1. Article 7 - Attribution of business profits
Presenters : CA Sanjiv Chaudhary
CA Nidhi Maheshwari
24 May 2013

2. The Journey Ahead…… 1 Backdrop- Why attribution? 2
Principles of Attribution under the Act 3
Principles of Attribution under Tax Treaty 4
Force of Attraction Rules 5
Computation principles 6
Landmark Judgments 7
Key Challenges & Takeaways

3. Backdrop- Why Attribution?...
Residence Country – generally taxation of global profits
Right of source country to tax profits of foreign enterprise operating in its jurisdiction – when Permanent Establishment (‘PE’) exists i.e. Source Based Taxation
- Only those profits which are attributable to PE in the source country
Attribution of profits – the next biggest controversy

4. Beneficial provisions of the Act or the Tax Treaty can be applied
Attribution of business profits of foreign enterprises- Governing Provisions
Under Income Tax Act and Rules (‘Domestic Law’):
Section 9(1)(i) of the Act read with Rule10
Under Tax Treaty:
Article 7 of Tax Treaties read with the provisions of the Act
Beneficial provisions of the Act or the Tax Treaty can be applied
Beneficial provisions shall prevail- Refer section 90/ 90A of the Act; section 90 provides for agreements between India and foreign countries/ territories and section 90A provides for agreements between specified associations in India and specified territories outside India [e.g. Taipei Economic and Cultural Center in New Delhi has signed a DTAA with the India - Taipei Association in Taipei in 2011; both Taipei Economic and Cultural Center in New Delhi and India - Taipei Association in Taipei have been notified as “specified associations” and “the territory in which the taxation law administered by the Ministry of Finance in Taipei is applied”, has been notified as the “specified territory” for the purpose of Section 90A].

5. Attribution under the Act5

6. Attribution of profits under the Act (1/2)
Section 9(1)(i) of the Act:
“The following incomes shall be deemed to accrue or arise in India:-
all income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situate in India.”
Explanation 1(a) to section 9(1)(i) of the Act:
“In the case of a business of which all the operations are not carried out in India, the income of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India”
This is text of the relevant provisions- s. 9(1)(i) and Explanation 1 (a) thereto

7. Attribution of profits under the Act (2/2)
Rule 10 of the Income-tax Rules:
In any case in which the Assessing Officer is of opinion that the actual amount of the income accruing or arising to any non-resident person whether directly or indirectly, through or from any business connection in India …………………………………… cannot be definitely ascertained, the amount of such income for the purposes of assessment to income-tax may be calculated :
(i) at such percentage of the turnover so accruing or arising as the Assessing Officer may consider to be reasonable, or
(ii) on any amount which bears the same proportion to the total profits and gains of the business of such person (such profits and gains being computed in accordance with the provisions of the Act), as the receipts so accruing or arising bear to the total receipts of the business, or
(iii) in such other manner as the Assessing Officer may deem suitable.”
……………. = or through or from any property in India or through or from any asset or source of income in India or through or from any money lent at interest and brought into India in cash or in kind 

8. Methods prescribed under Rule 10
Rule 10(i) - Presumptive Method
Income computed at such percentage of the turnover as the AO may consider reasonable
Ad hoc profits are estimated as attributable to the operations in India
Rule 10(ii) - Proportionate Method
Profits computed in ratio of India receipts to total receipts of the business
Proportionate profits based on worldwide income is attributed to the operations in India
Difficult method as worldwide income of the enterprise is to be computed under the Act before applying proportionate method
In case of different businesses, relevant business income needs to be considered
Rule 10(iii) - Discretionary Method
Such method as is deemed fit by tax authorities – AO may devise any mechanism on facts and circumstances of the case.

9. Relevant CBDT Circulars (1/2)
CBDT Circular No. 23 dated 23 July 1969 – Now withdrawn
Non-Resident selling goods from outside India to Indian customers on principal-to-principal basis through Agents in India
If the agent’s commission fully represents the value of the profit attributable to his service; it should prima facie extinguish the assessment.
This principle is now well established including by Supreme Court in the case of Morgan Stanley
This 40 year old circular clarified scope of business connection in case of NRs; Other circulars have also been withdrawn, i.e. circular 163 dated 29 May 1975 and circular 786 dated 7 February 2000

10. Relevant CBDT Circulars (2/2 )
CBDT Circular No. 5 dated 28 September 2004 – relevant extracts are reproduced below:
“Paragraph 2 contains the central directive on which the allocation of profits to a Permanent Establishment is intended to be based. The paragraph incorporates the view that the profits to be attributed to a Permanent Establishment are those which that Permanent Establishment would have made if, instead of dealing with its Head Office, it had been dealing with an entirely separate enterprise under conditions and at prices prevailing in the ordinary market. This corresponds to the “arm’s length principle”. Paragraph 3 only provides a rule applicable for the determination of the profits of the Permanent Establishment, while paragraph 2 requires that the profits so determined correspond to the profit that a separate and independent enterprise would have made. Hence, in determining the profits attributable to an IT-enabled BPO unit constituting a Permanent Establishment, it will be necessary to determine the price of the services rendered by the Permanent Establishment to the Head office or by the Head office to the Permanent Establishment on the basis of “arm’s length principle”.
This circular relates to “Taxation of BPO units” in India and lays down the principles of attribution of profits in India.

