Volume 6, Issue 9

10th June 2013

Tax Alert

Delhi Tribunal lays down four step procedure for attribution of profits to Permanent Establishment


The evaluation of the existence of a Permanent Establishment (PE) and attribution of profits thereto is a complex aspect of international taxation since it involves the interplay of domestic legislation vis-à-vis the provisions of tax treaties. Also, subjective interpretations and understanding of the business and industry by the taxpayers have led to protracted litigation between taxpayers and tax authorities on what reasonable attribution of profits would be.

Recently, the Delhi Bench of the Income Tax Appellate Tribunal (ITAT) in the case of Convergys Customer Management Group Inc (ITA Nos. 1443/Del/2012, 5243/Del/2011 & 1376/Del/2012) had to inter-alia decide whether the United States (US) company had a PE in India and if yes, how the profits should be attributed to the said PE. The ITAT, while deciding that the Indian subsidiary constituted a PE of the US company, laid down a four-step procedure to attribute profits to the Indian PE.  While there were various aspects which were subject matter of appeal in this case, the most interesting aspects relate to the constitution of a PE and attribution of profits to it, which have been discussed in this alert. 

Facts of the case

  • Convergys Customer Management Group Inc. (taxpayer) is a US company providing IT-enabled customer management services.
  • The taxpayer procures services from its Indian subsidiary, Convergys India Services Pvt. Ltd (CIS) for servicing its customers. CIS provides IT-enabled call centre/back-office support services to the taxpayer.
  • The taxpayer claimed that the services were procured from CIS on a principal to principal basis.
  • The taxpayer filed its tax return in India for Assessment Year (AY) 2006-07, reporting interest income and fees for included services from CIS.

Actions of the Assessing Officer

  • During assessment proceedings of the taxpayer for AY 2006-07 and AY 2008-09, the Assessing Officer (AO) made the following observations/adjustments to the taxpayer’s income:

Existence of PE

  • The AO held that the taxpayer has a Fixed Place PE in India and a place of management in India as per Article 5 of the India-US tax treaty as:
    • The employees of the taxpayer were seconded to CIS and they had a fixed place at their disposal in the form of premises of CIS;
    • The seconded employees were working on key positions in CIS such as Country Head and Managing Director;
    • The taxpayer had borne revenue expenses incurred for setting up call sites;
    • The taxpayer had provided free-of-cost assets, software in India, access to gateways, communication lines, etc. outside India to CIS for their use.
  • The AO alternatively held that the taxpayer has a Service PE and a Dependent Agent PE (DAPE) in India as per Article 5 of the India-US tax treaty.

Attribution of profits

  • After concluding that the taxpayer has a PE in India, the AO computed profits attributable to the Indian PE adopting a headcount basis and allocating its global revenue proportionately. The indirect expense allocation was made in a similar manner. 

Decision of the first appellate authority [CIT (A)] for AY 2006-07

  • Aggrieved by the said order for AY 2006-07, the taxpayer filed an appeal before the CIT(A). The CIT(A)’s observations/rulings were as under:

Existence of PE

  • The CIT(A) upheld the order of the AO as regards the existence of a Fixed Place PE of the taxpayer in India on the basis that CIS did not have economic or functional independence. However, the CIT(A) held that the taxpayer did not have a Service PE as the services rendered were covered as included services under Article 12 of the India-US tax treaty. Also, the taxpayer did not have a DAPE as the conditions mentioned in the India-US tax treaty were not satisfied.

Attribution of profits

  • The CIT(A) accepted that no further attribution is required to the extent of functions, assets and risks already captured in the transfer pricing analysis of CIS.
  • However, further profit was attributed on account of (i) assets deployed in India and (ii) entrepreneurial services to manage risk related to the service delivery performed in India.
  • The CIT(A) adopted an attribution mechanism linked to revenues generated in specific contracts.
  • The CIT(A) did not allow full deduction of expenses incurred outside India by invoking ceilings/limitations provided under Indian domestic tax laws.
  • Aggrieved by the CIT(A)’s order, the taxpayer and the AO filed cross appeals before the ITAT.
  • Interestingly, the AO accepted the CIT(A)’s decision with respect to Service PE and did not challenge it.

