ATTRIBUTION OF PROFITS TO A PERMANENT ESTABLISHMENT IN A SOURCE STATE

The determination of income of a
Multi-National Enterprise (MNE) having operations in various jurisdictions
faces many challenges. It is not easy to attribute profits to various
constituents of an MNE spread over multiple jurisdictions. OECD has so far adopted
a separate entity approach and recommended determination of profits on the
Arm’s Length Principle (ALP) based on a FAR (Functions, Assets and Risks)
analysis. However, of late ALP based on FAR has been challenged by many
developing nations (including India) on the ground that it is more skewed
towards residence-based taxation and does not take into account the place of
value creation, i.e., the market. In a traditional approach, profits are taxed
in a source country only if there is a Permanent Establishment (PE). It is
easier for MNEs to plan their affairs in a manner so as to avoid the presence
of a PE in a source country. Further, in a digitalised economy, it is extremely
difficult to attribute profits to various jurisdictions based on the traditional
approach. Therefore, many countries worldwide have moved away from ALP and
resorted to either the Formulary Apportionment Method (FAM) or a Presumptive
Basis of Taxation. This article compares and contrasts the different methods of
profit attribution and provides a contextual study to understand the proposed
amendments in Rule 10 of the Income-tax Rules, 1962 (the Rules) in respect of
attribution of profits to the operations of an MNE in India.

PRESENT
SYSTEM OF PROFIT ATTRIBUTION

Article 5 of a tax treaty lays down norms
for determination of a PE in the state of source. Article 7 of a tax treaty
stipulates principles of determination of profits attributable to a PE. The
existence of a PE in a source state gives a right to that state to tax profits
which are attributable to its operations. As we know, a treaty only provides
for distributive rules for taxing jurisdictions, leaving detailed computation
of profits to the respective domestic tax laws. For example, once it is
established that there is a PE in India, computation of profits attributable to
that PE will be subject to provisions of the Income-tax Act, 1961 (the Act).
However, Article 7 does provide certain restrictions or guidelines thereof for
computation of profits. A moot issue is to determine how much profits are
attributable to a PE in the source state.

Provisions under the Income-tax Act, 1961

Section 9 of the Act deals with income
deemed to accrue or arise in India. It does provide certain source rules for
determination of such income. However, as far as business income is concerned,
section 9(1)(i) provides that all income accruing or arising whether directly
or indirectly through or from any business connection in India… shall be deemed
to accrue or arise in India. Clause (a) of Explanation 1 to section 9(1)(i)
further provides that in the case of a business of which all the operations are
not carried on in India, the income of the business under this clause deemed to
accrue or arise in India, shall be only such part of income as is reasonably
attributable to the operations carried on in India.

The provision in tax treaties is similar, in
that it provides that if the enterprise carries on business as aforesaid, the
profits of the enterprise may be taxed in the other state; but only to the extent
as are attributable to that PE. There is one exception, i.e., a tax treaty
which follows the UN Model Convention providing for the force of attraction
rule. According to this rule, when an enterprise has a PE in a source state,
then the entire revenue from the source state may get taxed in the hands of
that enterprise, whether or not it is attributable to that PE. Many Indian tax
treaties do have this Rule. However, the force of attraction is restricted to
the revenue derived from the same or similar activities as that of the PE.

Thus, determination of profits attributable
to a PE is crucial for its taxability in the source state. Ideally, the PE
should maintain books of accounts and financial statements in India (for that
matter, any source state) for determination of profit or loss from its business
operations, for it is so mandated in India. However, where such books of
accounts are not maintained (may be due to the head office’s view of
non-existence of PE or for any other reason) or where it is not possible to
ascertain the actual profits from such books of accounts, then the assessing
officer (AO) can invoke the provisions of Rule 10 which provide for
determination of profits as a percentage of the turnover, proportionate profits
or in any other manner as he may be deem appropriate. Thus, Rule 10 gives wide
discretionary powers to the AO in determination of profits attributable to a
PE.

