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Article 7 - Attribution of business profits

Article 7 - Attribution of business profits. Presenters : CA Sanjiv Chaudhary CA Nidhi Maheshwari 24 May 2013. The Journey Ahead……. 1. Backdrop- Why attribution?. 2. Principles of Attribution under the Act. Principles of Attribution under Tax Treaty. 3. 4 .

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Article 7 - Attribution of business profits

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  1. Article 7 - Attribution of business profits Presenters : CA Sanjiv Chaudhary CA Nidhi Maheshwari 24 May 2013

  2. The Journey Ahead…… 1 Backdrop- Why attribution? 2 Principles of Attribution under the Act Principles of Attribution under Tax Treaty 3 4 Force of Attraction Rules 5 Computation principles 6 Landmark Judgments 7 Key Challenges & Takeaways

  3. Residence Country – generally taxation of global profits Right of source country to tax profits of foreign enterprise operating in its jurisdiction – when Permanent Establishment (‘PE’) exists i.e. Source Based Taxation - Only those profits which are attributable to PE in the source country Backdrop- Why Attribution?... Attribution of profits – the next biggest controversy

  4. Attribution of business profits of foreign enterprises- Governing Provisions Under Income Tax Act and Rules (‘Domestic Law’): • Section 9(1)(i) of the Act read with Rule10 Under Tax Treaty: • Article 7 of Tax Treaties read with the provisions of the Act Beneficial provisions of the Act or the Tax Treaty can be applied

  5. Attribution under the Act

  6. Attribution of profits under the Act (1/2) • Section 9(1)(i) of the Act: “The following incomes shall be deemed to accrue or arise in India:- 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.” • Explanation 1(a) to section 9(1)(i) of the Act: “In the case of a business of which all the operations are not carried out in India, the income of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India”

  7. Attribution of profits under the Act (2/2) • Rule 10 of the Income-tax Rules: In any case in which the Assessing Officer is of opinion that the actual amount of the income accruing or arising to any non-resident person whether directly or indirectly, through or from any business connection in India …………………………………… cannot be definitely ascertained, the amount of such income for the purposes of assessment to income-tax may be calculated : (i) at such percentage of the turnover so accruing or arising as the Assessing Officer may consider to be reasonable, or (ii) on any amount which bears the same proportion to the total profits and gains of the business 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.”

  8. Methods prescribed under Rule 10 • Rule 10(i) - Presumptive Method • Income computed at such percentage of the turnover as the AO may consider reasonable • Ad hoc profits are estimated as attributable to the operations in India • Rule 10(ii) - Proportionate Method • Profits computed in ratio of India receipts to total receipts of the business • Proportionate profits based on worldwide income is attributed to the operations in India • Difficult method as worldwide income of the enterprise is to be computed under the Act before applying proportionate method • In case of different businesses, relevant business income needs to be considered • Rule 10(iii) - Discretionary Method • Such method as is deemed fit by tax authorities – AO may devise any mechanism on facts and circumstances of the case.

  9. Relevant CBDT Circulars (1/2) • CBDT Circular No. 23 dated 23 July 1969 – Now withdrawn Non-Resident selling goods from outside India to Indian customers on principal-to-principal basis through Agents in India • If the agent’s commission fully represents the value of the profit attributable to his service; it should prima facie extinguish the assessment. • This principle is now well established including by Supreme Court in the case of Morgan Stanley

  10. Relevant CBDT Circulars (2/2 ) • CBDT Circular No. 5 dated 28 September 2004 – relevant extracts are reproduced below: “Paragraph 2 contains the central directive on which the allocation of profits to a Permanent Establishment is intended to be based. The paragraph incorporates the view that the profits to be attributed to a Permanent Establishment are those which that Permanent Establishment would have made if, instead of dealing with its Head Office, it had been dealing with an entirely separate enterprise under conditions and at prices prevailing in the ordinary market. This corresponds to the “arm’s length principle”. Paragraph 3 only provides a rule applicable for the determination of the profits of the Permanent Establishment, while paragraph 2 requires that the profits so determined correspond to the profit that a separate and independent enterprise would have made. Hence, in determining the profits attributable to an IT-enabled BPO unit constituting a Permanent Establishment, it will be necessary to determine the price of the services rendered by the Permanent Establishment to the Head office or by the Head office to the Permanent Establishment on the basis of “arm’s length principle”.

