Proposed India profit attribution rules reject OECD approach, add “sales” and “users” as apportionment factors

By Madhan N, PricewaterhouseCoopers Private Limited, India

India’s Central Board of Direct Taxes (CBDT) on April 18 asked for public feedback on proposed new rules for attributing profits to Indian permanent establishments (PEs) that differ from the authorized OECD approach (AOA).

The proposal, contained in a CBDT committee report, states that the post-2010 OECD model tax convention’s method of attributing profits, which puts reliance upon functions, assets, and risks for profit attribution to a PE, represents only the supply side and neglects the demand or sales side of activity.

The CBDT committee has instead suggested a new three-factor apportionment method to attribute profits to PEs in India, giving equal weight to sales, manpower, and assets. Moreover, in the case of digital businesses, a fourth factor of “users” is added.

Supply and demand

The committee observes that both the demand and supply of goods contribute to business profits. Hence, a jurisdiction that contributes towards demand by facilitating the economy and the ability of their residents to pay or by the maintenance of markets contributes towards the business profits of an enterprise. This, as per the committee, gives rise to a valid justification to tax of the profits to which the economies have contributed (through sales). 

The committee referred to practices followed in the US and Europe for attributing profits to their various states (in case of the US) and countries within the region (in case of Europe) and concludes that a mixed approach considering both the supply and demand side is most commonly adopted, though there are also instances of purely the demand approach, especially in certain US states. The committee observes also that a purely supply side approach does not appear to be practiced in Europe or the US.

The OECD’s adoption of the AOA in 2010 amounted to a shift from allowing domestic law approaches to a purely supply approach with profits exclusively determined with reference to functions, assets, and risks, the committee states. Further the committee notes that the AOA is not observed in international practice, even among the OECD countries and regions, which either opt for a mixed approach or a purely demand approach.

The committee observes that the AOA approach 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 in the global economy.

Instead, it can set a vicious cycle in place that is destined to lead to losses for all stakeholders. Thus, while the AOA approach may be favorable to the interests of certain countries that are net exporters of capital and technology, it is likely to have a very significant adverse impact on all other stakeholders, especially the developing economies like India, which are primarily importers of capital and technology.

The committee further observes that India has documented its disagreement with the revised Article 7 by not only reserving its right not to include it in its tax treaties but also documented the rejection of the approach inherent in it.  

India profit attribution

The committee also concluded that formulary apportionment might not be feasible due to practical constraints in obtaining details related to operations in other jurisdictions.

Instead, the committee recommends fractional apportionment based on apportionment of profits derived from India by assigning a weight of 33% each to sales, employees and wages, and assets. Since this approach is largely based on information related to Indian operations it is thus practicable.

The committee observes that such an approach can also be read into paragraph 4 of Article 7 of the UN Model Tax Convention and some of the Indian tax treaties as well as Rule 10 under the Indian domestic law.

Non-digital businesses

For regular businesses, the approach recommended by the report entails the following steps:

Step 1:  Determine the profits derived from Indian operations of the enterprise being the higher of:

(i) Global operational profit percentage on India sales; or (ii) 2% of the revenue or turnover derived from India.

Step 2:  Apportion the profits to the activities of the PE by assigning weights to sales, assets, and employees as follows:

 

Factors	Weight (multiplier) to be assigned
Sales: Proportion of PE sales in India / global sales of PE	0.33
Assets:  Assets employed by PE for sales in India / assets employed globally for sales in India	0.33
Number of employees:  Number of employees employed for Indian operations in India to total number of employees employed for Indian operations	0.16
Wages paid:  Wages paid for Indian operations in India to total wages incurred in relation for Indian operations	0.16

Digital businesses

Under the domestic laws, a digital business would be considered to have a ‘Significant Economic Presence’ (SEP) that constitutes a ‘business connection in India’ if there exists certain specified conditions – such as existence of users beyond a threshold (threshold yet to be prescribed) For digital business, the committee has taken the view that the role of the user has blurred the traditional demand and supply functions.

In this regard, for digital business, apportioning the profits derived from India is based on four factors of sales, employees (manpower & wages), assets and users. The users are assigned a 10% weight in cases of low and medium user intensity, while each of the other three factors is assigned a weight of 30%.

For digital models with high user intensity, users are assigned a weight of 20%, while the share of assets and employees is reduced to 25% each and keeping the weight of sales at 30%

This presented in the form of steps, below:

Step 1:  Determine the profits derived from Indian operations of the enterprise being the higher of:

(i) Global operational profit percentage on India sales; or (ii) 2% of the revenue or turnover derived from India.

Step 2:  Apportion the profits from Indian operations of the enterprise to the PE by assigning weights to sales, assets, and employees as follows:

 

Factors	Weight (multiplier) to be assigned where user intensity is low to medium	Weight (multiplier) to be assigned where user intensity is high
Sales: Proportion of PE sales in India / global sales of PE	0.30	0.30
Assets:  Assets employed by PE for sales in India / assets employed globally for sales in India	0.30	0.25
Number of employees:  Number of employees employed for Indian operations in India to total number of employees employed for Indian operations	0.15	0.125
Wages paid:  Wages paid for Indian operations in India to total wages incurred in relation for Indian operations	0.15	0.125
Users:	0.10	0.20

Note that in all the above cases where the PE is constituted on account of activities of the associated enterprise in India, in view of the principle laid down by the India Supreme Court in the case of DIT Vs Morgan Stanley, as well as the need to avoid double taxation of such profits in the hands of a PE, the committee concluded that profits derived from Indian operations that have already been subjected to tax in India should be deducted from the apportioned profits.

The committee observed that in a case where no sales take place in India or sales is less than INR 1 million (approx. USD 14,300) during the year, and the profits that can be apportioned to the supply activities have already been taxed in the hands of an Indian subsidiary, no further taxes would need to be paid by the PE.

Some thoughts

As noted by the committee, the current domestic rule on the attribution of profit to a PE in India is generic and allows a high level of discretion in its application. The committee notes with concern that very diverse methodologies seem to have been adopted in different cases in attributing profits to the PEs by the courts and other stakeholders in India. 

In view of the same, the report attempts to standardize the methodology of attribution of profits to PE in India.

It is commendable that CBDT has adopted a consultative approach and is inviting inputs. 

However, given this approach is different from the OECD AOA, the inconsistency could add to global disputes on taxing of profits derived by an MNE from its PE, if any, in India.

Article 7 of India’s tax treaties have different variations. Some treaties agree on the approach for attribution in the treaty itself and provide a fall back to the India rules only in case of exceptional difficulties in applying the article (example:  US, Germany, France) and some also rely on the Customary local rules of the respective countries (example:  UK, Singapore, Japan, Korea).

Given this update, and considering the line of thinking of the India tax authorities, it will be important to strategize and undertake a check of any PE existing in India and the possible attribution of profit to the PE. It will also be important for MNEs to evaluate optimal strategies for attaining certainty on questions of the existence of PE in India and attribution of profits to the PE.