[2017] 84 taxmann.

com 38 (Article)

[2017] 84 taxmann.com 38 (Article)

Date of Publishing: August 3, 2017

Arm’s length attribution of profits to PE (Part I):Evolution in Indian Jurisprudence

FATEMA HUNAID GAURAV JAIN

Partner, Grant Thornton India LLP CA

KRITI CHAWLA
CA

The existence of nexus between 'income' and 'taxing state' is a prerequisite for the right to tax. The
fundamentals of international tax revolving around the determination of 'taxing state' follow two forms of
taxation; residence based taxation regime and source based taxation regime.

Increased globalisation has resulted in multinational enterprises ('MNE') operating in multiple jurisdictions
giving rise to disputes on profit allocation. Tax authorities, especially in developing nations, are hence
concerned about erosion of due share of revenue resulting from significant operations of foreign entity in their
country. A correct and just allocation of profits between residence and source jurisdiction is hence imperative.

On global and domestic fronts, there is guidance available on determination of taxable presence of an MNE in
source state through Permanent Establishment ('PE'). However, absence of systematic, clear and detailed rules
on attribution of profits to PE is a cause of concern. In such situations, transfer pricing ('TP') has a pivotal role
to play to ensure appropriate attribution of profits to PE.

The guidance available on attribution of profits to PE and related statute are analysis in two parts:

♦ Part I - Evolution of attribution mechanisms in India landscape; and

♦ Part II - Guidance on attribution based on OECD BEPS1 Action Plan 7.
Section 92F(iii)(a) of the Income Tax Act, 1961 ('the Act') defines the term PE to mean "a fixed place of
business through which the business of an enterprise is wholly or partly carried on." In Indian jurisprudence,
following key principles emerge for attribution of profits to PE:

• PE's role in the economic value chain

Profits are attributed to PE on account of PE's participation in the economic life of the host country. This view
was established in ZTE Corpn v. Addl. DIT (IT) [2016] 159 ITD 696/70 taxmann.com 1 (Delhi) where ITAT2
held, "the most important aspect to be kept in mind is the level of PE's participation in the economic life of the
source country. It is primary nexus between the source country and PE's activities which produce the taxable
income to the taxpayer."
• PE is a separate and independent legal entity

Profits are attributed on the assumption that PE is distinct and separate enterprise dealing independently with
the enterprise of which it is a PE. This view was reiterated in M/S Seagate Singapore International as, "For the
purpose of computation of profits of PE, it should be treated as separate and distinct enterprise wholly
independent of the enterprise of which it is a PE."3 This separate entity approach has also found support in
Section 92F of the Act that defines the term 'enterprise'.

• Attribution in accordance with Arm's Length Principle

This principle finds reference in CBDT4 Circular No. 5/2004 that provides, "profits to be attributed to a PE are
those that PE would have made if, instead of dealing with its Head Office, it had been dealing with an entirely
separate enterprise under conditions and at prices prevailing in the ordinary market. This corresponds to the
arm's length principle."

Indian provisions on Attribution of Profits

Section 9(1)(i) of the Act provides basic framework for attribution of profits owing to 'business connection' in
India. In absence of specific provisions, Rule 10 of the Income Tax Rules ('the Rules') is relied upon. It provides
for determination of income of non-residents from business connection in India using:

♦ Such percentage of the turnover so accruing or arising as the AO 5 may consider to be reasonable,
or
♦ On any amount which bears the same proportion to the total profits or gains of the business of such
person as the receipts so accruing or arising bear to the total receipts of the business, or
♦ Such other manner as the AO may deem suitable.
Conjoint reading of Section 9(1) and Rule 10 highlight the necessity of incorporating detailed and specific
provisions on profit attribution. In absence of clear rules in India, judicial cases in the past have been decided
on the issue by adopting varied approaches. Hence, a transition could be observed in this regard.

Flow of attribution of profits in Judicial Context : The Observed Transition

Evolution of attribution of profits in judicial context

Anglo French Textile Co. Ltd. v. CIT [1953] 23 ITR 101 (SC) is one of the early rulings in Indian Judiciary on
attribution dating to the year 1952. The Supreme Court ('SC') considered figure of 10% on British Indian sales
as reasonable for attribution, basis the extent of operations carried out in British India.

Similarly, in Hukum Chand Mills Ltd. v. CIT [1967] 63 ITR 232 (SC), based facts of the case, 15% allocation was
considered reasonable for operations relating to contracts undertaken in British India (in the pre-independence
era the territory of British India was demarcated from Indore, where the company had operational mills for
manufacturing textiles.) In arriving at this figure, emphasis was laid on the then Rule 33 of the Income Tax
Rules, 1922. Rule 33 has now been replicated as Rule 10 explained above.

