commission from its buyers, calculated on a fixed percentage of the value of the goods exported to its clients outside India; typically, in the range of 5-6% for its 58 | Page Report on Profit Attribution to Permanent Establishments services and the taxpayer was remunerated at 1% of the value of the goods. As a result of the information gathered during survey it was established that the BVI Co was a non-functional entity and did not play an....
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....at CISPL constituted CMG's PE. The AO had adopted headcount as basis for allocating revenue and expenses. The Tribunal rejected the approach and used customer revenue as a base to which the global operating income percentage was applied. 59 | Page Report on Profit Attribution to Permanent Establishments · Step 1- Compute global operating income/profit percentage of a particular line of business as per annual report of the US Co . Step 2- This percentage should be applied to the end customer revenues with regard to the contracts/projects where services are procured from Ind co. The amount arrived at is the operating income/profits from the Indian operations . Step 3-Operating income/profits from the Indian operations is to be reduced by the profit before tax of Indian Co. This residual profit which represents income of the taxpayer is to be apportioned between Head Office and PE of the taxpayer . Step 4- Profit attributable to PE should be estimated on residual basis . The residual profits were attributed to PE at the rate of 15% 128. In Formula One World Championship Limited (FOWC) case [394 ITR 80 (SC)], the Supreme Court held FOWC as having a fixed plac....
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....sident company rendered repair and maintenance services and supplied spares to customers in India. While the income from repairs was offered to tax as FTS, the income from supply of spares was claimed to be not taxable on the ground that it had accrued outside India. The AO, CIT(A) and Tribunal took the view that the non-resident had DAPE in India and income earned from supplying spare parts was taxable in India. The AO held that 25% of the profits on sales of spare parts were chargeable to tax which was reduced to 10% by the CIT (A) & the Tribunal. The attribution of 10% was upheld by the Delhi High Court. The High Court observed that If all the risk taking functions of the enterprise have not been taken into account, there would be a need to attribute profits to the PE for those functions/risks of the dependent agent that have not been considered. 131. In Hyundai Rotem Company vs ADIT [TS-612-ITAT-2012(Delhi)], a project office of Hyundai Rotem Company (Korea) provided liaisoning, coordination and administrative support services to its head office on a cost plus basis. The AO did not accept the cost plus methodology and instead determined the income attributable on the basis o....
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....s to be a case for providing a simple and universally applicable rule to bring in greater certainty and predictability among the stakeholders and prevent avoidable tax litigation on this account. 62 | Page Report on Profit Attribution to Permanent Establishments Section 9 Need for Clarity in India's Approach on PE Attribution: Various Options for a More Specific Rules 9.1 Need for Greater Clarity and Objectivity 135. India's position in disagreeing with the revised Article 7, AOA and attribution of profits has been documented very clearly ever since the inception of this revision. The reasons for India's disagreement have also been consistently communicated and shared with other countries, as well as during the BEPS project and the follow up work on Action 7. Thus, India's position in this regard is very clear. Further, since India has not included the revised Article 7 in any of its tax treaties, there cannot possibly be any doubts on the fact that Indian tax treaties allow attribution of profits in a way that is different from the AOA, by resorting to the direct accounting method under Article 7 (2) and where that may not be possible, by apportionment of profits....
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....e relied upon for determining the profits attributable to the PE, the profits derived from such accounts will be the profits attributable to the PE, as permitted under paragraph 2 of Article 7 of tax treaties, which permits attribution of profits on the basis of the direct accounting method, treating PE as a distinct and separate entity. All applicable provisions of the Act for computing income under the head 'profits and gains of business or profession' will apply for this purpose. Certain payments or notional payments made by the PE to head office that may not be deductible under the provisions of paragraph 3 of Article 780 as well as section 44C of the Act shall not be deductible for this purpose. Where profits can be reasonably attributed in this way to the PE, the same completes the process, and paragraph 4 of Article 7 or Rule 10 of the Rules need not be invoked. 140. However, where separate accounts of PE are either not maintained or cannot be relied upon for determination of profits attributable to the PE, it is permissible under paragraph 4 of Article 7 of the tax treaty for the Assessing Officer to resort to attribution of profits by way of apportionment. In the Indian....
