July 2019

RECENT IMPORTANT DEVELOPMENTS – PART I

Mayur B. Nayak | Tarunkumar G. Singhal | Anil D. Doshi
Chartered Accountants

In this issue we are covering recent major developments in the field of International Taxation and the work being done at OECD in various other related fields. It is in continuation of our endeavour to update readers on major International Tax developments at regular intervals. The items included here are sourced from press releases of the Ministry of Finance and CBDT communications.

 

DEVELOPMENTS IN INDIA RELATING TO INTERNATIONAL TAX

 

(I) CBDT’s proposal for amendment of Rules for Profit Attribution to Permanent Establishment

 

The CBDT vide its communication dated 18th April, 2019 released a detailed, 86-page document containing a proposal for amendment of the Rules for Profit Attribution to Permanent Establishment, for public comments within 30 days of its publication. The CBDT Committee suggested a ‘three-factor’ method to attribute profits, with equal weight to (a) sales, (b) manpower, and (c) assets. The Committee justifies the three-factor approach as a mix of both demand and supply side that allocates profits between the jurisdictions where sales takes place and the jurisdictions where supply is undertaken. The CBDT Committee has recommended far-reaching changes to the current scheme of attribution of profits to permanent establishments.

 

The report outlines the formula for calculating “profits attributable to operations in India”, giving weightage to sales revenue, employees, wages paid and assets deployed.

 

The relevant portion of the ‘Report on Profit Attribution to Permanent Establishments’ containing the Committee’s conclusions and recommendations in paragraphs 179 to 200 is given below for ready reference:

 

“Conclusions and recommendations of the Committee

179.   After detailed analysis of the issues related to attribution of profits, existing rules, their legal history, the economic and public policy principles relevant to it, the international practices, views of academicians and experts, relevant case laws and the methodology adopted by tax authorities dealing with these issues, Committee concluded its observations, which are summarised in following paragraphs.

 

11.1 Summary of Committee’s observations and conclusions

 

180.   The business profits of a non-resident enterprise is subjected to the income-tax in India only if it satisfies the threshold condition of having a business connection in India, in which case, profits that are derived from India from its various operations including production and sales are taxable in India, either on the basis of the accounts of its business in India or where they cannot be accurately derived from its accounts, by application of Rule 10, which provides a wide discretion to the Assessing Officer. Where a tax treaty entered by the Central government is applicable, its provisions also need to be satisfied for such taxation. As per Article 7 of UN model tax convention (which is usually followed in most Indian tax treaties, sometimes with variations), only those profits of an enterprise can be subjected to tax in India which are attributed to its PE in India, and would include profits that the PE would be expected to make as a separate and independent entity. Under the force of attraction rules, when applicable, it would include profits from sales of same goods as those sold by the PE that are derived from India without participation of PE. Profits attributable to PE can be computed either by a direct accounting method provided in paragraph 2 or by an indirect apportionment method provided in paragraph 4 of Article 7.

 

181.   An analysis of Article 7 and its legal history shows that there are three standard versions. The Article 7 which exists in UN model tax convention is similar to the Article 7 as it existed in the OECD model convention prior to 2010, except that the UN model tax convention allows the application of force of attraction rules and restricts deduction of certain expenses payable to the head office by the PE. This Article in the OECD model convention was revised in 2010. Under the revised article the profits attributable to the PE are required to be determined taking into account the functions, assets and risk, and the option of determining them by way of apportionment has been excluded.

 

182.   One of the primary implications of the 2010 revision of Article 7 by OECD was that in cases where business profits could not be readily determined on the basis of accounts, the same were required to be determined by taking into account function, assets and risk, completely ignoring the sales receipts derived from that tax jurisdiction. This amounts to a major deviation, not only from the rules universally accepted till then, but also from the generally applicable accounting standards for determining business profits, where business profits cannot be determined without taking sales into account.

