Income from Business (Article 7)

Income from Business (Article 7)
Vikram Vijayaraghavan, Advocate M/s Subbaraya Aiyar, Padmanabhan & RAMAMANI (SAPR) Advocates, Chennai

Agenda Introduction to Article 7 The Model Conventions & Article 7
Article 7 in the MCs – A Deep Dive The Basic Rule (Article 7(1)) [with FoA & case studies] PE - Computation Hypothesis (Article 7(2)) PE – Computation of profits attributable (Article 7(3) and beyond) Model Commentary on computation of profits attributable to PE India’s DTAAs: Rubber hits the road! An Example Indian DTAA’s Article 7 Indian DTAA’s & Article 7 : Points to Note Indian Income Tax Act & Attribution of profits to PE S.9(1)(i), Explanation 1(a), Rule 10, Sec. 44C Indian cases – Attribution to PE Interplay between Article 7 and other Articles Summary

Introduction to Article 7

Article 7 : Income from business The bulwark of a DTAA
An important Article which is the cornerstone of every DTAA - business profits is the engine driving most enterprises today. This Article allocates taxing rights with respect to business profits of a Contracting State to the extent that these profits are not subject to different rules under other Articles of the Treaty. Incorporates basic principle that unless an enterprise of a Contracting State has a Permanent Establishment situated in the other state, the business profits of that enterprise may not be taxed by that other State This Article does not intend to trample upon other kinds of income such as dividends, immovable property rent etc.

Introduction to Article 7
Typically, where income is earned is called Source State and where the person who receives it is normally based is called Residence State Bottomline: It’s a Source vs. Residence country power struggle i.e., “Where is my portion of the tax pie?” Residence country typically has the right to tax the business profits subject to attribution of said profits to PE in Source State (Article 7 r.w. Article 5) : A logical proposition but the devil is in the details! Residence State? Source State?

The Model Conventions & Article 7

The Model Conventions & Article 7
The 3 major Model Conventions – the OECD, the UN and the US - have a checkered history on Article 7. It has evolved over time as globalization has rapidly increased Prior to OECD 2010 MC, the OECD and UN/US differed always on the Force of Attraction concept; however other things were more or less on the same lines Since the 2010 OECD MC, there is a divergence in the attribution of profits to PE with OECD very strongly advocating separate entity approach to arrive at ALP using only TP analysis : a marriage of Article 7 and 9 by OECD? So we really need to study 5 combinations! OECD MC 2008, OECD MC 2014 UN MC 2011 US MC 1996, US MC 2006

Article 7 in the MC’s – A deep dive

OECD Model Convention The Basic Rule - Article 7(1)
OECD MC 2008 OECD MC 2014 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. 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.

UN Model Convention The Basic Rule - Article 7(1)
UN MC 2001 & MC 2011 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.

US Model Convention The Basic Rule - Article 7(1)
US MC 1996 US MC 2006 The business 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 are attributable to that permanent establishment. 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 are attributable to that permanent establishment.

Article 7(1) Underlying principle
The principle which underlies Paragraph 1 has a long history and reflects international consensus that, as a general rule, until an enterprise as a State has a PE in another State, it should not be regarded as participating in the economic life of the other State to such an extent that the other State has taxing rights on its profits Many types of PE’s possible (agency PE, supervisory PE, service PE etc.) Exclusions to PE are usually when the operations in other State are in the nature of ancillary or preparatory activities (or) use of storage facility solely for delivery of goods (or) purchasing or info gathering activities (or) stock of goods maintenance for processing by another enterprise etc.

Article 7(1) Escaping the Source Axe!
Two possibilities to escape source taxation prima facie #1 “….carries on business in the other Contracting State….” (lets attack the fundamentals!) #2 Carries on business in the other Contracting State but there is no PE there (Indian taxpayer’s usual refrain!)

Article 7(1) Absence of “business”
Interesting Belgium case of Sogetra S.A.C.Etat Belge (1974) Belgian company entered into JV with Dutch company to carry out harbour work in Netherlands; another Belgian company was brought in to raise finance which merely lent money and agreed to share of profit. Lender argued that interest paid on loan was derived from PE and was therefore taxable only in The Netherlands. Cour de Cassation rejected this as the lender did not carry on business from a PE in The Netherlands Transvaal Associated Hide & Skin Merchants (Pty) Ltd vs Collector of Taxes, Botswana (SATC 97) Whether purchase of hides from abattoirs in Botswana and their preparation for sale and delivery constituted a business. Maisels J.A.’s referred to a dictum: “Anything which occupies the time and attention and labour of man for the purpose of profit is business”

Article 7(1) Presence of business…Absence of PE
Payment to Singapore companies for letting out cranes to Malaysian company – no PE in Malaysia and not Roaylty – hence “business profits”– Walter Wright (Singapore) Pte Ltd vs. DGIR (3 M.L.J 186) Per diem payment to Canadian owners of rail road freight cars for period of time those cars were used in US tracks classified as “rental income” and not “industrial and commercial profits” US Revenue Ruling Fees paid to French company for engineering services, the supply of machinery, erection and commissioning were not Royalties but “industrial and commercial profits” not taxable in India in absence of PE – Commr. Vs. Hindustan Paper Corp (77 Taxman 450 Calcutta HC)