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....h Assessing Officer has held the non- resident taxpayer has a PE and how the profit was attributed in such cases 142. From the analysis of the data received from the major centers, including Mumbai, Chennai, Hyderabad, Bangalore, Kolkata, Ahmedabad and Delhi, it was observed that there is little uniformity among the Assessing Officers in the manner of methods for profit attribution and application of rule 10. The results of this analysis reaffirm that the wide scope of discretion in respect of application of methods under rule 10 prevents any uniform approach regarding attribution of profits from coming into existence, and this may be resulting in concerns about lack of clarity and objectivity among stakeholders. This lack of a uniform and consistent approach may also be a major factor contributing to tax disputes and litigation, with resultant locked revenue and avoidable costs of litigation. 143. After taking into account the details elaborated in the preceding sections and the analysis referred above, the Committee unanimously arrived at a view that there is a need to consider possible options that can be adopted as a simple, uniform and consistent method of profit attribu....
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....46. One of the most talked about options for attributing profits on the basis of apportionment consists of formulary apportionment using a three factor formula, which in addition to sales, also takes into accounts manpower or wages or payroll denoting human activities as the second factor and assets or property as the third factor. This approach is largely the one which is adopted in a formulary apportionment by US, and is also proposed to be adopted by EU, apart from being advocated by a large group of academicians, experts and NGOs, including the Tax Justice Network. 147. However, such formulary apportionment requires availability of complete information about the country wise sales revenue as well as the deployment of manpower and assets, which 66 | Page Report on Profit Attribution to Permanent Establishments is not easily available. Although under the recently agreed norms of Country-by-Country (CbC) reporting, relevant information is to be shared about MNEs whose turnover exceeds the threshold limit set for CbC reporting (750 Million Euros) but for the MNEs with smaller turnover, this information will still not be available, even under CbCR. Further, it is not ful....
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.... By allocating one third to sales and two third to supply side, it accommodates the role of marketing activities, which would be represented by manpower and assets. Thus, it equitably distributes taxing rights between demand and supply jurisdictions. . This method uses a three factor formula which has a long precedence in international practices, and is also proposed in recent times by European Union. . The method is relatively simple and thereby avoids the more complicated methods often resorted to in Indian cases that often become a subject matter of disputes and litigation. . As it is based primarily on business operations in India, it avoids the need for extensive country by country information that may be required for consolidation of profits of the enterprise. 9.6 An Option for Attribution on the basis of Demand & Supply 152. The Committee also explored the option for attribution of profits on the basis of supply side factors by resorting to Functions, Assets and Risks (FAR) as advocated by OECD in AOA, along with demand side factors represented by Sales. The members were of the view that this option can have application in case of a PE that comes into existenc....
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....ty. Further, once its transactions with its associated enterprises are subjected to 'arms' length price' determination under section 92C of the Act by way of FAR analysis, they can be considered as appropriate representation of the profits contributed by supply side factors in India. 154. Accordingly, where the profits of Indian subsidiary are arrived at after the function, asset, risk analysis and are subjected to tax in India, they can be taken as the Indian profits contributed by the supply side, and no further attribution to the PE may be required in respect of supply side factors. In such cases, the attribution of profits to the PE would then be required only in respect of the contribution of the demand side factors. Following the consistent approach of allocating one third profits on the basis of sales, as in the case of US, EU and proposals advocated by various academicians, the Committee was of the view that the weightage of attribution on the basis of sales can be kept at 33%. It is felt that this would adequately represent the contribution of demand side factors in India that contribute to profits of foreign enterprise from doing business in India, and can be considere....
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....n India will invariably be attributable to the PE on the basis of sales. Thus, in case of a PE deriving profits from sales in India, where no part of these profits have been taxed in the hands of any Indian entity, the profits attributable to such PE would need to be determined by the Assessing Officer, but may not be less than 33% of Indian profits if no profit is to be attributed to India on account of factors other than sales. 159. The profits derived from India would need to be defined for the purpose of clarity. In the absence of separate accounts of Indian operations, an option that is also frequently practiced and sustained by the Courts in several cases as discussed earlier, could be to determine such profits by applying the global profit margin82 on the Revenue generated from customers within India, as under: Profits derived from India = Revenue derived from India83 x Global operational profit margin84 160. However, this leads to a possibility that where the global operations are resulting in operational losses, there may be no profits under this rule, even when Indian operations may be profitable. This is a concern that may need to be addressed by a specific rule....