11. Indian scenario: Some key judicial precedents (1/2)
Ad hoc Attribution – A few instances
Taxability of trading profits where sale is concluded in India
10% of supply – Annamalis Timber 41 ITR 781 (Madras HC)
Taxability of offshore supplies where PE played some role
20% of global profits – NETWORKS, OY : 96 TTJ 1 (Delhi ITAT, SB)
Taxability of offshore supplies where PE was involved in marketing activities
35% of the global profits (50% manufacturing, 15% R&D) – Rolls Royce (Delhi HC)
Taxability of CRS activities where agency PE played marketing activities
15% of the total revenues - Galileo International Inc : 114 TTJ 289 (Del. ITAT)
Taxability of back office operations where PE looks after operations and marketing activities of overseas affiliates
Global adjusted profits x India assets/Global assets : eFunds 42 SOT 165 (Delhi ITAT)

12. Indian scenario: Some key judicial precedents (2/2)
Principles of Attribution - Legal Position
Ahmedbhai Umarbhai & Co (1950) SCR 335
Profit apportionment on the basis of business activities, manufacturing profits taxable in the jurisdiction where manufacturing takes place
Morgan Stanley (292 ITR 416) (SC)
Profits attribution to PE based on functions assets and risks analysis
Rolls Royce Singapore Pvt Ltd (ITA No 1278/2010) dt August 30, 2011
TP principles should be applied to determine profits attributable to PE
Hyundai Heavy Industries : 291 ITR 482 (SC)
- Even if supply is considered to be integral part of installation, supply is not attributable to PE because it is at arm’s length; Direct billing to customer represents arm’s length
Instruction No. 5 of 2009 (withdrawing Instruction 1829), Para 4
1) Instruction no. 5 of 2009 was introduced to “withdraw instruction No. 1829” with the intent to give power to AO’s to apportion profit on the basis of functions, risks and assets (FAR).
2) Para 4 of Instruction no. 5 of 2009
4. It is also noticed that most of the profit is loaded in the offshore supply and the payments for the Indian portion of the contracts barely meets the expenses resulting into either losses in India or very low profit. The Assessing Officer's attempt to apportion profit correctly into various components of the overall project on the basis of functions, risks and assets is often resisted by the assessee taking recourse to the instruction. Further, even if it is proved that a part of the operations relating to supplies have taken place in India or the permanent establishment of the assessee had a role in offshore supply, the profit from offshore supply is claimed to be exempt under the instruction.

13. Attribution under Tax Treaties13

14. Framework of OECD Model - Article 7
Enterprise
Residence State
Source State
Art 5: Constitution of PE
Art 7: Taxation of PE
Article 7(1) - Charging provision
Article 7(3) - Elimination of double taxation
Recent Amendments in OECD Model and Commentary:
Attribution Report of December 2006(updated in July 2008 and 2010)
Recommendations for principles of attribution
Commentary update of July 2008 – Amendments in existing Article 7 Commentary
Article 7 in OECD Model which had 7 sub articles has given way to New Article 7–OECD update 2010
Accordingly, the commentary on Article 7 has also been amended
Article 7(4) - Limitation
Article 7(2) - Basis of profit attribution

15. Article 7(1) - Scope of taxation
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 that are attributable to the permanent establishment in accordance with the provisions of paragraph 2 may be taxed in that other State.
Key aspects:
PE test for each source of income
No guidance on how to interpret the term ‘profits of an enterprise’
Existence of PE must for attribution
Business should be carried on
- Preparatory activities do not trigger attribution
Only profits attributable to such PE is taxable in the source country
Applicability of Minimum Alternate Tax
MAT applicability-
Though section 115JB applies to ‘an assessee being a company’, the context and the legislative history of the MAT provisions does not warrant a direct application of the provisions of section 2(17) of the Act which defines the term ‘company’ as including a foreign company. The context and the legislative history of MAT provisions should be read as limiting the applicability of section 115JB to Indian companies (i.e. companies formed and registered under the Companies Act, 1956 and foreign companies who have established a place of business within India (for the purposes of section 591 of the Companies Act, 1956).
In any event, if a tax treaty applies and certain categories of income are taxable in India at beneficial rates/not taxable in India, an additional argument can be taken that the provisions of MAT under section 115JB form part of the computational mechanism under the Act and will apply only if they are more beneficial to a tax payer by virtue of section 90(2). This is not withstanding the fact that the provisions of section 115JB starts with a non-obstante clause.
Recent development
The Supreme Court by its order dated 7 May 2013 has admitted the ‘Special Leave Petition’ of Castleton Investments Limited, a company based in Mauritius. The assessee has sought to challenge the AAR ruling which, while granting capital gains tax exemption under India - Mauritius Tax Treaty, had ruled that Castleton would be required to pay Minimum Alternate Tax (MAT) in India with respect to capital gains arising from sale of shares of an Indian company.

16. Force of Attraction Rule
The concept of Force of attraction:
Is an exception to arm’s length principle as it seeks to tax not only the differential between arm’s length price and income offered but also the profits from sale of products in which PE is not involved.
Implies that when an enterprise constitutes a PE in another country, it brings itself within the fiscal jurisdiction of that another country to such a degree that such another country can properly tax all profits that the enterprise derives from that country, whether through the PE or not. It is the act of setting up a PE, which triggers the taxability of direct transactions in the source State.
Strengthens source based taxation
Seeks to attribute greater share of profits to source country
Principle of general ‘force of attraction’ present in UN & US MC 16

17. Force of Attraction Rule – UN MC
UN Model Convention
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;
sales in that other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment; or
other business activities carried on in that other State of the same or similar kind as those effected through that permanent establishment
- OECD model does not have Force of attraction
- Since goods are covered in clause (b), “Other business activities” in clause (c) would tantamount to services. <<However, in the case of SNC-Lavalin/ Acreas Inc Vs. ACIT, it was held that reference to sale of goods or merchandise in Clause (b) of Article 7(1) shall also mean to include rendering of services also. >>
‘Force of attraction’ rule not present in OECD Model Convention
Does exist in the US Model Convention

