Article 7 - Attribution of business profits

1

Article 7 - Attribution of business profits

Presenters : CA Sanjiv Chaudhary

CA Nidhi Maheshwari

24 May 2013

2

The Journey Ahead……

3

Backdrop- Why Attribution?...

• 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

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

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.

Methods prescribed under Rule 10

9

• 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

Relevant CBDT Circulars (1/2)

10

• 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”.

Relevant CBDT Circulars (2/2 )

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

Enterprise

Residence State Source State

Art 5: Constitution of

PE

Framework of OECD Model - Article 7

Article 7(1) - Charging provision

Article 7(2) - Basis of profit attribution

Article 7(3) - Elimination of double taxation

Article 7(4) - Limitation

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

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 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

Force of Attraction Rule – UN MC

‘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 IndiaType 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?

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 ………………

Examples: Type 2

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)

Income tax Act

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

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

Outside India

PE sells garments manufactured by HO

HO

Customers in India

Customers in India

Direct sale of garments by HO in India

Sale of pharmaceuticals in India

Type 1 Force of Attraction

In India

PE

25

Example: Attribution of Profit – Force of Attraction

Outside India

Negotiation and conclusion of sale of garments manufactured by HO

HO

Customers in India

Customers in India

Negotiating sale of pharmaceuticals in India

Conclusion of sale of pharmaceuticals

Type 2 Force of Attraction

In India

PE

26

Similar Goods – Examples

Commercially

interchangeabl

e and under the

same brand

name

Sellin

g D

eskt

op

Selling

Laptop

Similar

27

Similar Business activities – Examples

Characteristic

and use are

similarProv

idin

g AM

C

Serv

ices

Providing

system

installation

services

Not Similar

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)

Independent entity approach

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

30

Authorized OECD Approach: An outline

Determiningthe profits

of a PE

Functional / factual analysis

to determine the Activities

and conditions of the PE

Step1: Hypothesising the PE as a distinct

and separate enterprise

Functions performed

Assets used

Risk assumed

Capital and funding

Recognition of dealings

Step 2: determining the

profits of the PE

Comparability analysis

Applying transfer pricing

methods to attribute profits

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

34

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 )

Specific Article vs. Attribution to PE

35

Relevant extracts - Worley Parsons Services Pty. Ltd. In re. AAR ruling:

“…the prerequisite for attracting the exclusion clause is that "the services in respect of which the royalties are paid are effectively connected with the PE". It must be noted that the effective connection should be between the royalty generating services and the PE. The expression 'services' is significant and should be given due weight. It is not enough that there is a PE of the non-resident in the source country carrying out some activities in connection with the project or the work. The PE may be effectively connected with the project and the contract from a broader perspective but the connection contemplated by para 4 of art. XII is in respect of the services that fall within the purview of royalty. The PE or fixed base set up in the source country should be engaged in the performance of royalty generating services, irrespective of what other activities it performs. At least, it should facilitate the performance of such services. The terminology 'effective connection' denotes a real and intimate connection. Clear co-relation between the services which give rise to royalty income and the PE is a key factor for the purpose of exclusion of paras 1 and 2 of art. XII.

Specific Article vs. Attribution to PE

36

Basic construct of India Tax Treaties

Article Key ProvisionsArt 7(1)

Basic Rule • Income Attributable to PE • Force of Attraction Rule (if any) or Indirect attribution

Art 7(2) Computation Hypothesis

As if PE is • a distinct and independent enterprise • engaged in same or similar activities • under same or similar conditions

Art 7(3) Expense Deduction

• Actual Expense incurred, incl. reasonable allocation of General & Admin Overheads

• Whether in source state or in HO state• Subject to domestic law• No deduction for HO payment (except reimbursement of actual

expenses)

Others (varies from Treaty to Treaty)

• Applying Apportionment method in case of difficulty (reasonable) • Methodology applied consistently Y-on-Y• Exception (Purchase activity)

