India: Draft guidelines on attribution of profits to PE


​published on June 18, 2019 | reading time approx. 10 minutes


“In levying taxes and in shearing sheep, it is well to stop when you get down to the skin” (Austin O’Malley). Income of a foreign enterprise from activities in India would be subject to Indian Income Tax, if it has a Business Connection under the Income-Tax Act, 1961 (“ITA”)/Permanent Establish­ment (“PE”) in India under the respective Double Taxation Avoidance Agreement (“DTAA”). Identifi­cation/formation of PE as well as attribution of reasonable profits to the PE has been a grey area and under substantial litigation between the taxpayers and tax authorities in India as well as throughout the globe.



With the proclaimed aim to achieve certainty, consistency and predictability in respect of attribution of profits under the domestic law, the Central Board of Direct Taxes (“CBDT”) set up a Committee to analyze the existing scheme of profit attribution under Article 7 of DTAA, to examine contribution of demand and supply side factors in profit attribution and recommend changes in Rule 10 of the Income Tax Rules,1962 (“Rules”) to provide for specific guidance on profit attribution so as to reduce discretion to the Assessing Officer (“AO”).



Business Connection:

Under section 9 ITA, all income accruing or arising whether directly or indirectly to or from any business connection in India, or other income as mentioned in said section is deemed to accrue or arise in India.

The term Business Connection involves a relationship between the business of the foreign enterprise and some activity in India which contributes directly or indirectly to the earning of profits and gains by the foreign enterprise from such business in India.

Under section 5 ITA, a non-resident is liable to tax in India with respect to (i) income which is received or is deemed to be received in India by or on behalf of such non-resident; and (ii) income which accrues or arises or is deemed to accrue or arise in India.


Permanent Establishment (“PE”):

The concept of PE which is similar to Business Connection (subject to some aberration) is also there in the DTAA entered into by the India. Article 5 of the DTAA of the OECD Model Convention provides that a PE can be created in India for several reasons inter-alia including,



  • Article 7(2) of the DTAA provides for attribution of so much profits to the country in which PE constituted, if PE would have made as if it is 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 PE. Generally, under this article, attribution of profits to PE is to be made on the basis of accounts of the PE (i.e. Direct Accounting Method).
  • In case the determination of the profits to be attributed to PE is not possible under Article 7(2) or it gives rise to unreasonable difficulties, Article 7(4) of the DTAA provides that the attribution can be done by resorting to method customary in the contracting state either by means of either apportioning the total profits of the enterprise to that PE or estimating on any other reasonable basis. This method is similar to Indirect Apportionment method as provided by Rule 10 of the domestic Rule

DTAAs signed by India generally follow the characteristics of the OECD Model tax convention with some variations towards the UN Model Tax Convention which tends to give more taxing rights to developing countries. In 2010, the OECD revised Article 7 of the model convention and the commentary hereto and according to such revision the profit attributable to the PE is required to be determined taking into account Functions, Assets and Risk (“FAR”) of the PE and the option of determining such profit by way of apportionment has been excluded.

India raised reservation on the so-called Authorized OECD Approach (“AOA”) and does not apply it like most other countries do not. The CBDT now emphasized that the profit of an enterprise was made up of its costs (representing supply side factors) and its sales (representing demand side factors). However, as per the CBDT adopting FAR analysis for attribution of profits would only take care of the supply side functions of the supply chain and would not consider demand side factors such as market, demand, customer.


Summary of court rulings on attribution of profits to PE

The Committee has analyzed more than 20 judgements in India on profit attribution to PE which broadly laid down following principles:
  • Though India has raised its objection to the AOA, Indian judiciary including the Supreme Court of India has accepted FAR based approach for attribution of profit to PE.
  • Where the FAR is not correctly captured in TP studies, Indian courts tend to allocate extra profits to PEs under an estimate approach based on functions performed in India:


In the conclusion of this analysis, the CBDT  states that the lack of a universal rule would create uncertainties for taxpayers as well as result in more tax disputes and accepts need for providing a simple and universally applicable rule to bring in greater certainty and predictability among the stakeholders and prevent avoidable tax litigation on the issue of attribution of profits to PE.


View of academicians and economists

After discussing views of Prof. Klaus Vogel, Peggy Musgrave, Prof Joseph Stiglitz, Reuven S. Avi-Yonah, Dr. Ulrich Schreiber and several other authors, the Committee has concluded that sales representing demand side factor is valid ground for profit attribution. It also observes that there is no consensus of experts on Authorized OCED approach on profit attribution as it only considers supply chain factors for profit attribution ignoring demand side factors.