 

183.   Economic analysis of factors that affect and contribute to business profits makes it apparent that profits are contributed by both demand and supply of the goods. Accordingly, a jurisdiction that contributes to the profits of an enterprise either by facilitating the demand for goods or facilitating their supply would be reasonably justified in taxing such profits. The dangers of double taxation of such profits can be eliminated by tax treaties. If taxes collected facilitate economic growth in that jurisdiction, the demand for goods rises, which in turn also benefits the tax-paying enterprise, resulting in a virtuous cycle that benefits all stakeholders. On the contrary, if the jurisdiction is unable to collect tax from the non-resident suppliers, it would be forced to collect all the taxes required from the domestic tax-payers, which in turn would reduce the ability of consumers to pay, reduce their competitiveness, hurt economic growth and the aggregate demand, resulting in a vicious cycle, which will adversely affect all stakeholders, including the foreign enterprises doing business therein.

 

184.   Broadly, possible approaches for profit attribution can be summed in three categories – (i) supply approach allocates profits exclusively to the jurisdiction where supply chain and activities are located; (ii) demand approach allocates profits exclusively to the market jurisdiction where sales take place; (iii) mixed approach allocates profits partly to the jurisdiction where the consumers are located and partly to the jurisdiction where supply activities are undertaken.

185.   The mixed approach appears to have been most commonly adopted in international practices, though in some cases demand approach has also been favoured. In contrast, supply side does not appear to have been adopted anywhere, except in the 2010 revision of Article 7 of the OECD model convention, which requires determination of profits without taking sales into account. As a consequence, the contribution of demand to profits is completely ignored.

 

186.   A purview (sic) of academic literature and views suggests a wide acceptance in theory that demand, as represented by sales, can be a valid ground for attribution of profits. There also exists a diversity of views among academicians and experts on the validity of the revised OECD approach for profit attribution contained in the AOA. A number of international authors disagree with it and many have been critical of this approach.

 

187.   The AOA approach can have significant adverse consequences for developing economies like India, which are primarily importers of capital and technology. It 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. Instead, it can set a vicious cycle in place that can harm all stakeholders.

 

188.   The lack of sufficient justification or rationale and its potential adverse consequences fully justify India’s strongly-worded position on revised Article 7 of OECD model convention, wherein India has not only found it unacceptable for adoption in Indian tax treaties, but also rejected the approach taken therein. This view of India, that since business profits are dependent on sale revenues and costs, and since sale revenues depend on both demand and supply, it is not appropriate to attribute profits exclusively on the basis of function, assets and risks (FAR) alone, has been communicated and shared with other countries consistently and on a regular basis.

 

189.   Since, the revised Article 7 of OECD model tax convention has not been incorporated in any of the Indian tax treaties, the question of AOA being applicable on Indian treaties or profit attributed therein cannot arise. For the same reason, additional guidance issued by OECD with reference to AOA in respect of the changes in Article 5 introduced by the Action 7 of the BEPS project on Artificial Avoidance of PE Status, also does not have any relevance to Indian tax treaties. This, however, means that India cannot depend on OECD guidance and gives rise to a need for India to consider ways and means for bringing greater clarity and objectivity in profit attribution under its tax treaties and domestic laws, especially in consequence to the changes introduced as a result of Action 7.

 

190.   An analysis of case laws indicates that the courts have upheld the application of Rule 10 for attribution of profits under Indian tax treaties. In several such cases, the right of India to attribute profits by apportionment, as permissible under Indian tax treaties, has also been upheld by the courts. The judicial authorities do not appear to have insisted on a universal and consistent method. They have also upheld the wide discretion in the hands of the Assessing Officer under Rule 10 of the Rules, but corrected or modified his approach for the purpose of ensuring justice in particular cases. Thus, diverse methods of attributing profits by apportionment under Rule 10 of the Rules are in existence. In the view of the Committee, the lack of a universal rule can give rise to tax uncertainty and unpredictability, as well as tax disputes. Thus, there seems to be a case for providing a uniform rule for apportionment of profits to bring in greater certainty and predictability among taxpayers and avoid resultant tax litigation.