Article 7(1) “Force of Attraction” Principle
Principle of Force of Attraction primarily concerned with taxation of business profits in Source country Prevent tax evasion/avoidance through artifical contracts & business arrangements Identification of business txns. – source based taxation Three kinds of FoA found in Treaties: Pure force of attraction : all profits derived in source state taxable as profits of PE whether or not through PE Limited force of attraction : profits derived through PE as well as profits from sale of goods/activities same or similar to PE directly by HO in source country taxable as profits of PE No force of attraction : only profits derived through PE taxable Article 7(1) of the UN MC includes a limited form of Force of Attraction principle

Article 7(1) Pure Force of Attraction
Classic example of the Pure ‘Force of Attraction’ rule is Article III of the UK-USA Income-tax Convention, 1945 which read as follows: “(1) A UK enterprise shall not be subject to US tax in respect of its industrial or commercial profits unless it is engaged in trade or business in the United States through a PE situated therein. If it is so engaged, United States tax may be imposed upon the entire income of such enterprise from sources within the United States…” In other words, if an enterprise of a contracting country had a PE in the other country, it was taxable not only in respect of the profits attributable to the PE, but in respect of the entire profits arising from sources in that country!

Article 7(1) Limited FoA The raison-d-etre of the modified ‘Force of Attraction’ principle is best understood from the Commentary on UN Model Convention which states thus (paragraph 46): “This para reproduces art. 7, para 1, of OECD Model Convention, with the addition of the provisions contained in cls. (b) and (c). In the discussion preceding the adoption by the Group of Experts of this para, several members from developing countries expressed support for the “force of attraction” rule, although they would limit the application of that rule to business profits covered by art. 7 of the OECD Model Convention and not extend it to income from capital (dividends, interest and royalties) covered by other treaty provisions. The members supporting the application of the “force of attraction” rule also indicated that neither sales through independent commission agents nor purchase activities would become taxable to the principal under that rule.

Article 7(1) Limited FoA “Some members from developed countries pointed out that the “force of attraction” rule had been found unsatisfactory and abandoned in recent tax treaties concluded by them because of the undesirability of taxing income from an activity that was totally unrelated to the establishment and that was in itself not extensive enough to constitute a PE. They also stressed the uncertainty that such an approach would create for taxpayers. Members from developing countries pointed out that the proposed “force of attraction” approach did remove some administrative problems in that it made it unnecessary to determine whether particular activities were or were not related to the PE or the income involved attributable to it. That was the case especially with respect to transactions conducted directly by the home office within the country, but similar in nature to those conducted by the PE.

Article 7(1) Limited FoA However, after discussion, it was proposed that the “force of attraction” rule, should be limited so that it would apply to sales of goods or merchandise and other business activities in the following manner: if an enterprise has a PE in the other Contracting State for the purpose of selling goods or merchandise, sales of the same or a similar kind may be taxed in that State even if they are not conducted through the PE; a similar rule will apply if the PE is used for other business activities and the same or similar activities are performed without any connection with the PE.”

Article 7(1) #NoFOA Klaus Vogel explains the preference for a system which did not adopt the ‘Force of Attraction’ rule in (3rd Edition, Vol I, page 410): “This distribution of taxation according to the economic connection of the profits concerned is preferable to the principle of ‘attraction force’ because the former method proceeds from the enterprise’s individual organizational structure and avoids restricting entrepreneurial freedom of disposition through fictitiously allocating profits by way of generalizing standards. While OECD committee on fiscal affairs recognized that such extensive freedom of entrepreneurial disposition might also involve the risk of being abused, it thought that this risk should not be given undue weight and that much more importance should be attached to ensuring, both for tax purposes and otherwise, that international business contacts can be shaped according to commercial requirement.”

Article 7(1) Case Study #1 - FoA
DCIT vs. Roxon OY (106 ITD 489 Mumbai) Finish assessee company entered into contract to “design, manufacture, deliver, erect, test and commission certain bulk handling facility at Nava Sheva Port Trust and to impart training to the NSPT” Clearly assessee had PE in India : no dispute there AO went one step further and held that assessee was required to supply the equipment (offshore equipment supply) and install it in India as part of a turnkey contract, thus the supply was linked to the installation and chargeable to tax under the ‘Force of Attraction’ principle.