The Committee has examined the jurisprudence prevailing in various countries on the topic of profit attribution to PE, which can be summarized as under:



Based on the above analysis, the Committee observes that broadly there are three approaches namely (i) supply approach which allocates profits exclusively to the jurisdiction where supply chain and activities are located; (ii) demand approach which allocates profits exclusively to the market jurisdiction where the sales take place; and (iii) mixed approach which allocates profits partly to the jurisdiction where the consumers are located and partly to the jurisdiction where supply activities are undertaken. It further notes that Mixed approach appears to be most commonly used in the international practices.


Various options considered by the committee for attribution of profit

After noting that existing Rule 10 gives wide discretion to the AO, Committee discusses following approaches:


  • Formulary apportionment:

This option involves attribution of consolidated profit of MNC based on three factors namely sales, manpower and assets giving equal weightage (i.e. 33 per cent). However, there is a limitation on availability of country wise information pertaining to sales, assets and manpower. It also notes that Country-by-Country (“CbC”) reporting is only applicable to MNCs having high turnover and hence, smaller turnover cases cannot be catered through it.


  •  Fractional apportionment:

In this option, though equal weightage (i.e. 33 per cent) is assigned to sales, manpower and assets, it restricts its application to data pertaining to India specific operations and negates necessity of having consolidated global turnover and profit data. Committee finds considerable merit in this approach.


  • Demand and supply based approach:

The Committee notes that in cases where PE is created due to existence of subsidiary in India, supply side is taken care of in the taxation of Indian entity and further tested on arm's length principle. In such case, additional profit to be attributed based on sales can be determined by assigning it 33 per cent weightage. The same result can be achieved through computing total profits from Indian operation and deducting therefrom profits already taxed in the hands of Indian subsidiary. Thus, as per Committee in cases where PE arises due to existence of subsidiary, a minimum of 33 per cent of the profits derived from sales in India will invariably be attributable to the PE on the basis of sales.


Proposed formula for attribution of profit to PE

Having discussed law, economic factors, case laws and international practice etc., the Committee has recommended following:


1. In ase where the direct accounting method is used by the PE and accepted by the AO, profit attribution to PE would continue in accordance with the books of accounts maintained by the PE (as per domestic law/Article 7(2) of DTAA).


2. However, in cases where indirect apportionment method is required to be used under Rule 10 of the Rule or Article 7(4) of the DTAA, the Committee has proposed a formula based on mixed approach considering demand as well as supply side factors as follow:


a) After analysis of various possible approaches, the Committee has leaned in favor of Fractional Apportionment approach for attribution of profits to PE as follow:


Profits attributable to operations in India = Profits derived from India x [(SI/3xST) + (NI/6xNT) + (WI/6xWT) + (AI/3xAT)]




Profits derived from India = Revenue derived from India x Global operational profit margin (EBITDA)
SI = sales revenue derived by Indian operations from sales in India
ST = total sales revenue derived by Indian operations from sales in India and outside India
NI =number of employees employed with respect to Indian operations and located in India
NT = total number of employees employed with respect to Indian operations and located in India and outside India
WI= wages paid to employees employed with respect to Indian operations and located in India
WT = total wages paid to employees employed with respect to Indian operations and located in India and outside India
AI = assets deployed for Indian operations and located in India
AT = total assets deployed for Indian operations and located in India and outside India


To explain practical application of the above formula, let’s consider following hypothetical example.


  • F. Co. is full-fledged manufacturer of goods and has entered into agreement with I Co., a third-party agent, for carrying out marketing and sales support activities;
  • Mutually agreed remuneration for I Co. was 2 per cent commission over sales;
  • However, I Co. played principal role in concluding the contracts with the Indian Customers and hence, constituted Dependent Agent PE.

