Recent initiatives by the Organization for Economic Co-operation and Development (‘OECD’)

1. Recent initiatives by the Organization for Economic Co-operation and Development (‘OECD’)

2. Agenda • Background of the OECD • Evolution of the OECD Model Convention • Key amendments to OECD Convention / Commentary • Article 5 - Permanent Establishment • Article 8 - International traffic • Article 11 - Interest • Article 12 - Royalties • Article 26 - Exchange of Information • Other amendments to OECD Convention / Commentary (Articles 3, 10, 13, 15, 16, 18, 19, 20, 23A and 23B) • Other key updates • Discussion draft on the attribution of profits to PE • Discussion draft on Mutual Agreement Procedures • Public comments invited on issues relating to application of the transactional profit methods (1995 Transfer Pricing Guidelines) • Discussion draft on taxing business profits arising from e-commerce transactions

3. Background of the OECD • Forum of 30 democracies • Key member countries include major European economies, USA, Canada, Japan and Korea. India has agreed to join the fiscal affairs committee of the OECD as an observer • Seeks to promote trade between member countries • Promotes rules of the game on areas where multilateral understanding on issues is essential

4. Evolution of the OECD Model Convention • Potential double taxation of income identified as a significant barrier for trade in a global economy • Importance of having a uniform solution across different member countries to counter the problem of double taxation • OECD Model Convention developed as a basis for setting, in a uniform manner, certain commonly encountered problems in the field of international and domestic taxation, tax policy, administration, etc • First Convention published in 1963 which was revised in 1977 • 1992 publication of Model convention was the first step of an ongoing revision process to produce periodic updates

5. Amendments to OECD Convention / Commentary

6. Amendments to OECD Convention / Commentary • During 2005, OECD has • Amended the OECD model convention (Articles 15, 19 and 26) • Amended the OECD model commentary to • Article 3 – General Definitions • Article 5 – Permanent establishment • Article 8 – Shipping, Inland waterways transport and air transport • Article 10 – Dividends • Article 11 - Interest • Article 12 - Royalties • Article 13 – Capital Gains • Article 15 – Income from employment • Article 16 – Directors’ fees • Article 18 - Pensions • Article 19 – Government Service • Article 20 - Students • Article 23A, 23B – Exemption and Credit method • Article 26 – Exchange of information

7. Article 5 – Permanent Establishment

8. Article 5 – Permanent Establishment… Ministry of Finance (Tax Office) v Philip Morris (GmBH) 7682/02 (25 May 2002) Facts Various Nonresident Group Companies Licensing and Distribution Agreements Royalties And Gross Sales Proceeds Fees Services Offshore Italy Intertaba AAMS Issue Whether Italian subsidiary constitutes a PE in Italy?

9. Article 5 – Permanent Establishment… Principles enunciated by the Italian Supreme Court • A subsidiary can constitute a multiple PE of its non-resident group companies • Supervision or control of performance of a contract between a resident entity and a non-resident entity not an auxiliary activity under Article 5(4) • Participation of representatives or employees of a resident company in a phase of conclusion of a contract between a non-resident entity and a resident entity could fall within the concept of ‘authority to conclude contracts’ • Entrusting management of business transactions to subsidiary by a non resident company may result in the subsidiary constituting a PE even if entrusting limited only to a certain area of business • Substance over form approach to be used in determining the existence of a PE

10. Article 5 – Permanent Establishment… Amendments to OECD commentary • Rejection of the Multiple PE Principle • Distinction between foreign enterprise carrying on business through a fixed place located in premises of a group company andforeign enterprise providing services to a group company from its own premises “Indeed, the fact that a company’s own activities at a given location may provide an economic benefit to the business of another company does not mean that the latter company carries on its business through that location: clearly, a company that merely purchases parts produced or services supplied by another company in a different country would not have a permanent establishment because of that, even though it may benefit from the manufacturing of these parts or the supplying of these services.” – Para 42 of OECD commentary to Article 5 • Attendance/ participation in negotiations not conclusive but determinative of functions performed on behalf of an enterprise

11. Article 5 – Permanent Establishment… Analysis • Amendments are clarificatory in nature • Italy has inserted an observation stating that Italian jurisprudence should not be ignored when dealing with situations as stated earlier • Amendments do not address substance over form principle • Morgan Stanley and Co Inc AAR No 661 of 2005 • UPS AAR 542 CTR 328