18. Force of Attraction Rule
International Bureau of Fiscal Documentation - International Tax Glossary
“Principle under which a country may tax a foreign enterprise in respect of income it derives in that country if the enterprise maintains a permanent establishment there, irrespective of whether that income is derived through or otherwise economically connection with the permanent establishment……”
Different kinds of Force of Attraction in context of DTAA’s entered by India
Type 1:
- Once activities are same / similar
- Without specific requirement of role by PE
Type 2:
- Business reasons for not routing the direct business of HO through PE
- Tax avoidance motive need to be established
While we will be delving further into the above “Types of Force of Attraction” based upon the Indian tax treaties in subsequent slides, it is pertinent to make a Comparision of this concept vis a vis explanation to section 9(1)(i). It is important to consider the validity of the following argument:
“That as per explanation to Section 9(1)(i) of the Income-Tax Act, if a non-resident has a business connection in India, only so much of the profits are taxable in India which could be reasonably attributed to operations carried out in India. Since the supplies made outside India cannot be considered to be attributable to the operations carried on in India, the profits were not taxable under the domestic law.”
Comparision vis a vis explanation to section 9(1)(i) – Whether treaty can create a charge.

19. Force of Attraction… Examples Type 1: Article 7(1) of India USA DTAA
“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 (a) that permanent establishment ; (b) sales in the other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment ; or (c) other business activities carried on in the other State of the same or similar kind as those effected through that permanent establishment.”
Some other countries having similar Force of Attraction rule.
Cyprus
Denmark
Indonesia
New Zealand
Italy

20. ‘Directly and indirectly’ - Whether connotes ‘force of attraction’ rule?
Examples: Type 2
Article7(1) states that profit “directly or indirectly” attributable to the PE….. Taxable…
Protocol to Article 7 clarifies, as under:
“………….,it is understood the words directly or indirectly mean, …………., that where a permanent establishment takes an active part in negotiating, concluding or fulfilling contracts entered into by the enterprise, then, ………………………, there shall be attributed to the permanent establishment that proportion of ………………… contribution of the permanent establishment to those transactions bears to that of the enterprise as a whole. It is also understood that profits shall be regarded as attributable to the permanent establishment to the above mentioned extent, even when the contracts in question are made directly with the head office of the enterprise ………………
Does it widen the scope of Article 7? Is it wider than FoA rule?
Linklaters LLP (132 TTJ 20) (Mumbai Tribunal)
In Article 7 of some of the DTAAs, it was provided that enterprises carrying on business through PE in other contracting state may be charged to tax in relation to the profits of such enterprise as is directly or indirectly attributable to that PE. Even though scope of term 'directly' or 'indirectly' attributable to PE is also clarified in such DTAAs, yet the controversy that knocked the doors of judiciary all time was whether connotation of term 'indirectly attributable to' used in the tax treaties can be regarded as existence of 'Force of attraction rule' as defined in UN Model?
Latest ruling in Clifford Chance [2013] 33 taxmann.com 200 (Mumbai - Trib.) (SB) supports the above view. Discussed later in landmark rulings.
It has been held as under:
-- It would not be correct to say that the connotation 'profits indirectly attributable to permanent establishment' used in Article 7(1) extends to the two categories of incomes as specified in Article 7(1)(b)/(c) of the UN Model Convention and incorporate a 'force of attraction' rule as held by the Division bench of this Tribunal in the case of Linklaters LLP.
  -- When the connotation of 'profits indirectly attributable to permanent establishment' is defined specifically in Article 7(3) of the India-UK DTAA which clearly explains the scope and ambit of the profits indirectly attributable to the PE and the provisions of said Article being unambiguous and capable of giving a definite meaning, there is really no need to refer to the provisions of Article 7(1) of UN Model Convention which are materially different from the provisions of Article 7(1) of the India-UK DTAA, read with Article 7(3).
Article 7(3) of India-UK DTAA reads as under:
Where a permanent establishment takes an active part in negotiating, concluding or fulfilling contracts entered into by the enterprise, then, notwithstanding that other parts of the enterprise have also participated in those transactions, that proportion of profits of the enterprise arising out of those contracts which the contribution of the permanent establishment to those transactions bears to that of the enterprise as a whole shall be treated for the purpose of paragraph 1 of this Article as being the profits indirectly attributable to that permanent establishment.
India- Japan DTAA <favor of assessees>
While interpreting India-Japan DTAA in the case of Ishkawajima-harima Heavy Industries Limited, the Supreme Court held that income can be taxed in India only to the extent it is attributable to the part played by the Indian permanent establishment.

21. Force of Attraction Rule - Motive of Tax Avoidance
Article7(1) as per UN Model Convention
With an additional para, as under:
“The provisions of sub-paragraphs (b) and (c) above shall not apply if the enterprise proves that such sale or activity could not have been reasonably undertaken by the permanent establishment.” or
“may be considered attributable to that permanent establishment if it is proved that: (i) this transaction has been resorted to in order to avoid taxation in the Contracting State where the permanent establishment is situated, and (ii) the permanent establishment in anyway was involved in this transaction.”

22. Force of Attraction under the ITA? (1/2)
Income tax Act
Provisions of section 5(1) and 5(2) provides that income is taxable in India if it is received in India or deemed to be received in India or accrues or arises in India or is deemed to accrue or arise in India
Section 9 covers income which is deemed to accrue or arise in India
Internal note: This slide has to be read along with the next slide to appreciate its relevance

23. Force of Attraction under the ITA (2/2)
“9(1) The following incomes shall be deemed to accrue or arise in India:
All income accruing or arising, whether directly or indirectly, through or from business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situated in India.
[Explanation 1]. For the purposes of this clause
(a) In the case of a business of which all the operations are not carried out in India, the income of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India; …”
In Roxon OV : 103 TTJ 891 (Bom ITAT)-- In the concluding paragraph, though the Tribunal has mentioned about the alternative plea raised by the assessee that as per explanation to Section 9(1)(i) of the Income-Tax Act, if a non-resident has a business connection in India, only so much of the profits are taxable in India which could be reasonably attributed to operations carried out in India. Since the supplies made outside India cannot be considered to be attributable to the operations carried on in India, the profits were not taxable under the domestic law.
However, the ITAT did not adjudicated on the above.
In the absence of any decision taken on this alternative plea, it remains to be seen how far this proposition finds favour with the judicial authority.
Arguably, no force of attraction under the ITA – Do ‘force of attraction’ rules under the Indian tax treaties become meaningless?