Tribunal disagreed with Revenue and ruled in favour of assessee Considered in detail the FoA clauses of the relevant Treaty and gave 3 reasons why profits from supplies did not fall within its ambit: First is PE came into existence after supply transaction Second reason was, if anything, PE is deemed to be buying at market value and selling at same value to customer; billing was direct with customer and the hypothetical purchase & sale by PE did not result in any profits to be taxable Third reason is in offshore supply of equipments etc in a turnkey contract what can be taxed is only profits attributable to the work effectively carried out by PE

SNC-Lavalin vs. ACIT (110 TTJ Del 13) Assessee entered into contract with NHPC for Chamera project. Assesse claimed it had performed work relating to project even prior to setting up of PE but bills were raised after PE was established; claimed that profit not attributable to PE had to be excluded Tribunal held limited FoA under India-Canada DTAA applies and FoA holds good even for rendering of services It was held that as there was a composite contract for rendering services in connection with setting up of the Hydroelectric project, the work carried out outside India was deemed to have arisen in India as it was the same as the services rendered by the PE in India. The fact that the invoices for the said off-shore work was raised through the PE in India and accounted for in the books of project office set up in India sealed the fate of the assessee.

Sumitomo Corp. vs. DCIT (114 ITD 61 Del.) The assessee, a Japanese company, secured several contracts for supply of various equipment's to Maruti Udyog Ltd for its car project and also undertook to supervise the installation of the equipment's. The contracts were independent and not commercially a coherent whole. The period of supervision in the case of individual contracts did not exceed 180 days. The Department argued that there was a supervisory PE on the basis that the period of all contracts had to be aggregated. It was also argued that as the supervisory services were “effectively connected” with the PE, Article 12(5) applied and the fees thereof had to be assessed as business profits and not as fees for technical services

Tribunal held that as far as Article 12(5) was concerned, the State where the PE was located was entitled to tax only those profits which were economically attributable to the PE and arose as a result of activities of PE ITAT held that Article 12(5) adopted the “No Force of Attraction Principle”. It held that Article 12(5) made a distinction between income which was the result of activities of the PE and income which arose by reason of direct dealings by the enterprise from the head office without the aid or assistance of the PE. The term “effectively connected” was held not to be the opposite of “legally connected” but as being “really connected”. It was held that the connection had to be seen not in the form but in real substance. ITAT also repelled aggregation argument by Department with regard to FoA rule and held that different contracts were not part of a coherent whole and aggregating them would violate the FoA rule

Article 7(1) Case Study #4 – FoA
ITO vs. LinkLaters LLP (40 SOT 51 Mum.) Whether services rendered by UK law firm from outside India to Indian clients was taxable in India given that assessee had a PE? India-UK DTAA does not have standard “Force of Attraction” clause in the usual format but merely provides that if enterprise of one Contracting State carries on business in other Contracting State through PE, “the profits of the enterprise may be taxed in the other State but only so much of them as is directly or indirectly attributable to that permanent establishment“ The Tribunal held that connotation of the phrase “profits indirectly attributable to permanent establishment” incorporated FoA rule. It held that in addition to taxability of income in respect of services rendered by the PE in India, ANY income in respect of the services rendered to an Indian project (similar to the services rendered by the PE) is also taxable in India irrespective of fact whether such services are rendered through PE or directly by the general enterprise.

Tribunal held that this indirect attribution, in view of the specific provisions of the India-UK tax treaty, was enough to bring the income from such services within the ambit of taxability in India. The Tribunal emphasized that the twin conditions that had to be satisfied for taxability of related profits are (i) the services should be similar or relatable to the services rendered by the PE in India; and (ii) the services should be ‘directly or indirectly attributable to the Indian PE’ i.e. rendered to a project or client in India. The effect of the judgement is that the entire profits relating to services rendered by the assessee, whether rendered in India or outside India, in respect of Indian projects became taxable in India!! This ruling has been struck down (thankfully!) restored by subsequent Mumbai Special Bench in ADIT vs. Clifford Chance (TS-194-ITAT-2013 Mum)

Article 7(1) FoA - Points to Ponder
Around 30 of ~85 Indian DTAA’s contain some form of FoA. Many DTAA’s Limited FoA (Canada, Belgium, USA, Italy, Denmark) Some DTAA’s limited Limited FoA!! (NZ, Indonesia) Some adopt UN Model with “Right to Prove otherwise” (Sri Lanka, Cyprus, Germany) Some adopt OECD Model with variation (directly or indirectly attributable to PE) (Japan, Singapore, UK, Malta, Oman) Can we take refuge under the Indian Income Tax Act which has only attribution to PE concept and no FoA?

OECD MC - Article 7(2) PE : Computation Hypothesis
Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. 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 other parts of the enterprise.

UN MC - Article 7(2) PE : Computation Hypothesis
Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.

US MC – Article 7(2) PE - Computation Hypothesis
Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the business profits that it might be expected to make if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions. For this purpose, the business profits to be attributed to the permanent establishment shall include only the profits derived from the assets or activities of the permanent establishment. Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits that it might be expected to make if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions. For this purpose, the profits to be attributed to the permanent establishment shall include only the profits derived from the assets used, risks assumed and activities performed by the permanent establishment

Article 7(2) PE – Computation Hypothesis
Approach to determine profit of the PE. Historically two approaches: Relevant business activity (or) Functionally separate entity OECD recommends “functionally separate entity” approach Profit should be determined by applying arm’s-length principle – OECD TP Guidelines should be applied Clear movement towards Article 7(2) and Article 9 being closely tied together : ALP is fundamental to the mix!

