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Member consultation: CBDT’s draft rules on attribution of profits to PEs

The CBDT has on 18.04.19 released draft rules (available here) on attribution of profits to permanent establishments. These would have widespread ramifications for multinational companies that are having sales in India or users in India.  The rules appear to be timed with a view to pre-empt the discussions on the digital economy at the OECD/ G20 and could also be a harbinger of the significant economic presence criteria.  The proposed rules give a go-by to transfer pricing principles based on functional analysis and bench-marking, preferring to adopt fractional formulary allocation for attribution of profits to the PE.

Key observations from the report of the constituted Committee:

  1. The Committee explains its rationale for not adopting the OECD guidance that gives primacy to the Functions, Assets & Risk (FAR) while attributing profits to PEs, opining that the OECD approach considers only supply side factors (manpower and assets) and ignores the demand side factors (sales). Accordingly, Committee observed that it can have significant adverse consequences for developing economies like India, that are primarily importers of capital and technology.
  2. After explaining the reasons and economic considerations for dissenting from the FAR based approach of profit attribution, the Committee proposed a formula based approach (referred to as fractional apportionment method) for taxing MNEs having PE in India by giving equal weightage to factors like Sales, Manpower and Assets. Thereby, the Committee included demand side factor (sales) in the formula for profit attribution, which is ostensibly ignored under FAR based approach. The Committee justifies the three factor approach as a mix of both demand (sales) and supply side (manpower and assets), that allocates profits between the jurisdiction where sales/ demand takes place and the jurisdiction where factors of production operate, i.e supply is undertaken.

Profits attributable to operations in India = Profits derived from India x [ (33.33%*India Sales/Global Sales) + (16.67%*Indian employees/Global employees) + (16.67%(Indian wages/Global wages) + (33.33%*Indian assets/Global assets) ]

Where, Profits derived from India = Revenue derived from India x Global operational profit margin

  1. The report also states MNEs that are incurring global losses or a global profit margin of less than 2 percent and have operations in India will be deemed to have made a profit of 2 percent of Indian revenue or turnover and will be taxed accordingly.
  2. In light of the ‘Significant Economic Presence’ concept legislated by India for predominantly digital businesses, Committee recommends a four factor approach including an additional factor of ‘Users’. This is considering the role and relevance of ‘users’ and their contribution to business profits of digital MNEs. The users should be assigned a weight of 10% / 20% depending on the user intensity. In such cases, the weights of manpower and assets would be reduced to 30% / 25% each, keeping the weight of sales fixed at 30%.
  3. Further, report adds that the profits derived from Indian operations that have already been subjected to tax in India in the hands of a subsidiary, should be deducted from the apportioned profits.
  4. The report recommends that in a case where no sales takes place in India, and the profits that can be apportioned to the supply activities are already taxed in the hands of an Indian subsidiary based on appropriate arm’s length remuneration, then no further profits are attributable to the PE.

High-level potential impact:

  1. The enterprises that contribute heavily through their supply side (Manpower and Assets) and demand side (Demand) activities would likely attribute a higher share of their profits to their operations in India, and as a result pay higher taxes.
  2. In cases where no sales takes place in India, and the profits that can be apportioned to the supply activities (say development/ production activities) are already taxed in the hands of an Indian subsidiary based on appropriate arm’s length remuneration, having regard to the functional analysis, then no further profits are attributable.  This should come as a welcome relief to development centres that are Indian branches of overseas entities.
  3. Further, the proposed formula includes only tangible assets as a factor and appears to ignore intangible properties, which are the crown jewels of the enterprises, especially in the technology sectors. Accordingly, intangible property will not have any impact on profit attribution because fair value is not being reckoned.
  4. In cases of digital enterprises that undertake activities through a digital platform, it would almost always result in reality higher attribution of profits than in case of a non-digital scenario because of adding fourth factor in profit attribution (10% or 20%  of weight based on user intensity). While the committee deliberated on the significance of digitalisation and role of users in value creation and profit of an enterprise, in the report it does not define the term ‘users’ and threshold of users for including them in the formula. It only discusses various kinds of users (active and passive depending on the level of participation) and assign different weights depending on level of intensities.  This results in ambiguity as to the difference between users and customers, especially in the context of SaaS/ PaaS and cloud, for instance, as to whether the user factor would apply, and if so, to what extent.

Members are requested to provide us inputs on how these rules may be improved so as to ensure fairness and certainty on the incidence of taxation in a manner that imposes the least compliance burden. Kindly provide appropriate justification and examples to substantiate your point of view. Provide your inputs at the earliest and no later than on 08.05.19 (Wednesday) so that we may finalise our submission. In the interim, do reach out to us to Tejasvi Gupta <> and Ashish Aggarwal <> to discuss any specific issue.

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