Clauses (b) to (e) of Explanation 1 to
section 9(1)(i) of the Act provide various instances where income of a non-resident
from certain activities will not be deemed to accrue or arise in India.
However, Explanation 2 explicitly includes dependent agent within the scope of
business connection. Again, a question arises as to the role played by the
dependent agent and profits attributable to his activities in the dual
capacity: one, as an agent, and two, as a representative of the foreign
enterprise (as a PE).

Authorised OECD Approach (AOA)

At present, there are three versions of
Article 7 that feature in tax treaties worldwide, namely, (i) article 7 in the
OECD Model Convention (OECD MC) prior to 2010, (ii) article 7 in the revised
OECD Model Convention post-2010, and (iii) article 7 of the UN Model Convention
(UN MC). The distinguishing features of the above versions are given below.

Versions (i) and (iii) are similar in that
the pre-2010 OECD MC and the UN MC contain the provision of considering PE as a
separate and distinct enterprise. The PE, in this case, is considered as being
a separate and independent entity from its head office, such that it would
maximise its own profits. The PE, therefore, would be maintaining separate
books of accounts based on principles of accounting as applicable to a separate
and distinct entity. Klaus Vogel has referred to such a method as ‘separate
accounting’ or ‘direct method’. India supports this view and most of its tax
treaties are based on this principle.

However, in 2010, OECD changed its stance
and amended article 7 based on its report on the ‘Attribution of Profits to
Permanent Establishments’. In the said report and the new article 7 in its
model tax convention, OECD pronounced AOA as a preferred approach for
attribution of profits to a PE. AOA is also based on the ‘separate entity
approach’, though profits are to be determined based on Functions performed,
Assets employed and Risks assumed (FAR).

AOA provides
options for application of the new article 7 introduced in the OECD Model Tax
Convention in 2010 which requires that profits attributable to PE are in
accordance with the principles developed in the OECD Transfer Pricing
Guidelines wherein the PE is first hypothesised as a functionally separate
entity from the rest of the enterprise of which it is a part, and then profits
are determined by applying the comparability analysis and FAR approach.

The AOA recommends a two-step approach for
determination of profits attributable to a PE:

Step 1: A
functional and factual analysis of the PE, aligned with FAR analysis, as
recommended in transfer pricing guidelines;

Step 2: A
comparability analysis to determine the appropriate arm’s length return (price)
for the PE’s transactions on the basis of FAR analysis.

AOA is based on ALP, which in turn is
determined based on FAR analysis under transfer pricing, which essentially considers
the supply side of the transaction and ignores the demand side, i.e., the
market or sales; and, therefore, India has rejected the same.

There is one
more issue in the revised article 7 of the OECD MC. Its pre-2010 version
recognised and acknowledged that apportionment of profits based on one of the
criteria, namely, receipts (or sales revenue), expenses and working capital,
was a reasonable way of apportioning profits to the PE. This was based on
paragraph 4 of the pre-2010 version of the OECD MC which gave an option to
attribute profits by way of an apportionment if it was customary to do so in
the state of PE. However, the revised OECD MC dropped this paragraph. The
impact of this change is that even where accounts are not available or
reliable, one needs to attribute profits to a PE based on FAR without
considering the market or sales. India’s position is very clear in that it
would also take the demand side or sales into consideration for attribution of
profits to a PE.

Shortcomings of ALP

Section 92F(ii) defines the ‘Arm’s Length
Price’ as a price which is applied or proposed to be applied to a transaction
between persons other than associated enterprises, in uncontrolled conditions.

Thus, a transaction between two or more AEs
needs to be compared with a similar transaction between two unrelated parties,
for the same or similar product or service, in the same or similar
circumstances. These two unrelated parties, whose transactions are compared
with that of AEs, must have similar functions, assets or risks as that of the
AEs. It is practically impossible to find such comparable companies or
transactions.

Section 92C prescribes six methods to
determine the ALP. Pricing depends upon many factors other than FAR. ALP fails
to take into account all aspects of a business. One cannot easily find
comparables for many businesses that are engaged in specialised services or
businesses, especially specialised product-lines involving complex intangibles.

