5/6/2019 CBDT’s Proposal on Profit Attribution to PEs – Paving New Pathways?

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CBDT’s Proposal on Pro t Attribution to PEs – Paving New Pathways?

May 02,2019 Rate this story:          

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Tehmina Sharma, Partner, Transfer Hemali Thakkar, Manager, Transfer

Pricing, Deloitte Haskins & Sells LLP Pricing, Deloitte Haskins & Sells LLP

Discussion on Attribution of pro ts to PEs has been making the buzz for a while now. However, with increasing business
complexities, the issue is becoming more contentious. Couple that with the fact that tax authorities globally are becoming more
informed about the adverse impact to the exchequer from BEPS, the issue of attribution of pro ts to PEs is now all the more
signi cant.

The authorised OECD approach (AOA) emphasises on an analysis of the functions, assets and risks (FAR Analysis) as a means to do
so. However, India has always been vocal about its reservations to the AOA. The CBDT, on 18 April 2019, issued an 86-pager report
for public consultation, laying out proposals for amendment of the Rules for pro t attribution to PEs. In this report, the CBDT
attempts to provide a synopsis of the evolution of global practices, Indian regulations, practices adopted in various jurisdictions and

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views of academicians and experts on the same. The report also contains India’s recommendations on the regulations to be adopted
in India. In the ensuing paragraphs, the authors have endeavored to bring out a crisp summary of pertinent pointers from the report
along with a couple of model case studies.

Prevalent laws in India:

Indian regulations o er limited guidance on the determination of income in the case of non-residents. Rule 10 provides that in any
case where the Assessing O cer is of the opinion that the actual amount of the income accruing or arising to any non-resident
person cannot be de nitely ascertained, the amount of such income for the purposes of assessment to income-tax may be calculated
by:

·         Presumptive Method: Ad-hoc pro ts as a percentage of revenue estimated as attributable to the PE

·         Proportionate Method: Proportionate pro ts based on world income attributed to the PE

·         Other Method: In such other manner as the tax authority may deem suitable

Not only are the regulations ambiguous at this stage, but also put immense power in the hands of the Assessing O cer to adopt an
approach which may bring about a colossal degree of uncertainty and unpredictability for taxpayers, driving them towards expensive
and prolonged litigation.

CBDT’s rationale on the recommendations:

India has always been in disagreement to the AOA, which places immense focus on the FAR analysis as a means to determine the
pro t attributable to a PE, because functions de ne the supply side factors of a transaction with no cognizance of demand side
factors. Also, total pro t is an interplay of the “quantity of sales” and “pro t per unit”. Thus, unless one takes both into consideration,
the results would be lop-sided. This may have adverse impact on developing nations, which attract high demand and are importers of
capital and technology. The demand for products in developing countries have relatively lesser to do with marketing e orts of the
supplier and more to do with the ability to pay and the disposable income of customers. Further, while carrying out a TP analysis, the
intent is to determine the value added by each step in a supply chain. However, when the objective is to determine attributable
pro ts, it is pertinent to also consider demand as well.

The report also sketches a parallel with BEPS Action Plan 1 on digital economies, where the UK government observed that it is the
active user participation that creates value for digital businesses, and the jurisdictions in which users are located should be entitled
to tax a proportion of those businesses’ pro ts.

Another area discussed is that of ‘synergy rents’, which do not get captured in a plain FAR analysis. Synergy rents can be considered
as excessive pro ts that are derived from the ‘comparative advantage’ of di erent economies, for which they ought to be recouped
appropriately. 

Proposed route:

The CBDT has now proposed a means, using fractional apportionment with equal weightage to following three parameters:

·         Sales;

·         Manpower and wages (one-sixth each); and

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.         Assets

The reports attempt to justify  that in case of a PE that comes into existence by the presence of an Indian subsidiary, which is
separately taxed in India on its own income, a plain FAR analysis may su ce to be an appropriate representation of the pro ts
contributed by the supply side factors in India, and no further attribution to the PE would be then required. However, a 33 percent
weightage may be given to sales. The same results may be deducted in the hands of the Indian subsidiary from the pro ts already
taxed, to avoid double taxation.

The report further suggests that in all circumstances, the “pro ts derived from Indian operations” be the higher of:

a.     Revenue derived from India as multiplied by the  global operating pro t margin; or

b.    A minimum rate of 2% of the gross revenue or turnover derived from Indian operations, to protect India’s revenue interests, in
cases where the global business operations face an operational loss.

