Transcript Permanent Establishment Service PE - IFA)

Permanent Establishment
Service PE - Agency PE
Attribution of Profits
Radhakishan Rawal
February 17, 2006
1
Overview
• Article 5 - Permanent
Establishment
• Agency PE
• Service PE
• Attribution of Profits
• Article 7 - Business Profits
2
Article 5 - Permanent Establishment
3
Significance of PE
• Decisive condition for the taxation of income from
business activities
• This rule is designed to ensure that business
activities are not be taxed by the state unless and
until they have created significant economic
bonds between the enterprise and that state
4
Types of PE



Basic Rule PE
Agency PE
Service PE
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Agency PE [Article 7(5)]
 Dependent agent



Habitually exercising authority to conclude
contracts
Maintenance of stock and delivery of goods
Securing orders
6
Dependent Agent
 Ordinary course of business
 Wholly or almost wholly
 Two entity approach
7
Service PE
 Article 5(3)
The term ‘permanent establishment’ encompasses:
(a)….(b) The furnishing of services, including consultancy
services,
by an enterprise through employees or other personnel
engaged by the enterprise for such purpose, but only if
activities of that nature continues (for the same or a connected
project) within the country for a period or periods aggregating
more than six months within any twelve month period.
 No clause for ‘fees for technical services’ in UN Model
8
Service PE
 Special features of Indian DTAAs



‘Same or connected projects’
Services other than technical services
Services to related party – one day PE
9
Criteria for Service PE in certain DTAAs signed by India
(no. of days within 12 months period)
USA
Services to
Unrelated parties
Related parties
UK
Singapore Canada Australia
90
90
90
90
90
1
30
30
1
1
10
Issues
 ‘Other personnel’ - non-individuals?
 Calculation of number of days – Man days
v. Solar days
11
Service PE under the Act
 Finance Act,2002 - Section 92F(iiia)
 “Permanent establishment, referred to in clause (iii),
includes a fixed place of business through which the
business of enterprise is wholly or partly carried on.”
 Memorandum to the Finance Act, 2002
 “It is proposed….. to provide a separate definition of
permanent establishment on the lines of the definition
found in the tax treaties entered into by India ….”
12
Service PE
 OECD Project on taxation of services
13
Attribution of profits
14
Attribution of profits


Attribution of profits to various activities of the
business
Attribution in case of transactions between branch
and head office
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Example
Locality A
Profits 500
Variation I
Profits 700
Locality B
Purchase @10 per KG
Sales @15 per KG
Profits
Profits
??
Locality C
??
Locality B
Purchase @8 per KG
Sales @15 per KG
Time spent 2 hrs
Time spent 3 hrs
Profit 400 (200 + 200) ?
Profit 300 ?
Profits ??
Profits ??
16
Locality C
Variation 2
Purchase @8 perKG
Agents cost 50
Time spent 1 hrs
Locality B
Sales @15 per KG
Profits 650
Time spent 3 hrs
Other income from
Profits 330 (280-50+100) ? Profits - 420 ?
1 hr 100
Profits 162.50 (650/4)
Profits 487.50 (650/4)*3
Total profits 750
Variation 3
Purchase @8 per KG
Profits 600
Agents cost 100
Other income from
Time spent 0 hrs
2 hr - 200
Total profits 800
Profits 0 (no time spent)
Sales @15 per KG
Time spent 3 hrs
Profits 600
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Analysis
Particulars
Purchase price
Agent's cost
Variation 1Variation 2Variation 3
1
2
3
1000
800
800
800
0
0
50
100
Total payment in Locality A / C
1000
800
850
900
200
300
0
280
420
0
162.5
487.5
100
0
600
200
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Profits for - Purchasing
- Selling
- Others
Basic
Transactions between head office
and branch
 A person can not trade with himself and
make profits
 Betts Hartley Huett And Company Ltd. v.
CIT (Calcutta HC)(116 ITR 425)
 ABN Amro Bank v. ADIT (Kol ITAT) (97
ITD 89)
 Dresdner Bank AG v. Addl. CIT(Mum
ITAT) (105 TTJ 149)
19
Attribution of profits…. a
guesswork ?

Blue Star Engg. (73 ITR283) (Bom)
“We are not impressed by the said submission of
Mr. Mehta. 25%, no doubt, is some guesswork
done by the Income-tax officer, but substituting
it by 10% again would be nothing more than
indulging in further guesswork”
20
Attribution of profits…. a
guesswork ?….