 

191.   A detailed analysis of methods adopted by tax authorities for attributing profits in recent years also highlights similar diversity in the methods adopted by assessing officers for attribution of profits, which reaffirms the need to consider possible options that can be consistently adopted as an objective method of profits attribution under Rule 10 of the Rules, and bring greater clarity, predictability and objectivity in this exercise. Any options considered for this purpose must be in accordance with India’s official position and views and must address its concerns.

 

192.   Accordingly, the Committee considered some options based on the mixed or balanced approach that allocates profits between the jurisdiction where sales take place and the jurisdiction where supply is undertaken. The Committee did not find the option of formulary apportionment method apportioning consolidated global profits feasible, in view of the practical constraints in obtaining information related to jurisdictions outside India. Thus, the Committee considers that it may be preferable to adopt a method that focuses on Indian operations primarily and derives profits applying the global profitability, with necessary safeguards to prevent excessive attribution on the one hand and protect the interests of Indian revenue on the other.

 

193.   The Committee found the option of Fractional Apportionment based on apportionment of profits derived from India permissible under Indian tax treaties as well as Rule 10, and relatively feasible as it is based largely on information related to Indian operations. Out of various possible options of apportioning profits by a mixed approach, the Committee found considerable merit in the three-factor method based on equal weight accorded to sales (representing demand) and manpower and assets (representing supply, including marketing activities).

 

194.   After taking into account the principle laid down by the Hon’ble Supreme Court in the case of DIT vs. Morgan Stanley, and the need to avoid double taxation of profits from Indian operations in the hands of a PE, which is primarily brought into existence either by the presence of an Indian subsidiary carrying on parts of an integrated business, whose profits are separately taxed in its hands in India, the Committee found it justifiable that the profits derived from Indian operations that have already been subjected to tax in India in the hands of a subsidiary should be deducted from the apportioned profits. The Committee observed that in a case where no sales takes place in India, and the profits that can be apportioned to the supply activities are already taxed in the hands of an Indian subsidiary, there may be no further taxes payable by the enterprise.

 

195.   In this option, in order to ensure objectivity and certainty, profits derived from India need to be defined objectively. The Committee considers that the same can be arrived at by multiplying the revenue derived from India with global operational profit margin [in order to avoid any doubt the global operational profit margin is the EBITDA margin (earnings before interest, taxes, depreciation and amortization) of a company]. However, the Committee also noted the need to protect India’s revenue interests in cases where an enterprise having global losses or a global profit margin of less than 2%, continues with the Indian operations, which could be more profitable than its operations elsewhere. In the view of the Committee, the continuation of Indian operations justifies the presumption of higher profitability of Indian operations, and in such cases a deeming provision that deems profits of Indian operations at 2% of revenue or turnover derived from India should be introduced.

 

196.   After taking into account the developments in taxation of digital economy and the new Explanation 2A, inserted by the Finance Act, 2018, explicitly including significant economic presence within the definition of business connection, the Committee considered it necessary to take into account the role and relevance of users in contributing to the business profits of multi-dimensional business enterprises. Users can be a substitute to either assets or employees and supplement their role in contributing to profits of the enterprise.

 

197.   After considering various aspects of users’ contribution, the Committee came to the conclusion that user data and activities contribute to the profits of the multi-dimensional enterprises and there is a strong case of taking them into account, per se, as a factor in apportionment of profits derived from India by enterprises conducting business through multi-dimensional business models where users are considered crucial to the business. The Committee concluded that for such enterprises, users should also be taken into account for the purpose of attribution of profits, as the fourth factor for apportionment, in addition to the other three factors of sales, manpower and assets.

 

198.   Although a recent amendment of the 2016 proposal for CCCTB has proposed assigning a weight to the users that is equal to the other three factors of sales, manpower and assets, the Committee found it preferable to assign a relatively lower weight of 10% to users in low and medium user intensity models and 20% in high user intensity models at this stage, with the corresponding reduction in the weightage of employees and assets except for sales being assigned 30% weight in apportionment in both the fact patterns. Given the rapid expansion of digital economy and the ongoing developments related to rules governing its taxation, it may be necessary to monitor the role of users and their contribution to profits in future and accordingly assess the need for considering a review of the weight assigned to users in subsequent years.