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


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


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


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


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

SalesLess: Expenses incurred-Cost of garments imported (to be on arm’s length basis based on FAR)-Personnel cost of branch employees-Rent of branch office premises-General administrative expenses of HO – Rs. 20,000 (10% allocable to PE)-Depreciation on branch assets-Royalty on intangible assets (assuming economic ownership rests with HO)Total expensesProfit attributable to PE

Rs. 1,00,000 Rs. 70,000 Rs. 3,000 Rs. 5,000 Rs. 2,000 Rs. 2,000 Rs. 3,000 Rs. 85,000 Rs. 15,000

US

India

PE sells garments manufactured by F Co.

F Co.

Customers in IndiaBranch

Profit & Loss A/c of Branch as a PE of F Co. for India tax purpose:

45

Example: Attribution of Profit – Service PE

US

IndiaOnshore Activities

F Co.

Customers in India

Total man days spent on job Offshore man days Onshore man daysProject revenue Revenue attributable to India (PE only on account of onshore)Less: Expenses incurred -Personnel cost-Depreciation on India assets (Assuming all assets acquired from India)-Royalty for know-howTotal costProfit taxable in India

1000 mandays 600 mandays 400 mandays Rs.1,000,000 Rs. 400,000

Rs. 75,000 Rs. 75,000 Rs. 100,000 Rs. 250,000 Rs. 150,000

Ren

derin

g of

lega

l se

rvic

es

Offshore Activities

Service PE

46

Example: Attribution of Profit – Agency PE …

SalesLess: Cost of goods paid to F Co. (Based on FAR / TNMM)

Less: Commission @ 20% of sales (agent sufficiently remunerated)Profit attributable to PE

Rs. 100,000Rs. 80,000Rs. 20,000Rs. 20,000NIL

Dependent Agent

US

India

F Co.

Customers in India

Sup

ply

of g

arm

ents

to

agen

t

Pay

men

t of c

omm

issi

on

Sale of garments to final customer

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

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

MS Co.

MSAS

India

USA

Activities Outsourced

Remunerated at arms

length price

50

ProfitAttribution

NO

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:

Morgan Stanley and Co – SC Ruling

Service PE was Upheld

51

Ishikawajima-Harima Heavy Industries Ltd. v. DIT 158 Taxman 259 (SC)• All income of turnkey projects not assessable in India merely due to PE• Only part of income attributable to the operations carried out in India by

PE taxable• Offshore supply not taxable if property in goods passed outside India• The fact that the contract signed in India is not material• If services have been rendered outside India and have nothing to do

with the PE then they cannot be attributable to the PE• Offshore services – sufficient territorial nexus – apart from utilization in

India, need to be rendered I India or have a live link to fall within Article 12 of the DTAA (This resulted in insertion of an Explanation to Section 9(1) by FA 2007 w.r.e.f. 1.6.1976)

• In Jindal Thermal Power Co. Ltd. v DCIT (2009) 182 Taxman 252 (Kar), the Court has held that criteria of rendering services in India as laid down by the Supreme Court has not been done away by the Explanation

52

Galileo International Inc – Delhi HC

Airlines

Galileo Inc.

Travel Agent TA

Distributor

Telecom Service Provider

Payment Payment

Does not charge fees



Services of Distributor

Provides support services and Equipments

Fees

approaches

Passengers

Payment

Lines &

Nodes

Line

s &

N

odes

INDIA

Server

USA

53

Ruling:

Profit Attribution YES

“…On the basis of such analysis of functions performed, assets used and risk shared in two different countries, the income can be attributed. In the present case, we have found that majority of the assets i.e., host computer which is having very large capacity which processes information of all the participants is situated outside India. The CRS as a whole is developed and maintained outside India. The risk in this regard entirely rests with the appellant and that is in USA, outside India. However, it is equally important to note that but for the presence of the assessee in India and the configuration and connectivity being provided in India, the income would not have generated. Thus the initial cause of generation of Income is in India also. On the basis of above facts we can reasonably attribute 15 per cent of the revenue accruing to the assessee in respect of bookings made in India as income accruing or arising in India and chargeable under section 5(2) read with section 9(1)(i) of the Act.”