In recent past, rulings pertaining to profit attribution were pronounced considering Rule 10 together with
specific provisions in the Act. In Dy. DIT (International Taxation) v. Nipro Asia Pte Ltd. [2017] 79
taxmann.com 154 (Delhi - Trib.)6, the AO, in absence of any correct TP study, adopted provisions of Rule 10
using 'selective financial figures' from public websites. ITAT rejected AO's computation (negating use of
publicly available data) and assessed income based on Section 44BB and 44BBB of the Act which provides for
presumptive profit rate of 10%. Similar view was upheld in Nortel Networks India International Inc. v. Dy. CIT
(International Taxation) [2014] 65 SOT 158 (URO)/49 taxmann.com 147 (Delhi - Trib.) and GE Energy Parts
Inc. v. ADIT (International Taxation) [2017] 78 taxmann.com 2 (Delhi - Trib.)

Going further, in Motorola Inc., ITAT allocated 20% profits to PE contending that PE played role in negotiation
and conclusion of contracts and supply of equipment in India. Similarly, in Galileo International Inc., 15%
profit attribution was considered sufficient owing to the role played by PE in negotiating contracts.

Formulary Apportionment in attribution of profits

In 2013, in Convergys Customer Management Group Inc. v Asstt. DIT [2013] 58 SOT 69/34 taxmann.com 24
(Delhi - Trib.), formulary apportionment was adopted as the basis of allocation. The Tribunal used end
customer revenue as the base to which a global operating income percentage was applied to arrive at profits
attributable to the Indian operations.

In India, current provisions on attribution as defined under Rule 10 are akin to the formulary approach.
However, globally, there has been no agreement on the use of formulary apportionment owing to practical
difficulties.

Importance of FAR analysis in Arms-Length attribution of profits

Landmark decision by SC in DIT (International Taxation) v. Morgan Stanley and Co. [2007] 292 ITR 416/162
Taxman 165 (SC) Inc. throws light on the importance of transfer pricing analysis in attribution of profits to PE.
It lays, "The impugned ruling is correct in principle insofar as the associated enterprise, that also constitutes
a PE, has been remunerated on an arm's length basis taking into account all the risk-taking functions of the
enterprise. In such cases, nothing further would be left to be attributed to the PE."

Similarly, in Rolls Royce Singapore (P.) Ltd. v. Asstt. DIT [2012] 347 ITR 192/202 Taxman 45/13
taxmann.com 81 (Delhi), it was emphasized that profits attributable to PE in India is made having regard to
FAR Analysis. The AO held that 25% of the profits on sale of spare parts to customers in India was chargeable
to tax which was reduced to 10% by CIT (A)7 and upheld by ITAT. To substantiate this reduction, it explained,
"The risk assumed by PE in India is very limited. It is only performing the functions of soliciting contracts for
sale of assessee's products or promoting the sales. All other main or core activities regarding the
arrangements or acquisition of products supplied by the assessee company to the Indian customers are
performed in Singapore."Hence, a detailed transfer pricing analysis is imperative.

In a recent decision in Arrow Electronics India Limited, a Singapore Company, opened Liaison Office ('LO') in
Bangalore which was established to be the Indian PE. Placing considerable reliance on FAR analysis for profit
attribution, it was held, "there is no mathematical formula for working out profits of Indian operations and
that of Singapore operations. Functions, Assets and Risk analysis is the best way to arrive at profits".
Allocation of weights in terms of functions performed, risk borne and assets owned (FAR) by the LO formed
basis of profit allocation. The final quantification computed by AO, based on detailed FAR analysis, upheld by
the Tribunal, was attributable as 40:60 to the LO and the Head Office.

Concluding remarks

Estimation of attribution of profits to PE has been a matter of continuous debate before the Courts/Tribunal in
India. As has been established in abundant case laws, it is purely a matter dependent on the facts and
circumstance of each specific case. In this context, gradual movement of Indian judiciary towards reliance on
FAR analysis for attribution makes TP compliance imperative subsequently. Attribution of profits, in that case,
will have to be undertaken as per the arm's length principle.

Globally, OECD BEPS has been the 'matter of the moment'. Accordingly, BEPS Action 7 on 'Additional
guidance on attribution of profits to PE' sets out 'high level general principles' on attribution. Much in line with
the arm's length principle together with reliance on FAR analysis, the discussion in Part II will hence focus on
global landscape in relation to profit attribution. Jointly, the discussion will focus on attribution principle as
per Article 7 of the OECD Model8 applied to specific cases addressed in Action 7.

■■

1. Organization of Economic Cooperation and Development; Base Erosion and Profit Shifting project
2. Delhi Bench of Income Tax Appellate Tribunal ('ITAT')
3. This view has been established in varies cases in Indian Judiciary including, Rolls Royce Singapore
Private Limited (Delhi High Court Judgment), M/S IJM (India) Infrastructure Limited (Hyderabad
Bench) etc.
4. Central Board of Direct Taxes ('CBDT')
5. Assessing Officer
6. AY 2003-04; pronounced on 16/02/2017
7. Commissioner of Income Tax (Appeals)
8. OECD Model Convention on Income and on Capital