12. Article 8 – International Traffic

13. Article 8 – International Traffic… Key amendments Profits from operation of ships or aircrafts in international traffic to include ‘profits’ from activities: • ‘directly connected’ to international traffic operations and • ‘ancillary’ to international traffic operations

14. Article 8 – International Traffic… Typical examples of ‘directly connected’ / ‘ancillary’ activities • operation of a bus service connecting a town with an airport primarily in relation to international flights • sale of tickets by an enterprise on behalf of other enterprises at a location maintained for its own sales • advertising in magazines distributed on board ships or aircraft or at ticket offices • leasing of containers • activities carried out on the basis of pooling agreements with other enterprises engaged in international transport, for example, to provide spare parts or maintenance services in certain locations

15. Article 8 – International Traffic… British Airways Plc v DCIT 80 ITD 90 (Del)… Facts • British Airways Plc (‘BA’) rendered technical/engineering/traffic handling services to other airlines in India • BA had a separate engineering set up in metropolitan cities of India • The engineers certified airworthiness of aircrafts of BA and other airlines before take off • Payments for services were made on per flight basis and cleared through IATA clearance house as per agreements between airlines Issue • Whether payments received by an airline from other airlines for certifying the airworthiness of the aircraft before take off is in the nature of receipts from international traffic under Article 8 of OECD model convention?

16. Article 8 – International Traffic… British Airways Plc v DCIT 80 ITD 90 (Del) Held Payments received by an airline from other airlines in India for provisions of a certificate for airworthiness before their take off, are not in nature of receipts from international traffic under Article 8 on account of following: • Imparting such service was separate planned activity not covered under “Air Transport Services” • Non rendering of such service will not have any impact on working of assessee’s own airline • Revenues were not insignificant that can be overlooked Analysis Revised OECD commentary contrary to the above decision

17. Article 8 – International Traffic… Lufthansa German Airlines v Deputy CIT 90 ITD 310 (Delhi)… Facts • Lufthansa German Airlines (‘Lufthansa’), engaged in operation of aircrafts in the international traffic, operates in India through a branch • Lufthansa is a member of the “International Airlines Technical Pool” (‘IATP’) • As an IATP member, Lufthansa extends line maintenance facilities to other IATP members in India

18. Article 8 – International Traffic… Lufthansa German Airlines v Deputy CIT (90 ITD 310) (Delhi) Issue • Whether payments received by Lufthansa from other airlines for line maintenance facilities under IATP agreement are in the nature of receipts from international traffic under Article 8? Held • Income derived by Lufthansa from participation in a pool not taxable in view of Article 8(4) of tax treaty Analysis Controversy in the above judgment set at rest as a specific clarification inserted in OECD commentary to state “Where an airline enterprise agrees under an IATP agreement, to provide spare parts or maintenance services to other airlines landing at a particular location……………activities carried on pursuant to that agreement will be ancillary to the operation of aircraft in international traffic”

19. Article 8 – International Traffic… AP Moller Maersk Agency India (P) Ltd v DCIT 89 ITD 563 (Mum)… Facts A.P.Moller, Maersk Agency India (P) Ltd(‘AP Moller’) receives slot charges and ancillary charges from other shipping company in India. Issue Whether slot charges received by AP Moller from other shipping companies are covered under Article 9 (International Traffic) of the India- Denmark Tax Treaty? Held “DTAA is silent over taxing the profits of shipping company derived otherwise than from the operation of ships. In such eventuality, the profits can be taxed in India as per the provisions of the Income Tax Act, 1961”

20. Article 8 – International Traffic AP Moller Maersk Agency India (P) Ltd v DCIT (89 ITD 563) (Mum) Analysis • Specific insertion in revised commentary to include ‘code-sharing’and ‘slot-charteringarrangements’in the definition of ‘directly connected’ and ‘ancillary’ activities • Amendment to OECD commentary contrary to above decision

21. Article 11 - Interest

22. Article 11 – Interest… In case of an overseas borrowing, interest income becomes liable to be taxed twice, first by the Source State and then by the Resident State which could in certain cases result in partial double taxation and lead to adverse economic consequences. To illustrate:

23. Article 11 – Interest… Amendment to the OECD commentary Contracting State may provide for exclusive taxation in the Resident State of the beneficiary of categories of interest stated below • Interest paid to State, its political subdivision and to central banks • Interest paid by a State or its political subdivision, a local authority or statutory body thereof • Interest paid pursuant to export financing programs • Interest paid to financial institutions • Interest on credit sales • Interest paid to tax exempt entities such as pension funds

24. Article 11 – Interest… Triangular cases… Lender Borrower State B State A PE – beneficiary of loan State C Interest

25. Article 11 – Interest Triangular cases Amendment to the OECD commentary • Use of multilateral convention or alternative formulation of second sentence of Article 11(5) stated below: “Where however, the person paying the interest, whether he is a resident of a Contracting State or not, has in a State other than that of which he is a resident a permanent establishment in connection with which the indebtedness on which the interest is paid was incurred, and such interest is borne by such permanent establishment, then such interest shall be deemed to arise in the state in which the permanent establishment is situated”

26. Article 12 - Royalties

27. Article 12 – Royalties… Amendment to OECD commentary • Supplier to abstain from granting information / property to anyone else other than the licensee • Payment for exclusivity of information / property considered as royalty • Qualifies as “any kind received as consideration for…….the right to use the property or information”

28. Article 12 – Royalties… Aktiebolaget Volvo v Federal Commissioner of Taxation 78 ATC 4316 (1978)… Facts • Volvo Australia Pty Ltd (‘ACo’), an Australian Resident company is a subsidiary of a Sweden company (‘SCo’) • ACo imports products manufactured by SCo for resale • As per agreement between ACo and SCo, ACo has exclusive rights to sell SCo’s products in Australia Issue Whether payments made by ACo to obtain exclusive rights of sale in Australia is royalty?

29. Article 12 – Royalties Aktiebolaget Volvo v Federal Commissioner of Taxation 78 ATC 4316 (1978) Held Payments made by ACo are not royalty. Analysis • Specific insertion in revised commentary to include payments made to secure exclusivity of information or an exclusive right to use property constitutes ‘royalties’ • Amendment to OECD commentary contrary to the above decision

30. Article 26 – Exchange of Information

31. Article 26 – Exchange of Information Amendments to Model Convention • Para 4 introduced – requested State to provide information even if it has no domestic interest • Para 5 introduced – Contracting State cannot decline from supplying information solely because information held by bank, financial institution, etc Amendments to OECD commentary • “Necessary” information vis-à-vis “forseeably relevant” information

32. Other amendments

33. Other amendments… • Article 3 – General Definitions Commentary to definition of “international traffic” amended to clarify that the definition is not applicable to an enterprise having its place of effective management in one Contracting State (say India) when its the ship/ aircraft is operated between two places in another Contracting State (say US) • Article 10 - Dividends Insertion to commentary on Article 10 to provide that States may agree bilaterally to exempt from source taxation dividend income derived by pension funds and similar entities. • Article 13 – Capital Gains Insertion to commentary on Article 13 to provide that States may agree bilaterally to exempt capital gains on shares, derived by pension funds and similar entities, from source taxation.

34. Other amendments… Article 15 – Income from employment • Clarified that the term ‘salaries wages and other similar remuneration’ includes stock options • Clarifications regarding issues arising in relation to taxability of employee stock-options inserted • Clarified that income from exercise of employment in a Contracting State would be taxable in that State irrespective of when that income is paid, credited or definitively acquired by the employee • Clarification inserted regarding the term ‘in any twelve month period commencing or ending in the fiscal year concerned’

35. Other amendments… Article 16 – Directors’ fees • Clarified that the term ‘fees and other similar payments’ includes employee stock-options • Clarifications regarding issues arising in relation to taxability of employee stock-options inserted Article 18 – Pensions Significant amendments made to the commentary Article 19 – Government Service • Model convention amended to make Article 19 applicable to remuneration similar to ‘pension’

36. Other amendments Article 20 – Students • Clarification inserted that payments to students for any independent services covered under Article 15 and 7 are not covered under Article 20 • Where the recipient's training involves work experience, there should be a distinction between payment for services and payment for maintenance, education and training Article 23A and 23B – Exemption and credit method • Commentary amended to clarify the following • Situations where same item of income is subject to full tax liability in two countries at different times • Relief of double taxation of income or capital by the State of residence would be available even though the State of source taxes it in an earlier or later year

