Thought leadership from our experts

Draft profit attribution rules by India – Emergence of new controversy or end of it?

The concept of Permanent Establishment has as much history as the history of double tax conventions itself. The concept has seen subjected to all sort of controversies around the world ranging from its very existence to the profit that is required to be allocated once its existence has been established. Recognising the significance of such issues relating to profit attribution to PEs as well as the need to bring clarity and predictability, the Central Board of Direct Taxes in India had formed a committee to recommend changes to the existing profit attribution rules. The committee has released its report for public consultation on April 2019.

Key contentions of the Committee

The primary contention of the committee is around the Authorised OECD Approach (AOA) which places reliance on the FAR analysis for profit attribution to PEs. In the draft report the committee has contended that OECD approach completely ignores the demand side factors and that it contributes to the business profits as such as the supply side factors does. Building up on the premise, the report recommends a "fractional apportionment", which is more akin to a "formulary apportionment" in true sense, based on three equally weighted factors namely sales (representing demand), employees (manpower & wages) and assets (representing supply including marketing activities).

In case of a digital economy business, the committee considered the option of assigning users the same weight as the other three. However, the committee noted that different weights are to be assigned to different categories of digital businesses depending upon the level of user intensity. Based on these factors, the committee finally prescribed formulas for derivation of the profits taxable in India.

Requirement for revised attribution rules from the Government perspective

In the report the committee has cited uncertainty and unpredictability associated with application of exiting attribution rules as of the one primary reasons for the need of revised attribution rules. The report recognises that existing rules lacks specificity and accords broad discretion to the AO without any specific guidance. Though one can hardly deny that the primary reason cited in the report is true and existing attribution rules needed revision to provide better clarity and predictability for investors and MNCs, it is also true that CBDT have long disagreed with FAR based AOA approach for profit attribution to PEs. The committee observed that the AOA is tilted towards the supply side approach by determining profits exclusively for supply side factors with reference to FAR analysis and thereby ignores the role of demand side factors. By using a "Fractional apportionment" using apportionment of the profits derived from India based on three equally weighted factors, the committee believes a balance can be achieved.

Need for a more 'balanced approach'

The approach of attributing profits based on "arm's length principle" is not a new concept which has emerged in 2010 from OECD, but a concept which is in line with Indian TP rules and has also withstood the judicial scrutiny in India including that from the Supreme Court of India. There is plethora of judgements in India which has upheld the significance of TP principles for profit attribution to PE and a formulary apportionment has generally been preferred in case of inadequate TP analysis. In fact, the tax authorities in the past have also initiated transfer pricing assessment proceedings for a PE or an alleged PE to determine the attribution of profits.

The fact of the matter is that the "formulary apportionment" as proposed usually fails in aligning the economic outcome with value creation in contrast to the arm's length approach which applies a symmetric principle of functions, assets and risks as determinants for arm's length remuneration for both demand and supply side factors. Thus, the contention of CBDT in the draft rules that TP principles does not represent the demand side factors is flawed. In fact the formulary approach which uses factors such as manpower, assets, wages are essentially proxies for functions but blatantly ignores the risk parameters that is associated with functions and asset ownership. Therefore, there is no need for the proposed formula and India may resort to TP mechanism which is now revamped pursuant to the recommendations of BEPS standards, more particularly Action plan 8-10 i.e. Aligning Transfer Pricing Outcomes with Value Creation. The recommendations have been endorsed by India and once imported and applied in Indian context may have adequately considered all the key concerns in relation to attribution of profits to a PE.

The draft rules also recommend that in case of losses a deemed global operational profit margin will be considered at 2%. The proposal may have adverse effect on certain sectors wherein the margins are lower owing to various economic factors. It would be prudent to undertake a detailed analysis and carve out few specific industries such as Banking, Insurance which are highly regulated and exhibits unique characteristics in terms of its complex business model, profits and associated risks. It may also be prudent to allow offsetting of losses incurred in one year against the profit of future years to avoid double taxation arising from deemed profit. A mechanism to allow credit for the taxes paid based on such deemed profit, against the taxes payable on actual profits in the subsequent year may also be considered.

In relation to the digital economy, the draft rules provide that "User participation" contributes to business profits and thereby must be assigned weightage similar to other three factors. It is pertinent to note international consensus is still evolving around taxation of digital economy and action by any country must be after an international consensus is reached on the issue. However, if India goes ahead with the preposition, since the large portion of revenues of major MNEs in digital economy space come from advertising activities which are already subject to Equalization Levy in India, the rules must specifically exclude income from advertisement revenues from the proposed formula or there must be simultaneous withdrawal of Equalisation Levy in the hands of the payer.

Conclusion – Impact on the litigation scenario

It is true that the existing profit attribution rules lack specificity and accord arbitrary powers in the hands of AO. Consequently, during the course of assessment proceedings the field officers are often inclined to apply the existing provisions to make an ad-hoc and arbitrary tax adjustment. Even though in majority of cases adjustments are deleted by higher forums, it leads to unnecessary outlay of resources as well as lead to an environment of tax uncertainty. Thus, it might be reasonable to contend that existing attribution rules needed a complete overhaul. The intention of the CBDT of providing an objective formula which may lead to simplicity and certainty is well placed. However, the pertinent question is that whether the proposed rules, in its current form and structure, is holistic enough to provide tax certainty and at the same time ensure that economic outcomes are aligned with value creation. The probability of the response in positive is quite remote.

As the attribution rules proposes a formula which is driven by factors, there may always be litigation around the substance and location of the production factors used in the formula (employees, assets, wages). Uncertainty may also prevail in situations where a PE or business connection is established due to captive services including BPO, KPO, Contract R&D, procurement function etc but their presence does not lead to any receipt or revenue from sales in India.

In terms of tax treaty practice, including in the India treaty network, business profits are allocated to a PE based on arm's length basis. The concept of "arm's length principle" is embedded in the Indian treaties and the proposed formulary approach for profit attribution may not be accepted by the treaty partners leading to double taxation.

Other potential issue could be around complexities around data required for the formula. As the numerator requires India related information and denominator include factors from outside of India, there might be litigative issues on account of different financial year end, valuation methodologies for assets etc.

Considering the above factors, it may be reasonable to assume that litigation might be far from over and we might well be ushering into new era of litigative issues. The government may however take pragmatic steps to reduce litigation involved around the proposed approach and provide the much-required tax certainty for MNCs. One of the possible approaches that the government may adopt is to propose the same formulary approach as optional to the tax payer or rather as a "Safe harbour benchmark". The tax payer may be extended an option to either opt for such formula or follow the AOA of analysing the FAR of the participating entities and determine profits to be attributed to a PE. Such an approach will be consistent with many presumptive taxation provisions that are currently there in the Act and will meet the obligations of the treaties while providing requisite clarity and objectivity to the determination of the PE profits.

It is interesting to note that APA rules provide that it can be filed for the purposes of profit attribution to a PE. The government must now make an endeavour to encourage the APA route to obtain certainty on profit attribution. Such an approach would provide fresh impetus to the APA program and ensure that unnecessary and prolonged ligations are avoided through alternate dispute resolution process.