24. Example: Attribution of Profit – Force of AttractionHO
Sale of pharmaceuticals in India
Outside India
In India
Customers in India
Direct sale of garments by HO in India PE
Customers in India
PE sells garments manufactured by HO
Type 1 Force of Attraction

25. Example: Attribution of Profit – Force of AttractionHO
Conclusion of sale of pharmaceuticals
Outside India
In India
Negotiating sale of pharmaceuticals in India
Customers in India PE
Customers in India
Negotiation and conclusion of sale of garments manufactured by HO
Type 2 Force of Attraction

26. Similar Goods – Examples
ABC Ltd
Customers in India
Permanent Establishment
Similar
Commercially interchangeable and under the same brand name
Selling Laptop
Selling Desktop
The practical issue that requires clarity is the meaning of “same or similar”. The word “same” may mean resembling in every aspect, or identical; on the other hand, the word “similar” may mean almost resembling, or alike. A reference can be a customs notification which provides meaning of the term “similar goods”. However, the basis on which “sameness” or “similarity” has to be determined is a question of debate. In another context, the Supreme Court had held that common management, administration, fund, and so on could result in two businesses being treated as “same business”.
Similar goods under Customs valuation Rules
"similar goods" means imported goods -
 (i) which although not alike in all respects, have like characteristics and like component materials which enable them to perform the same functions and to be commercially interchangeable with the goods being valued having regard to the quality, reputation and the existence of trade mark;
(ii) produced in the country in which the goods being valued were produced; and
 (iii) produced by the same person who produced the goods being valued, or where no such goods are available, goods produced by a different person,
  but shall not include imported goods where engineering, development work, art work, design work, plan or sketch undertaken in India were completed directly or indirectly by the buyer on these imported goods free of charge or at a reduced cost for use in connection with the production and sale for export of these imported goods;

27. Similar Business activities – Examples
ABC Ltd
Customers in India
Permanent Establishment
Not Similar
Characteristic and use are similar
Providing system installation services
Providing AMC Services

28. Article 7(2): Approaches to determine profit
- relevant business activity; or
- functionally separate entity.
Recommended approach – OECD report suggest functionally separate entity approach as preferable
Profit should be determined by applying the arm’s length principle – OECD Transfer Pricing Guidelines could be applied
Traditional - Relevant business activity approach
Profits defined as the profit of the business activity in which PE has some participation
Never more than the worldwide profits of the PE
If enterprise makes a loss, PE cannot have a positive income
Scientific - Functionally separate entity approach
Profits defined as the profit that the PE would have earned at arm’s length if it were a distinct and separate enterprise performing same or similar functions
PE can have positive profits whereas enterprise makes a loss
Judicial precedents holding that arms length remuneration to Agency PE extinguishes tax liability
Morgan Stanley and Co Inc [Supreme Court]
SET Satellite (Singapore) Pte Ltd [Bombay High Court]
BBC Worldwide Ltd [Delhi Tribunal]
Galileo International Inc [Delhi Tribunal] (Del HC does not deal with attribution)

29. Independent entity approach
Article 7(2)
For the purposes of this Article and Article [23A] [23B], the profits that are attributable in each Contracting State to the permanent establishment referred to in paragraph 1 are the profits it might be expected to make, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the permanent establishment and through the other parts of the enterprise
Independent entity approach

30. Authorized OECD Approach: An outline
Determining
the profits
of a PE
Step1: Hypothesising the PE as a distinct and separate enterprise
Step 2: determining the profits of the PE
Functional / factual analysis to determine the Activities and conditions of the PE
Functions performed
Comparability analysis
Assets used
Applying transfer pricing methods to attribute profits
Risk assumed
Capital and funding
Recognition of dealings

31. Single v/s Two taxpayer approach - Meaning
Two tax payer approach mooted
Party / Tax Payer
Residential Status
Indian Dependent Agent Co
Resident
Dependent Agent PE
Non-resident
Foreign Co
Transaction between
Applicable provisions requiring arm’s length payment
Indian Dependent Agent Co. and Foreign Co
Article 9 if both are Associated Enterprise
Dependent Agent PE and the head office (Foreign Co)
Article 7(2)
Following argument is taken towards “two-tax payer approach” <refer DDIT Vs. Set Satellite (Singapore) 106 ITD 175 (Mum, Tribunal)>
Tax treaties provide that where a dependent agent carries on specified activities (habitual authority to conclude contracts, maintenance of stock of goods, secures orders), F Co. shall be deemed to have a permanent establishment.
If Dependent Agent would have constituted PE of F Co., the treaty could have provided “DA shall be deemed to be PE of F Co.”
The question now is “Whether arms length remuneration to Agency PE extinguishes tax liability?” This stands resolved with Bombay HC’s ruling in Set Satellite where reliance was placed on Apex court’s ruling in Morgan Stanley to hold that no further tax liability may arise by virtue of DAPE where the agent has been remunerated at arm’s length.