Moreover, availability of data in the public
domain at the time of entering into the transaction for comparison purposes is
a big challenge. Public data is available only in cases of commodity trading
through exchanges. Maintenance of contemporaneous documentation and valuation
thereof are another big challenge.

Profit Split Method

The Profit Split Method (PSM) is applicable
when transactions are so interrelated that it might not be logical or practical
to evaluate the same individually. Independent entities in such scenarios may
agree to pool their total profits and distribute them to each of the
participating entities based on an agreed ratio. Thus, PSM uses a logical basis
and divides profits among participating entities to a transaction similar to
what independent entities would have apportioned for arriving at such an
arrangement.

The PSM method first identifies the outcome
of the transaction (i.e., the net profit of the transaction) of the group. The
profit then is to be divided among the entities of the group on an economically
rational basis such that profits would have been distributed in an arm’s length
arrangement. The total profit may be the profit from the transactions or a
residual profit that cannot readily be assigned to any of the entities of the
group, e.g., profits arising from unique intangibles. The contribution of each
entity is based upon a functional analysis of each entity. Reliable external
market data, if available, is always given preference.

The PSM method, although a method under the
arm’s length approach, is in reality based on the principles which are used for
the purpose of ‘Formulary Apportionment’.

The positive aspect of every PSM approach is
that it examines the controlled transactions under review in a prudent manner
as it is a two-sided method where every MNE concerned is evaluated. Thus, the
PSM method will be beneficial if the underlying contribution involves
intangibles owned by two or more MNEs, as no transfer pricing method other than
PSM would be applicable. PSM offers flexibility because it considers the
specific facts and circumstances of MNEs which cannot be found in comparable
independent enterprises. Moreover, a real actual profit is being split which
generally does not leave any of the MNEs concerned with an unreasonably high
profit since each MNE is appraised. It also removes the possibility of double
taxation as the total profit is split and distributed to the various
constituent entities across jurisdictions.

Challenges of PSM – lack of availability
of data and functions

There are two fundamental disadvantages with
the PSM. First, the application of PSM usually includes a weak and sometimes
doubtful connection of external market data with the controlled transactions
under consideration, resulting in a comparison with a certain amount of
subjectivity. Moreover, there is the lack of availability of data; both
taxpayers and tax administrations might find it hard to obtain reliable
information from MNEs in foreign countries. This inconvenience might materially
affect the reliability of the method since the profit should be an economical
assessment based on each and every function undertaken by the MNE, preferably
using external comparables which can support the valuation. (Source: Markham,
Michelle – Transfer Pricing of Intangible Assets in the US, the OECD and Australia:
Are Profit Split Methodologies the Way Forward?)

FORMULARY APPORTIONMENT METHOD (FA)

The Meaning of FA

As the name suggests, it is the
apportionment of the profits / losses of a corporation based on some
predetermined formula, over its different units or group of companies operating
under common control, across different jurisdictions based on significant
economic presence.

Formulary Apportionment, popularly known as
unitary taxation, allocates profit earned (or loss incurred) by an MNE wherein
its entity has a taxable presence. It is an alternative to the separate entity
approach under which a branch or PE within a jurisdiction is reckoned as a
separate entity, requiring prices for transactions with other parts of a
corporation or a group thereof, according to ALP.

As opposed to this, FA assigns the group’s
total global profit (or loss) to each jurisdiction based on certain variables
such as the proportion of assets, sales or payroll in that particular
jurisdiction. It is thus akin to PSM in a sense.

Under this method, all entities of the group
are viewed as a single entity (unitary combination) and therefore the method is
also known as unitary taxation worldwide. This method requires combined
reporting of the group’s results.

Advantages of FA

A unitary approach would replace the
following major elements which create fundamental problems for taxation of MNEs
under the ALP:

(i)   The need for analysing arm’s length price,
that is, an analysis of internal accounts and transactions for determining the
appropriate arm’s length price;

(ii)   The need to deal with complex anti-avoidance
rules, such as thin capitalisation, controlled foreign corporations, limitation
of benefits et al to prevent base erosion and profit shifting;

(iii) Quantification of contribution of intangibles
in income generation;

(iv) Freedom from
litigation arising from source and residence attribution rules;

(v) Lesser compliance burden on MNEs.