  11. Indian scenario: Some key judicial precedents (1/2) • Ad hoc Attribution – A few instances • Taxability of trading profits where sale is concluded in India • 10% of supply – Annamalis Timber 41 ITR 781 (Madras HC) • Taxability of offshore supplies where PE played some role • 20% of global profits – NETWORKS, OY : 96 TTJ 1 (Delhi ITAT, SB) • Taxability of offshore supplies where PE was involved in marketing activities • 35% of the global profits (50% manufacturing, 15% R&D) – Rolls Royce (Delhi HC) • Taxability of CRS activities where agency PE played marketing activities • 15% of the total revenues - Galileo International Inc : 114 TTJ 289 (Del. ITAT) • Taxability of back office operations where PE looks after operations and marketing activities of overseas affiliates • Global adjusted profits x India assets/Global assets : eFunds 42 SOT 165 (Delhi ITAT)

  12. Indian scenario: Some key judicial precedents (2/2) • Principles of Attribution - Legal Position • Ahmedbhai Umarbhai & Co (1950) SCR 335 • Profit apportionment on the basis of business activities, manufacturing profits taxable in the jurisdiction where manufacturing takes place • Morgan Stanley (292 ITR 416) (SC) • Profits attribution to PE based on functions assets and risks analysis • Rolls Royce Singapore Pvt Ltd (ITA No 1278/2010) dt August 30, 2011 • TP principles should be applied to determine profits attributable to PE • Hyundai Heavy Industries : 291 ITR 482 (SC) • - Even if supply is considered to be integral part of installation, supply is not attributable to PE because it is at arm’s length; Direct billing to customer represents arm’s length • Instruction No. 5 of 2009 (withdrawing Instruction 1829), Para 4

  13. Attribution under Tax Treaties

  14. Art 5: Constitution of PE Framework of OECD Model - Article 7 Residence State Source State Enterprise Art 7: Taxation of PE Article 7(1) - Charging provision Article 7(3) - Elimination of double taxation Article 7(4) - Limitation Article 7(2) - Basis of profit attribution

  15. Article 7(1) - Scope of taxation Article 7(1): The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits that are attributable to the permanent establishment in accordance with the provisions of paragraph 2 may be taxed in that other State. Key aspects: • PE test for each source of income • No guidance on how to interpret the term ‘profits of an enterprise’ • Existence of PE must for attribution • Business should be carried on - Preparatory activities do not trigger attribution • Only profits attributable to such PE is taxable in the source country • Applicability of Minimum Alternate Tax

  16. Force of Attraction Rule

  17. Force of Attraction Rule – UN MC UN Model Convention • The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to • that permanent establishment; • sales in that other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment; or • other business activities carried on in that other State of the same or similar kind as those effected through that permanent establishment ‘Force of attraction’ rule not present in OECD Model Convention Does exist in the US Model Convention

  18. Force of Attraction Rule International Bureau of Fiscal Documentation - International Tax Glossary “Principle under which a country may tax a foreign enterprise in respect of income it derives in that country if the enterprise maintains a permanent establishment there, irrespective of whether that income is derived through or otherwise economically connection with the permanent establishment……” Different kinds of Force of Attraction in context of DTAA’s entered by India Type 1: - Once activities are same / similar - Without specific requirement of role by PE Type 2: - Business reasons for not routing the direct business of HO through PE - Tax avoidance motive need to be established Comparision vis a vis explanation to section 9(1)(i) – Whether treaty can create a charge.

  19. Force of Attraction… Examples Type 1: Article 7(1) of India USA DTAA “The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to (a) that permanent establishment ; (b) sales in the 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 the other State of the same or similar kind as those effected through that permanent establishment.” Some other countries having similar Force of Attraction rule. Cyprus Denmark Indonesia New Zealand Italy

  20. ‘Directly and indirectly’ - Whether connotes ‘force of attraction’ rule? Examples: Type 2 Article7(1) states that profit “directly or indirectly” attributable to the PE….. Taxable… • Protocol to Article 7 clarifies, as under: “………….,it is understood the words directly or indirectly mean, …………., that where a permanent establishment takes an active part in negotiating, concluding or fulfilling contracts entered into by the enterprise, then, ………………………, there shall be attributed to the permanent establishment that proportion of ………………… contribution of the permanent establishment to those transactions bears to that of the enterprise as a whole. It is also understood that profits shall be regarded as attributable to the permanent establishment to the above mentioned extent, even when the contracts in question are made directly with the head office of the enterprise ………………

  21. Force of Attraction Rule - Motive of Tax Avoidance Article7(1) as per UN Model Convention • With an additional para, as under: “The provisions of sub-paragraphs (b) and (c) above shall not apply if the enterprise proves that such sale or activity could not have been reasonably undertaken by the permanent establishment.” or “may be considered attributable to that permanent establishment if it is proved that: (i) this transaction has been resorted to in order to avoid taxation in the Contracting State where the permanent establishment is situated, and (ii) the permanent establishment in anyway was involved in this transaction.”