Fixed and Agency PE was Upheld

54

Ruling:

Profit Attribution YES

“…since the revenue attributable in respect of the booking made in India is only 0.45 Euro (15 per cent of Euro 3) and commission paid to Interglobe was Euro 1, there was no income which was taxable in India.”

Upheld by Delhi High Court subsequently


55

Rolls Royce Plc – Delhi Tribunal Ruling

Facts RRIL’s liaison office (‘LO’) carried out activities only in

respect of RR Plc LO’s key responsibility includes securing orders and

solicit request for quotation/purchase orders for RR Plc’s products

The employees of RR Plc visit India frequently and use premises of the LO

Employees of RRIL participate in meetings with customers where significant matters regarding contracts with RR Plc are discussed and decisions are taken

RR Plc on various occasions designated RRIL as sole contact point in respect of certain customers (eg. to send orders/quotations/acceptances, etc)

RRIL marketed certain after sales/other services provided by RR Plc to present/potential customers of RR Plc

RRIL provided certain advise/recommendations to RR Plc as regards certain customer proposals

RR Plc

India

UK

Indian Customer

Service Agreement Reimbursement

of Cost + Mark Up

Equipment SalesRRIL

RRIL (India LO)

Services

56

Ruling:

All profits directly and indirectly attributable to the PE to be considered

However, under Article 7(4) of the Treaty, computation could be on proportionate basis

Since no specific P&L provided, computation to be under Rule 10

50% to be attributed to manufacturing 15% to be attributed to R&D 35% to be attributed to marketing Only marketing done in India Hence profits to be attributed to India – 35%

YESProfit Attribution

Rolls Royce Plc – Delhi Tribunal Ruling

Fixed Place & Agency PE was Upheld

57

Set Satellite (Singapore) Pte Ltd vs. DCIT (Mum HC)

India Agent (dependant)

Arms length remuneration

Existence of an Agency PE

Agency Agreement

Fee

Customers (Advertisers)

Singapore

India

Sing Co (Business of creating,

marketing & distributing TV channels)

58

Ruling:

No further profit

attributable to Dependent agent PE in

India

CBDT Circular 23 of 1969 is applicable to SET Singapore since:− it’s business activities in India where wholly channeled

through its agent (SET India); − the contracts to sell (the ad slots) are made outside India; and

the sales are made on a principal to principal basis

Thus, if commission to SET India fully represents the value of the profit attributable to its service - it should prima facie extinguish the assessment.

Under Article 7(2) profit attributable to a PE would be the profit it might be expected to earn it were a separate and independent entity carrying out similar activities – i.e. the arm’s length profit

Dependant agent paid commission @ 15% - Circular 742 recognizes that Indian agents of FTCs generally retain 15% as service charges

Since, commission paid to SET India is at arm’s length - no further profits can be attributable to its activities in the hands of SET Singapore’s PE in India in terms of Circular 23 r.w. Article 7(2)

Considering the Morgan Stanley judgment, if the correct arms length price is applied then nothing further would be left to be taxed in the hands of the FCo

since

Set Satellite (Singapore) Pte Ltd vs. DCIT (Mum HC)

Agency PE was Upheld

Whether principle laid down holds good even

after withdrawal of Circular 23?

59

Convergys Customer Management Group Inc – Delhi Tribunal

Facts CCM was a company incorporated in the

USA

CCM procured services from CIS on principal to principal basis :

- IT enabled call centre services

- Back office support services ;

- CCM staff visited CIS for supervision/direction and control

- CCM also provided certain hardware and software assets on free of cost basis to CIS CIS

CCM

India

USA

Services Subcontracted

Overseas Customers

60

Relying on the CBDT Circular No. 5 of 2004, Supreme Courts decision in case of Morgan Stanley and OECD Guideline, the Tribunal held that no further profits can be attributed to a PE once an arm's length price has been determined

However, the taxpayer had submitted that it does not prepare India specific accounts, therefore the attribution of profits on the basis as disclosed in the TP study for assets and software cannot be accepted.

