- Profits from business activities are attributable broadly on account of two categories i.e., purchase of goods / provision of services and sale of goods / services. The underlying principle for attribution is that where activities belonging to any of the aforesaid category are carried out in a jurisdiction, the profits contributed by these activities needs to be attributed to that jurisdiction for the purposes of taxation. This position is emanating from section 9 of Income-tax Act, 1961 and Rule 10 of Income-tax Rules, 1962.
- As per Section 9 of IT Act, any income arising through the business connection is deemed to accrue or arise in India. As per Explanation 1(a) to section 9(1)(i), where all operations are not carried out in India, the income is deemed to accrue or arise in India “only” to the extent of those profits that is attributable to the business activities carried out in India.
- The business profits of non-resident covered by tax treaty can be taxed to the extent permissible under applicable DTAA. Business profits of an enterprise are attributable in India if it exceeds the essential nexus threshold of PE under Article 5 – Permanent establishment of applicable DTAA. It is then, profits are attributed as per Article 7 of DTAA or Rule 10 of IT Rules.
- The Rules of attribution in tax treaties usually take any of the following three standard versions of Article 7:
- Pre-2010 OECD Model Convention:
- It has similarities with UN Model Conventions except that it excludes force of attraction rule and limitation of deductibility of expenses.
- Revised 2010 OCED Model Convention including changes recommended by Final report on action plan 7 in respect of Article 5:
- Profits are attributed as per two-step process followed in Authorised OECD Approach [AOA]. Under this approach, firstly, Functions, Asset and Risks (FAR) analysis is undertaken under OCED TP guidelines and secondly, comparability analysis is undertaken to determine arm’s length price. It gives an illusion that profits attribution and transfer pricing study can be undertaken in an integrated manner by common FAR analysis.
- Article 7 of UN Model Convention including changes recommended by Final report on action plan 7 in respect of Article 5:
- Article 7 of most of Indian DTAA corresponds to UN Model. As per this provision, profits are attributed to the PE under direct accounting as if it were a distinct entity. This method is referred as direct method or separate accounting. Where detailed accounts are not available, Revenue can fall back on domestic law for fractional apportionment or indirect attribution of profits. For this purpose, Rule 10 of IT Rules is prescribed for indirect attribution of profits. The said Rule 10 prescribes 3 options i.e., presumptive method, proportionate method and discretionary method.
- UN model recognises Force of Attraction rule. Once PE is said to be established for an enterprise in respect of particular business or sale, all profits of the PE generated in the contracting jurisdiction is chargeable to tax irrespective of whether part of the functions are carried out by the same PE or some other foreign enterprise.
- UN model recognises limitation of deduction of expenses. No deduction is allowed in respect of royalties, fees, commission or interest. All payments to Head office otherwise than towards reimbursement of expenses of actual expenses are allowed.
- Revised Article 7 of OECD Model Convention is not acceptable for the following reasons:
- AOA approach not recommended:
- FAR under AOA represents supply side factors. It seeks to allocate taxing rights to the origin jurisdiction i.e., the place where the enterprise employs its input / factors of production. Conceptually, AOA creates nexus to the income producing factors to the income generation by analysing input factors i.e., functions performed (labour), assets utilised (capital) and risks assumed. FAR approach is detrimental to developing countries.
- FAR under AOA ignores contribution of market based factors derived by the foreign enterprise from that jurisdiction. The primary location where business profits are created is the market where customer is located. The income-tax base in India is not on value addition but on business profits and therefore, both factors of supply and sales have to be taken into account in determining profits. Again, what is relevant is not intrinsic value of the product but cost and price. The demand factor is dependent upon purchasing power of utility which is again dependent upon the state of general economy and its maintenance by public funds, infrastructure, subsidies and other measures taken to strengthen the economy. The price is dependent upon quality, monopoly factors, nature of product, availability of substitutes etc. Under market based approach / ‘destination principle’, the taxing rights are allocated to the jurisdiction where goods / services are sold.
- The international tax practice is mostly mixed approach i.e., supply and demand and in some cases, it is demand approach.
- Option to fall back on domestic laws for indirect apportionment of profits is omitted under Article 7 of Revised 2010 OECD Model convention.