  22. Force of Attraction under the ITA? (1/2) Provisions of section 5(1) and 5(2) provides that income is taxable in India if it is received in India or deemed to be received in India or accrues or arises in India or is deemed to accrue or arise in India Income tax Act Section 9 covers income which is deemed to accrue or arise in India

  23. Force of Attraction under the ITA (2/2) “9(1) The following incomes shall be deemed to accrue or arise in India: All income accruing or arising, whether directly or indirectly, through or from 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 situated in India. [Explanation 1]. For the purposes of this clause (a) In the case of a business of which all the operations are not carried out in India, the income of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India; …” Arguably, no force of attraction under the ITA – Do ‘force of attraction’ rules under the Indian tax treaties become meaningless?

  24. Example: Attribution of Profit – Force of Attraction HO Sale of pharmaceuticals in India Outside India In India Customers in India Direct sale of garments by HO in India PE Customers in India PE sells garments manufactured by HO Type 1 Force of Attraction

  25. Example: Attribution of Profit – Force of Attraction HO Conclusion of sale of pharmaceuticals Outside India In India Negotiating sale of pharmaceuticals in India Customers in India PE Customers in India Negotiation and conclusion of sale of garments manufactured by HO Type 2 Force of Attraction

  26. Similar Goods – Examples Similar Commercially interchangeable and under the same brand name Selling Laptop Selling Desktop

  27. Similar Business activities – Examples Not Similar Characteristic and use are similar Providing system installation services Providing AMC Services

  28. Article 7(2): Approaches to determine profit • Approaches to determine profit: - relevant business activity; or - functionally separate entity. • Recommended approach – OECD report suggest functionally separate entity approach as preferable • Profit should be determined by applying the arm’s length principle – OECD Transfer Pricing Guidelines could be applied

  29. Article 7(2) For the purposes of this Article and Article [23A] [23B], the profits that are attributable in each Contracting State to the permanent establishment referred to in paragraph 1 are the profits it might be expected to make, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the permanent establishment and through the other parts of the enterprise Independent entity approach

  30. Authorized OECD Approach: An outline Determining the profits of a PE Step1: Hypothesising the PE as a distinct and separate enterprise Step 2: determining the profits of the PE Functional / factual analysis to determine the Activities and conditions of the PE Functions performed Comparability analysis Assets used Applying transfer pricing methods to attribute profits Risk assumed Capital and funding Recognition of dealings

  31. Single v/s Two taxpayer approach - Meaning Two tax payer approach mooted

  32. Article 7(3) - Provisions Where, in accordance with paragraph 2, a Contracting State adjusts the profits that are attributable to a permanent establishment of an enterprise of one of the Contracting States and taxes accordingly profits of the enterprise that have been charged to tax in the other State, the other State shall, to the extent necessary to eliminate double taxation on theses profits, make an appropriate adjustment, the competent authorities of the Contracting states shall if necessary consult each other

  33. Article 7(4) - Provisions Where profits include items of income which are dealt with separately in other Articles of this Convention, then the provisions of those Articles shall not be affected by the provisions of this Article Other Articles to prevail

  34. Specific Article vs. Attribution to PE • Effective Connection Vs Attribution • Article 12(3) of the OECD Model Convention: • “The provisions of paragraph 1 shall not apply if the beneficial owner of the royalties, being a resident of a Contracting State, carries on business in the other Contracting State in which the royalties arise through a permanent establishment situated therein and the right or property in respect of which the royalties are paid is effectively connected with such permanent establishment. In such case the provisions of Article 7 shall apply. • Bechtel (AAR) ( 228 ITR 487) • Ishikawajima-Harima Heavy Industries Ltd. Vs DIT (SC) (288 ITR 408) • Worley parsons services Pty. Ltd. (AAR ) (313 ITR 273 )

  35. Specific Article vs. Attribution to PE • Relevant extracts - Worley Parsons Services Pty. Ltd. In re. AAR ruling: • “…theprerequisite for attracting the exclusion clause is that "the services in respect of which the royalties arepaid are effectively connected with the PE". It must be noted that the effective connection should bebetween the royalty generating services and the PE. The expression 'services' is significant and shouldbe given due weight. It is not enough that there is a PE of the non-resident in the source country carryingout some activities in connection with the project or the work. The PE may be effectively connectedwith the project and the contract from a broader perspective but the connection contemplated by para 4of art. XII is in respect of the services that fall within the purview of royalty. The PE or fixed base set upin the source country should be engaged in the performance of royalty generating services, irrespectiveof what other activities it performs. At least, it should facilitate the performance of such services. Theterminology 'effective connection' denotes a real and intimate connection. Clear co-relation between theservices which give rise to royalty income and the PE is a key factor for the purpose of exclusion ofparas 1 and 2 of art. XII.