32. Article 7(3) - Provisions
Where, in accordance with paragraph 2, a Contracting State adjusts the profits that are attributable to a permanent establishment of an enterprise of one of the Contracting States and taxes accordingly profits of the enterprise that have been charged to tax in the other State, the other State shall, to the extent necessary to eliminate double taxation on theses profits, make an appropriate adjustment, the competent authorities of the Contracting states shall if necessary consult each other

33. Article 7(4) - Provisions
Where profits include items of income which are dealt with separately in other Articles of this Convention, then the provisions of those Articles shall not be affected by the provisions of this Article
Other Articles to prevail

34. Specific Article vs. Attribution to PE
Effective Connection Vs Attribution
Article 12(3) of the OECD Model Convention:
“The provisions of paragraph 1 shall not apply if the beneficial owner of the royalties, being a resident of a Contracting State, carries on business in the other Contracting State in which the royalties arise through a permanent establishment situated therein and the right or property in respect of which the royalties are paid is effectively connected with such permanent establishment. In such case the provisions of Article 7 shall apply.
Bechtel (AAR) ( 228 ITR 487)
Ishikawajima-Harima Heavy Industries Ltd. Vs DIT (SC) (288 ITR 408)
Worley parsons services Pty. Ltd. (AAR ) (313 ITR 273 )
Where income is effectively connected with PE, Article 7 shall prevail. Also applicable in case of interest and dividend.

35. Specific Article vs. Attribution to PE
Relevant extracts - Worley Parsons Services Pty. Ltd. In re. AAR ruling:
“…the prerequisite for attracting the exclusion clause is that "the services in respect of which the royalties are paid are effectively connected with the PE". It must be noted that the effective connection should be between the royalty generating services and the PE. The expression 'services' is significant and should be given due weight. It is not enough that there is a PE of the non-resident in the source country carrying out some activities in connection with the project or the work. The PE may be effectively connected with the project and the contract from a broader perspective but the connection contemplated by para 4 of art. XII is in respect of the services that fall within the purview of royalty. The PE or fixed base set up in the source country should be engaged in the performance of royalty generating services, irrespective of what other activities it performs. At least, it should facilitate the performance of such services. The terminology 'effective connection' denotes a real and intimate connection. Clear co-relation between the services which give rise to royalty income and the PE is a key factor for the purpose of exclusion of paras 1 and 2 of art. XII.

36. Computation Hypothesis Others (varies from Treaty to Treaty)
Basic construct of India Tax Treaties
Article
Key Provisions
Art 7(1)
Basic Rule
Income Attributable to PE
Force of Attraction Rule (if any) or Indirect attribution
Art 7(2)
Computation Hypothesis
As if PE is
a distinct and independent enterprise
engaged in same or similar activities
under same or similar conditions
Art 7(3)
Expense Deduction
Actual Expense incurred, incl. reasonable allocation of General & Admin Overheads
Whether in source state or in HO state
Subject to domestic law
No deduction for HO payment (except reimbursement of actual expenses)
Others (varies from Treaty to Treaty)
Applying Apportionment method in case of difficulty (reasonable)
Methodology applied consistently Y-on-Y
Exception (Purchase activity)
Purpose- The Indian treaties are based on Old OECD/ UN and have paragraph dealing with Expense deduction. Also, article 7(3) of the tax treaties has been discussed hereinafter.
Old OECD Article 7(3)- In determining the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes 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
Old OECD Article 7(5)- No profits shall be attributed to a permanent establishment by reason of the mere purchase by that permanent establishment of goods or merchandise for the enterprise
No profits shall be attributed to PE for mere purchase of goods for the enterprise
Goods shall include services
The benefit would not be available if PE carries out other activities including purchases

37. Computation of Profits Attributable to PE37

38. Article 7(3) of Indian DTAA’s Principles of computation of Income of PE
In determining profits of a PE
Deduction shall be allowed for expenses (including executive & general administrative)
Incurred for the PE
Incurred in or outside the source country
In accordance with and subject to limitations of domestic law
No deduction – amount paid by PE to the HO or to any other offices of the enterprise, except reimbursement of actual expenses
For use of patents or other rights in the form of royalties, fees or other similar payments
For specific services performed or for management in the form of commission
For money lent in the form of interest (exception for banking enterprises as explained by CBDT Circular 740)
Similarly, income received by PE from HO for aforesaid purposes shall be ignored

39. Computation of profits attributable to PE under the Act
Attribution of income to the extent of operations / activities carried in trade
Nothing attributable if activities are preparatory or auxiliary in nature e.g. purchasing of goods
No specific mechanism provided for attribution of profits
Transfer pricing rules can be applied
Rule 10 of the Income-tax Rules can be applied
Function / Asset / Risk analysis imperative to determine profit attribution – Morgan Stanley

40. Computation of profits attributable to PE under the Act
Rule 10 – Method of Attribution under the Act:
Determination of actual profits if it can be ascertained
Methods prescribed in Rule 10 are not accurate methods
These involve estimation and subjectivity
Hukumchand Mills Ltd. v. CIT, 103 ITR 548 (SC)
Can be followed only when the AO is of the opinion that profits cannot be definitely ascertained
Rule is last in priority list and is to be applied in exceptional situations
Rule 10(i) - Presumptive Method
Adhoc profits is estimated as attributable to the PE
Hukumchand Mills Ltd. v. CIT, 103 ITR 548 (SC)- ITAT had held it just to apportion a % of profits as having been arisen in British India. High court too held in favor of the assessee. The Apex court held that in the absence of some statutory or other fixed formula, any finding on the question of proportion involves some element of guess work. The endeavour can only be to be approximate and there cannot in the very nature of things be great precision and exactness in the matter. As long as the proportion fixed by the Tribunal is based upon the relevant material, it should not be disturbed.

