Draft CBDT guidelines on Profit Attribution to Permanent Establishment
Permanent Establishment (PE) and attribution of profits to a PE is a very complex subject. From an Indian tax standpoint, there has been a fair amount of litigation on the said issue. Indian tax laws provided little guidance on profit attribution in the form of Rule 10 and provided unlimited powers to the tax officer for attributing the profits in India. Accordingly, there was a dire need to have appropriate attribution rules which provides certainty and remove arbitrary approach that was being followed.
Draft guidelines on profit attribution to permanent establishments, issued by Central Board of Direct Taxes (CBDT), is a welcome move and step in the right direction to have certainty on profit attribution.
Current Profit Attribution Rules
As per the Indian tax laws, the income of a non-resident, which accrues or is deemed to accrue in India (i.e., by having a Business Connection/PE), is taxable in India. Once a Business Connection/PE is established, the income attributable to such Business Connection/PE is taxed in India. As per current rules, if a tax officer is of the opinion that the actual income, accruing/arising through a Business Connection/PE, cannot be ascertained, then the tax officer can follow any of the following methods:
- The percentage of turnover as the Tax Officer considers reasonable
- A proportionate approach, i.e., by considering the ratio of the profit/receipts to the total profit/receipts; or
- Any other method deemed suitable.
Existing rules provide discretionary powers to the tax officer in profit attribution. This often results in high profits being attributed to the Indian Business Connection/PE, which sometimes lead to high-pitched tax assessments for foreign companies. In light of this, there was a dire need to have certain standard rules to avoid uncertainty.
Accordingly, Draft guidelines on profit attribution to permanent establishments issued by CBDT would be helpful to achieve certainty.
Current Profit Attribution Rules
CBDT had set-up a committee to examine the existing profit attribution rules, examine the contribution of demand and supply side in profit attribution, and recommend changes to profit attribution rules. The committee rejected the authorized Organisation for Economic Co-operation and Development (OECD) approach, which is based on Functions Assets and Risks performed as provided under transfer pricing guidelines. The OECD approach provides for greater taxing rights to the country of the resident taxpayer. The committee was of the view that the Indian treaties are based on UN- model convention and hence rejected the authorized approach of OECD. Furthermore, the committee also highlighted that India had expressed its reservations with respect to the same on an international diaspora. Moreover, the current method of profit attribution under Rule 10 is inconsistent with international practices and results in prolonged litigation.
In view of the above, in its report, the Committee has considered three methods for profit attribution to the PE which are as follows:
This is one of the most talked about option for attributing profits basis a three formula factor. This method considers aggregate sales (first factor), manpower, wages or payroll (second factor) and assets or property (third factor) in relation to Indian operations.
It was discussed that the said approach will require complete information about the country-wise sales revenue as well as the deployment of manpower and assets, which are not easily available. Although it was discussed that these details would be provided in MNC’s Country by Country Report (CbCr), however, since the threshold for CbCr reporting is Euro 750 million, the details of many MNC’s with small turnover may still not be available. Also, the usage of data collected under CbCr has its own challenges.
This method looks at apportionment of profits derived from India and does not require consolidation of profits of the enterprise from different tax jurisdiction. This method is currently prescribed under rule 10 of the income tax rules and has also been applied and upheld in many judicial precedents.
This method takes into account the demand-side- and supply-side factors. This method allocates one third to sales and two third to the supply side. Thus, it equally distributes taxing rights between demand and supply jurisdiction.
Attribution based on demand and supply factors
This method looks at apportioning profits from Indian operations (in and outside India) based on sales (representing the demand factors, 33% weight), manpower and assets (being supply factors, together 67% weight).
Considering the above, the committee has provided following mechanism for attribution profit to the PE:
Computing the Profit to be Attributed
The profit derived from India shall be the revenue derived from India multiplied by the global profit margin (generally the EBITDA margin). However, globally if an entity results in a loss, a minimum profit margin at 2% of the gross revenue would have to be applied.
The committee provides for a minimum profit attribution of 2% in the case where global operations are loss-making under the assumption that Indian business would be profitable. Thus, India should not be deprived of its fair share of taxes merely because global operations are loss making.
Manner of Attributing the Profit Computed (as per ‘A’ above)
The profit derived shall be attributed in the following manner:
In the above formula, sales shall mean the proportion of sales derived by Indian operations from sales in India to total sales revenue derived by Indian operations from sales in India and outside India.
Employees shall mean the proportion of employees employed with respect to Indian operations and located in India to total employees employed with respect to Indian operations and located in India and outside India. The quantum of wages and assets shall be determined on the similar basis.
In cases where entities, having Significant Economic Presence (SEP) in India, the profit shall be attributed by considering the above factors (i.e., sales, employees, wages) and ‘users’. Furthermore, it recommends that users should be assigned weight of 10% (along with sales at 30%, employees and wages at 15% each and assets at 30%) in cases of low- and mediumintensity users and 20% (along with sales at 30%, employees and wages at 12.5% each and assets at 25%) in cases of high-intensity users.
In cases where a Business Connection/ PE is constituted in India via an associated enterprise (AE), which receives payments for sale/services in excess of INR 10,00,000, then profits shall be attributed as per above scenarios. However, such profits would be reduced by the profits already subjected to tax in the hands of AE. Alternatively, in cases where the AE receives payments less than INR 10,00,000 and remunerated at arm’s length, no further attribution would be required.
While having a set of uniform profitattribution rules is the need of the hour, the current rules may have some challenges. This approach may pose many challenges for the multinationals, constituting a PE in India, as the standard arm’s length approach that is determined based on the FAR analysis may no longer be relevant. This approach assumes that the Indian PE would be involved in the sales function and hence attribution based on sale-side factor would be required in all cases. This approach may lead to absurd results in cases where the Indian PE does not have much role in sales due to the brand of the foreign enterprise. Ideally, the arm’s length approach should cover all the profits derived by an Indian PE and unless the transfer pricing study is not appropriate, resorting to other methods may not give a fair result. The only exception provided under the approach is the constitution of a PE in cases where revenues are not generated in India (or are less than INR 1 million from India), and the Indian entity is remunerated at arm’s length. In all other cases, the revenues to be attributed to India would have to be considered based on the three factors of sales, supply, and assets.
Furthermore, as per the current formulae provided, there could be issues in gathering data, determining low-, medium-, and high-intensity users. Also, minimum profit attribution of 2%, in case of global losses, can pose challenges for Foreign Companies to claim a tax credit in the home country, which may lead to double taxation.
Currently, these rules are open for modifications vide suggestions from various stakeholders. As a result, it is still possible that the said rules could be further tweaked after considering the challenges posed by the said rules.