Hukumchand Mills Ltd (103 ITR 548)(SC)
“In the absence of some statutory or other fixed
formula, any finding on the question of
proportion involves some element of guesswork.
The endeavor can only be to be approximate
and there cannot in the very nature of things be
great precision and exactness in the matter.”
21
Approach of courts on attribution



Lower authorities [AO, CIT(A), ITAT] in a better
position to decide the issue
AARs reject questions on attribution of profits
The courts prefer to not to interfere unless attribution
found to be unreasonable or arbitrary
New Consolidated Fields (125 Taxman 959) (SC)
Mewar Textile Mills (60 ITR 423) (SC)


22
Methods under the Act



Computation Method
Presumptive Method
Proportionate Method
23
Article 7 - Business Profits
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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
of the enterprise may be taxed in the other State but
only so much of them as is attributable to that
permanent establishment.
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Article 7(2)
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.
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OECD Commentary para 2
 Para 2 does not authorise the Tax Authorities to
ignore the Branch accounts and work on hypothetical
figures. The starting point should be the accounts.
 The tax authorities should rely on symmetrically
prepared accounts.
 Accounts to be rectified when required to arrive at
AL profits.
 Transfer of assets from PE to HO should be treated
as transaction resulting in profit whether the
organization as a whole has realized the profit or not.
 Ignore certain transactions if such transactions cannot
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be expected between two independent organizations.
Article 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.
28
OECD Commentary para 3



Profit to be charged when the enterprise sells the
goods or provides the service in its normal course
of business.
No profit to be charged if the expense incurred is
to rationalize overall cost of the organization or
increase in a general way its sales.
When goods are not given to PE for resale but for
general use then only related cost should be
shared, say depreciation on machinery, based on
use of the machinery.
29
OECD Commentary para 3
Intangibles
 Difficulty in allocating the ownership of the
intangibles to any particular part of the organization.
The cost incurred for creation of intangibles may be
treated as attributable to all the parts of the
organization which make use of it.
 The cost incurred should be allocated without any
mark up to the PE.
30
OECD Commentary para 3
Services
 Mark up shall be charged to PE when the enterprise
provides such services on commercial terms or is in
the business of providing such services.
 General management activity say training provided
to the employees of the various parts of the enterprise
- no mark up to be charged to the PE.
Interest
 No interest to be charged between the enterprise and
the PE. Interest may be charged in the case of
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financial enterprise ( e.g. bank )
Example
Tungus Plc. Supply of raw materials to PE
( AL price Rs. 7,000 )
PE processes the materials and sells it in India
PE uses brand name ( Tungus ) belonging to HO
PE uses technical know how of HO
Capital contributed by HO to the PE
General overheads of HO
General Marketing cost of HO
Special marketing costs incurred by HO
PE contributes 10% of total turnover
Rs.10,000
Rs. 20,000
Rs.100,000
Rs. 5,000
Rs. 4,000
Rs. 500
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Example
PE’s P & L a/c
PE Books
MC Method
Rs.
Rs.
Rs.
Sales
20,000
Raw materials
10,000
General overheads ( 10% )
500
General marketing cost (10% ) 400
Special Mkt cost ( actuals )
500 11,400
Profit before tax
8,600
Rs.
20,000
7,000
500
400
500
8,400
11,600
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OECD PE Profit Attribution Project
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OECD PE Profit Attribution Project
 Aim: to seek consensus on how to hypothesise PE
as distinct and separate enterprise and to apply
Transfer Pricing Guidelines by analogy
 Draft Reports have been published in four interrelated Parts:

Part I – General Principles

Part II – Banking

Part III – Global Trading

Part IV – Insurance
 All follow “functionally separate enterprise” approach35
Two-step approach
1.
Hypothesise PE as “distinct and separate
enterprise” engaged in “same or similar activities”
under “same or similar conditions” and “dealing
wholly independently” with enterprise of which it is
a part
2.
Determine profits of hypothesised separate
enterprise by applying OECD’s 1995 Transfer
Pricing Guidelines by analogy to “dealings”
between PE and other parts of enterprise
36
 First step − done by applying principles of
Transfer Pricing Guidelines by analogy to
perform a factual and functional analysis:



to identify functions performed, assets
used, and risks assumed by the PE,
to attribute adequate free capital to the PE
in light of its risks, and
to identify any “dealings” between PE and
the enterprise of which it is a part
37
 Second step − PE must be attributed
profits that it would have earned at arm’s
length if it were a legally distinct and
separate enterprise performing same or
similar functions under same or similar
conditions
38
Example
Books
PE’s P & L a/c
Rs.
MC
Rs.
OECD Report
Rs.
Sales
20,000
Raw materials
10,000
General overheads ( 10% )
500
General marketing cost (10% ) 400
Special Mkt cost ( actuals )
500
20,000
7,000
500
400
500
11,400
8,400
8,540
8,600
11,150
11,460
Profit before tax
20,000
7,000
550 10% AL
440 10% AL
550 10% AL
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Current Status
 Published new versions of Parts I - III in
December 2006
Way forward
 Publish new version of Part IV in 2007
 Publish draft implementation package
(Model/Commentary changes) during
2007
40
UN Model and AOA
 UN Model adopted mainly by the
developing countries
 UN Model promotes source based taxation
 Commentary on UN Model substantially
adopts the OECD Commentary
41
Article 7 of the OECD and UN Model
• Article 7(1) of the UN Model allows limited ‘force of
attraction rule’
• Article 7(3) of UN Model prevents recognition of
internal payments
− Interest, Royalties or other similar payments
− Commission for specific services
− Management fees
• Exceptions
− Reimbursement of expenses
− Interest for banking enterprises
42
Adoption of AOA in treaties based on
UN Model
• It would not be possible to adopt AOA for treaties
based on UN Model
• Adoption of AOA possible only if Article 7 of
treaties is amended
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Thank You
[email protected]
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