 

11.2 Recommendations

 

199.   In view of the above, the Committee makes the following recommendations:

 

(i)   Rule 10 may be amended to provide that in the case of an assessee who is not a resident of India, has a business connection in India and derives sales revenue from India by a business all the operations of which are not carried out in India, the income from such business that is attributable to the operations carried out in India and deemed to accrue or arise in India under clause (i) of sub-section(1) of section 9 of the Act, shall be determined by apportioning the profits derived from India by three equally weighted factors of sales, employees (manpower and wages) and assets, as under:

 

Profits attributable to operations in India =

‘Profits derived from India’ (“Profits derived from India” = Revenue derived from India x Global operational profit margin as referred in paragraph 159.) x [SI/3xST + (NI/6xNT) +(WI/6xWT) + (AI/3xAT)]

 

Where,

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

 

(ii)  The amended rules should provide that ‘profits derived from Indian operations’ will be the higher of the following amounts:

a. The amount arrived at by multiplying the revenue derived from India x Global operational profit margin, or

b. Two percent of the revenue derived from India

 

(iii) The amended rules should provide an exception for enterprises in case of which the business connection is primarily constituted by the existence of users beyond the prescribed threshold, or in case of which users in excess of such prescribed threshold exist in India. In such cases, the income from such business that is attributable to the operations carried out in India and deemed to accrue or arise in India under clause (i) of sub-section (1) of section 9 of the Act, shall be determined by apportioning the profits derived from India on the basis of four factors of sales, employees (manpower and wages), assets and users. The users should be assigned a weight of 10% in cases of low and medium user intensity, while each of the other three factors should be assigned a weight of 30%, as under:

 

Profits attributable to operations in India in cases of low and medium user intensity business models =

‘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, the users should be assigned a weight of 20%, while the share of assets and employees be reduced to 25% each after keeping the weight of sales as 30% as under:

 

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]

 

(iv) The amended rules should also provide that where the business connection of the enterprise in India is constituted by the activities of an associate enterprise that is resident in India and the enterprise does not receive any payments on accounts of sales or services from any person who is resident in India (or such payments do not exceed an amount of Rs. 10,00,000) and the activities of that associated enterprise have been fully remunerated by the enterprise by an arm’s length price, no further profits will be attributable to the operation of that enterprise in India.

 

(v) However, where the business connection of the enterprise in India is constituted by the activities of an associate enterprise that is resident in India and the payments received by that enterprise on account of sales or services from persons resident in India exceeds the amount of Rs. 10,00,000 then profits attributable to the operation of that enterprise in India will be derived by apportionment using the three factors or four factors as may be applicable in his case and deducting from the same the profits that have already been subjected to tax in the hands of the associated enterprise. For this purpose, the employees and assets of the associated enterprise will be deemed to be employed or deployed in the Indian operations and located in India.

 

200.   The Committee recommends the amendment of Rule 10 accordingly. The Committee also recommended that an alternative can be amendment of the IT Act itself to incorporate a provision for profit attribution to a PE.”


The Bombay Chartered Accountants’ Society has also given its comments and suggestions in this regard. The final rules based on the public comments received are awaited.

 

(II)    Finance Minister N. Sitharaman bats for 'SEP'-based solution to vexed digitalisation issue at G-20 meet (Source: Press Release of Ministry of Finance dated 9th June, 2019)

The Union Minister for Finance and Corporate Affairs, Mrs. Nirmala Sitharaman, attended the G-20 Finance Ministers’ and Central Bank Governors’ meeting and associated events and programmes on 8th and 9th June, 2019 at Fukuoka, Japan. She was accompanied by Mr. Subhash C. Garg, Finance Secretary and Secretary, Economic Affairs, Dr. Viral Acharya, Deputy Governor of the RBI, and other officers.

 

Mrs. Sitharaman flagged serious issues related to taxation and digital economy companies and to curb tax avoidance and evasion. She highlighted the issue of economic offenders fleeing legal jurisdictions and called for cohesive action against them.

