PE in India - Proposed Amendments in Rules

Introduction

1. With the view to bring greater clarity and predictability in the matter of profit attribution to Permanent Establishment ("PE") in India, the Central Board of Direct Taxes ("CBDT") has formed a Committee to examine the existing scheme of profit attribution and to recommend the amendments. The Committee has issued a report on 18^th April 2019 proposing the amendments to the rules for profit attribution open for public consultation.This Article discusses in details the various amendments proposed by the Committee, the objective behind the amendments and the critical analyses of the same.   

As per section 5 of the Income-tax Act, 1961 (hereinafter referred to as "the Act") taxability of non-residents is limited to income that accrues or arises in India or is deemed to accrue or arise in India. The incomes which are deemed to accrue or arise in India are specified in Section 9 of the Act which provides that all income accruing or arising through or from any business connection in India shall be deemed to accrue or arise in India. Once an enterprise satisfies the taxability nexus of business connection under the Act and of Permanent Establishment under the Tax Treaty, depending upon the facts, its profits attributable to business connection becomes taxable in India. Such profits are taxable only to the extent they are attributable to India.

Diagrammatical Representations

2. Under the Act, Rule 10 is applicable for the profit attribution where the detailed and accurate accounts are not available. However, Rule 10 lakhs specificity and gives major discretion to AO without any clear and specific guidance. Thus, recognizing the significance of issues relating to attribution of profits and for the need of bringing greater clarity and predictability to the applicable tax regime, a Committee was formed by the CBDT to examine the existing scheme of profit attribution and recommend changes.

2.1Under the Double Tax Avoidance Agreements ("DTAAs"), Article 7 provides the applicable rules for the profit attribution. At present, three standard versions of Article 7 exist in tax treaties as provided below:

India has a tax treaty network with 96 countries and the Indian tax treaties are largely based on the provisions of UN model tax convention with certain variations. India has also expressed its reservation on the Authorized OECD Approach ("AOA Approach") introduced by OECD in post 2010 model. India does not agree with the AOA approach to attribute profits to the PE on the basis of Functional, Assets and Risk ("FAR") Analysis as it only considers the supply side factors and ignores the demand side factors.

Economic Basis for the Allocation

3. There are different approaches for profit attribution as depicted below:

The tax base for the income or corporate tax is Business profit, which is surplus of business receipts over business expenses. The Committee observed that the business profits are determined by both demand and supply factors, and, thus, the profits shall also be allocated to the jurisdiction that contributes towards demand. The revision of Article 7 by OECD in 2010 followed the pure supply approach by seeking to attribute the profits only on the basis of the FAR analysis, completely ignoring the demand side factors. The Committee highlighted that the AOA approach restricts the taxing rights of the jurisdiction that contributes to business profits by facilitating demand, and thereby has the potential to break the virtuous cycle of taxation that benefits all stakeholders in the global economy and, thus, have an adverse impact on the counties like India, which are primarily importers of capital and technology.

The Committee considered that the mixed or balanced approach considers both, the demand and supply factors and is, therefore, appropriate for the attribution of the profits. It is also the most commonly followed approach by various countries.

Committee's Recommendations

4. The Committee observed that the application of formulary apportionment method is not feasible as it requires the complete information about the country wise sales revenue, manpower and assets, which is not easily available. Based on these challenges, the Committee suggested fractional approach on apportionment of profits derived from India which focusses on Indian operations and derives profits applying global profitability.

The Committee has suggested 3 factor apportionment approach by assigning equal weights to sales, manpower and assets, thus representing a mix of both supply and demand related factors. The committee has recommended the following formula for the attribution of profits:

Profits Attributable to operations in India

= 'Profits derived from India' x [SI/3xST + NI/6xNT) + (WI/6xWT) + (AI/3xAT)]

Where,

S_I = sales revenue derived by Indian operations from sales in India

S_T = total sales revenue derived by Indian operations from sales in India and outside India

N_I =number of employees employed with respect to Indian operations and located in India

N_T = total number of employees employed with respect to Indian operations and located in India and outside India

W_I= wages paid to employees employed with respect to Indian operations and located in India

W_T = total wages paid to employees employed with respect to Indian operations and located in India and outside India

A_I = assets deployed for Indian operations and located in India

A_T = total assets deployed for Indian operations and located in India and outside India

Further, the profits derived from India operations will be higher of the following:

(a)		Revenue derived from India X Global operational profit margin
(b)		2% of the revenue derived from India

Where,

♦		Revenue derived from India includes all the receipts arising or accruing or is deemed to accrue or arise from India which are chargeable under the head profits and gains of business and profession.
♦		Global operational Profit Margin shall be determined as an EBITDA margin of the enterprise.

Profit Attribution in case of Significant Economic Presence ("SEP")

5. For attribution of the global profits to the PE in India, in case of SEP, the Committee proposes the inclusion of 'users' as the fourth factor for apportionment, in addition to the other three factors of sales, manpower and assets. The committee is of the opinion that the user data and participation contribute to the value and profits of the business in digital economy and, hence, shall be taken into account for the appropriation of profits to the SEP.