Article 7(2) Authorized OECD approach
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 Source: ICAI Article 7 Webinar: 24 May 2014

Article 7(2) PE - Separate Entity Approach
Difficulty in this approach is simply that PE is not a separate entity It cannot enter into legally binding contracts with remainder of enterprise of which it is part It cannot borrow funds or pay interest or royalties to the remainder of the enterprise Thus to apply these guidelines developed in context of separate enterprises means creating functionally separate enterprise as an artificial construction i.e., a separate enterprise fiction

Article 7(2) Expenses of a PE: the bird’s-eye view!
Three kinds of expenses for the PE: expenses that PE itself incurs in India expenses that the foreign company incurs at head office level exclusively for the Indian PE and expenses that the foreign company incurs at head office level generally for its business which also benefits the PE being a part of the legal entity. With respect to direct expenditure i.e., clause (a) there is little dispute; it is always deductible by PE Attribution of exclusive expenditure & apportionment (by key) of general HO expenditure is always contentious – especially the latter i.e., apportionment .

Article 7(3)….and beyond Computation of profits attributable to PE
A bit of history…. OECD MC 2008 (i.e., prior to 2010), UN MC 2001 & 2011, US MC 1996 & 2006 were all along on the same lines – few differences such as FoA, Attribution to Permanent Establishment Report 2008, OECD changed things! OECD MC 2010 made significant differences to Article 7 In other words, US & UN Model follow the old OECD Model. Indian treaties typically follow these too New OECD Model Article 7 framework reflects the growing trend of using ALP as the backbone and integrating everything under the TP umbrella What were the changes in OECD Model post 2008 ? OECD Model modified Article 7(2) to incorporate F.A.R, removed the old OECD MC’s Article 7(3), 7(4), 7(5) and 7(6). New Article 7(3) relating to corresponding adjustment introduced

Article 7(3)…. Computation of profits attributable to PE
OECD MC 2014 Art 7(3) 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 these profits, make an appropriate adjustment to the amount of the tax charged on those profits. In determining such adjustment, the competent authorities of the Contracting States shall if necessary consult each other.

OECD MC 2008 (prior to OECD MC 2010) Art. 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. Art 7(4) Insofar as it has been customary in a Contracting State to determine the profits to be attributed to a permanent establishment on the basis of an apportionment of the total profits of the enterprise to its various parts, nothing in paragraph 2 shall preclude that Contracting State from determining the profits to be taxed by such an apportionment as may be customary; the method of apportionment adopted shall, however, be such that the result shall be in accordance with the principles contained in this Article. Art 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. Art 7(6) For the purposes of the preceding paragraphs, the profits to be attributed to the permanent establishment shall be determined by the same method year by year unless there is good and sufficient reason to the contrary.

UN MC 2011 Art 7(3) In the determination of the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the business 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. However, no such deduction shall be allowed in respect of amounts, if any, paid (otherwise than towards reimbursement of actual expenses) by the permanent establishment to the head office of the enterprise or any of its other offices, by way of royalties, fees or other similar payments in return for the use of patents or other rights, or by way of commission, for specific services performed or for management, or, except in the case of a banking enterprise, by way of interest on moneys lent to the permanent establishment. Likewise, no account shall be taken, in the determination of the profits of a permanent establishment, for amounts charged (otherwise than towards reimbursement of actual expenses), by the permanent establishment to the head office of the enterprise or any of its other offices, by way of royalties, fees or other similar payments in return for the use of patents or other rights, or by way of commission for specific services performed or for management, or, except in the case of a banking enterprise, by way of interest on moneys lent to the head office of the enterprise or any of its other offices.

UN MC 2011 Art 7(4) In so far as it has been customary in a Contracting State to determine the profits to be attributed to a permanent establishment on the basis of an apportionment of the total profits of the enterprise to its various parts, nothing in paragraph 2 shall preclude that Contracting State from determining the profits to be taxed by such an apportionment as may be customary; the method of apportionment adopted shall, however, be such that the result shall be in accordance with the principles contained in this Article. Art 7(5) For the purposes of the preceding paragraphs, the profits to be attributed to the permanent establishment shall be determined by the same method year by year unless there is good and sufficient reason to the contrary. (NOTE: The question of whether profits should be attributed to a permanent establishment by reason of the mere purchase by that permanent establishment of goods and merchandise for the enterprise was not resolved. It should therefore be settled in bilateral negotiations.)

US MC 2006 Art 7(3) In determining the profits of a permanent establishment, there shall be allowed as deductions expenses that 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 (∗) Art 7(4) 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. Art 7(5) For the purposes of the preceding paragraphs, the profits to be attributed to the permanent establishment shall be determined by the same method year by year unless there is good and sufficient reason to the contrary.