 

The Finance Minister noted the urgency to fix the issue of determining the right nexus and profit allocation solution for taxing the profits made by digital economy companies. Appreciating the significant progress made under the taxation agenda, including the Base Erosion and Profit Shifting (BEPS), tax challenges from digital economy and exchange of information under the aegis of G-20, she congratulated the Japanese Presidency for successfully carrying these tasks forward.

 

She noted that the work on tax challenges arising from the digitalisation of economy is entering a critical phase with an update to the G-20 due next year. In this respect, Mrs. Sitharaman strongly supported the potential solution based on the concept of ‘significant economic presence’ of businesses taking into account the evidence of their purposeful and sustained interaction with the economy of a country. This concept has been piloted by India and supported by a large number of countries, including the G-24. She expressed confidence that a consensus-based global solution, which should also be equitable and simple, would be reached by 2020.

 

Welcoming the commencement of automatic exchange of financial account information (AEOI) on a global basis with almost 90 jurisdictions successfully exchanging information in 2018, the Finance Minister said this would ensure that tax evaders could no longer hide their offshore financial accounts from the tax administration. She urged the G-20 / Global Forum to further expand the network of automatic exchanges by identifying jurisdictions, including developing countries and financial centres that are relevant but have not yet committed to any timeline. Appropriate action needs to be taken against non-compliant jurisdictions. In this respect, she called upon the international community to agree on a toolkit of defensive measures which can be taken against such non-compliant jurisdictions.

 

Earlier, she participated in the Ministerial Symposium on International Taxation and spoke in the session on the ongoing global efforts to counter tax avoidance and evasion. During the session, she also dwelt on the tax challenges for addressing digitalisation of the economy and emphasised that nexus was important. Mrs. Sitharaman also raised the need for international co-operation on dealing with fugitive economic offenders who flee their countries to escape from the consequences of law. She also highlighted the fugitive economic offenders’ law passed by India which provides for denial of access to courts until the fugitive returns to the country. This law also provides for confiscation of their properties and selling them off.

 

She drew attention to the practice permitted by many jurisdictions which allow economic offenders to use investment-based schemes to obtain residence or citizenship to escape from legal consequences and underlined the need to deal with such practices. She urged that closer collaboration and coordinated action were required to bring such economic offenders to face the law.

 

India’s Finance Minister highlighted the need for the G-20 to keep a close watch on global current account imbalances to ensure that they do not result in excessive global volatility and tensions. The global imbalances had a detrimental effect on the growth of emerging markets. Unilateral actions taken by some advanced economies adversely affect the exports and the inward flow of investments in these economies. She wondered if the accumulation of cash reserves by large companies indicated the reluctance of these companies to increase investments. This reluctance could have adverse implications on growth and investments and possibly leading to concentration of market power. She also urged the G-20 to remain cognizant of fluctuations in the international oil market and study measures that can bring benefits to both the oil-exporting and importing countries.

In a session on infrastructure investment, Mrs. Sitharaman emphasised on the importance of making investments in cost-effective and disaster resilient infrastructure for growth and development. She suggested the G-20 focus on identifying constraints to flow of resources into the infrastructure sector in the developing world and solutions for overcoming them. She also took note of the close collaboration of India, Japan and other like-minded countries, aligned with the Sendai Framework, in developing a roadmap to create a global Coalition on Disaster Resilient Infrastructure.

 

The Japanese Presidency’s priority issue of ageing was also discussed. Mrs. Sitharaman highlighted that closer collaboration between countries with a high old-age dependency ratio and those with a low old-age dependency ratio was necessary for dealing with the policy challenges posed by ageing. She suggested that if ageing countries with shrinking labour force allow calibrated mobility of labour with portable social security benefits, the recipient countries can not only take care of the aged but also have a positive effect on global growth. She said that India’s demography presented a dual policy challenge since India’s old-age dependency ratio is less than that of Japan, while at the same time India’s aged population in absolute numbers exceeds that of Japan. She detailed the policy measures that the Government of India is taking to address these challenges.

 

While speaking on the priority of Japanese Presidency on financing of universal health coverage (UHC), she emphasised the importance of a holistic approach which encompasses the plurality of pathways to achieve UHC, including through traditional and complementary systems of medicine.