  36. Basic construct of India Tax Treaties

  37. Computation of Profits Attributable to PE

  38. Article 7(3) of Indian DTAA’sPrinciples of computation of Income of PE • In determining profits of a PE • Deduction shall be allowed for expenses (including executive & general administrative) • Incurred for the PE • Incurred in or outside the source country • In accordance with and subject to limitations of domestic law • No deduction – amount paid by PE to the HO or to any other offices of the enterprise, except reimbursement of actual expenses • For use of patents or other rights in the form of royalties, fees or other similar payments • For specific services performed or for management in the form of commission • For money lent in the form of interest (exception for banking enterprises as explained by CBDT Circular 740) • Similarly, income received by PE from HO for aforesaid purposes shall be ignored

  39. Computation of profits attributable to PE under the Act • Attribution of income to the extent of operations / activities carried in trade • Nothing attributable if activities are preparatory or auxiliary in nature e.g. purchasing of goods • No specific mechanism provided for attribution of profits • Transfer pricing rules can be applied • Rule 10 of the Income-tax Rules can be applied Function / Asset / Risk analysis imperative to determine profit attribution – Morgan Stanley

  40. Computation of profits attributable to PE under the Act Rule 10 – Method of Attribution under the Act: • Determination of actual profits if it can be ascertained • Methods prescribed in Rule 10 are not accurate methods • These involve estimation and subjectivity • Hukumchand Mills Ltd. v. CIT, 103 ITR 548 (SC) • Can be followed only when the AO is of the opinion that profits cannot be definitely ascertained • Rule is last in priority list and is to be applied in exceptional situations Rule 10(i) - Presumptive Method • Adhoc profits is estimated as attributable to the PE

  41. Computation of profits attributable to PE under the Act Rule 10(ii) - Proportionate Method • Proportionate profits based on world income is attributed to the PE • Difficult method as World income of the enterprise is to be computed under the ITA before applying proportionate method • In case of different businesses relevant business income be considered Rule 10(iii) - Discretionary Method • Attribution in some other method

  42. Computation of profits attributable to PE under the Act Specific provisions for computing profits: • All provisions applicable as is applicable to resident enterprise for e.g. section 32, 40(a), 43B, etc,. • Section 44C – Branch • Section 44D and 44DA – Taxability of royalties and FTS • Section 115JB – MAT provisions

  43. Computation of profits attributable to PE under the Act Presumptive basis of taxation • Income is computed on presumptive basis • Provisions of sections 28 to 44 not applied • Applied in case of specific types businesses/assesses • It is not in line with the principles laid down in Article 7(2) Examples • Shipping business (u/s 44B) - 7.5% of gross revenue • Business of Exploration (u/s 44BB) - 10% of gross revenue • Business of Aircraft (u/s 44BBA) - 5% of gross revenue • Turnkey Power Projects (u/s 44BBB) - 10% of gross revenue

  44. Example: Attribution of Profit – Fixed place PE F Co. US India PE sells garments manufactured by F Co. Branch Customers in India Profit & Loss A/c of Branch as a PE of F Co. for India tax purpose:

  45. Example: Attribution of Profit – Service PE F Co. Offshore Activities US Rendering of legal services India Onshore Activities Service PE Customers in India

  46. Example: Attribution of Profit – Agency PE … F Co. US Supply of garments to agent Payment of commission India Sale of garments to final customer Dependent Agent Customers in India Credit / Inventory risk by HO

  47. APA route for Permanent Establishment As per the recently issued APA Guidance with FAQs by the income-tax department, APA application may be possible in case the applicant admits PE in India (FAQ no. 23)

  48. Landmark Judgements

  49. MS Co. ActivitiesOutsourced USA India Remunerated at arms length price MSAS Morgan Stanley and Co – SC Ruling • Supreme Court of India • Facts • Activities outsourced by MS Co. to Indian group entity MSAS: • Equity / fixed income research • Account reconciliation; • IT enabled services, etc • MS Co. staff visited India for monitoring/quality control (stewardship) • MS Co. staff deputed to MSAS • MSAS reimburses salary cost to MS Co. • Employees deputed continue to be employed with MS Co., which pays salary to the deputees outside India

  50. Morgan Stanley and Co – SC Ruling • PE definition under Section 92F(iii) of the IT Act is inclusive so as cover various types of PE under DTAA such as Service PE, Agency PE, Construction PE, etc. • Profits of PE determined based on what an independent enterprise under similar circumstances might be expected to derive • Profits of MS Co. which have economic nexus with PE attributable • AE that constitutes PE and is remunerated on arms length basis taking into account all risk taking functions of the multinational enterprise – no further attribution • If TP analysis does not adequately reflect functions performed / risks assumed by the enterprise – there would be need to attribute profits for those functions / risks Ruling: Service PE was Upheld Profit Attribution NO

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