- India has consistently rejected the approach proposed by OECD in revised Article 7 of its 2010 update and its subsequent updates. As per the preamble of OECD convention, interest of member OECD countries takes precedence over non-member countries. FAR approach is supportive to developed countries and not to developing countries.
- Currently, Rule 10 offers wide scope for discretion as noticeable in various court decisions. Therefore, there is a need for more precise rules for attributing profits in India to bring greater certainty and predictability among stakeholders and prevent avoidable tax litigation on this count.
- Committee recommends uniform method of apportionment of profits:
- Where India centric accounts are available as mandated under new Companies Act, 2013 in respect of foreign companies operating in India, separate accounting method is relied upon.
- Where separate books of accounts are not available or where AO has rejected India centric books of accounts for some reason or there is specific reason recorded by AO that the accounts maintained does not reflect profits attributable to PE as an independent and separate entity, the attribution would be as follows:
- Profits attributable in India = Revenue derived from India x Global operational profit margin Where,
- Revenue derived from India includes revenue arising or accruing or deemed to accrue or arise from India which are chargeable under the head profits and gains of business or profession;
- Global operational profit margin is EBITDA margin
- In case of global losses or where global profit margin is less than 2 percent, the profits attributable to Indian operations would be at the floor rate of 2 percent of revenue or turnover from India;
- In case, profits attributable on account of supply side factors is already subjected to tax in the hands of Indian subsidiary (being subjected to arm’s length price), one-third of “profits attributable in India” is regarded as profits derived on account of sales factors as per the international practice. In case, no sales takes place in India, no further attribution of profits in India;
- In the absence of Indian subsidiary, 33 percent of profits attributable in India represent contribution of demand side factors and 67 percent of said profits would be presumed to be contributed by supply factors.
- Steps to be followed:
- The profits derived from India will be taken at 2% of the revenue in case of global losses;
- 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);
- To reduce profits of Indian subsidiary that is already taxed.
The committee recommends following revision of Rule 10 of IT Rules or otherwise as amendment in the IT Act itself:
- ‘Profits derived from Indian operations’ will be the higher of the following amounts:
- Revenue derived from India x Global operational profit margin or
- Two percent of the revenue derived from India
- In case of business connection in India, other than those falling under para 8.3 below:
Profits attributable to operations in India = ‘Profits derived from India’ x [SI/3xST + (NI/6xNT) + (WI/6xWT) + (AI/3xAT)]
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;
WI= 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 India and outside India;
AI = assets deployed for Indian operations and located in India;
AT = total assets deployed for Indian operations and located in India and outside India.
- In case, business connection is primarily constituted by the existence of users beyond the threshold prescribed under Explanation 2A to section 9(1)(i):
- Profits attributable to operations in India in cases of low and medium user intensity business models, 10 percent weight is assigned to user factor and other factors are assigned weight of 30 percent:
‘Profits derived from India’ x [0.3 x SI/ST + (0.15 x NI/NT) +(0.15 x WI/WT) + (0.3 x AI/3xAT)] + 0.1]
- In case of digital models with high user intensity, 20 percent is assigned to user factor, 25 percent to assets, 25 percent to employees and 30 percent to sales:
Profits attributable to operations in India in cases of high user intensity business models = ‘Profits derived from India’ x [0.3 x SI/ST + (0.125 x NI/NT) + (0.125 x WI/WT) + (0.25 AI/3xAT)] + 0.2]
[Note 1: Provided that where enterprise having business connection in India does not receive any payment from users in India or the payment does not cross the threshold of Rs 10 lakhs and the associated enterprise in India has been fully remunerated at ALP, no further attribution is required.
Note 2: Provided that where, the enterprise having business connection in India receives payments exceeding Rs 10 lakhs, the profits attribution as derived in paragraph 8.3.1 or 8.3.2 above would be reduced by profits already subjected to tax in India in the hands of associated enterprise.]
Source: Report on profit attribution to PE prepared by Committee constituted by CBDT released as draft rules for public consultation vide ref no. F. No. 500/33/2017-FTD.I dated 18.04.2019
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