 

(III) Ratification of the Multilateral Convention to Implement Tax Treaty-Related Measures to Prevent Base Erosion and Profit Sharing (Source: Press Release of the Ministry of Finance dated 12th June, 2019)

 

Text of the Press Release of the Ministry of Finance dated 12th June, 2019:

 

“Ratification of the Multilateral Convention to Implement Tax Treaty-Related Measures to Prevent Base Erosion and Profit Shifting.

 

The Union Cabinet, chaired by the Prime Minister, Mr. Narendra Modi, has approved the ratification of the Multilateral Convention to Implement Tax Treaty-Related Measures to Prevent Base Erosion and Profit Shifting (MLI).

 

IMPACT

The Convention will modify India's treaties in order to curb revenue loss through treaty abuse and base erosion and profit shifting strategies by ensuring that profits are taxed where substantive economic activities generating the profits are carried out and where value is created.

 

DETAILS

i. India has ratified the Multilateral Convention to Implement Tax Treaty-Related Measures to Prevent Base Erosion and Profit Shifting, which was signed by the Hon'ble Finance Minister, Mr. Arun Jaitley, at Paris on 7th June, 2017 on behalf of India;

ii.   The Multilateral Convention is an outcome of the OECD / G-20 Project to tackle Base Erosion and Profit Shifting (the "BEPS Project") i.e., tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity, resulting in little or no tax being paid. The BEPS Project identified 15 actions to address base erosion and profit shifting (BEPS) in a comprehensive manner;

iii.  India was part of the ad hoc group of more than 100 countries and jurisdictions from G-20, OECD, BEPS associates and other interested countries which worked on an equal footing on the finalisation of the text of the Multilateral Convention, starting May, 2015. The text of the Convention and the accompanying Explanatory Statement was adopted by the ad hoc Group on 24th November, 2016;

iv.  The Convention enables all signatories, inter alia, to meet treaty-related minimum standards that were agreed as part of the final BEPS package, including the minimum standard for the prevention of treaty abuse under Action 6;

v. The Convention will operate to modify tax treaties between two or more parties to the Convention. It will not function in the same way as an amending protocol to a single existing treaty, which would directly amend the text of the Covered Tax Agreement. Instead, it will be applied alongside existing tax treaties, modifying their application in order to implement the BEPS measures;

vi.  The Convention will modify India's treaties in order to curb revenue loss through treaty abuse and base erosion and profit shifting strategies by ensuring that profits are taxed where substantive economic activities generating the profits are carried out and where value is created.

BACKGROUND

The Convention is one of the outcomes of the OECD / G-20 project, of which India is a member, to tackle base erosion and profit shifting. The Convention enables countries to implement the tax treaty-related changes to achieve anti-abuse BEPS outcomes through the multilateral route without the need to bilaterally re-negotiate each such agreement which is burdensome and time-consuming. It ensures consistency and certainty in the implementation of the BEPS Project in a multilateral context. Ratification of the multilateral Convention will enable application of BEPS outcomes through modification of existing tax treaties of India in a swift manner.

 

The Cabinet Note seeking ratification of the MLI was sent to the Cabinet on 16th April, 2019 for consideration. Since the said Note for Cabinet could not be taken up in the Cabinet due to urgency, the Hon'ble Prime Minister, vide Cabinet Secretariat I.D. No. 216/1/2/2019-Cab dated 27.05.2019 has approved ratification of MLI and India's final position under Rule 12 of the Government of India (Transaction of Business) Rules, 1961 with a direction that ex-post facto approval of the Cabinet be obtained within a month. Consequent to approval under Rule 12, a separate request has already been sent to the L&T Division, MEA, for obtaining the instrument of ratification from the Hon'ble President of India vide this office OM F.No. 500/71/2015-FTD-I/150 dated 31/05/2019.”

 

In Part II of the Article, we will cover various developments at the OECD relating to International Taxation. We sincerely hope that the reader would find the above developments to be interesting and useful. 

 


 

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