41. Computation of profits attributable to PE under the Act
Rule 10(ii) - Proportionate Method
Proportionate profits based on world income is attributed to the PE
Difficult method as World income of the enterprise is to be computed under the ITA before applying proportionate method
In case of different businesses relevant business income be considered
Rule 10(iii) - Discretionary Method
Attribution in some other method

42. Computation of profits attributable to PE under the Act
Specific provisions for computing profits:
All provisions applicable as is applicable to resident enterprise for e.g. section 32, 40(a), 43B, etc,.
Section 44C – Branch
Section 44D and 44DA – Taxability of royalties and FTS
Section 115JB – MAT provisions
Section 44C- HO expense incurred outside India and allowed as deduction cannot exceed 5% of adjusted total income.
Section 44D- [applicable up to 31 March 2003] Limit to deduction of expenses which can be claimed- limited to 20% of gross amount of royalties (further adjustments to be made to this)
Section 44DA- [applicable from 1 April 2003] Royalty, etc effectively connected with PE in India [HO expenses not allowed, expenditure not wholly and exclusively incurred for PE not allowed]
MAT applicability-
Though section 115JB applies to ‘an assessee being a company’, the context and the legislative history of the MAT provisions does not warrant a direct application of the provisions of section 2(17) of the Act which defines the term ‘company’ as including a foreign company. The context and the legislative history of MAT provisions should be read as limiting the applicability of section 115JB to Indian companies (i.e. companies formed and registered under the Companies Act, 1956 and foreign companies who have established a place of business within India (for the purposes of section 591 of the Companies Act, 1956).
In any event, if a tax treaty applies and certain categories of income are taxable in India at beneficial rates/not taxable in India, an additional argument can be taken that the provisions of MAT under section 115JB form part of the computational mechanism under the Act and will apply only if they are more beneficial to a tax payer by virtue of section 90(2). This is not withstanding the fact that the provisions of section 115JB starts with a non-obstante clause.
Recent development
The Supreme Court by its order dated 7 May 2013 has admitted the ‘Special Leave Petition’ of Castleton Investments Limited, a company based in Mauritius. The assessee has sought to challenge the AAR ruling which, while granting capital gains tax exemption under India - Mauritius Tax Treaty, had ruled that Castleton would be required to pay Minimum Alternate Tax (MAT) in India with respect to capital gains arising from sale of shares of an Indian company.

43. Computation of profits attributable to PE under the Act
Presumptive basis of taxation
Income is computed on presumptive basis
Provisions of sections 28 to 44 not applied
Applied in case of specific types businesses/assesses
It is not in line with the principles laid down in Article 7(2)
Examples
Shipping business (u/s 44B) - 7.5% of gross revenue
Business of Exploration (u/s 44BB) - 10% of gross revenue
Business of Aircraft (u/s 44BBA) - 5% of gross revenue
Turnkey Power Projects (u/s 44BBB) - 10% of gross revenue

44. Example: Attribution of Profit – Fixed place PEUS
India
PE sells garments manufactured by F Co.
F Co.
Customers in India
Branch
Profit & Loss A/c of Branch as a PE of F Co. for India tax purpose:
Sales
Less: Expenses incurred
Cost of garments imported (to be on arm’s length basis based on FAR)
Personnel cost of branch employees
Rent of branch office premises
General administrative expenses of HO – Rs. 20,000 (10% allocable to PE)
Depreciation on branch assets
Royalty on intangible assets (assuming economic ownership rests with HO)
Total expenses
Profit attributable to PE
Rs. 1,00,000
Rs ,000
Rs ,000
Rs ,000
Rs ,000
Rs ,000
Rs ,000

45. Example: Attribution of Profit – Service PE
F Co.
Offshore Activities US
Rendering of legal services
India
Onshore Activities
Service PE
Customers in India
Total man days spent on job
Offshore man days
Onshore man days
Project revenue
Revenue attributable to India (PE only on account of onshore)
Less: Expenses incurred
-Personnel cost
-Depreciation on India assets (Assuming all assets acquired from India)
-Royalty for know-how
Total cost
Profit taxable in India
1000 mandays
600 mandays
400 mandays
Rs.1,000,000
Rs ,000
Rs ,000
Rs ,000
Rs ,000
Rs ,000
Simplistic example. Force of attraction not considered.

46. Example: Attribution of Profit – Agency PE …
F Co. US
Supply of garments to agent
Payment of commission
India
Sale of garments to final customer
Dependent Agent
Customers in India
Credit / Inventory risk by HO
Supreme court decision of Morgan Stanley
Bombay High court decision in case of Set Satellite
However, OECD Report on Attribution of Profits to PE – July 2010 follows the ‘double taxpayer approach’ wherein the dependent agent and the principal, on behalf of whom it is acting, may theoretically constitute two separate, potential taxpayers.
Sales
Less: Cost of goods paid to F Co. (Based on FAR / TNMM)
Less: 20% of sales (agent sufficiently remunerated)
Profit attributable to PE
Rs. 100,000
Rs. 80,000
Rs. 20,000
NIL

47. APA route for Permanent Establishment
As per the recently issued APA Guidance with FAQs by the income-tax department, APA application may be possible in case the applicant admits PE in India (FAQ no. 23)

48. Landmark Judgements 48

49. Morgan Stanley and Co – SC Ruling
Supreme Court of India
Facts
Activities outsourced by MS Co. to Indian group entity MSAS:
Equity / fixed income research
Account reconciliation;
IT enabled services, etc
MS Co. staff visited India for monitoring/quality control (stewardship)
MS Co. staff deputed to MSAS
MSAS reimburses salary cost to MS Co.
Employees deputed continue to be employed with MS Co., which pays salary to the deputees outside India
MS Co.
MSAS
India
USA
Activities Outsourced
Remunerated at arms length price

