India: Attribution of profits to a Permanent Establishment and Associated Transfer Pricing Compliance

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Applicability of TP provisions to a PE

Often it is seen that the foreign enterprises carry out their business in India, which then lead to creation of different type of PEs, including: 

• Fixed Place PE – Created through presence of a physical location (office, branch, factory, etc.) used for business activities.
  
• Agency PE – Created where a dependent agent habitually concludes contracts on behalf of the foreign entity.
  
• Service PE – Created when employees or personnel of a foreign company provide services in India beyond a specified period (to be read as per the specific Tax Treaty).
  
• Construction PE – Created in a situation when a construction or installation project last more than a prescribed number of days (to be read as per the specific Tax Treaty).

Historically, some taxpayers contended that since the foreign company and its PE constitute the same legal entity, thereby the TP provisions should not apply to transactions involving the PE. However, the Special Bench of the Ahmedabad Tribunal in TBEA Shenyang Transformer [ITA 581/Ahd/2017] addressed this issue directly. The ruling clarified that, per Section 92F(iiia) of the Indian Income-tax Act, 1961, an “enterprise" includes a permanent establishment.

Accordingly, the issue can be considered to be broadly settled, and thus it is imperative that a PE is to be treated as a separate taxable entity for the purpose of determining the income attributable to it. Transactions between the PE and other parts of the foreign enterprise (such as the head office or other associated enterprises) must be conducted at arm's length.

Methods of Attributing Profits to a PE in India

Though a PE and the foreign enterprise are the same legal person, international tax treaties and OECD guidance advocate treating the PE as a distinct and separate entity for the purposes of profit attribution. This principle is also embodied in Article 7 of most DTAAs India has with Treaty partners and the same is reflected in the Authorized OECD's Approach ('AOA').

Approach 1 – Ad-hoc global formulary apportionment

In this context, it is important to highlight that as India doesn't officially follow AOA, and for the said reason generally it is observed that the tax authorities tend to apply an arbitrary profit attribution method often based on global formulary apportionment i.e. based on percentage of global profits of foreign enterprise.

This arbitrary approach has also been accepted by judicial forums on various occasions in India, in cases where the taxpayers didn't maintain a transfer pricing study report and/ or transfer pricing study report was rejected for being inadequate and/ or the taxpayers couldn't produce or didn't maintain separate books of accounts for the PE.

To illustrate further, the Indian Jurisprudence has broadly indicated profit attribution ranging from 10 per cent to 50 per cent of global profits related to Indian sales for Agency PEs, particularly where sales and marketing functions are performed in India. 

Approach 2 - Functional analysis and application of TP Principles (FAR based attribution)

As an alternative to the above approach, and something which is more globally aligned, this alternative approach involves attributing profits based on a functional, assets, and risks (FAR) analysis in line with TP principles. Under this method, the PE is treated as a distinct enterprise and profits are allocated based on the functions performed, assets employed, and risks assumed.

This method has also been judicially deliberated and have been approved by judicial forums in India when applied diligently by taxpayers. For instance, a recent judgment by the Mumbai Tribunal in the case of Fincantieri SPA [supra] reaffirmed the validity of a FAR based profit attribution. Additionally, the landmark Supreme Court decision in Morgan Stanley [292 ITR 416] has already established certain principles that when an associated enterprise constituting a PE is remunerated at arm's length for its functions, there may be no further income to attribute to the PE. Similar positions have been upheld in other judgments, including SET Satellite (Bombay High Court) and Daikin Industries (Delhi Tribunal), reinforcing the importance of functional analysis and robust TP documentation. 

Way forward​

To mitigate the risk of arbitrary profit attribution and associated tax penalties, taxpayers with Indian PEs should ideally adopt the following best practices: 

• Conduct a comprehensive FAR analysis documenting the roles and involvement of the foreign enterprise (head office) and Indian PE across all business activities.
• Maintain supporting documentation and evidence to substantiate the above mentioned FAR analysis.
• Undertake a benchmarking study using public databases to determine arm's length compensation for the PE's functions/ activities.
• Maintain separate books of accounts for the PE, appropriately recording cost allocations and arm's length revenues.
• Undertake compliance with Indian TP regulations like filing of Form 3CEB, maintaining TP documentation (Local File)  and Master File related filings.

Thus, following these practices, taxpayers can present a defensible position before tax authorities and higher appellate forums, thereby minimizing the risk of income being attributed on an ad hoc basis.