permanent establishment - wirc€’authorised oecd approach then attributes profits to pe on the...

Permanent establishment

– Attribution of profits

Rakesh G. Alshi

October 2012

©2012 Deloitte Touche Tohmatsu India Private Limited

Synopsis

• Introduction to PE (Sec 9 & Article 5)

• Article 7 – At a Glance

• Article 7 vs. Article 9 – Profit Allocation

• Attribution of Profits

‒ Domestic Law

‒ OECD: Authorised Approach

• Judicial Precedents

• Practical Example on Attribution of Profits

2

©2012 Deloitte Touche Tohmatsu India Private Limited 3

Introduction

Question: Can country B tax part of seller‟s profit

Does seller has a PE in country B

3

SELLER Sale

BUYER

Country A Country B

Costs = $110

Seller‟s profit = $40 Pays price of $150

$150

©2012 Deloitte Touche Tohmatsu India Private Limited 4

Introduction

Section 9(1)(i) of the Income-tax Act ('ITA')

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

4


Introduction

OECD Model Convention

• Art 5(1) – Basic Rule (Fixed place PE)

• Art 5(2) – PE Inclusions

• Art 5(3) – PE in relation to construction /

installation projects / services

• Art 5(4) – List of exceptions (The Negative List)

• Art 5(5) – Dependent agents may be a PE

• Art 5(6) – Independent agents not a PE

• Art 5(7) – Associated Enterprises - Control of a subsidiary does not constitute a

PE

5


Article 7 – At a Glance

Para 1 - Part I - Existence of PE & attribution of Profits to business of such PE

Part II - Force of Attraction Rule (UN Model)

Para 2 - Principle of distinct and separate enterprise approach

Para 3 - Principles of Computation of income of PE

Para 4 - Source country can follow principles of apportionment, if customarily

followed

Para 5 - No allocation of profits for mere purchase of goods for the enterprise

Para 6 - Consistent use of Attribution method

Para 7 - Given priority to other article if profits include income taxable under other

article like CG, FTS, Royalty etc

6


Attribution of Profit

7


Attribution of Profits

• Instances of attribution of income – Clarification by CBDT

• No income will be deemed to accrue or arise in India if a Non-Resident sells

goods to Indian customer (including Indian subsidiary) provided that:

‒ The contracts to sell are made outside India

‒ The sales are made on a principal-to-principal basis and at arm‟s length

‒ The non-resident exercises no control over the business of the resident (the

subsidiary does not act as an agent of the parent company)

• If agent‟s commission fully represents value of profit attributable to his services

‒ prima-facie extinguishments of assessment

• If there be a business connection in India, the whole of the profit accruing or

arising from the business connection is not deemed to accrue or arise in India. It

is only that portion of the profit which can reasonably be attributed to the

operations of the business carried out in India, which is liable to income tax

….. CBDT Circular No. 23 dated July 27, 1969 (now withdrawn)

8


Attribution of Profits – Domestic Law

• Methods of Attribution….

• Presumptive Method [Rule 10(i)]

‒ Ad-hoc profits is estimated as attributable to the PE

• Proportionate Method [Rule 10(ii)]

‒ 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

9

Sections Nature of Business Extent of Taxable Income

44B Shipping business 7.5% of gross revenue

44BB Business of Exploration 10% of gross revenue

44BBA Business of Aircraft 5% of gross revenue

44BBB Turnkey Power Projects 10% of gross revenue


International Guidelines &

Judicial Precedents at India

10


International Guidelines / Rulings

Authorised OECD Approach

• Functionally Separate Entity Approach

‒ OECD Report on Attribution of profits has considered two approaches:-

• Relevant business activity approach

• Functionally separate entity approach (as used in Set Satellite (ITAT) decision)

‒ However, it has selected “Functionally separate entity approach”(FSE) as its

authorised approach.

‒ PE and Agent are not the same but are two taxable units distinct from each

other (concept of PE is hypothetical and fictional)

• Attribution Step 1 : Functional and Factual analysis

‒ Determine functions undertaken by dependent agent enterprise (DA) both on its

account and on behalf of non-resident enterprise

‒ DA to be rewarded for service it provides to the non-resident enterprise.

‒ PE will be attributed the assets and risks of the non-resident enterprise relating

to functions performed by DA on behalf of non-resident, together with sufficient

capital to support those assets and risks.

