Bilateral international tax treaties set the principles for taxation of international business. Under these, profits of a multi-national enterprise are taxable only in the country where the enterprise is resident. However, this rule is subject to an exception when the enterprise has a permanent establishment (PE) in another country. In that case, profits that are “attributable” to the PE may be taxed in the country where the PE is situated. The attribution of profits to PEs has always been subject to controversy as practices of countries and their interpretation have varied considerably. However, over the last several years a broad consensus has evolved under the so-called “authorized OECD approach” or AOA. Under the AOA, profits to be attributed to a PE are the profits that the PE would have earned at arm’s length if it were a legally distinct and separate enterprise performing the same or similar functions under the same or similar conditions. In other words, profits attributable to a PE are to be determined by applying the arm’s length principle. Without specifically acknowledging the AOA, Indian courts, including the Supreme Court, have generally upheld the principle underlying the AOA. However, disputes often arose on how to apply some of the principles.
In order to achieve greater clarity and predictability, the Central Board of Direct Taxes (CBDT) constituted a committee to examine the existing scheme and recommend changes to the existing rule. The Committee’s report was released for public consultation on April 18, 2019.
The Committee has rejected the AOA and the arm’s length principle, which underlies the AOA as an acceptable approach for India. After considering various options, the Committee has recommended what it calls the mixed or balanced approach that allocates profits between the jurisdiction where sales take place and the jurisdiction where supply is undertaken, with necessary safeguards to prevent excessive attribution on one hand and protect the interests of Indian revenue on the other. The report, therefore, concludes that the option of ‘fractional apportionment’ based on apportionment of profits derived from India would be acceptable under tax treaties as well as the Indian income-tax law. The Committee was of the view that this option is relatively feasible as it is based largely on information related to Indian operations. The Committee found considerable merit in the three-factor method based on equal weight accorded to sales (representing demand) and manpower and assets (represent supply, including marketing activities). Further, in case of attribution of profits to a ‘significant economic presence’, the Committee has recommended that user contribution can be a substitute to either assets or employees and considered the option of following the approach of the European Union (EU) in the Common Consolidated Corporate Tax Base (CCCTB).
Overall, the Committee’s recommendations seem to consider the needs of India as a capital-importing country to tax profits derived from the ‘market jurisdiction’. However, a number of aspects of the proposals may need reconsideration. Some of the aspects deviate from an international consensus and may be viewed by India’s tax treaty partners as a unilateral measure which is inconsistent with the tax treaty. This has the risk of exposing international businesses to double taxation. This is also likely to increase the compliance and administrative burden on taxpayers.
Allocation of tax jurisdiction has been based traditionally on the principles of residence and source. Whereas most developed -- capital-exporting -- countries apply the residence principle, capital-importing countries, in general, continue to apply the source principle in exercising their natural taxing powers on events taking place within their territory. Over the last decade, economies are increasingly globalising and business models are changing, inter alia, as a consequence of intense growth of the service sector and the development of the digital economy. These developments have put pressure on the source principle, adversely impacting tax revenues of developing countries. Against this backdrop, the logical solution for capital and technology importing countries appear to be a new configuration of the source principle or a search for alternatives. Whatever the approach, the need for evolving an international consensus and adopting a globally coordinated approach is imperative.
Multinational enterprises with business operations in India should review the implications of the recommendations on their business models, as well as consider any risk of double taxation. It is important for companies to monitor the developments in this area and actively engage with the policymakers.
The writer is partner, international tax services, EY India.
Views expressed are personal