UN Model Commentary on Computation of expenses attributable to PE
The UN MC specifically excludes certain deductions by PE in Art. 7(2), the UN Model Commentary provides the rationale: “41. The treatment of interest charges raises particular issues. First there might be amounts which, under the name of interest, are charged by a head office to its permanent establishment with respect to internal “loans” by the former to the latter. Except for financial enterprises such as banks, it si generally agreed that such internal “interest” need not be recognized. This is because: From a legal standpoint, the transfer of capital against payment of interest and an undertaking to repay in full at due date is really a formal act incompatible with the true legal nature of a PE From the economic standpoint, internal debts and receivables may prove to be non existent, since if an enterprise is solely or predominantly equity funded it ought not to be allowed to deduct interest charges that it has manifestly not had to pay….” 42. For these reasons, the ban on deductions for internal debts and receivables should continue to apply generally, subject to special situation of banks….

OECD Model Commentary 2014 on Computation of expenses attributable to PE
OECD MC 2014 Commentary deleted a number of paragraphs from Article 7 of previous versions of its MC. The rationale is explained in detail in its Model Commentary as follows: “38. Article 7, as it read before 2010, included the following paragraph 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.” Whilst that paragraph was originally intended to clarify that paragraph 2 required expenses incurred directly or indirectly for the benefit of a permanent establishment to be taken into account in determining the profits of the permanent establishment even if these expenses had been incurred outside the State in which the permanent establishment was located, it had sometimes been read as limiting the deduction of expenses that indirectly benefited the permanent establishment to the actual amount of the expenses.

“39. This was especially the case of general and administrative expenses, which were expressly mentioned in that paragraph. Under the previous version of paragraph 2, as interpreted in the Commentary, this was generally not a problem since a share of the general and administrative expenses of the enterprise could usually only be allocated to a permanent establishment on a cost-basis. 40. As now worded, however, paragraph 2 requires the recognition and arm’s length pricing of the dealings through which one part of the enterprise performs functions for the benefit of the permanent establishment (e.g. through the provision of assistance in day-to-day management). The deduction of an arm’s length charge for these dealings, as opposed to a deduction limited to the amount of the expenses, is required by paragraph 2. The previous paragraph 3 has therefore been deleted to prevent it from being misconstrued as limiting the deduction to the amount of the expenses themselves.

“That deletion does not affect the requirement, under paragraph 2, that in determining the profits attributable to a permanent establishment, all relevant expenses of the enterprise, wherever incurred, be taken into account. Depending on the circumstances, this will be done through the deduction of all or part of the expenses or through the deduction of an arm’s length charge in the case of a dealing between the permanent establishment and another part of the enterprise. 41. Article 7, as it read before 2010, also included a provision that allowed the attribution of profits to a permanent establishment to be done on the basis of an apportionment of the total profits of the enterprise to its various parts. That method, however, was only to be applied to the extent that its application had been customary in a Contracting State and that the result was in accordance with the principles of Article 7. For the Committee, methods other than an apportionment of total profits of an enterprise can be applied even in the most difficult cases. The Committee therefore decided to delete that provision because its application had become very exceptional and because of concerns that it was extremely difficult to ensure that the result of its application would be in accordance with the arm’s length principle.”

“42. At the same time, the Committee also decided to eliminate another provision that was found in the previous version of the Article and according to which the profits to be attributed to the permanent establishment were to be “determined by the same method year by year unless there is good and sufficient reason to the contrary.” That provision, which was intended to ensure continuous and consistent treatment, was appropriate as long as it was accepted that the profits attributable to a permanent establishment could be determined through direct or indirect methods or even on the basis of an apportionment of the total profits of the enterprise to its various parts. The new approach developed by the Committee, however, does not allow for the application of such fundamentally different methods and therefore avoids the need for such a provision” Bottomline: OECD has clearly moved to a separate entity model driven by ALP analysis using its Transfer Pricing Guidelines

India’s DTAA’s

India’s DTAAs Rubber hits the road!
We saw the Model Conventions; what do India’s negotiated DTAAs with various Countries? Most of India’s DTAA’s follow the UN MC and the old OECD MC (2008) Have limited Force of Attraction (FoA) rule Deductions of expenses allowed for purpose of PE including executive and general administrative expenses Have clause which subjects allowability of expenses to domestic laws of the State in which PE is situated Allow apportionment wherever necessary/applicable

India’s DTAA’s: An example India-Belgium DTAA
ARTICLE 7 - BUSINESS PROFITS 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 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 that 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 that other State of the same or similar kind as those effected through that permanent establishment. 2. Where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall be attributed to such permanent establishment the profits which it might be expected to derive if it were an independent enterprise engaged in the same or similar activities under the same or similar conditions and dealing at arm's length with the enterprise of which it is a permanent establishment.