‒ Authorised OECD approach then attributes profits to PE on the basis of those

assets, risks and capital. 11



OECD Authorised Approach

• Attribution Step 2 : Determine profits based upon comparability analysis

‒ PE should obtain an arm‟s length return for it‟s functions, taking into account

the assets used & risks assumed in the same manner as would a comparable

enterprise.

‒ Profits should be attributed to the PE by applying methods described under

OECD‟s TP guidelines.

• Theory vs. Practical applicability

‒ OECD has focused on theoretical aspect of this hypothetical PE whereas

Australian Tax Office has gone ahead an provided specific examples on how to

attribute profits to a PE

12


Determining

the profits

of a PE

Functional/

factual analysis

to determine the

activities and

conditions of

the PE

Step 1:

hypothesising the PE

as a distinct and

separate enterprise

Step 2:

determining the

profits of the

PE

Functions performed

Assets used

Risks assumed

Capital and funding

Recognition of dealings

Comparability

analysis

Applying transfer pricing

methods to attribute

profits

OECD Approach

13


Important Judicial Precedents

Morgan Stanley & Co1 [Supreme Court (‘SC’)]

• Facts

‒ Morgan Stanley & Co („MS & Co‟) has a wholly owned subsidiary in India

‒ Indian subsidiary provides support to group‟s front office and infrastructure unit functions

in their global operations

‒ Pursuant to an agreement with Indian subsidiary, MS & Co proposed to send its

employees / personnel to India:

• For stewardship and other similar activities

• To work under control of Indian subsidiary and substantively perform functions within

capacity of Indian subsidiary‟s staff MNC India captures order(s) and negotiates price

• Held

‒ No fixed place PE under Article 5(1) of India – USA Treaty

‒ Does not have a “Service PE” on account of employees performing stewardship activities

‒ Would create a “Service PE” on account of deputation of employees to Indian subsidiary

‒ No further profits will be required to be attributed to the foreign enterprise where an

associated enterprise that constituted a PE is remunerated on arm‟s length basis taking

into account all the risk-taking functions of the enterprise.

14

1 292 ITR 416



Rolls Royce Plc2 [Income Tax Appellate Tribunal (‘ITAT’)]

• Facts

‒ Rolls Royce Plc („RRPLC‟), UK was engaged in the business of supplying aero engines to

Indian customers

‒ Rolls Royce India Limited („RRIL‟), subsidiary of RRPLC, with offices in India engaged in

business of providing support services to RRPLC

‒ Employees of RRPLC visit India frequently, occupy and use premises of RRIL during visits for

business purposes. Does not have a “Service PE” due to employees performing stewardship

activities

‒ Indian customers were required to route orders through office of RRIL Would create a “Service

PE” on account of deputation of employees to Indian subsidiary

‒ One of the arguments placed was “As long as Indian subsidiary is remunerated for services

rendered on an arm‟s length basis and all its actual income brought to tax, no further profits are

attributable to PE in India”.

• Held

‒ RRPLC has a business connection under section 9(1)(i) of the Act

‒ RRPLC has a PE in India within the meaning of Article 5(1) of the Treaty

‒ Employees of RRIL functionally accountable to RRPLC

‒ Activities undertaken by RRIL much more than what was specified in the agreement

‒ Activities undertaken by RRIL are not preparatory or auxiliary in nature

‒ Activities of RRIL an essential and significant part of business activity of RRPLC

15

2 113 TTJ 446



• RRPLC has a PE in India under Article 5(4)(c) of the Treaty

‒ RRIL is dependent on RRPLC acting wholly for RRPLC

‒ RRIL and its employees solicit and receive orders wholly and exclusively on behalf of

RRPLC

• ITAT allocated 35% of global profits from India sales towards marketing activities

• Held the same to be taxable in India [PE in India under Article 5(4)(c) of Treaty]

‒ Activities carried on outside India not taxable

• 50% of profits allocated towards manufacturing activities

• 15% of profits allocated towards research and development activities

‒ Activities carried out in India and allocated profits thereon is taxable

• Contracts signed outside India yet the negotiations took place in India

• 35% of profits allocated towards marketing activities taxable in India

16



Nokia, Ericsson & Motorola3 (ITAT - Special Bench) \

• Facts

‒ Motorola Inc („Motorola‟), Ericsson Radio Systems AB („Ericsson‟) and Nokia Networks