50. Morgan Stanley and Co – SC Ruling
PE definition under Section 92F(iii) of the IT Act is inclusive so as cover various types of PE under DTAA such as Service PE, Agency PE, Construction PE, etc.
Profits of PE determined based on what an independent enterprise under similar circumstances might be expected to derive
Profits of MS Co. which have economic nexus with PE attributable
AE that constitutes PE and is remunerated on arms length basis taking into account all risk taking functions of the multinational enterprise – no further attribution
If TP analysis does not adequately reflect functions performed / risks assumed by the enterprise – there would be need to attribute profits for those functions / risks
Service PE was Upheld
Profit
Attribution NO

51. Ishikawajima-Harima Heavy Industries Ltd. v. DIT 158 Taxman 259 (SC)
All income of turnkey projects not assessable in India merely due to PE
Only part of income attributable to the operations carried out in India by PE taxable
Offshore supply not taxable if property in goods passed outside India
The fact that the contract signed in India is not material
If services have been rendered outside India and have nothing to do with the PE then they cannot be attributable to the PE
Offshore services – sufficient territorial nexus – apart from utilization in India, need to be rendered I India or have a live link to fall within Article 12 of the DTAA (This resulted in insertion of an Explanation to Section 9(1) by FA 2007 w.r.e.f )
In Jindal Thermal Power Co. Ltd. v DCIT (2009) 182 Taxman 252 (Kar), the Court has held that criteria of rendering services in India as laid down by the Supreme Court has not been done away by the Explanation

52. Galileo International Inc – Delhi HC
Airlines
Payment
Payment
INDIA
USA 
Does not charge fees
approaches
Travel Agent TA  
Provides support services and Equipments
Does not charge fees 
Does not charge fees 
Passengers
Server
Services of Distributor
Distributor
Galileo Inc.
Lines & Nodes
Fees
Lines & Nodes
Payment
Telecom Service
Provider

53. Fixed and Agency PE was Upheld
Galileo International Inc – Delhi HC
Ruling:
“…On the basis of such analysis of functions performed, assets used and risk shared in two different countries, the income can be attributed. In the present case, we have found that majority of the assets i.e., host computer which is having very large capacity which processes information of all the participants is situated outside India. The CRS as a whole is developed and maintained outside India. The risk in this regard entirely rests with the appellant and that is in USA, outside India. However, it is equally important to note that but for the presence of the assessee in India and the configuration and connectivity being provided in India, the income would not have generated. Thus the initial cause of generation of Income is in India also. On the basis of above facts we can reasonably attribute 15 per cent of the revenue accruing to the assessee in respect of bookings made in India as income accruing or arising in India and chargeable under section 5(2) read with section 9(1)(i) of the Act.”
Fixed and Agency PE was Upheld
Profit Attribution
YES

54. Upheld by Delhi High Court subsequently
Galileo International Inc – Delhi HC
Ruling:
“…since the revenue attributable in respect of the booking made in India is only 0.45 Euro (15 per cent of Euro 3) and commission paid to Interglobe was Euro 1, there was no income which was taxable in India.”
Profit Attribution
YES
Upheld by Delhi High Court subsequently

55. Rolls Royce Plc – Delhi Tribunal Ruling
Date
Rolls Royce Plc – Delhi Tribunal Ruling
Facts
RRIL’s liaison office (‘LO’) carried out activities only in respect of RR Plc
LO’s key responsibility includes securing orders and solicit request for quotation/purchase orders for RR Plc’s products
The employees of RR Plc visit India frequently and use premises of the LO
Employees of RRIL participate in meetings with customers where significant matters regarding contracts with RR Plc are discussed and decisions are taken
RR Plc on various occasions designated RRIL as sole contact point in respect of certain customers (eg. to send orders/quotations/acceptances, etc)
RRIL marketed certain after sales/other services provided by RR Plc to present/potential customers of RR Plc
RRIL provided certain advise/recommendations to RR Plc as regards certain customer proposals
RR Plc
Service Agreement
Reimbursement of Cost + Mark Up
RRIL
Equipment Sales
Services UK
India
RRIL (India LO)
Indian Customer

56. Fixed Place & Agency PE was Upheld
Date
Rolls Royce Plc – Delhi Tribunal Ruling
Ruling:
All profits directly and indirectly attributable to the PE to be considered
However, under Article 7(4) of the Treaty, computation could be on proportionate basis
Since no specific P&L provided, computation to be under Rule 10
50% to be attributed to manufacturing
15% to be attributed to R&D
35% to be attributed to marketing
Only marketing done in India
Hence profits to be attributed to India – 35%
Fixed Place & Agency PE was Upheld
Profit Attribution
YES 56

57. Set Satellite (Singapore) Pte Ltd vs. DCIT (Mum HC)
Sing Co
(Business of creating, marketing & distributing TV channels)
Agency Agreement
Singapore
India
Fee
India Agent (dependant)
Customers (Advertisers)
Arms length remuneration
Existence of an Agency PE

58. No further profit attributable to Dependent agent PE in India
Set Satellite (Singapore) Pte Ltd vs. DCIT (Mum HC)
Ruling:
CBDT Circular 23 of 1969 is applicable to SET Singapore since:
it’s business activities in India where wholly channeled through its agent (SET India);
the contracts to sell (the ad slots) are made outside India; and the sales are made on a principal to principal basis
Thus, if commission to SET India fully represents the value of the profit attributable to its service - it should prima facie extinguish the assessment.
Under Article 7(2) profit attributable to a PE would be the profit it might be expected to earn it were a separate and independent entity carrying out similar activities – i.e. the arm’s length profit
Dependant agent paid 15% - Circular recognizes that Indian agents of FTCs generally retain 15% as service charges
Since, commission paid to SET India is at arm’s length - no further profits can be attributable to its activities in the hands of SET Singapore’s PE in India in terms of Circular 23 r.w. Article 7(2)
Considering the Morgan Stanley judgment, if the correct arms length price is applied then nothing further would be left to be taxed in the hands of the FCo
Agency PE was Upheld
No further profit attributable to Dependent agent PE in India
since
Whether principle laid down holds good even after withdrawal of Circular 23?

