The Central Board of Direct Taxes (the Board) issued a draft report last week, seeking consultation on amendments proposed to the income attribution rules applicable to non-residents having a business connection and/or a permanent establishment (PE) in India. Presently, the rule for attributing income to a PE in India is enshrined in Rule 10 of Income Tax Rules, 1962 which are intended to complement attribution principle adopted by India in its tax treaties.
Whilst courts/tribunals in India have endorsed the application of Rule 10 in many instances of PE litigation, it is the inconsistent application and unpredictability of this principle that has proven to be a bane. The Board-constituted committee has now proposed more specific guidelines to replace such a discretionary apportionment approach with a fractional apportionment method.
PE attribution — a recap
In the context of Indian tax treaties, income attribution approach is broadly aligned to UN MC approach (or say pre-2010 OECD MC), which even though espouses the ‘single entity’ approach under Article 7(2), at the same time makes way for an alternate method under specific cases which is customary in source state (India, in this context), provided the outcome is in conformity with the ‘single entity’ approach. Historically, Rule 10 under domestic tax law has been hailed as the customary approach for income attribution, which allows significant discretion to the Revenue authorities towards determining income attribution to a PE in India.
Revised rules
In arriving at its recommendations, the experts’ committee delved into historic approaches to income attribution, and has put forth an arguable premise to demonstrate how the OECD’s authorised approach based on FAR-linked Transfer Pricing method, grossly overlooks demand-side factors such as market country dynamics, sales volume and efforts, customers’ willingness and ability to pay premium, that contribute to income generation.
The report also recognises, rightfully so, that the wide scope of discretion presently available to the Indian Revenue in applying Rule 10, must pave way for a consistent and universally implementable rule. With that, the key takeaways are:
Apportionment method for income attribution to business connection/PE is to be based on three factors, i.e., sales, employee and assets. While a global formulary approach, in theory, is best suited, lack of global data may pose a significant challenge
‘Fractional apportionment’ approach, on the other hand, does not require consolidation of profits of the non-resident, and therefore, more suited to determine profit attribution to the PE by multiplying India-specific profits by a fraction based on equal weights assigned to each of three factors
In the case of digital businesses, the revised rules allow adoption of fourth factors, i.e., ‘users’, and assigns weight between 10 to 20 percent, depending upon the user intensity
The committee recommends excluding profits which are otherwise subject to tax in India, e.g., in the form of income of the subsidiary of the foreign non-resident enterprise. This is consistent with the ratio laid down by the Supreme Court in the Morgan Stanley case
Levy of tax on minimum attribution of 2 percent of revenue derived from India, in cases where the global operations yield losses or earn lower profits The fractional apportionment is to be resorted to only if book of accounts are either not maintained by the Indian PE, or are not adequate to enable ascertainment of profits
Arguably, revisions proposed to profit attribution rules do seek to curtail the scope of discretion in determining the PE income, by allocating weights to factors contributing towards profitability of an enterprise. That said, there are a set of potential implementation challenges that may emerge. For one, the proposed amendment to income attribution rules is essentially a unilateral measure by India, and doesn’t necessarily align with majority of its tax treaties with OECD members, bound by OECD’s authorised approach to income attribution. India’s revised position thus, will invariably create a mismatch in those cases as to the quantum of profits to be taxed in India and in residence country, respectively.
Levy of tax on minimum attribution of 2 per cent of revenue derived from India could also lead to inconsistent allocation of taxable profits. Ability to collate reliable data in respect of global and India sales, manpower and assets would be another significant challenge.
The Board would be alert to any possible concern including, if required, a broader policy alignment vis-à-vis treaties with OECD members and practical challenges to implementation of fractional apportionment to PE attribution.
Singhania is Partner, Deloitte India