Permanent Establishment

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Permanent Establishment Service PE - Agency
PE Attribution of Profits
Radhakishan Rawal February 17, 2006
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Overview

• Article 5 - Permanent
• Establishment
• Agency PE
• Service PE
• Attribution of Profits
• Article 7 - Business Profits

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Article 5 - Permanent Establishment
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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

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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

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Dependent Agent

• Ordinary course of business
• Wholly or almost wholly
• Two entity approach

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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

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Service PE

• Special features of Indian DTAAs
• Same or connected projects
• Services other than technical services
• Services to related party one day PE

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(No Transcript)
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Issues

• Other personnel - non-individuals?
• Calculation of number of days Man days v. Solar
  days

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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 .

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Service PE

• OECD Project on taxation of services

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Attribution of profits
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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
Locality B
Purchase _at_10 per KG
Sales _at_15 per KG
Profits 500
Profits ??
Profits ??
Locality B
Locality C
Variation I
Purchase _at_8 per KG
Sales _at_15 per KG
Time spent 2 hrs
Time spent 3 hrs
Profit 400 (200 200) ?
Profit 300 ?
Profits 700
Profits ??
Profits ??
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Locality C
Locality B
Purchase _at_8 perKG
Sales _at_15 per KG
Variation 2
Agents cost 50
Profits 650 Other income from 1 hr 100 Total
profits 750
Time spent 1 hrs
Time spent 3 hrs
Profits 330 (280-50100) ?
Profits - 420 ?
Profits 162.50 (650/4)
Profits 487.50 (650/4)3
Purchase _at_8 per KG
Sales _at_15 per KG
Variation 3
Profits 600 Other income from 2 hr - 200 Total
profits 800
Agents cost 100
Time spent 0 hrs
Time spent 3 hrs
Profits 0 (no time spent)
Profits 600
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Analysis
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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)

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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

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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.

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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)

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Methods under the Act

• Computation Method
• Presumptive Method
• Proportionate Method

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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 be expected between two independent
  organizations.

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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.
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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.

30
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.

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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 financial enterprise ( e.g. bank )

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Example
Tungus Plc. Supply of raw materials to PE
Rs.10,000 ( AL price Rs. 7,000 ) PE
processes the materials and sells it in India
Rs. 20,000 PE uses brand name ( Tungus )
belonging to HO PE uses technical know how of
HO Capital contributed by HO to the PE
Rs.100,000 General overheads of HO
Rs.
5,000 General Marketing cost of HO
Rs. 4,000 Special marketing
costs incurred by HO Rs.
500 PE contributes 10 of total turnover
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Example
PE Books MC Method
PEs P L a/c 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. 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
  inter-related Parts
• Part I General Principles
• Part II Banking
• Part III Global Trading
• Part IV Insurance
• All follow functionally separate enterprise
  approach

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Two-step approach

• 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 OECDs 1995 Transfer
  Pricing Guidelines by analogy to dealings
  between PE and other parts of enterprise

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• 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

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• Second step - PE must be attributed profits that
  it would have earned at arms length if it were a
  legally distinct and separate enterprise
  performing same or similar functions under same
  or similar conditions

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Example
Books MC OECD Report
PEs P L a/c 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 11,150
Rs. 20,000 7,000 550
440 550
8,540 11,460
10 AL 10 AL 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

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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

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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

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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 radhakishan.rawal_at_in.pwc.com