59. Convergys Customer Management Group Inc – Delhi Tribunal
Facts
CCM was a company incorporated in the USA
CCM procured services from CIS on principal to principal basis :
IT enabled call centre services
Back office support services ;
CCM staff visited CIS for supervision/direction and control
CCM also provided certain hardware and software assets on free of cost basis to CIS
CCM
India
USA
Services Subcontracted
Overseas Customers
CIS

60. Fixed Place PE was Upheld
Convergys Customer Management Group Inc – Delhi Tribunal
Relying on the CBDT Circular No. 5 of 2004, Supreme Courts decision in case of Morgan Stanley and OECD Guideline, the Tribunal held that no further profits can be attributed to a PE once an arm's length price has been determined
However, the taxpayer had submitted that it does not prepare India specific accounts, therefore the attribution of profits on the basis as disclosed in the TP study for assets and software cannot be accepted.
Further in the facts and circumstances of the case PSM was not the correct method for attribution of profits to the taxpayer’s PE in India.
Departmental observation that further attribution was required for entrepreneurial services for managing risk related to the service delivery performed in India by CCM was held to be completely without any basis.
Fixed Place PE was Upheld
Profit
Attribution
Yes

61. Fixed Place PE was Upheld
Convergys Customer Management Group Inc – Delhi Tribunal
The Tribunal held that department’s methodology was not acceptable and made the following observations:
With regard to Revenue’s approach in considering revenue of CCM as a multi-national enterprise as the starting point, :
Revenue of taxpayer cannot be considered as revenue of the PE
Department ought to have considered the expenditure incurred outside India for arriving at the profit of CCM with regard to the contracts wherein services have been procured from CIS
Provisions of Section 44C of the Act having been invoked in attributing income of the taxpayer without allowing the cost incurred to earn the revenue outside India (thereby attributing the entire receipts) was incorrect.
Fixed Place PE was Upheld
Profit
Attribution
Yes

62. Fixed Place PE was Upheld
Convergys Customer Management Group Inc – Delhi Tribunal
The Tribunal prescribed the correct approach to arrive at attributable profits as under:
Computing global operating income percentage of the customer care business as per annual report
Above percentage to be applied to the end-customer revenue with regard to contracts/projects subcontracted to CIS to arrive at operating income from Indian operations.
The operating income from India operations to be reduced by the profit before tax of CIS to arrive at profit attributable to Indian PE
Estimation of profit based on above residual profit
For the purpose of attribution on residual profits, reliance was placed on two Supreme Court rulings that had dealt on profit attribution to Indian PEs. In the case of Anglo French Textile Co, 10% attribution was held reasonable and in Hukum Chand Mills Ltd., 15% attribution was held reasonable. The Tribunal held that the adoption of the higher figure of 15% for attribution of the Taxpayer’s PE will meet the ends of justice.
Fixed Place PE was Upheld
Profit
Attribution
Yes

63. Service Providers – Force of Attraction
LLP Fiscally transparent for UK tax purpose; Partners of LLP are liable to tax
Facts
LLP, UK based Law firm (fiscally transparent for UK tax purpose) rendered legal advisory services to clients having Indian projects
LLP did not have Office / branch in India
Personnel of LLP rendered services in India / overseas
LLP filed Nil tax return in India
LLP
Clients
Provision of legal advisory services UK
India
Issues for Consideration
Applicability of ‘Force of attraction’ rule for offshore services
Indian Projects
Partners and Staff members of LLP visited India for rendering services

64. Service Providers – Force of Attraction
Profits indirectly attributable to PE’ incorporates the Force of Attraction rule
Services rendered not only in India but also in UK are taxable
The same observations were also made by the Mumbai Tribunal in the case of Linklaters LLP. Reliance was placed by the Tribunal on the provisions of Article 7(1)(b) and 7(1)(c) of the UN Model Convention as well as on the UN Model Convention Commentary
Overruled recently by ITAT SB in Clifford Chance; SB concluded that reliance on UN commentary is not required and profits shall be attributed to PE on the basis of its contribution; Article 7(3) clearly explains the scope and ambit of the profits indirectly attributable to the PE.
Applicability
of Force of Attraction
Clifford Chance:
The Division Bench’s conclusion in the case of Linklaters LLP on the basis of provisions of Article 7(1)(b) and 7(1)(c) of the UN Model Convention as well as on the UN Model Convention Commentary is misplaced.
On a perusal of Article 7(1) of the India-UK tax treaty read with Article 7(3), it was held that the provisions thereof are not at all akin to the provisions of Section 7(1)(b) and 7(1)(c) of the UN Model Convention.
Given that ‘profits indirectly attributable to permanent establishment’ are defined specifically in Article 7(3) of the India-UK tax treaty clearly explaining scope and ambit of the profits indirectly attributable to the PE and the provisions of said article being unambiguous and capable of giving a definite meaning, there is really no need to refer to the provisions of Article 7(1) of UN Model Convention which are materially different from the provisions of Article 7(1) of the India-UK tax treaty read with Article 7(3) thereof. 64

65. Key takeaways 65

66. Key takeaways PE – a dynamic concept
Especially with emergence of economic and technological advancements
Attribution – very contentious in practice
Documenting functional analysis – key defense
Attribution vis-à-vis arm’s length payments
OECD commentary vs. Indian judicial precedents
Well documented Transfer pricing policy- Important to defend claims from
revenue authorities

67. Q & A

68. Thank You