37. Other key updates

38. Other key updates OECD has issued certain drafts for discussion on • Article 7 - Attribution of Profits to PE (Parts I to IV), • Article 25 - Mutual Agreement Procedure, (Discussion draft on proposal for improving mechanisms for the resolution of the tax treaty disputes) • Are current treaty rules for taxing business profits appropriate for e-commerce? • Issues relating to application of the transactional profit methods (1995 Transfer pricing guidelines)

39. Discussion draft on the attribution of profits to PE

40. Attribution of profits to PE… Key principles relating to attribution of profits to a PE… Two step Analysis Step I: Determining the ‘profits of an enterprise’ • Relevant business activity approach • Functionally separate entity approach Step II – Attribution of profits of enterprise to PE

41. Attribution of profits to PE… Key principles relating to attribution of profits to a PE Analysis • Functionally separate entity approach is the preferred approach • Reliance on 1995 Transfer Pricing Guidelines for determination of arm’s length profit • Arm’s length principles between associated enterprise in Article 9 to be applied by analogy • Attribution of profits primarily dependent on facts • Advisable to maintain appropriate documentation

42. Attribution of profits to PE… Symmetrical application of authorised OECD approach… • Accounts prepared on symmetrical basis used as basis for attribution • Values of transactions or methods of attributing profits or expenses in books of PE exactly correspond to values / methods in books of head office Issues addressed • Taxpayers who produce symmetrical accounts should in principle be able to satisfy both tax administrations that an arm’s length amount of profits have been attributed to the PE • Problems relating to two countries applying different approaches to capital attribution can be resolved by application of Article 23 that obliges the home state to give relief by way of exemption or credit in relation to profits attributed to the host state

43. Attribution of profits to PE… Symmetrical application of authorised OECD approach Issues not addressed • Limitation concerning as to how the countries define the term “profits” • The methods of computing “profits” may be different under the domestic laws of the home and host country • Elimination of double taxation requires changes to be made in domestic laws of the home country on double taxation relief and Article 23 of the OECD Model Tax convention

44. Attribution of profits to PE… Key principles relating to attribution of profits to a PE… Step II - Attribution of profits of enterprise to PE Determination of profits attributable to PE Functional and Factual analysis Applying arm’s length principle to determine profits attributable to the PE Hypothesize PE as a distinct and separate person Recognition of dealings Determination of functions / activities Determination of arm’s length compensation by applying transfer pricing methods Attribution of assets Attribution of profits in respect of dealings by reference to comparable transaction between independent enterprises Attribution of risks Attribution of capital Determination of free capital Determination of funding costs

45. Attribution of profits to PE… Attribution of profits to a dependent agent… • In case of dependent agent PE host country technically has rights to tax two different legal entities • the agent, and • the PE • Generally, profits attributed to a dependent agent PE on the same basis as for other types of PEs ie as per the authorised OECD approach Single taxpayer approach • Payments of an arm’s length reward to a dependent agent enterprise extinguishes profits attributable to dependent agent PE

46. Attribution of profits to PE… Attribution of profits to a dependent agent Single taxpayer approach Criticism • This approach does not consider risks and rewards which although legally belonging to the non resident enterprise, are attributable to the PE as a result of the activity of the PE • This approach distinguishes between a fixed place of business PE and a dependent agent PE • This approach renders Article 5(5) redundant as there would not be any profit consequences for a dependent agent PE

47. Attribution of profits to PE Attribution of profits to a PE Analysis • “When the PE of the enterprise in India is remunerated for its services at arm's length by the enterprise and as long as all its actual income is brought to tax, no further income can be attributed in the hands of the PE of the enterprise” - Morgan Stanley and Co. 661 of 2005 (AAR) • “Where a non-resident’s sales to Indian customers are secured through the services of an agent in India, the assessment in India of the income arising out of the transaction will be limited to the amount of profit which is attributable to the agent’s services……..if the agent’s commission fully represents the value of profit attributable to his service it should prima facie extinguish the assessment” – Circular 23 of 1969

48. Discussion draft on Mutual Agreement Procedures

49. Mutual Agreement Procedure Key recommendation of OECD • Use of additional dispute resolution techniques, in particular arbitration process Other issues addressed by OECD • Time limit for submission of request of MAP • Meaning of probability of taxation • Denial of access to MAP • Suspension of collection of tax • Suspension or remission of interest and penalties • Manual on Effective Mutual Agreement Procedure

50. Taxing business profits arising from e-commerce transactions