1 Permanent Establishment Service PE - Agency PE Attribution of Profits Radhakishan Rawal February 17, 2006

2 Overview Article 5 - Permanent Establishment Agency PE Service PE Attribution of Profits Article 7 - Business Profits

3 Article 5 - Permanent Establishment

4 Significance of PE Decisive condition for the taxation of income from business activities This rule is designed to ensure that business activities are not be taxed by the state unless and until they have created significant economic bonds between the enterprise and that state

5 Types of PE l Basic Rule PE l Agency PE l Service PE

6 Agency PE [Article 7(5)] §Dependent agent l Habitually exercising authority to conclude contracts l Maintenance of stock and delivery of goods l Securing orders

7 Dependent Agent §Ordinary course of business §Wholly or almost wholly §Two entity approach

8 Service PE § Article 5(3) The term ‘permanent establishment’ encompasses: (a)….(b) The furnishing of services, including consultancy services, by an enterprise through employees or other personnel engaged by the enterprise for such purpose, but only if activities of that nature continues (for the same or a connected project) within the country for a period or periods aggregating more than six months within any twelve month period. § No clause for ‘fees for technical services’ in UN Model

9 Service PE §Special features of Indian DTAAs l ‘Same or connected projects’ l Services other than technical services l Services to related party – one day PE

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11 Issues §‘Other personnel’ - non-individuals? §Calculation of number of days – Man days v. Solar days

12 Service PE under the Act §Finance Act, Section 92F(iiia) l “Permanent establishment, referred to in clause (iii), includes a fixed place of business through which the business of enterprise is wholly or partly carried on.” §Memorandum to the Finance Act, 2002 l “It is proposed….. to provide a separate definition of permanent establishment on the lines of the definition found in the tax treaties entered into by India ….”

13 Service PE §OECD Project on taxation of services

14 Attribution of profits

15 Attribution of profits l Attribution of profits to various activities of the business l Attribution in case of transactions between branch and head office

16 Example Locality ALocality B per per KG Profits 500 Profits ?? Locality C Locality B per per KG Profits 700 Time spent 2 hrsTime spent 3 hrs Profit 400 ( ) ? Profits ?? Profit 300 ? Profits ?? Variation I

17 Locality C Locality B per KG Time spent 1 hrsTime spent 3 hrs per per KG Profits 0 (no time spent)Profits 600 Agents cost 50 Profits 650 Other income from 1 hr 100 Total profits 750 Profits 330 ( ) ?Profits ? Profits (650/4)Profits (650/4)*3 Variation 2 Agents cost 100 Time spent 0 hrs Time spent 3 hrs Variation 3 Profits 600 Other income from 2 hr Total profits 800

18 Analysis

19 Transactions between head office and branch §A person can not trade with himself and make profits §Betts Hartley Huett And Company Ltd. v. CIT (Calcutta HC)(116 ITR 425) §ABN Amro Bank v. ADIT (Kol ITAT) (97 ITD 89) §Dresdner Bank AG v. Addl. CIT(Mum ITAT) (105 TTJ 149)

20 Attribution of profits…. a guesswork ? l Blue Star Engg. (73 ITR283) (Bom) “We are not impressed by the said submission of Mr. Mehta. 25%, no doubt, is some guesswork done by the Income-tax officer, but substituting it by 10% again would be nothing more than indulging in further guesswork”

21 Attribution of profits…. a guesswork ?…. l Hukumchand Mills Ltd (103 ITR 548)(SC) “In the absence of some statutory or other fixed formula, any finding on the question of proportion involves some element of guesswork. The endeavor can only be to be approximate and there cannot in the very nature of things be great precision and exactness in the matter.”

22 Approach of courts on attribution  Lower authorities [AO, CIT(A), ITAT] in a better position to decide the issue  AARs reject questions on attribution of profits  The courts prefer to not to interfere unless attribution found to be unreasonable or arbitrary l New Consolidated Fields (125 Taxman 959) (SC) l Mewar Textile Mills (60 ITR 423) (SC)

23 Methods under the Act l Computation Method l Presumptive Method l Proportionate Method

24 Article 7 - Business Profits

25 Article 7(1) The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment.

26 Article 7(2) Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.

27 OECD Commentary para 2  Para 2 does not authorise the Tax Authorities to ignore the Branch accounts and work on hypothetical figures. The starting point should be the accounts.  The tax authorities should rely on symmetrically prepared accounts.  Accounts to be rectified when required to arrive at AL profits.  Transfer of assets from PE to HO should be treated as transaction resulting in profit whether the organization as a whole has realized the profit or not.  Ignore certain transactions if such transactions cannot be expected between two independent organizations.