OY („Nokia‟) executed contracts with Indian telecom operators

• For supply of advanced network equipment

‒ Motorola and Nokia had wholly owned subsidiaries in India

‒ Additionally Nokia had a liaison office in India

‒ Ericsson had a branch for the first 3 months and later a wholly owned subsidiary of a

group company

‒ Equipment was supplied from overseas; installation was carried out in India

• Held

‒ Motorola and Ericsson were held not to constitute a PE in India

‒ Nokia was held to constitute a „fixed base‟ PE in India on the basis that the Indian

subsidiary was a „virtual projection‟ of Nokia

‒ ITAT allocated 20% of global profits from India sales towards marketing activities

17

3 95 ITD 269



Galileo International Inc. vs. DCIT

• Facts

‒ Galileo International Inc.(Galileo US) is in the business of computerized reservation

system (CRS).

‒ Galileo US appointed on unrelated distributor to market and distribute CRS to travel

agents in India.

‒ CRS is a seamless process with transactions originating & concluding at travel agents

desk.

‒ All travel agents situated in India. Additionally, the equipment, connectivity & configuration

are provided by Galileo US

• Held

‒ Galileo US has a fixed place PE in India as the source of revenue is partially existent in

the computer installed by Galileo US through its agents at Travel Agent‟s premises.

‒ Unrelated Distributor is functionally & financially dependent on Galileo US – hence an

agency PE.

‒ 15% of revenue accruing to Galileo in respect of bookings made in India was income

accruing/arising in India.(Further, Galileo US may deduct remuneration paid to

distributors)

‒ Amadeus Global Travel Distribution SA

‒ This ruling is on similar lines of Galileo International

18



SET Satellite (Singapore) Pte Limited4 (ITAT)

(Later overruled by Mumbai High Court – based on Morgan Stanley Ruling)

• Facts

‒ SET Satellite (Singapore) Pte Limited is engaged in the business of broadcasting TV

channels

‒ Set India Private Limited („DA‟) markets ad space to advertisers in India on its behalf for

an arm‟s length commission

• Held

‒ Dependent agent PE („PE‟) and DA are not the same but two distinct taxable units

‒ Tax liability of the enterprise in respect of its PE is not extinguished by making an arms‟

length payment to DA

‒ Taxability of PE should be determined on the basis of Functional and Risk Analysis in

respect of the business carried on by it

• Remuneration paid to DA would be treated as an expense of PE

19

4 106 ITD 175



BBC Worldwide Ltd.

• Facts

‒ BBC Worldwide Limited (BBC UK) operated as consumer media company in the areas of

television, publishing and program licensing etc.

‒ BBC UK appointed its indirect subsidiary as authorized agent in India for the purpose of

soliciting orders for the sale of advertising airtime

‒ Commission rate of 15% of the Indian revenues was fixed as consideration

• Held

‒ The ITAT held that the commission of 15% is already determined to be at arm‟s length.

‒ Relying on the decision of Morgan Stanley, the ITAT held that if the correct arm‟s length

price is applied and paid to dependent agent, nothing further would be left to be taxed in

the hands of the foreign enterprise.

20



Linklaters LLP (Mumbai ITAT)

• Facts

‒ Linklaters LLP a UK based law firm rendered legal services to clients with operations /

projects in India. Linklaters LLP did not have an office in India.

‒ For rendering services, its partners and employees visited India

‒ As the services rendered in India exceeded 90 days, a Service PE came into existence

• Held

‒ Utilisation of service in India is sufficient to attract taxability in India

• considering the retrospective amendment to section 9(1) by Finance Act 2010

‒ Hypothetical independence in Article 7(2) is confined to PE‟s transactions with its head

office and branches and does not extend to transactions with third parties

‒ As regards quantum of profits attributable to PE, Article 7(1) provides for the taxability of

profits “directly or indirectly” attributable to the PE.

• The words profits attributable to the PE incorporate the „force of attraction‟ principle.

‒ Thus, 100% profit relating to services rendered by the taxpayer whether in India or

outside India in respect of Indian projects is taxable in India.

