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Set principles for income attribution
December, 25th 2007

Close on the heels of the Morgan Stanley decision of the Supreme Court, the Delhi Income Tax Appellate (Tribunal) has rendered two landmark rulings in the case of Rolls Royce and Galileo International Inc, dealing with constitution of permanent establishment (PE) and income attribution principles.
Attribution of profits has been a vexed question in international law, and in terms of complexity, the question of determination of PE may be considered as its second cousin. Simply stated, income of a non-resident foreign company is taxed if it has a PE in India.
Having established that the foreign company has a PE, the important determination to be made is what portion of the income should be attributed to such PE. The definition of what constitutes PE is a subject matter of interpretation under each treaty. In the absence of a treaty, the Revenue resorts to business connection rule for bringing the non-residents income to tax in India.
Recently, the Apex Court attempted to clarify the law on attribution principles in the Morgan Stanley case. The industry, particularly IT and ITEs, breathed a sigh of relief as the Court ruled that no attribution of profits was required where the Indian arm of a foreign company was compensated at arms length i.e. after due consideration of the functions performed and the risks borne in India. The two recent tribunal decisions, though rendered solely on facts, have again brought the issue to forefront in so far as determination of PE and attribution is concerned.
Rolls Royce (RR) case
RR, manufacturers of aircraft engines, operates a liaison office in India. The Liaison Office did not comply with return filing requirement since its operations were non-income generating or, at best, the activities were classified as preparatory and auxiliary for India-UK treaty purposes, which are specific exclusions from constitution of PE. However, Revenue took the view that the Liaison Office constituted a dependant agent PE of the UK entity.
On the basis of a survey undertaken by the Revenue in the premises of the liaison office, the Revenue was able to vindicate its stand that Rolls Royce constituted a PE in India. As a fact finding authority, the Tribunal recorded a finding based on documents unearthed in the course of the survey
The Tribunal ruled that though contracts were signed outside India, the negotiations took place in India and hence, marketing profits arose from Indian operations residing within RRs liaison office. Applying the principle of apportionment laid down by the Apex Court in the 1950s in the Ahmedbhais case, the Tribunal directed the Revenue to charge to tax 35 per cent of profit.
While reduction of attribution from 75 to 35 per cent is welcome, it is viewed arbitrarily high and appears no less perplexing. Tax experts have questioned the justification for 35 per cent attribution without regard to arms length principle and use of scientific transfer pricing methodology.
Galileo Case
Galileo International Inc is in the business of maintaining and operating the system for providing electronic global distribution services to airlines and tour operators by connecting travel agents with the assistance of Computerised Reservation System (CRS). Galileo appointed an independent Indian agent as Distributor to market and distribute CRS services to travel agents in India.
The distributor, in turn, enters into Subscriber Agreements with travelling agencies with access codes, equipment, communications link and support services. The travel agent has an option to access Galileos CRS or may chose to access other CRS.
Galileo is remunerated outside India by the airlines and does not receive any remuneration from travel agents. Galileo pays fees for acting as a distributor and providing communication services. The distributor in turn charges fees from the travelling agents.
The Revenue held that income arose to Galileo as a result of hardware and systems installed in India. Further, profit on each segment booked through computers installed (in India) constitute a PE and that the distributor was an agent under India-US treaty.
In summary, the Tribunal held that a computer hardware with its operating systems constituted a PE, particularly since the distributor was an agent acting on behalf of Galileo.
It is for the Tribunal to find facts and for the high courts and the Supreme Court to lay down the law applicable to such facts.
In RRs case, the Revenue department relied on survey findings for latter years to arrive at conclusion for earlier years. This is clearly a subject matter of debate. In the well reasoned Galileo order, whether a computer can constitute a PE or not is clearly debatable.
Well, if the European tax courts have adjudicated on whether a pipeline or vending machine is a PE, Indian courts will now adjudicate on computer constituting a PE. I have no doubt that substantial question of law arises in both cases, besides complex e-commerce cross border tax issue in Galileos case.
Income from international cross-border trade and investment may be taxed either in the source country or the country of residence. Residence taxation is based on the principle that tax payers should contribute towards the public services provided by the country where they are residents. Source taxation is justified by the view that the country which provides an opportunity to generate income should have the right to tax.
The degree of source versus residence tax depends on each treaty; capital-exporting richer countries prefer the OECD model treaty; which is favourable to residence, while capital-importing developing countries tend to favour the UN model treaty, which is more favourable to source.
With India no longer a predominant capital importer, but rather, a significant capital exporter, it is time that India reviewed its model treaty. It appears that we shall shift more towards a residence model. If we dont, we shall run the risk of being meted stricter source-based interpretation in countries that follow source rules. It will be interesting to see how our treaty model goes through a change as we embark on path to become a OECD member.
Mukesh Butani
The author is a partner of BMR & Associates. Views expressed are personal
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