One critical aspect here is what is “Revenue derived from India”? Here Paragraph 159 states that: “…In the absence of
separate accounts of Indian operations, an option that is also frequently practiced and sustained by the Courts in several
cases as discussed earlier, could be to determine such pro ts by applying the global pro t margin on the Revenue generated
from customers within India…”

Further, it may be noted that footnote 83 on Page 70 of the CBDT report states the following: “Revenue derived from India includes
all receipts arising or accruing or is deemed to accrue or arise from India which are chargeable under the
head Pro ts and gains of business or profession”.

Now, there seems to be some ambiguity around this. While Paragraph 159 requires one to consider revenue generated from
customers within India alone (thereby not considering revenue derived from sales outside India), going by section 9(1)(i), one may
say this “revenue derived from India” may also engulf revenue from sales outside India which could be deemed to accrue or arise
from India. Also, one may argue that revenue and sales revenue are not necessarily the same.

Yet another variance suggested is where a non-resident person having a business connection in India is primarily constituted by
existence of users beyond the prescribed threshold in India, the weights shall be attributable to user intensity as well, as follows:

· In case of low and medium user intensity, 10% weights to users and 30% each to the other factors (sales;  manpower and
wages; and assets); and 
·    In case of high user intensity, 20% weights to users and 25% each to assets and employees and manpower; and 30% to
sales
Model Case Study:
Model Case Study 1:

Profits attributable to operations in India =

Profits derived from Indian operation X {[ICo. Sales / (3 X Total Sales)] + [ICo. Employees / (6 X Total Employees)]
+ [ICo. Wages / (6 X Total Wages)] + [ICo. Assets / (3 X Total Assets)]}

Now, take cognisance of the colours used above to correlate with the information below:

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Global operational profit margin of the MNC A 13%

Sales revenue derived by Indian operations from sales in India C INR 90 crores

Total sales revenue derived by Indian operations from sales in C INR 130 crores
India and outside India

Number of employees employed with respect to Indian D 1,500

operations and located in India

E 1,750
Total number of employees employed with respect to Indian
operations and located in India and outside India

F INR 20 crores
Wages paid to employees employed with respect to Indian
operations and located in India

G INR 23 crores
total wages paid to employees employed with respect to Indian
operations and located in India and

outside India

H INR 1 crore
Assets deployed for Indian operations and located in India

I INR 1.2crores
total assets deployed for Indian operations and located in India
and outside India

Now, using the above as given, Profits derived from Indian operations shall be calculated as higher of:

Basis the above,

Profits attributable to operations in India =

Profits derived from Indian operation X {[ICo. Sales / (3 X Total Sales)] + [ICo. Employees / (6 X Total Employees)]
+ [ICo. Wages / (6 X Total Wages)] + [ICo. Assets / (3 X Total Assets)]}

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i.e. Profits attributable to operations in India = 11.70 crores X {[90 crores / (3 * 130 crores)] + [(1,500 / (6*1,750)]
+ [20 crores / (6 X 23 crores)] + [(1 crore / (3 X 1.2 crores)]}

i.e. Profits attributable to operations in India = 11.70 crores X [(0.2308) + (0.1429) + (0.1449) + (0.2778)]

i.e. Profits attributable to operations in India = 9.32 crores 

Model Case Study 2:

Now, imagine a case where the MNC makes losses at a global level (say -13% in the above example). For
determining Profits derived from Indian operations, calculations shall be as follows:

Multiplication of (Revenue derived from India) with J = -13% * B (-) INR 11.70 crores
the (Global operational profit margin)

A minimum rate of 2% of the gross revenue or K = 2% of B INR 1.80 crores

turnover derived from Indian operations, to protect
India’s revenue interests, in cases where the global
business operations face an operational loss

Hence, Profits derived from Indian operations Higher of J or INR 1.80 crores
K, i.e. K

Now, Profits attributable to operations in India = 1.80 crores X [(0.2308) + (0.1429) + (0.1449) + (0.2778)]

i.e. Profits attributable to operations in India = 1.43 crores 

Conclusion and way forward:

The CBDT has been quite mindful in ensuring that India’s interests in the scheme of things are well protected. Having said this, with
the global Transfer Pricing regulations aiming to bring in consistency across economies and FAR being adopted as a means to
determine arm’s length price, the proposed approach of the CBDT attempts to opt for a path less travelled, and one which may not
necessarily be in synchronization with actual business economics and the commercial environment. The one pertinent positive move
by the CBDT is that they have not made an autocratic move and have instead sought public comments to sense the pulse of the
taxpayers. 

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