28 Article 7(3) In the determination of the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the business of the permanent establishment including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere.

29 OECD Commentary para 3 Profit to be charged when the enterprise sells the goods or provides the service in its normal course of business. No profit to be charged if the expense incurred is to rationalize overall cost of the organization or increase in a general way its sales. When goods are not given to PE for resale but for general use then only related cost should be shared, say depreciation on machinery, based on use of the machinery.

30 OECD Commentary para 3 Intangibles  Difficulty in allocating the ownership of the intangibles to any particular part of the organization. The cost incurred for creation of intangibles may be treated as attributable to all the parts of the organization which make use of it.  The cost incurred should be allocated without any mark up to the PE.

31 OECD Commentary para 3 Services  Mark up shall be charged to PE when the enterprise provides such services on commercial terms or is in the business of providing such services.  General management activity say training provided to the employees of the various parts of the enterprise - no mark up to be charged to the PE. Interest  No interest to be charged between the enterprise and the PE. Interest may be charged in the case of financial enterprise ( e.g. bank )

32 Example Tungus Plc. Supply of raw materials to PE Rs.10,000 ( AL price Rs. 7,000 ) PE processes the materials and sells it in India Rs. 20,000 PE uses brand name ( Tungus ) belonging to HO PE uses technical know how of HO Capital contributed by HO to the PE Rs.100,000 General overheads of HO Rs. 5,000 General Marketing cost of HO Rs. 4,000 Special marketing costs incurred by HO Rs. 500 PE contributes 10% of total turnover

33 PE’s P & L a/c Rs. Rs. Sales 20,000 Raw materials 10,000 General overheads ( 10% ) 500 General marketing cost (10% ) 400 Special Mkt cost ( actuals ) ,400 Profit before tax 8,600 Rs. Rs. 20,000 7, ,400 11,600 PE Books MC Method Example

34 OECD PE Profit Attribution Project

35 OECD PE Profit Attribution Project §Aim: to seek consensus on how to hypothesise PE as distinct and separate enterprise and to apply Transfer Pricing Guidelines by analogy §Draft Reports have been published in four inter- related Parts: l Part I – General Principles l Part II – Banking l Part III – Global Trading l Part IV – Insurance §All follow “functionally separate enterprise” approach

36 Two-step approach 1.Hypothesise PE as “distinct and separate enterprise” engaged in “same or similar activities” under “same or similar conditions” and “dealing wholly independently” with enterprise of which it is a part 2.Determine profits of hypothesised separate enterprise by applying OECD’s 1995 Transfer Pricing Guidelines by analogy to “dealings” between PE and other parts of enterprise

37 §First step − done by applying principles of Transfer Pricing Guidelines by analogy to perform a factual and functional analysis: l to identify functions performed, assets used, and risks assumed by the PE, l to attribute adequate free capital to the PE in light of its risks, and l to identify any “dealings” between PE and the enterprise of which it is a part

38 §Second step − PE must be attributed profits that it would have earned at arm’s length if it were a legally distinct and separate enterprise performing same or similar functions under same or similar conditions

39 PE’s P & L a/c Rs. Sales 20,000 Raw materials 10,000 General overheads ( 10% ) 500 General marketing cost (10% ) 400 Special Mkt cost ( actuals ) ,400 Profit before tax 8,600 Rs. 20,000 7, ,400 11,150 Rs. 20,000 7, ,540 11,460 10% AL Books MC OECD Report Example

40 Current Status §Published new versions of Parts I - III in December 2006 Way forward §Publish new version of Part IV in 2007 §Publish draft implementation package (Model/Commentary changes) during 2007

41 §UN Model adopted mainly by the developing countries §UN Model promotes source based taxation §Commentary on UN Model substantially adopts the OECD Commentary UN Model and AOA

42 Article 7 of the OECD and UN Model Article 7(1) of the UN Model allows limited ‘force of attraction rule’ Article 7(3) of UN Model prevents recognition of internal payments − Interest, Royalties or other similar payments − Commission for specific services − Management fees Exceptions − Reimbursement of expenses − Interest for banking enterprises

43 Adoption of AOA in treaties based on UN Model It would not be possible to adopt AOA for treaties based on UN Model Adoption of AOA possible only if Article 7 of treaties is amended

44 Thank You