The above would enable simplification of the
international tax system, which shall benefit both taxpayers and tax
administrations.

At present, a majority of the transfer
pricing disputes undergoing several rounds of litigation are generally decided
in favour of the taxpayer. This is so in the U.S., India and other countries.
This is bound to happen in the absence of clear guidance on transfer pricing
issues. Matters pertaining to selection of appropriate comparable(s), usage of
the most appropriate method for benchmarking the transaction, management fees,
cost allocation arrangements, royalty pay-outs, etc., have been and continue to
be under litigation.

On the other hand, the unitary taxation
method, if not totally, would at least reduce and significantly contribute in
settling disputes. Further, in many cases in countries where significant
economic activities are carried out, there may not be any significant
difference in corporate tax rates. Hence, in the absence of wide differences in
corporate tax rates, there may be no significant compulsion or reason to
minimise a firm’s global tax liability by relocating production activities.

Limitations of FA

There are two primary questions that need to
be addressed for successful implementation of FA.

Q1) How and what shall be the basis for
the apportionment formula?

Generally, an overwhelming consensus on the
determination of weights for the factors would be decided by negotiations and
trade-offs. Historical data provides that the factors have been generally given
equal weight, that is, one-third each (sales, labour and assets employed).

Approach of the United States of America

The water’s edge approach of the States in
the US has tilted the balance towards sales. This approach apportions income to
production and sale equally, i.e., 50% of income is apportioned based on sales
and 50% on production (assets and labour quantify production).

[Water’s edge election basically says that
you (as a business or entity) agree to be taxed within the jurisdiction for the
sales that occur within that state, but only within the parameters laid down by
that state.]

Approach of the European Union

On the other hand, in 2012 the EU amended
the proposal drafted by the EU Commission, from equal weights to the three
factors, to 10% for sales, 45% for assets and 45% for labour.

Differences in preferences

Countries where wage rates are higher would
favour payroll rather than headcount in respect of the labour factor. This
would tend to benefit from the inclusion of the assets factor with an equal
weight. Therefore, such countries can concede that the labour factor be based
on the number of employees.

Conversely, although countries which have
attracted large-scale manufacturing activities would benefit in terms of tax
revenues on account of the labour factor, they should also be willing to accept
a significant weightage for other factors. If the same has not been accepted,
there may be MNEs who would relocate their investments because of formula
over-weight tilt towards the labour factor. Therefore, it is essential that a
fine balance between factors of production and sales is achieved. This is
because some part of the income can be said to be attributable to (a) assets
employed for production, (b) number of employees on the payroll, and (c) the
sales function, of course.

Therefore, one may propose a ratio of 1
(assets employed): 1 (number of employees): and 2 (sales function). This is
because it gives equal importance to all factors of production as well as the
sales function. Further, equal importance is also given to the internal two (2)
factors of production as well, namely, capital and entrepreneurship.

Q2) 
Would it be appropriate to apply a general formula for all industries?

Evidently not. This issue has been debated
since the unitary approach was first mooted in the 1930s. The cause for concern
is that some types of industries do have special characteristics in need of a
special formula.

Examples

Transportation industries such as shipping,
aviation, etc., pose an issue because the assets which they are dependent upon
are mobile. In order to address the special nuance of this business, these
could be taxed based on the value of traffic between two contact (entry / exit)
points.

In the case of other nuanced industries,
such as extractive industries, the modern approach of ‘resource rent taxation’
is a more effective mode of taxation. Therefore, the interaction between
resource rent taxation and general corporate taxation would require a special
consideration.

However, for the purpose of achieving
neutrality, a general apportionment formula applied to most types of businesses
would be appropriate for allocating a general tax on income or profits.

