Tax body proposes new rules on profit attribution

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The Central Board of Direct Taxes (CBDT) recommended significant amendments to the current rules on attribution of profits to permanent establishments (PEs) in a report issued on 18 April 2019.

The report is based primarily on the fact that the Authorized OECD (Organization for Economic Co-operation and Development) Approach (AOA) on the attribution of profits does not take into account sales receipts and other demand-side factors derived from the source jurisdiction. Article 7 of the OECD Model Tax Convention requires attributable profits to be determined based on the functions performed, assets deployed, and risks assumed by the PE in the source jurisdiction.

Fractional apportionment method

In the CBDT’s view, the AOA allocates profits exclusively to the jurisdiction where supply chain activities are located, which limits the taxing rights of source jurisdictions that contributed to business profits by facilitating the demand for goods and services. In addition, the report acknowledges the lack of specificity and clear guidance regarding the application of existing domestic rules on attribution of profits, as contained in rule 10 of the Income Tax Rules, 1962. These rules permit tax officers to select any method for attribution of profits that they deem suitable, which has resulted in uncertainty and consequent tax litigation around computing attributable profits.

The report recommends a fractional apportionment method for determining profits attributable to India, i.e. by determining and then apportioning the “profits derived from India” using three equally weighted factors of sales (representing demand), manpower and assets (together representing supply). For this purpose, “profits derived from India” would be arrived at by applying the global profit margin, which is deemed to be the EBITDA (earnings before interest, taxes, depreciation and amortization) margin of the enterprise, to the revenue generated from Indian customers.

The report also recommends a floor rate of “profits derived from India” at 2% of the turnover derived from Indian operations to protect India’s revenue interests in cases involving enterprises incurring global losses, or having a global operational profit margin of less than 2%. Attributable profits are then determined by applying the equi-weighted formula to the “profits derived from India”, in the following manner:

  1. Profits derived from India are equal to revenue derived from India multiplied by global operational profit margin, where revenue derived from India includes all receipts arising or accruing or are deemed to accrue or arise from India that is chargeable under the head profits and gains of business or profession, and global operational profit margin means the EBITDA margin of the enterprise.
  2. Profits attributable to operations in India = (1) x [(SI/3ST) + (NI/6NT) + (WI/6WT) + (AI/3AT)], where
    • SI = sales revenue derived by Indian operations from sales in India
    • ST = total sales revenue derived by Indian operations from sales in India and outside India
    • NI = number of employees employed for Indian operations and located in India
    • NT = total number of employees for Indian operations and
      located in India and outside India
    • WI = wages paid to employees for Indian operations who located in India
    • WT = total wages paid to employees employed for Indian
      operations and located in India and outside India
    • AI = assets deployed for Indian operations and located in India
    • AT = total assets deployed for Indian operations and located in India and outside India

Digital business

For attribution of profits made by digital businesses, the report recommends the inclusion of an additional factor – user contribution. The report notes that users can be a substitute for either assets or employees, or they may supplement their roles in contributing to the profits of the business. For digital business models involving low to medium user contribution, the report assigns a weight of 10% to users, while a higher weight of 20% has been assigned to digital business models involving high user contribution. In both cases, there would be a corresponding reduction in the weight assigned to employees and assets, but with sales continuing to be given a weight of 30%. This would be represented as follows:

Profits attributable to operations in India in case of low and medium user intensity business models = (1) x [(0.3SI/ST) + (0.15NI/NT) + (0.15WI/WT) + (0.3AI/AT) + 0.1]

Profits attributable to operations in India in case of high user intensity business models = (1) x [(0.3SI/ST) + (0.125NI/NT) + (0.125WI/WT) + (0.25AI/AT) + 0.2]

To prevent double taxation, the report recommends that profits that may have already been taxed in India (for instance, in the hands of an Indian subsidiary that gives rise to a PE in India) be deducted from the profits from Indian operations of the enterprise.

The report also notes that the fractional apportionment method would be used only in those situations where there are no Indian financial statements, or where the books of account have been rejected under law, or where for specific reasons recorded by the tax officer the accounts do not adequately reflect the profits that can be attributable to the PE as an independent and separate entity.

Alternatively, the report recommends the amendment of the Income Tax Act itself to incorporate provisions on profit attribution to PEs. The CBDT has invited suggestions and comments from stakeholders and the general public on the conclusions outlined in the report to be submitted within 30 days from its date of publication.

The business law digest is compiled by Nishith Desai Associates (NDA). NDA is a research-based international law firm with offices in Mumbai, New Delhi, Bengaluru, Singapore, Silicon Valley, Munich and New York. It specializes in strategic legal, regulatory and tax advice coupled with industry expertise in an integrated manner.