Though there are a number of judicial precedents on attribution, there seems to be no single formula, as the issue itself depends on the factual analysis of each case.
In todays age of globalisation, the operations of modern businesses extend over different parts of the globe and various tax jurisdictions. The fact is that even though business operates without any national boundaries, tax systems around the world are based on national considerations.
The question of allocating the corporate profits to different operations has always assumed utmost significance, as the governments of the respective jurisdictions want a fair share of the taxes in respect of the operations carried out in that jurisdiction.
In the Indian context, with the liberalisation of the economy coupled with factors such as cost-effective and quality manpower, India has become a lucrative destination for investment and outsourcing of operations by multinational companies.
It is in this context that the Indian government is closely scrutinising the operations of multinational companies in India, either directly or through a liaison office, branch office, project office or a subsidiary.
Conceptually, under the Income-Tax Act, 1961, foreign companies are taxable in India only if they have a business connection (BC) as defined under Section 9(1)(i) of the Act, or a permanent establishment (PE) as defined under the relevant Double Taxation Avoidance Agreement (DTAA).
In case the foreign company has a BC or a PE in India, only so much of the income which is attributable to the operations carried out in India is taxable in India. The formula for determining the quantum of taxable income in India is prescribed under Rule 10 of the I-T Rules.
The said Rule 10 provides that where the tax authorities consider that the correct amount of income derived by the non-resident cannot be determined, any of the following methods could be applied:
As a certain percentage of the turnover;
The same proportion to the global profits of the taxpayer as the turnover in India bears to the global turnover; or
Any other method which may be reasonable.
Even though Rule 10 provides for profit attribution, in the past, different courts have adopted different methods, depending on the factual and functional matrix involved in each case.
Rolls Royce case
In the latest ruling on the issue, the Delhi Bench of the ITAT (Income-Tax Appellate Tribunal), in the Rolls Royce Plc. (RRPLC) case, ruled that 35 per cent of the global profits of the company in respect of sales effected in India would be attributable to the activities of its PE in India. The brief facts of the case are as follows:
RRPLC, a tax resident of the UK, supplied aero-engines and spare parts to its Indian customers which, among others, included Hindustan Aeronautics Ltd, the Indian Navy and the Indian Air Force.
RRPLC had a subsidiary, Rolls Royce India Ltd (RRIL).
RRIL entered into an agreement with RRPLC to provide certain services to the latter. RRIL was compensated by RRPLC for providing such services
During the survey operations carried out by the tax authorities, it was found that the activities of RRIL also included marketing and liaison services, market analysis, technical support, customer relationship interface, strategic planning, and so on, on behalf of RRPLC.
Based on these survey findings, the tax authorities alleged that RRPLC was having a business connection under Section 9(1)(i) of the Act, as well as a PE under Article 5 of the DTAA between India and UK. It was held that:
the premises of RRIL constituted a fixed place PE of RRPLC under Article 5(1) of the DTAA;
the premises of RRIL was a PE under Artcile 5(2)(f) of the DTAA, since it was used for receiving or soliciting orders for RRPLC;
RRIL was a dependant agent of RRPLC under Article 5(4)(c) of the DTAA, as it was routinely securing orders for RRPLC.
The Delhi ITAT confirmed the aforesaid findings and conclusions of the tax authorities based on the following:
RRILs premises was a fixed place of business at the disposal of RRPLC through which RRPLC conducted its business in India (no formal legal right required for using the premises);
The activities carried on through the fixed place was not preparatory or auxiliary, but a core activity of marketing, negotiating the contracts and selling of products;
RRIL almost acted like a sales office of RRPLC in India;
RRIL solicited and received orders wholly and exclusively on behalf of RRPLC; and
RRIL was a projection of RRPLC in India.
On the question of attribution of profits to India, the ITAT relied on the empirical decision of the Supreme Court in the Ahmedbhai Umarbhai case.
After allocating 50 per cent to the manufacturing operations and 15 per cent to research and development carried outside India, the ITAT attributed 35 per cent of the global profits in respect of Indian sales as income taxable in India.
Looking at the approach to attribution, the ITAT has, in a way, followed the formula adopted in the landmark case of the Special Bench in the Motorola Inc case.
One of the arguments put forth before the Tribunal was that since RRIL was being remunerated at arms length price (ALP) and the said ALP was accepted by the Transfer Pricing Officer (TPO), no further attribution could be done. Hence, the payment of ALP to RRIL should extinguish the assessment of RRPLC in India. Though the Tribunal acknowledged that determination of ALP is a relevant step for attribution of income, no conclusions were drawn thereon.
Arms length price
On the above issue of payment of ALP, the Supreme Court, in the Morgan Stanley & Co. case, held that where the Indian subsidiary constituted a service PE for the foreign company in India, and the Indian subsidiary was compensated at ALP based on proper factual and functional analysis, no further profits could be attributed to the Indian PE.
However, the Division Bench of the Mumbai Tribunal, in the SET Satellite (Singapore) Pte. Ltd case, held that dependant agent and dependant agent PE are two different concepts and they have to be separately taxed. For this, they relied on the OECD Report Attribution of Profits to PE and the guide issued by the Australian Tax Office titled Attributing Profits to a Dependant Agent Permanent Establishment. Mere payment of ALP to dependant agent does not extinguish tax liability of the foreign company in India.
Further, the Ahmedbhai Umarbhai case was decided by the Supreme Court in 1950 in the context of a manufacturing company. The manner of doing business has undergone a sea change since then. The kind of clear distinction of profit centres between two jurisdictions made in the Ahmedbhai case may not be possible in the present situation. Moreover, such simpliciter allocation to different functions in a services sector may pose difficulties. And yes, the peculiarities and the complexities associated with e-commerce transactions add to the difficulty.
Though a good number of judicial precedents are available on the subject of attribution, there seems to be no single formula or an answer, as the issue itself depends on the factual analysis of each case. In a nutshell, the issue still remains a puzzle to be solved, and there can be no fix-all solution.
K. R. Girish Himanshu Patel (The authors are Bangalore-based chartered accountants.)