India-Belgium DTAA (contd.)
3. (a) In the determination of the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the business 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, subject to the limitations of the taxation laws of that State : Provided that where the law of the State in which the permanent establishment is situated imposes a restriction on the amount of the executive and general administrative expenses which may be allowed, and that restriction is relaxed or overridden by any Convention or Agreement between that State and a third State which is a member of the OECD which enters into force after the date of entry into force of this Agreement, the competent authority of that State shall notify the competent authority of the other Contracting State of the terms of the corresponding paragraph in the Convention or Agreement with that third State immediately after the entry into force of that Convention or Agreement and, if the competent authority of the other Contracting State so requests, the provisions of this sub-paragraph shall be amended by protocol to reflect such terms.

(b) However, no such deduction shall be allowed in respect of amounts, if any, paid (otherwise than towards reimbursement of actual expenses) by the permanent establishment to the head office of the enterprise or any of its other offices, by way of royalties, fees or other similar payments in return for the use of patents or other rights, or by way of commission or other charges for specific services performed or for management, or, except in the case of a banking enterprise, by way of interest on moneys lent to the permanent establishment. Likewise, no account shall be taken, in the determination of the profits of a permanent establishment, for amounts charged (otherwise than towards reimbursement of actual expenses), by the permanent establishment to the head office of the enterprise or any of its other offices, by way of royalties, fees or other similar payments in return for the use of patents or other rights, or by way of commission or other charges for specific services performed or for management, or, except in the case of a banking enterprise, by way of interest on moneys lent to the head office of the enterprise or any of its other offices.

4. Insofar as it has been customary in a Contracting State to determine the profits to be attributed to a permanent establishment on the basis of an apportionment of the total profits of the enterprise to its various parts, nothing in paragraph 2 or paragraph 3 shall preclude such Contracting State from determining the profits to be taxed by such an apportionment as may be customary; the method of apportionment adopted shall, however, be such that the result shall be in accordance with the principles laid down in this Article. 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 purpose of export to the enterprise of which it is the permanent establishment. 6. For the purposes of the preceding paragraphs, the profits to be attributed to the permanent establishment shall be determined by the same method year by year unless there is good and sufficient reason to the contrary. 7. Where profits include items of income which are dealt with separately in other Articles of this Agreement, then the provisions of those Articles shall not be affected by the provisions of this Article.

India’s DTAA’s: Points to note
India-UK DTAA (and India-Oman DTAA) has a paragraph on indirect attributability to PE “3. 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.” Some DTAA’s like India-USA, India-Canada, India-Germany have an additional “estimation” provision in Article 7(2) Art. 7(2) “... In any case, where the correct amount of profits attributable to a permanent establishment is incapable of determination or the ascertainment thereof presents exceptional difficulties, the profits attributable to the permanent establishment may be estimated on a reasonable basis provided that the result shall be in accordance with the principles laid down in this Article.”

India’s DTAAs: Points to Note
Few DTAA’s such as India-Italy and India-Japan don’t seem to have provision to subject PE expense deduction to domestic tax laws India-Cyprus DTAA has peculiar FoA exception to Art. 7(1)(b) & (c) “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” India-Sri Lanka, India-Singapore DTAA’s seem to have no FoA provision

Indian Income Tax Act & Attribution of profits to PE

Indian Income Tax Act & Attribution to PE
Section 9(1)(i) of the IT 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”

Indian Income Tax Act & Attribution to PE Taxability of Foreign Agency commission
Withdrawal of Circular 23 & the whole agency commission fiasco Circular withdrawal doesn’t change the underlying statute! Assuming foreign agent has no PE here in India; Article 7 of Treaty empowers Residence country to tax (and) S.9(1)(i) read with Explanation 1(a) makes it not exigible to tax in India If not exigible to tax in India, no question of TDS (GE India Technology Centre Pvt. Ltd. Vs. CIT 327 ITR 456 SC) Dept.’s lookout is to how to construe the agency agreement as Fees for Technical Services (FTS) so that PE restriction is removed by deeming fiction of S.9(1)(vi) r.w its Explanation’s CIT vs. Faizan Shoes 48 taxmann.com 48 (Mad)

Indian Income Tax Act & Attribution to PE Rule 10 of IT Rules
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.”

Indian Income Tax Act & Attribution to PE Rule 10 of IT Rules (contd.)
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 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.

Indian Income Tax Act & Attribution to PE CBDT Circular No
Indian Income Tax Act & Attribution to PE CBDT Circular No th Sept. 2004 “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”.

Ad-hoc attributions: Typical Indian judicial flavour!
Issue ITAT Ruling Citation Taxability of trading profits where sale is concluded in India 10% of supply Annamalais 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 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)

S.44C – Deduction of head office expenditure in the case of non-residents
In 1976, Indian legislature realized the need of placing some checks and balances for deductibility of PE expenses that are not incurred in India. Section 44C was introduced in the Income tax Act, 1961 (‘the Act’) for this purpose. Circular no. 202 in July 1976 issued which stated that it is extremely difficult to scrutinize and verify claims in respect of head office expenses, particularly in the absence of account books of the head office which are kept outside India. It added that foreign companies operating through branches in India sometimes try to reduce the incidence of tax in India by inflating their claims in respect of head office expenses. It was with a view to getting over these difficulties section 44C was introduced. Section 44C defines head office expenses and lays down limit to which such expenses can be claimed as deduction from PE profits.

