| Will OECD guidance bring tax certainty? | |
| DIRECT TAX | | Mukesh Butani / New Delhi August 11, 2008, 5:45 IST | |
Indian PE Darshan
The term PE ( in India) is more synonym to Permanent establishment than to Private Equity! In my interactions with Tax Directors of MNC’s, I seldom come across a situation where no questions have been asked on Indian PE or rather more specifically, How India interprets the term PE.
The theory of inconsistency applies not just to tax administrators, but also tax advisors. I guess, part of the blame lies in our principle driven ( rather than rule driven) manner of interpreting tax law and part lies with Indian tax administration’s obsession to apply strict source based rules, fearing erosion of tax base.
The Revenue by holding or applying strict source based rules tend to bring to tax profits of a foreign enterprise to India by holding that the foreign enterprise has a PE in India and attributing greater share of such profits.
Recently, the Organization for Economic Cooperation and Development (OECD), a 30 member club of developed nations released its final report on profit attribution to permanent establishments (PE’s).
The report marks the culmination of a long drawn process that began in 1995 with the introduction of an earlier guidance – ‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations’ (OECD Guidelines). Since then, the possibility of applying similar principles for taxing PEs has been the most debated topic in international tax law.
PE and profit attribution linked
As a part of its support role, OECD undertakes research on taxation covering diverse issues ranging from tax evasion to transfer pricing. Its recent most initiatives – ‘Report on the Attribution of Profits to Permanent Establishments’ followed by an ‘Update to Model Tax Convention’ in July 2008 mark the convergence of two separate but related streams of international taxation – ‘transfer pricing’ and ‘profit attribution’. This is most timely given the maze of complex issues India is presently grappling with.
As a sub-discipline of international tax, transfer pricing deals exclusively with valuation of intra-group transactions. A PE on the other hand is a legal fiction that determines tax liability of a foreign enterprise. It is a fundamental principle of international tax that a source State can tax a non resident foreign enterprise only if it has a PE. Equally important but more complex is the next determination — the extent to which profits are attributable to the PE.
New approach to profit attribution
Historically, attribution has been based on guesswork and crude logic in most economies, barring a few. Countries have generally applied a formulaic approach for determining profits attributable to PE (as a percentage of sales or using similar criteria). India has somewhat a similar approach, popularly called Rule 10, though, the authority to apply such method is with the Revenue.
The OECD approach discards the age old practice of apportionment and ushers arm’s length principle as the ‘new approach to attribution’. Its clearly a departure from the arbitrary approach and besides keeping pace with the reality of modern trade and commerce, its rational and scientific.
Application of transfer pricing principles (contained in OECD Guidelines) to a PE constitutes the bedrock of the new approach. A PE is a virtual projection of the foreign enterprise in the source state. Yet for analytical purposes, it is hypothesized as an entity ‘separate and distinct’ from the foreign enterprise and attributed a return commensurate with functions, assets and risks undertaken by it (‘separate entity approach’).
A corollary of the arm’s length principle is that profit shall be attributed to the PE only where facts and circumstances justify and not as a matter of rule. Hence, where an enterprise (that creates a PE) has been adequately remunerated for its functions, no profits may be attributed to the PE.
Indian PE cocktail
Our origin of PE and income attribution debate may be traced to pre-independence era when apportionment principles were applied for determining profits attributable to ‘business connection’ (domestic law concept similar to PE). Hence, in the Anglo-French Textile case as well as Ahmedbhai’s case, the Supreme Court gave its verdict on a rough estimate of taxable profits, having regard to the nature of business operations undertaken in India.
That was an era when transfer pricing tools were absent and reliance on thumb rule was inevitable. However, since then significant strides forward have been made in the municipal and international law. Arm’s length principle is now widely recognised as the most appropriate mode for profit attribution, particularly given that we have comprehensive Transfer Pricing legislation
Recently, the question occupied centre-stage as the Tax Tribunal pronounced a number of rulings on the subject. The trend in these decisions is a pointer towards the fact that perhaps the ghost of attribution continues to haunt Indian Courts.
The thumb rule has been applied repeatedly throwing up arbitrary figures that are not based on any rationale – whether it is 15 percent in Galileo’s case (for online booking services) or 35 percent for marketing services in the case of Rolls Royce.
Surprisingly, intensive reliance on modern concepts of PE in the context of agency business ( for Rolls) and e commerce model ( for Galileo ) have been made use for the determination of existence of PE in India. Having determined that the foreign enterprise has PE, for attribution purposes, principles laid down by the courts (over 5 decades old ) have been used. Foreign investors find this puzzling and misdirected.
Earlier in Sony Entertainment’s case (SET), the Tax Tribunal stretched attribution principle to an extreme holding that profits were attributable to PE despite arm’s length payment to the Indian enterprise. Thankfully, the Supreme Court has seemingly overruled SET principles in ‘Morgan Stanley’ case, aligning Indian law with OECD principles. Even so, Indian Courts are yet to come to terms with the new approach to profit attribution, as borne out from recent decisions.
OECD guidance Implications for India
Though, India is not an OECD member state, OECD guidelines play a supplementary role on issues where Indian legislation is silent. From Morgan Stanley to recent decisions on transfer pricing (Egain Communication, Star TV ), Indian Tax tribunals and Courts have consistently approved reliance on OECD guidance. In a similar vein, one hopes that Revenue and Courts willingly accept and apply OECD principles while deciding questions on attribution.
Not only is the new approach scientific, but implies certainty for taxpayer and reduced risk of double taxation. Moreover, acceptance of OECD principles does not necessarily imply erosion of source based taxation.
Transfer pricing principles may not allow profit attribution as a sweeping rule but they ensure that the exchequer gets its due from economic activity undertaken in India. In fact, so strong is the dictum of arm’s length principle that, in cases, it may even tax a foreign multinational where the enterprise as a whole makes losses. Hence, fears of a treasury run down are ruled out and a consistent application of arm’s length principle augurs well for investment and taxation alike.
In summary, it would be interesting to see how Indian tax policy makers and administrators embrace the OECD principles, given that India has marched ahead of its “ observer status ” and is now engaged in “enhanced dialogue”, a pre cursor to entering the elite OECD member nation club.
The author is a Partner with BMR Advisors. Views expressed herein are personal
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