Attribution of profits to DAPE based on the above facts using formula proposed by the Committee can be determined as follow:


Step – 1: Profits derived from India (INR in MN)


Step – 2: Computation of weightage





  • The Committee has further proposed that in case foreign enterprise has a Subsidiary PE in India and (i) Indian Subsidiary does not receive any payments on accounts of sales or services in India [or such payments do not exceed an amount of INR 1 MN]; and (ii) the activities of that Indian Subsidiary have been fully remunerated by the foreign enterprise at arm’s length, no further profits will be attributable to the Subsidiary PE.
  • In the above case, if the Indian Subsidiary receives payment for sale or service in India exceeding INR  1 MN, the formula for attribution of profits to PE as provided in paragraph 3(a) above would be applicable. Further, from such attributable profits to PE deduction would be allowed for the profits that have already been subjected to tax in the hands of the Indian Subsidiary.


d) Exception for Business Connection having Significant Economic Presence (“SEP”):

As per Explanation 2A added to Section 9 of ITA, rules are yet to be prescribed for threshold of number of local Users/local Revenue which will establish nexus in the form of SEP and form business connection. For such cases, the committee has proposed four factor formula for attribution of profits assigning weightages to sales, employees (manpower & wages), assets and users. The users would be assigned a weight of 10 per cent in cases of low and medium user intensity, while each of the other three factors should be assigned a weight of 30 per cent. In case of digital models with high user intensity, the users would be assigned a weight of 20 per cent, while the share of assets and employees would be reduced to 25 per cent each after keeping the weight of sales as 30 per cent.


In our view, while the Committee has provided various analysis and explanations for proposing the approach for attribution to PE, however following points remains either unaddressed or unexplained and needs clarification in the final report:
  • In case of application of direct accounting method, whether income and expenditure would still have to be allocated between the head office and the PE based on the FAR assumed?


  • The formula needs greater clarification with respect to definitions of various terms such as sales, manpower, assets and users, which, are used in the denominator for quantifying the weightage. For example, in case of a DAPE, if a F Co. has centralized manufacturing facility at Germany and products are sold worldwide through agents including in India, whether total assets of F. Co which includes manufacturing assets for the globe would be considered in the denominator at AT in the formula or only assets used for manufacturing goods sold in India would be considered? In case of determining the value of assets under the later scenario, there would be considerable practical difficulty.


  • As per the report, global operational profit margin would mean EBITDA of a company. However, the question arises whether the company would mean F. Co of which PE is created in India or ultimate holding company of F Co. where the profits are globally consolidated? Practically, the margin of the foreign enterprise constituting a PE in India and not of the ultimate parent/holding company of such foreign enterprise would be appropriate to consider EBIDTA.  For e.g. If F Co., Germany is held by FA Co., Switzerland and DAPE is constituted for F Co. in India, Global Profit margin of F Co., Germany should be considered for attribution of profits to DAPE in India. Above view looks appropriate even if we consider that in above case, F Co. is only a distributor while FA Co. is a manufacturer of products sold in India. In such case substantial profits earned by F Co. from Indian operations would be attributed to DAPE in India as it is playing principal role in concluding the contracts on behalf of the distributor i.e. F Co. while FA Co. would continue to enjoy its share of manufacturing and related profits of Indian operations.


  • Whether it would be correct to assume that in case the PE in India maintains books of accounts for its Indian operations, can it continue to follow arm’s length principle approach to determine reasonableness of attribution in view of Article 7(2) of DTAA? Or even in such case demand side factors as mentioned in the formula need to be considered to determine reasonableness of profit attributable to the PE? Or to put this question in other way, whether the AO will have power to go to proposed Rule 10 read with Article 7(4) of DTAA, without rejecting book of accounts maintained by the PE as maintained under Article 7(2) of DTAA?


  • Considering such amendment to the Rule or ITA happens prospectively, whether it will have implications on open litigations i.e. whether FAR approach will be adopted by judiciary or proposed formula would be followed. Further its implications on pending cases of Advance Pricing Agreement/Mutual Agreement Procedure may undergo change.



On the one hand, it is a positive step from the Indian Government as some clarity is spelt out for the attribution to the PEs through its local tax laws, considering the divergent rulings on the matter. However, on the other hand, proposed formulary approach may lead to excessive attribution to Indian PE despite the lower functions carried out as well as assets assumed (considering criteria of “sales to India” and “sales attributed to Indian operations”), as more stress is given to demand side. Attribution of profits based on criteria of employees and assets to India would still have to be based on functions performed e.g., how can a German workman or a sales manager be split between Indian and non-Indian operations or how should the assets he is using be split? Hence, it can be said that while only FAR approach is said to be not acceptable, the discussion is shifted to another level instead of providing a simplified approach. Further, from the perspective of multinational group, India’s proposed formulary approach may lead to double taxation as similar approach would not be followed in other countries.


It is expected that the final report will clarify the ambiguities in the present draft some of which are covered in para 4 above. However, if the ambiguities are not appropriately addressed, it may also result into higher attribution and greater litigation.

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