S.44C – Deduction of head office expenditure in the case of non-residents
It covers all executive and general administration expenses including rent, rates, taxes, insurance, salary, travelling etc. incurred outside India. The definition in the Act is inclusive and the tax treaties do not provide any definition. Usually, the executive and general administrative expenses include expenses that are related to the overall management of the enterprise and in addition to the specifics in the inclusive definition it can encompass depreciation, expenses related to office equipment, expenses on periodic meetings, training and skill enhancement, market research and analysis, expenses on standard operating procedures, marketing costs for the overall enterprise etc. The limit of deduction is restricted to five percent of adjusted total income even if the expenses actually incurred and attributable to the PE are higher.

S.44C –Few case laws… CIT vs. Emirates Commercial Bank Ltd. (262 ITR 55 Mum. HC) Provisions of S.44C cover only those expenses which are common for various locations and require apportionment; does not effect expenses incurred exclusively for PE John Wyeth & Brother Ltd. vs. CIT (312 ITR 80 Mum. HC) HO Allocation of R&D expenses will not fall under S.44C restriction as it is not general administrative or executive in nature JCIT vs. American Express Bank (ITA 5904/Mum/2000, ITAT Mum.) Expenses incurred by HO in relation to solicitation of NRI deposits and other expenditure incurred for Branch AO applied S.44C to restrict the expense deductions claimed by assessee PE ITAT decided in favour of assessee and said expenditure incurred for PE should be allowable u/s 37(1) and not restricted by S.44C

Indian cases - Attribution of profits to PE Case #1: Morgan Stanley
SC delivered a landmark judgment in the case of DIT (Intl. Tax.), Mumbai v. Morgan Stanley and Co. Inc. (Civil Appeal 2914 of 2007 SC), ruling that the outsourcing of services such as back-office operations to a captive service provider will not per se create a permanent establishment of the parent in India. It has also accepted the single-entity approach for the attribution of profits to a PE by ruling that the payment of an arm’s-length price by the nonresident to the PE extinguishes any further attribution of profits to tax. And it has reiterated the importance of considering an economic nexus before taxing a nonresident’s global profits in India.

Indian cases - Attribution of profits to PE Case #2: Ishikawajima-Harima Heavy Industries Ltd. vs. 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 in 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 and subsequently FA 2010)

Indian cases – Attribution of profits to PE Case #3: Rolls Royce PLC (ITA No.493/2008)
Rolls Royce India Ltd. (RRIL) liasion office carried out activities only in respect of Rolls Royce Plc RRIL India key responsibility was securing orders, solicit request for quotation/orders for RRPlc products RRIL, India personnel actively work with RRPlc and are involved in meetings with clients, where contracts are discussed and decisions taken RRPlc designated on certain occasions RRIL, India as sole point of contact in respect of some customers RRIL India marketed certain after sales/other services provided by RRPlc to customers and also provided advise/recommendation as regards cutomer proposals ITAT held all profits directly and indirectly attributable to PE to be considered; profits attributed to India set at 35% using Rule 10 as only marketing done in India

Indian cases – Attribution of profits to PE Case #4: Set Satellite DIT vs. Set Satellite (ITA No.944/2007) Where the assessee had a ‘Dependent Agency Permanent Establishment’ (‘DAPE’) (“SET India”) in India and it was admitted by the Revenue that the assessee had paid ‘arms length’ remuneration to the said dependent agent but the Tribunal still held (106 ITD 75) that notwithstanding the taxability of the said dependent agent in accordance with domestic law, the assessee had to be assessed in respect of the profits attributable to the said DAPE, held, reversing the judgement of the Tribunal

Indian cases – Attribution of profits to PE Few other cases…
DIT vs. Set Satellite (Singapore) Pte. Ltd. (ITA No.1676 of 2011 Mum. HC) : Royalty income not taxable in India since there is no link between payment of Royalties and taxpayer’s PE in India Ahmedbhai Umarbhai & Co (1950) SCR 335) : Profit apportionment on the basis of business activities, manufacturing profits taxable in the jurisdiction where manufacturing takes place 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 DIT vs. Galileo Advertising 180 Taxman 357 Delhi. HC) : Held that 15% of revenue generated from bookings within India is taxable in India.

Interplay of Article 7 & other Articles

Interplay of Article 7 & other Articles Specific Article vs. Article 7
All Model Conventions agree on this. Phew! “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.” Specific trumps over the General: when the characterization of payment belongs to one of the types covered by a specific Article of the convention, that has to apply and not the catch-all business profits Article 7.