21


Practical Example on

Attribution of Profit

22


MNC Group

ForCo

IndCo

Customers

Sales

Support

Services

Outside India

In India

Business Structure

23


Functional profile of IndCo

IndCo: Functional and Risk Profile

• Independent support service provider for sales in India

• Solicit orders on price & terms laid down by ForCo

• Provide market information

• Undertake market research on competition & pricing

• Prepare & suggest future business plans

• Draft strategic, operational, marketing and sales plans

• Act as a forum for customer grievances

• Provides assistance in inventory management

• Provide administrative assistance to conduct promotions/marketing events

• Track sales target achievements by customers

• Follow up with customers for payment

• Cannot accept orders on behalf of ForCo

• Does not hold product inventory

• Does not undertake bad debts and product risk

24


Functional profile of ForCo

ForCo: Functional and Risk Profile

• Determines price, terms and conditions for sale

• Authority to accept/reject order(s) submitted by IndCo

• No order binding until accepted by ForCo

• Shipment of products to Indian customers

• Training sales personnel of IndCo

• Investment in working capital- primarily of Inventory and Accounts Receivable

• Market fluctuation risks undertaken

• Bad debt risks borne

• Inventory Risks borne:- Procurement, Holding and Breakages.

• Legal and Economic Ownership of Brands

25



• Summarized FAR analysis

26

FAR ForCo IndCo

Functions

Product ordering √√

Marketing – sales force √√

Marketing / advertising strategy √√

Inventory Management √√

Delivery / Shipping Management √√

Debt management and collections √√

After Sales Support √√

Assets

Brand √√

Property, plant and equipment (distribution) √√

Inventory √√

Receivables √√

Risks

Inventory Risk √√

Credit Risk √√

Foreign Exchange Risk √√


Legal Interpretations on existence of PE

• Agency PE under Article 5(4)

‒ Arguable no Agency PE for ForCo since:

• ForCo determines the price, terms and conditions at which goods are sold;

• IndCo merely communicates same to customers in India

• IndCo, an agent of independent status of ForCo

• IndCo ought to be regarded as legally and economically independent of ForCo

• IndCo is engaged in manufacture and distribution of products which constitute

significant activity / function / business for IndCo

• Activities of IndCo under GTME business does not constitute wholly or almost wholly

significant activity / function / business for IndCo

• IndCo in ordinary course of its business renders sales and marketing services to ForCo

• IndCo has no authority to conclude contracts

• IndCo premises not at disposal of / earmarked for ForCo

• IndCo only forwards order(s) to ForCo for its approval

• IndCo only service provider / facilitator

27


Likely stand of Revenue Authorities

(after scratching economic substance!!)

ForCo has taxable presence in India if:

• Basic PE Rule under 5(1)

‒ All orders routed through IndCo

‒ IndCo captures order(s) and negotiates price

‒ Premises of IndCo are at the disposal of ForCo

‒ ForCo employs services of IndCo to conduct business

‒ IndCo is virtual projection of ForCo at India

• ForCo has Agency PE under Article 5(4)(c) in India if:

‒ IndCo is dependent on ForCo and is acting wholly for MNC Group

‒ Promotions / Marketing events are handled entirely by IndCo with no

interactions with ForCo

‒ Solicits orders and handles price negotiations

‒ Places orders with ForCo on behalf of customers

‒ Deals with pricing queries and negotiations

‒ Indian customers route their orders through IndCo

‒ Core activity of marketing, negotiating and selling undertaken by IndCo

28


Assuming there is PE

Attribution of Profit to ForCo

29



• Step I – Functional Analysis of PE

30

FAR ForCo IndCo PE

Functions

Product ordering √√ √√

Marketing – sales force √√ √√

Marketing / advertising strategy √√ √√

Inventory Management √√ √√

Delivery / Shipping Management √√ √√

Debt management and collections √√ √√

After Sales Support √√ √√

Assets

Brand √√

Property, plant and equipment (distribution) √√

Inventory √√

Receivables √√

Risks

Inventory Risk √√

Credit Risk √√

Foreign Exchange Risk √√



• Step II: Undertake comparability analysis to reward FAR of the PE

‒ Characterisation: Distributor

‒ Comparable Search for Distribution Companies: Prowess & Capitaline

‒ Apply appropriate filters for arriving at final comparable companies

31

Results Operating Margin

Upper Quartile 5%

Median 4%

Lower Quartile 2%

Arithmetic Mean 3%


Exposure Summary – Indian Rulings & International

Guidelines

Particulars

• Morgan Stanley / BBC (Nil - if remunerated at arm's length)

• Rolls Royce (35% of Global Profits)

• Nokia, Ericsson & Motorola (20% of Global Profits)

• Galileo and Amadeus (15% of Revenue)

• Linklaters (ITAT) – 100% of Global Profits (force of attraction principle)

• Set Satellite (ITAT) / OECD / ATO (@3.27% OM)

32


Questions

33


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