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....the Companies Act 2013 and therefore, the modified rule will be used only in those situations where there are no India centric financial statements or where the books of account have been rejected under the appropriate provisions of the Act or where for some specific reason that is recorded by the AO, the accounts do not adequately reflect the profits that can be attributable to the PE as an independent and separate entity.86 163. In practice, this method can be applied in the following steps: (i) By determining the profits derived from Indian operations of the enterprise. Where the enterprises is incurring global losses, or its global operational profit margin is less than 2%, the profits derived from India will be taken at 2% of the revenue or turnover derived from India. (ii) By apportioning the profits from Indian operations of the enterprise to the PE on the basis of the three factors of sales (33% weight) and manpower and assets (together 67% weight). (iii) By deducting any profits from Indian operations of the enterprise, any profits that may have already been taxed in India (for instance, in the hands of an Indian subsidiary which gives rise to the PE of the ent....
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....ell as an Indian subsidiary participating in the integrated business, the Committee arrived at a view that profits derived from Indian operations that have already been subjected to tax in India should be deducted from the apportioned profits. The Committee observed that in a case where no sales takes place in India, and the profits that can be apportioned to the supply activities have already been taxed in the hands of an Indian subsidiary, no further taxes would need to be paid by the PE. 168. The Committee observes that the profits derived from India need to be defined objectively, and considers that the same can be arrived at by multiplying the revenue derived from India with the global operational profit margin. However, acknowledging the contribution of market jurisdictions, where the enterprise is having global losses or where its global operational profit margin is less than 2%, the same can be arrived at by deeming the global operational profit margin to be 2%. 72 | Page Report on Profit Attribution to Permanent Establishments Section 10 Profit Attribution in Significant Economic Presence Nexus 10.1 Taxable Nexus based on Significant Economic Presence ....
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....ictions to undertake activities on the digital platform provided by 73 | Page Report on Profit Attribution to Permanent Establishments these enterprises, on which these individuals, often referred to as "users" undertake activities that lead to value creation and profits for the digital enterprises87. 173. It is also significant to note that in all cases of an activity ascribed to an enterprise that is carried out by an individual, such individual carries out the activity (that leads to creation of value and profits for the enterprise) primarily for its own benefit which may be available to her as salary, fees, contractual payments, rights or other non-financial valuables. Given this analogy, the so called 'users' whose activities create value and profits for the enterprises, without being directly remunerated financially, may not be very different from the other individuals like employees, contractual workers or vendors and accordingly, the activities carried out by 'users' need to be treated at par with the activities carried out by such other individuals. 174. Thus, it is apparent that user data and user participation contribute to value and profits for the busine....
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....thout mass are also important (e.g., cloud computing). The categorisation is represented in the figure below89: High User Participation Intensity Low E-commerce .Collaborative Social networks consumption Manufacturing - Cloud computing - E-commerce (tangible goods) (intangible goods) 10.3 Committee's Observations 176. The Committee, after detailed deliberation, considered the various aspects of users' contribution in the digital economy and also the fact that the role of user has blurred the traditional demand and supply functions. Taking these factors into consideration, the Committee arrived at a unanimous view that user contribution can be a substitute to either assets or employees, and supplement their role in contributing to profits of the enterprise. However, putting users together with either manpower or assets can pose significant challenges in distributing their respective shares within the assigned weight for their category (i.e. 33% for manpower or 33% for assets). Accordingly, the Committee found it reasonable that for business models in which users contribute significantly to the profits of the enterprise, they should also be taken into ac....