Interplay of Article 7 & other Articles Payments “effectively connected” with PE
“6. The provisions of paragraphs 1 and 2 of this Article shall not apply if the beneficial owner of the royalties or fees for technical services, being a resident of a Contracting State, carries on business in the other Contracting State in which the royalties or fees for technical services arise through a permanent establishment situated therein, or performs in that other State independent personal services from a fixed base situated therein, and the right, property or contract in respect of which the royalties or fees for technical services are paid is effectively connected with such permanent establishment or fixed base. In such case, the provisions of Article 7 (Business profits) or Article 15 (Independent personal services) of this Convention, as the case may be, shall apply.” (India-UK DTAA)

Interplay of Article 7 & other Articles Payments “attributable to” PE
“6. The provisions of paragraphs 1 and 2 shall not apply if the beneficial owner of the royalties or fees for included services, being a resident of a Contracting State, carries on business in the other Contracting State, in which the royalties or fees for included services arise, through a permanent establishment situated therein, or performs in that other State independent personal services from a fixed base situated therein, and the royalties or fees for included services are attributable to such permanent establishment or fixed base. In such case the provisions of Article 7 (Business Profits) or Article 15 (Independent Personal Services), as the case may be shall apply.” (India-USA DTAA)

Interplay of Article 7 & other Articles Few case laws…
Worley Parsons Pty Ltd. (In re 747 of 2007) The services rendered and the work undertaken by the applicant-Australia n company in terms of the Agreement for Basic Engineering and Procurement services fall within the scope of `royalties’ as defined in Article XII(3) of the DTAA between India and Australia and the receipts are taxable in India by virtue of Article XII(2); under the Income-tax Act too, they are so taxable The exclusion clause under Article XII (4) of the DTAA is not attracted in view of the absence of the effective connection between PE and the services, and therefore, the royalty income is liable to be taxed under Article XII(2) of the DTAA read with section 9(1)(vi) and other charging provisions of the Act.

ADIT (IT) 3 (2) v. Bunge Agribusiness Singapore Pte. Ltd. [ITA No 6116 & 6117 (Mum.) of 2008] Assessee, a Singapore based company, received service fees from its 100 per cent Indian subsidiary for rendering legal and accounting services and cost sharing arrangements. AO treated those services to be taxable as fees for included services under article 12(4) of Indo-Singapore DTAA. On Appeal, assessee contended that it had a PE in India to which the aforementioned receipts belonged in relevant years. Therefore, the receipts would be assessed under Article 7 of the DTAA as business profits. CIT (A) upheld the claim and split the consideration as 25% for technical services and 75% as business receipts. Revenue files Appeal before ITAT. Tribunal held: Paragraph 1 & 2 of Article 14 which regulates the taxability of royalty for fee for technical services in the State in which it arise on the gross amount at the specified rate will not be applicable if these receipts are effectively connected with PE or fixed base. Therefore, provisions of Article 7 will apply

In ACIT vs. Clough Engineering (130 ITD 137 Delhi SB), Special Bench of Tribunal in ACIT vs. held that interest earned on income-tax refund is taxable on gross basis at 15% under Article 11 of India-Australia DTAA and not under Article 7 r.w. Article 11(4) Tribunal held that even if debt is connected to receipts of PE it cannot be said to be effectively connected with such receipts because responsibility to tax lies with assessee foreign company from the final profit ascertained as on last day of previous year Following Clough(supra), Bechtel International Inc. vs. ADIT (ITA No.5198/Mum/2010) held in favour of assessee that interest on income-tax refund was not effectively connected with assessee PE in India

Interplay of Article 7 & other Articles Points to ponder…
Spice Telecom vs. ITO (113 TTJ 502 Bang.) In absence of FTS clause in India-Mauritius Treaty, payments will be governed by Article 7 of said tax treaty DCIT vs. TVS Electronics (TS-421-ITAT-2012(Chny)) Domestic law prevails if no provision exists for particular head of income under Treaty (??!!)

Summary Article 7 r.w. Article 5 forms the cornerstone of any DTAA
Number of changes made to the Article 7 in the MC’s especially OECD Latest OECD MC and UN/US MC’s seem to diverge significantly Concept of PE dynamic Even more so with advent of electronic commerce! Attribution always contentious and complicated Move to use ALP and TP as the basis of attribution Indian Income Tax Act has its own set of provisions and rules Force of Attraction rules Not enshrined in OECD Model as they don’t find favour in developed countries but used by developing nations such as India who follow the UN Model in this regard When payments come under Specific Articles, those Articles get invoked and not Article 7 Except for payments effectively connected to/attributable to PE

Thanks! Presentation By Vikram Vijayaraghavan, Advocate / c/o M/s Subbaraya Aiyar, Padmanabhan & RAMAMANI (SAPR) Advocates New No 114, Royapettah High Road, Chennai – , / Acknowledgments: Ms. Bhavya Rangarajan & Mr.Dhiraj Raman, SAPR Advocates

Income from Business (Article 7)

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