The committee has suggested the weight age of 10% and 20% to the users for low user intensity business and high user intensity business respectively. The Committee has suggested the following formula:

(1) For low and medium user intensity

'Profits derived from India' x [0.3 X SI/ST + 0.15 X NI /NT) + (0.15X WI /WT ) + (0.3 AI /AT ) +0.1 ]

For

(2) High user intensity

'Profits derived from India' x [0.3 X SI/ST + 0.15 X NI /NT) + ( 0.15X WI /WT ) + (0.3 AI /AT ) +0.1 ]

Comments

6. The Attribution of profits is a complex and litigated issue, and thus, the Committee's report is a welcome step taken by CBDT towards providing a uniform approach for profit attribution. However, there are certain issues/challenges as highlighted below:

♦		As specified in the report, the Assessing Officer has the liberty to reject the accounts by citing some specific reasons. With respect to this certain guidelines should be given defining situations under which AO may reject the accounts of the entity. Keeping it wholly at the discretion of AO would lead to lot of litigation.
♦		The Committee in its report has proposed to amend Rule 10 wherein it has rejected the AOA Approach; however, clarification is required whether Section 92 of the Act would be applicable in determining the arm's length price of the transactions between the PE and the Associated Enterprises ("AEs").
♦		India has expressed strong reservations against the AOA Approach on the basis that it takes into consideration only the supply side factors and not the demand side factors, however, a true and proper FAR Analysis may take into consideration all the factors including demand side factors.
♦		Formula based approach recommended by the Committee, completely ignores the risk being taken by PE and the HO. It only considers the sales and cost factors in fixed weights. Though this aspect advocates the UN model and adopts the theory of force of attraction, it discourages the compensation to HO for taking the risk.
♦		The minimum threshold of 2% for the profits derived from India recommended by the Committee may pose double taxation issues for taxpayers. When global profit percentage has been considered where the entity is into profits, it would be unjust to consider a minimum threshold where non-resident enterprise is into losses. This is clearly a revenue centric approach and prejudicial to taxpayers.
♦		The Committee has recommended the formula for the attribution of the profits, however, the formulae recommended need a lot of clarifications, otherwise it will create more confusion and litigation. Some of the points that require clarification are highlighted below:

•

Following clarification is required in respect of the Global Profits for the calculation of Global Operational Profit Margin:

-		Whether the global profits as reflected in standalone accounts of Head office or consolidated accounts of head office are to be considered.?
-		How the global profits will be computed when the company is involved in more than 1 business segment.?
-		How the global profits will be computed in case of different financial year ending of the Head office?
-		Also, clarification is required on whether the global profits need to be computed as per Indian accounting standards or Generally Accepted Accounting Standards?

•		The Committee has proposed to use EBITDA margin (Earnings Before Interest, Tax, Depreciation and Amortization) for the computation of Global Operational Profit Margin, however, we are of the view that using EBITDA is grossly wrong and Profit Before Tax ("PBT") shall be used as an appropriate indicator because until and unless company does not have funds – it cannot source its assets, raw material, labour, etc. Further, until the company has assets it cannot manufacture goods. Further, the Committee has itself accepted contribution of assets in profits by using three factor formula wherein one of the factors is asset.
•		The formula requires use of sales revenue derived by Indian operation from sales in India and outside India. In case PE is not maintaining separate books guidance is also required to determine the value of sales revenue by the Indian operations.
•		Clarification is required in relation to which employees are to be considered while calculating the number of employees, viz., whether the personnel on retainership basis or part time employees are to be considered or not. Also, it is a huge challenge to determine the number of employees with respect to Indian operations and located outside India. In the operational pattern of multinational organization, employees of various group entities contribute to operations which finally results in Sales or supply which is relevant for India operations.
•		In relation to assets deployed for Indian operations and located in India, what assets are to be included, i.e., whether the intangible assets, leased assets, current assets are to included or not

7. The Profit Attribution in the case of SEP

-		The Committee has stressed upon the importance of taking into account the user participation as a factor for apportionment of the profits of SEP, however, it has not given a specific definition of the users that shall be considered while apportioning the profits. The definition of users is ambiguous and open ended, and, thus, clarification is required on whether both active and passive users are to be considered while determining the number of users? Also, only the users adding to the value of the enterprise shall be considered, however, practically classifying value adding and non-value adding users would be difficult.
-		The Committee has decided the weight of 10% and 20% to the users for low user intensity business and high user intensity business respectively. However, the classification of a business into low or high user intensity has not been specifically defined and is highly subjective.
-		The Committee has apportioned a flat factor to the users as per their intensity; however, no weights have been assigned to such factors. This is inappropriate as the 2 enterprises operating in a high intensity user business and having different number of users have been kept on similar footing and 0.2 flat factor has been assigned to both such enterprises without giving any consideration to the number of users involved.

Therefore, the attempt of CBDT of enhancing the uniformity of Rule 10 is a welcome move; however, various assumptions and computational aspects need to be reviewed to ensure that there are no interpretational issues.