Further in the facts and circumstances of the case PSM was not the correct method for attribution of profits to the taxpayer’s PE in India.

Departmental observation that further attribution was required for entrepreneurial services for managing risk related to the service delivery performed in India by CCM was held to be completely without any basis.


Fixed Place PE was Upheld

ProfitAttribution

Yes

61

The Tribunal held that department’s methodology was not acceptable and made the following observations:

With regard to Revenue’s approach in considering revenue of CCM as a multi-national enterprise as the starting point, :

Revenue of taxpayer cannot be considered as revenue of the PE

Department ought to have considered the expenditure incurred outside India for arriving at the profit of CCM with regard to the contracts wherein services have been procured from CIS

Provisions of Section 44C of the Act having been invoked in

attributing income of the taxpayer without allowing the cost incurred to earn the revenue outside India (thereby attributing the entire receipts) was incorrect.



ProfitAttribution

Yes

62

The Tribunal prescribed the correct approach to arrive at attributable profits as under:

Computing global operating income percentage of the customer care business as per annual report

Above percentage to be applied to the end-customer revenue with regard to contracts/projects subcontracted to CIS to arrive at operating income from Indian operations.

The operating income from India operations to be reduced by the profit before tax of CIS to arrive at profit attributable to Indian PE

Estimation of profit based on above residual profit

For the purpose of attribution on residual profits, reliance was placed on two Supreme Court rulings that had dealt on profit attribution to Indian PEs. In the case of Anglo French Textile Co, 10% attribution was held reasonable and in Hukum Chand Mills Ltd., 15% attribution was held reasonable. The Tribunal held that the adoption of the higher figure of 15% for attribution of the Taxpayer’s PE will meet the ends of justice.



ProfitAttribution

Yes

63

• LLP, UK based Law firm (fiscally transparent for UK tax purpose) rendered legal advisory services to clients having Indian projects

• LLP did not have Office / branch in India

• Personnel of LLP rendered services in India / overseas

• LLP filed Nil tax return in India

Facts

• Applicability of ‘Force of attraction’ rule for offshore services

Issues for Consideration

ClientsLLP

Partners and Staff members of LLP visited India for

rendering services

Provision of legal advisory services

LLP Fiscally transparent for UK tax purpose; Partners of LLP are liable

to tax

UK

India

Indian Projects

Service Providers – Force of Attraction

64

Service Providers – Force of Attraction

Applicability of Force of Attraction

Overruled recently by ITAT SB in Clifford Chance; SB concluded that reliance on UN commentary is not required and profits shall be attributed to PE on the basis of its contribution; Article 7(3) clearly explains the scope and ambit of the profits indirectly attributable to the PE.

• Profits indirectly attributable to PE’ incorporates the Force of Attraction rule

• Services rendered not only in India but also in UK are taxable

• The same observations were also made by the Mumbai Tribunal in the case of Linklaters LLP. Reliance was placed by the Tribunal on the provisions of Article 7(1)(b) and 7(1)(c) of the UN Model Convention as well as on the UN Model Convention Commentary

65

Key takeaways

66

Key takeaways

• PE – a dynamic concept

– Especially with emergence of economic and technological advancements

• Attribution – very contentious in practice

• Documenting functional analysis – key defense

• Attribution vis-à-vis arm’s length payments

• OECD commentary vs. Indian judicial precedents

Well documented Transfer pricing policy- Important to defend claims from

revenue authorities

67

Q & A

68

Thank You

Article 7 - Attribution of business profits

Documents

Transcript of Article 7 - Attribution of business profits