Attribution of profits to a Permanent Establishment (PE) of a Multinational Enterprises (MNE) in India has been a commonly ligated matter and marred with uncertainty. The Indian tax administration has placed for public comments report of the Committee constituted to examine the existing scheme of profit attribution to PE, with the intent of framing guidelines for profit attribution, bringing certainty and transparency. While the debate on the proposals will surely continue for long, the document is a valuable read for India’s position which highlight India reservation to the authorized OECD approach for PE income attribution.
The Committee in its report emphasizes the fact that the Indian tax treaties are predominantly based on UN Model Convection which under Article 7 legitimizes attribution of profits to a PE on the basis of apportionment of the total profits of the enterprise to its various parts. Such methods is adoptable where profits cannot be determined through a direct method i.e. based on verifiable books of accounts prepared as per acceptable accounting standards. In contrast, Article 7 of OECD model convention post 2010 advocates the approach of allocation taking into account the functions performed, assets used and risks assumed (FAR analysis) by the enterprise through the permanent establishment and through the other parts of the enterprise.
The Committee has observed that business profits are contributed by both demand and supply of the goods. Article 7 of the OECD Model Tax Convention and approach recommended by OECD (based on FAR) is purely supply side approach towards profit attribution and disregards the role of demand in contributing to profits attributable to PE. Further, the Indian tax treaties have not included the concept of Income attribution based on FAR as advocated by OECD model convention, thereby permitting attribution of profits in a manner different from the authorized OECD approach i.e. by resorting to the direct accounting method and where that may not be possible, by apportionment of profits.
Accordingly, the Committee has suggested PE profit attribution based on a combination of (i) profits derived from Indian operations and (ii) three factor method based on equal weight accorded to sales (representing demand), manpower and assets (representing supply including marketing activities). In other words, profits of the multinational enterprise will first be apportioned for India sales (amount arrived at by multiplying the revenue derived from India x Global operational profit margin). As a second step, such profits will be attributed proportionately to (a) sales within and outside India; (b) employees and wages within and outside India; and (c) assets deployed within and outside India for Indian operations, each with 33% weightage. Further to address a situation whether the multinational enterprise suffers losses or has profit margin less than 2%, a margin of 2% of revenue derived from India sale is proposed to be regarded as deemed profit for India operation, thereby recommending minimum base level taxation. With regard to digital economy, where nexus to taxation is attributed to the concept of significant economic presence, considering the role of users, a fourth factor (i.e. user intensity) needs to be further built into the income attribution formulae.
The OECD approach for income attribution based on FAR analysis, which the Committee regards as factoring only supply side attributes (and not demand) finds favour with the Committee where no sales takes place in India. For instance, where a multinational enterprise constitutes a PE in India and compensates the PE at arm’s length basis FAR analysis and further such enterprise does not have any sales in India, no further income will be attributable to India (in absence of any play of demand side factor). However, where sales are made in India, the reading of the Committee report suggests formulae based attribution would become the rule and additional income attributable would become taxable in India (post allowance of income apportioned to supply factors and offered to tax in India).
Given the development, there will be a significant transformation to the concept and impact on income attribution to permanent establishments in India, should the proposed recommendation be formulated into mandatory rules. The demand side factors which the Committee consider as an important consideration would seemingly lead to attribution of 33 percent of the profits derived from sale in India even if no further attribution is required to be made in absence of other factors. It will be interesting to see how the courts view the principles around income attribution in light of the divergence in OECD approach and Indian tax administration position.