How Taxation Rules Are Changing For Foreign Companies Operating In India

Business profit that a foreign company derives from India, is taxable here only when the company has a permanent establishment (PE) in the country, as per Indian income tax law and applicable tax treaty between India and the relevant country. In cases, where a foreign company has a PE in India, the profits ‘attributable’ to the PE are liable to tax in India. The Indian tax law does not provide adequate guidance on how the attribution of profits should be done to the PE, but has given wide powers to assessing officers to audit and recompute income in the manner as they deem fit.

Relying on international best practices, taxpayers have argued for attribution to be based on activities undertaken by the PE in India. That would be by analysing the functions performed, assets employed, and risk assumed by the PE in India, as part of transfer pricing (TP) analysis, and arriving at profits that the PE would have earned in an arm’s length scenario. However, Indian revenue authorities have often believed more in allocation of global profits to India, with respect to PE operations in India. This is referred to as formulary apportionment. The different approaches have resulted in a protracted controversy.

In order to examine this issue and provide guidance, the Central Board of Direct Taxes formed a committee. The committee submitted its report to CBDT, which was released on April 18, 2019, for public comments within 30 days.

The most fundamental change that the committee has proposed, is a deviation from application of the functions, assets, and risk-based transfer pricing analysis to a new methodology called ‘fractional apportionment’, in order to attribute profits to the PE, primarily on account of following reasons:

• The committee seems to be of the opinion, that FAR (Functions, Assets and Risk) analysis-based TP approach considers only supply-side factors and ignores the demand side factors.
• The committee believes that such an approach restricts the taxing rights of the jurisdiction that contributes to business profits, by facilitating demand and may be favourable to the interests of countries that are net exporters of capital and technology, against developing economies like India, which are primarily importers of capital and technology.
• Hence, the committee proposed that taxation of a PE in India should be done in a mixed manner considering both demand and supply-side approach.

In view of the above, the committee proposed that business profits attributable to a PE of foreign companies in India shall be determined by apportioning the profits derived from India by three equally-weighted factors -- of sales, employees (manpower and wages) and assets. Sales represent demand/market, manpower and assets represent supply including marketing activities, relating to the PE operations in India and outside.

Further, in the case of attribution of profits to PE of digital businesses, the committee has recommended ‘user contribution’ as a fourth additional factor, depending upon their intensity in business. The committee recommended that in case of low and medium user intensity business models, 10 percent weight shall be assigned to users and 30 percent to each of the other three factors. However, in the case of high user intensity digital models, users shall be assigned a weight of 20 percent, while 25 percent each to assets and employees, and 30 percent to sales.

It seems that this may be prescribed later, but the report refers to ‘international guidance’, which suggests that manufacturing and cloud computing businesses are likely to have low-intensity users; while e-commerce businesses are likely to have medium user intensity. Collaborative consumption and social network businesses are said to have high user intensity.

Observations On The Report

• The proposed change seems to completely discard transfer pricing principles by replacing the economic concept of value creation/contribution, with an ad-hoc allocation of profits, in order to build a case for demand-side factors, even if no FAR exists to create that demand.
• The weights in fractional apportionment are ad-hoc/standard and not defined based on actual relative economic value addition.
• If a group sets up a subsidiary to do business in India, vis-à-vis a branch, the taxable profits according to the proposed law, would be different. This may not make economic logic and may not be fair.
• While arriving at attributable profits, the committee proposes a deemed rate of minimum of 2 percent if the actual profit rate is lower. This may be unfair and would amount to taxing notional income where the real income is actually lesser or even loss.
• Further, the profit rate is defined as EBITDA. Hence, to exclude depreciation, interest and even research and development costs may be unfair for companies which have asset-intensive operations and those that require major R&D investment.
• It is also unclear how global profit would be identified in situations where a group has multiple business segments or activities and only one or a few of them are conducted in India.

Overall, the CBDT’s intention to provide guidance on the subject is welcome.

We believe that such tax policy objectives may be achieved by proper application of transfer pricing principles in line with international best practices.

Groups 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.

Vijay Iyer is Partner and National Leader, Transfer Pricing, at EY India. Prateek Goyal, Senior Manager, Transfer Pricing, EY India, also contributed to the article. Views expressed are their personal.

The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.