Presumptive Taxation (PT)

As stated above, determination or
computation of profits in the source state is not an easy task and therefore there
is always an uncertainty about attribution of income and allowability of
expenses. Moreover, compliance burden is also high. In order to address these
issues, many countries give the option of presumptive taxation to
non-residents. Under this, irrespective of actual profit or loss, a certain
percentage of the gross receipts from the state of source is deemed to be
income and taxed therein. Once a taxpayer is covered by the presumptive tax
scheme, he would be relieved from the rigours of compliances.

The Income-tax Act, 1961 contains provisions
for taxing income of non-residents on presumptive basis. Some illustrative
provisions are given below:

Distinction between PSM / FA / PT

The stark difference between the Profit
Split Method (PSM), the Formulary Apportionment Method (FA) and the Presumptive
Taxation Method (PT) is the manner of calculation of profits.

Profit Spilt Method: In this method, total profits earned by related entities in
different jurisdictions is determined and then the same are attributed to each
one of them on a separate entity approach (following the arm’s length
principle), based on FAR analysis. In this case, usually the market or demand
side is overlooked or given less importance. This method is criticised in that
it is more skewed towards the country of residence of the enterprise.

Formulary Apportionment Method: Here, the actual profits of the MNE at the global level are
distributed to the participating entities. However, the distribution is based
on a predetermined formula with or without weightage. This method does take
care of demand side arising from ‘sales’, which is usually one of the factors
of profit allocation in the FA. This method considers all entities across the
globe under a single MNE as a single unit and consequently it is known as
‘Unitary Method’ as well.

Presumptive Taxation: This method rests on an altogether different footing. It does not
take into account the actual profit or loss of the business undertaking.
Instead, it presupposes a certain element of profit in the source state and
levies taxes based on a notional estimation. Normally, presumptive taxation is
given as an option to the taxpayer to have a tax certainty and reduce
litigation. If the actual profits are lower or there are losses, then the
taxpayer may opt for regular computational provisions along with related
compliances. Safe-harbour provisions under the TP Regulations are akin to
presumptive taxation.

PROPOSED PROFIT ATTRIBUTION RULE (COMBINATION
OF FA AND PT)

The CBDT Committee has recommended amendment
of Rule 10 of the Income-tax Rules to provide for detailed profit attribution
rules. It rejected the AOA for profit distribution, which is based on ALP
taking into account FAR analysis. It may be noted that AOA does not take into
account the demand side of a transaction.

The committee
suggested distribution of profits based on three factors carrying equal
weightage, namely, (a) sales (b) manpower and (c) assets. It is claimed that
the combination of these three factors would take into consideration both the
demand and the supply side of a transaction.

The draft report on Profit Attribution
outlines the formula for calculating ‘profits attributable to operations in
India’, giving due weightage to sales revenue, wages paid to employees and
assets deployed.

(Please refer to the July, 2019 issue of
the BCAJ for a detailed discussion on the proposed Profit Attribution Rules.)

CONCLUSION

Attribution of profits is a complex
exercise, more so when such attribution is related to complex intangibles or a
PE. The Arm’s Length Principle looks good in theory, but impracticable in real
ground situations. Therefore, even after decades of its existence, there are
litigations galore. Further, FAR analysis takes into account only the supply
side, giving less or no weightage to the demand side. On the other hand,
presumptive taxation, which uses estimation, may result in double taxation as
the residence country may deny the credit of taxes paid on presumptive basis.
The plausible solution seems to be a distribution of profits based on a
predetermined formula, i.e., the Formulary Apportionment Method.

However, unless there is a universal
consensus this method also is not practicable. Moreover, availability of data
at a global level or the willingness of a Multi-National Enterprise to share
such data could be a challenge. Difference in accounting treatment, difference
in taxable year, fluctuating exchange rates, changes in domestic tax laws, tax
incentives in different jurisdictions, etc., are all issues for which there are
no answers. This only proves that we are living in an imperfect world and that
we need to accept the imperfect tax system as the hard reality of life in an
era of cross-border transactions and the continuing emergence of giant
multinationals that rule the roost, with law-makers lagging far behind.