Generally, guidance on the attribution principles is derived from the OECD model tax convention (OECD MC), United Nations’ model tax convention (UN MC), associated commentaries, authorized OECD approach, and various judicial pronouncements.
The authorised OECD approach as well as the OECD MC provides that the profits should be attributed to a PE keeping in mind its functional, asset and risk (FAR) profile. FAR analysis is the foundation of any transfer pricing (TP) based arm’s length analysis. Both the UN and OECD MC provide for an attribution by treating the PE to be a separate and distinct entity. The UN MC also provides for certain additional conditions like force of attraction rule and limitation of deduction of certain expenses while attributing such profits.
Taking cue from the available guidance, countries have developed their domestic attribution principles/practices, considering their socio-economic factors and legal framework.
India’s stated position has been that it does not agree with the authorised OECD approach since it believes that the same is more suited for countries which are net exporters of capital and technology. However, while Indian domestic tax laws grant wide powers to the tax officers to assess / re-assess the income attributable to a PE, there is limited guidance on the attribution principle per se. Thus, the tax officer could assess the income/ profits attributable to a non-resident either as a percentage of the turnover accruing or arising in India, or in the same proportion as such receipts bear to the total receipts of such business, or in any other manner which the tax officer may deem fit. Over the years, this has resulted in various disputes between the taxpayers and the income-tax authorities.
Recognising the inherent arbitrariness in the existing rules, a committee formed by the Central Board of Direct Taxes (apex body for administration of direct tax laws in India) has come-out with a public consultation paper on revised profit attribution principles/rules. The proposed methodology aims to eliminate the diverse approaches adopted by tax officers during revenue audits/tax assessments
CBDT panel recommendations
The committee observed that business profits are a result of both, supply as well as demand side factors. It further observed that a FAR based attribution ignores the contribution to business profits made by demand side factors such as access to marketplace etc.
The committee took into consideration the guidance under OECD and UN MC, international best practices, judicial precedents available and the data gathered from field level, and has accordingly recommended adopting a ‘fractional apportionment approach’.
Under this approach, the committee has recommended a three-factor based formula in order to compute the profits attributable to a PE in India. The formula gives equal weightage to the three factors, namely: sales, employees (headcount and wages) and assets as under:
Profits attributable to operations in India = Profits derived from India x [SI/3xST + (NI/6xNT) + (WI/6xWT) + (AI/3xAT)] where,
Profits derived from India Revenue derived from India x Global operational profit margin
•Revenue derived from India is defined to mean ‘All receipts arising or accruing or is deemed to accrue or arise from India which are chargeable under the head Profits and gains of business or profession’, and
•Global operational profit margin means ‘Ebitda (earnings before interest, taxes, depreciation and amortization) margin of a company or 2%, whichever is higher’
SI is sales revenue derived by Indian operations from sales in India
ST is total sales revenue derived by Indian operations from sales in India and outside India
NI is number of employees employed with respect to Indian operations and located in India
NT is total number of employees employed with respect to Indian operations and located in India and outside India
WI is wages paid to employees employed with respect to Indian operations and located in India
WT is total wages paid to employees employed with respect to Indian operations and located in India and outside India
AI is assets deployed for Indian operations and located in India
AT is total assets deployed for Indian operations and located in India and outside India
Approach for digital businesses
In case of digital businesses, the committee has suggested that the number of ‘users’ is a critical component. Therefore, it has proposed inclusion of ‘users’ as a fourth factor in such businesses with a weightage of 10% in case of low and medium user-intensity business models and 20% in rest of the businesses where there is a significant economic presence.
Accordingly, in case of digital businesses the other three factors, namely, sales, employees (headcount and wages) and assets will be given a weightage of 30% each, where a 10% weightage is assigned to number of ‘users’. However, where ‘users’ are assigned a higher weightage of 20%, the weightage of assets and employees shall be reduced to 25% each and sales will continue to have a 30% weightage.
In case a resident group entity constitutes PE of the foreign entity in India, the profits computed by above formula shall be reduced by the amount of profits already subjected to tax in India in the hands of such resident entity.
The committee has also proposed that no further attribution will be required where such resident group entity has been remunerated at arm’s length and the foreign enterprise does not receive any payments on account of sales or services from any person who is resident in India or such payments do not exceed `10 lakh.
The committee has however suggested that the newly proposed methodology shall apply only in cases where:
•India-centric financial statements are not available
•Books of accounts have been rejected under the appropriate provisions of the Indian Income-Tax Act, 1961
•Accounts do not adequately reflect the profits that can be attributed to the PE as an independent and separate entity and reasons are recorded by the tax officer.
The road ahead
The report has sparked an interesting debate that a profit attribution exercise carried out on TP principles (i.e., based on FAR analysis) ignores demand side factors. It has questioned the hitherto international consensus within the tax community that TP principles provide a scientific and rationale approach for profit attribution. If the committee’s views are adopted, it may have wider ramifications on TP analysis carried out for inbound business models where customers are based in India.
While the proposed fractional apportionment will go a long way in putting an end to the diverse attribution approaches adopted by the tax officers during revenue audits / tax assessments, it may fuel further litigation on account of certain practical challenges which may be faced while applying the proposed formula. Some of the practical limitations under the proposed three/ four-factor based formula could be:
• This method requires availability of complete information about country wise revenue as well as deployment of manpower and assets which may not be easily available.
• Various terms used in the formula like details of employees present in India and abroad and wages paid to them, details of assets located in India and abroad may give rise to various interpretation issues. For example, treatment of common employees, common assets, etc.
• In case of digital businesses, weightages of 10% and 20% have been proposed for number of users, depending on the whether a particular business model has low/ medium or high user intensity. However, the report does not lay down any objective manner of classifying different digital businesses within these categories.
• The draft report proposes application of a single formula for all profit attribution exercises, except a variation proposed for digital businesses, ignoring the vast differences which exist between different industries and their impact on business profitability.
• The committee has proposed a floor rate of 2% as a minimum threshold of profits which have to be declared in India. However, it may prove onerous for global companies faced with operational losses at the group level. Such groups may face a situation wherein they are required to offer some income to tax in India, thereby resulting into double taxation.
It would be interesting to see how the public consultation process shapes up the final report.
The Indian government has time and again signalled its intent to bring down litigation and create an investor friendly environment. While the committee’s recommendations are based on a detailed analysis of the guidance available in India and the practices adopted around the world, the report may impact ongoing mutual agreement procedures/bilateral advance pricing agreements under discussion between India and other countries. Nevertheless, the draft report is a remarkable step and only time will tell about its impact on reducing disputes related to profit attribution in India.
Rajeev Jain and Varun Gupta contributed to this article.
Vikas Vasal is national leader-tax at Grant Thornton in India.