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....fies the threshold condition of having a business connection in India, in which case, profits that are derived from India from its various operations including production and sales are taxable in India, either on the basis of the accounts of its business in India or where they cannot be accurately derived from its accounts, by application of rule 10, which provides a wide discretion to the Assessing Officer. Where a tax treaty entered by the Central government is applicable, its provisions also need to be satisfied for such taxation. As per Article 7 of UN model tax convention (which is usually followed in most Indian tax treaties, sometimes with variations), only those profits of an enterprise can be subjected to tax in India, which are attributed to its PE in India, and would include profits that the PE would be expected to make as a separate and independent entity. Under the force of attraction rules, when applicable, it would include profits from sales of same goods as those sold by the PE that that are derived from India without participation of PE. Profits attributable to PE can be computed either by a direct accounting method provided in paragraph 2 or by an indirect apporti....
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....egate demand, resulting in a vicious cycle, which will adversely affect all stakeholders including the foreign enterprises doing business therein. 184. Broadly, possible approaches for profit attribution can be summed in three categories- (i) supply approach allocates profits exclusively to the jurisdiction where supply chain and activities are located; (ii) demand approach allocates profits exclusively to the market jurisdiction where sales take place; (iii) mixed approach allocates profits partly to the jurisdiction where the consumers are located and partly to the jurisdiction where supply activities are undertaken. 185. The mixed approach appears to have been most commonly adopted in international practices, though in some cases, demand approach has also been favored. In contrast, supply side does not appear to have been adopted anywhere, except in 2010 revision of Article 7 of the OECD model convention, which requires determination of profits without taking sales into account. As a consequence, the contribution of demand to profits is completely ignored. 186. A purview of academic literature and views suggests a wide acceptance in theory that demand, as represented by....
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....of rule 10 for attribution of profits under Indian tax treaties. In several such cases, the right of India to attribute profits by apportionment, as permissible under Indian tax treaties, has also been upheld by the courts. The judicial authorities do not appear to have insisted on a universal and consistent method. They have also upheld the wide discretion in the hands of Assessing Officer under rule 10 of the Rules, but corrected or modified his approach for the purpose of ensuring justice in particular cases. Thus diverse methods of attributing profits by apportionment under rule 10 of the Rules are in existence. In view of the Committee, the lack of a universal rule can give rise to tax uncertainty and unpredictability, as well as tax disputes. Thus, there seems to be a case for providing a uniform rule for apportionment of profits to bring in greater certainty and predictability among taxpayers and avoid resultant tax litigation. 191. A detailed analysis of methods adopted by tax authorities for attributing profits in recent years also highlight similar diversity in the methods adopted by assessing officers for attribution of profits, which reaffirms the need to consider po....
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.... profits that can be apportioned to the supply activities are already taxed in the hands of an Indian subsidiary, there may be no further taxes payable by the enterprise. 195. In this option, in order to ensure objectivity and certainty, profits derived from India need to be defined objectively. The Committee considers that the same can be arrived at by multiplying the revenue derived from India with global operational profit margin91. However, the Committee also noted the need to protect India's revenue interests in cases where an 91 In order to avoid any doubt the global operational profit margin is the EBITDA margin (Earnings before interest, taxes, depreciation and amortization) of a company 80 | Page Report on Profit Attribution to Permanent Establishments enterprise having global losses or a global profit margin of less than 2%, continues with the Indian operations, which could be more profitable than its operations elsewhere. In view of Committee, the continuation of Indian operations justifies the presumption of higher profitability of Indian operations, and in such cases, a deeming provision that deems profits of Indian operations at 2% of revenue or turnove....
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.... business all the operations of which are not carried out in India, the income from such business that is attributable to the operations carried out in India and deemed to accrue or arise in India under clause (i) of sub-section(1) of section 9 81 | Page Report on Profit Attribution to Permanent Establishments of the Act, shall be determined by apportioning the profits derived from India by a three equally weighted factors of sales, employees (manpower & wages) and assets, as under: Profits attributable to operations in India = 'Profits derived from India'92 x [S1/3xST + (N1/6xNT) +(W1/6xWT) + (A)/3xAT)] Where, SI = sales revenue derived by Indian operations from sales in India ST = total sales revenue derived by Indian operations from sales in India and outside India NI=number of employees employed with respect to Indian operations and located in India NT = total number of employees employed with respect to Indian operations and located in India and outside India W= wages paid to employees employed with respect to Indian operations and located in India WT = total wages paid to employees employed with respect to Indian operations and located in I....