Decision of the Dispute Resolution Panel for AY 2008-09

  • The Dispute Resolution Panel (DRP) confirmed the draft order of the AO for AY 2008-09. Aggrieved by the same, the taxpayer filed an appeal before the ITAT.

Key Issues before the ITAT

  • Whether it could be said that the taxpayer had a PE in India?
  • If yes, whether the profits attributable to the PE as computed by the CIT(A) were correct?

Taxpayer’s contentions before the ITAT

Existence of PE

  • The mere existence of a subsidiary cannot lead to a conclusion of existence of a PE.
  • The allegations that people on assignment to CIS were employees of the taxpayer are based on surmises and conjectures.
  • The provision of assets and software free of cost cannot lead to a conclusion that the taxpayer was carrying on business in India.
  • The taxpayer was merely engaged in procuring services from India and therefore would fall within the exclusion clause provided in the India-US tax treaty.

Attribution of profits

  • The starting point for attribution of profits should be the arm’s length return/remuneration of the PE based on its Functions, Assets and Risk (FAR) profile. Since CIS has been remunerated at arm’s length, no further profits need to be attributed to CIS.
  • Further, the taxpayer has claimed that the substantial risk of procurement of these services from CIS lies with the taxpayer and since its customers are outside India, the aforesaid risk resides outside India. Hence, no profits should be attributed on account of management of risks.
  • Without prejudice, while computing the profits of the taxpayer, there is no question of applying the provisions of the ITA and hence, the deduction of expenses incurred outside India should be allowed.

ITAT’s Ruling

Existence of PE

  • The ITAT held that the taxpayer had a Fixed Place PE in India based on the following observations:
    • The employees of the taxpayer frequently visited the premises of CIS to provide supervision, control and direction over the operations of CIS;
    • Such employees had a fixed place of business at their disposal;
    • CIS was practically a projection of taxpayer’s business in India. CIS carried on its business under control and guidance of the taxpayer without assuming any significant risk;
    • The taxpayer had provided free-of-cost hardware and software assets to CIS.

Attribution of profits

  • The ITAT disagreed with the CIT(A)’s observation that further profits need to be attributed on account of management of risks as the risk in the present case resides outside India. The ITAT held that even otherwise no attribution for risks can be made as per Article 7(5) of the India-US tax treaty.
  • However, the ITAT held that further attribution should be made on account of the free-of-cost assets and software provided to CIS.
  • The ITAT held that the attribution of profits to the PE should be carried out according to the transfer pricing principles.
  • The ITAT laid down a four-step approach to arrive at the profits attributable to the PE and derived the figure of residual profits to be attributed between USA and India.
  • For attribution of residual profits, the ITAT relied on the judgments of the Supreme Court to arrive at a percentage of 15% of residual profits to be attributed to the PE.
  • Further, the ITAT held that since the income of the taxpayer is assessed in the hands of the PE, the income was not liable for tax withholding at source and hence, the taxpayer is liable to interest on the shortfall in taxes paid.

SKP’s Comments

  • The ruling acts as a mixed bag for foreign multinational corporations having subsidiaries in India.
  • This is one of the few rulings in the Indian context where a subsidiary has been held to constitute a Fixed Place PE rather than Service PE/DAPE, which is normally the case. Thus, foreign companies can no longer believe that setting up a subsidiary eliminates PE exposure.
  • Foreign companies would thus need to carefully analyse their business operations in India to ensure they do not constitute a PE in India which would require a business and tax review.   
  • Having said that, foreign companies, especially those operating their customer support functions from India, can take a cue from this ruling in reviewing their profit attribution strategy and transfer pricing analysis in light of the profit attribution mechanism suggested in this ruling.