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Does India’s proposals on attribution of profits to PEs solve the issue?

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Suchint Majmudar and Mudigonda Vishweshwar of Deloitte India discuss India’s proposed amendments on the attribution of profits to permanent establishments (PEs) of non-resident enterprises, and provide their observations.

India’s Central Board of Direct Taxes (CBDT) on April 18 issued a draft report on the attribution of profits to permanent establishments (PEs) of non-resident enterprises in India. The report proposes changes to India’s rules in this area and invites public comments to be submitted electronically by May 18.

The report’s theme seems to revolve around the ideology reflected in this passage cited in the report:

“The oranges upon the trees in California are not acquired wealth until they are picked, and not even at that stage until they are packed, and not even at that stage until they are transported to the place where demand exists and until they are put where the consumer can use them.” - League of Nations Document E.F.S.73.F.19 Economic and Fiscal Commission, Report on Double Taxation, 1923.


When a jurisdiction taxes profits to the extent of its contribution, while avoiding double taxation, the ‘virtuous’ cycle of taxation can operate in the globalised economy. The rules for the attribution of profit are a fundamental feature of the international tax system. Over time, there have been significant developments and controversies around the attribution of profits to PEs, and more fundamentally, the transfer pricing (TP) aspects of that attribution.

TP and profit attribution are intricately linked with the issue of taxing the profits of foreign enterprises. Profit is a function of the quantum of sales, price, and cost of goods. Cost works on the supply side, while price and quantum of sales depend on the interaction of demand and supply. Hence, both the demand and supply sides play an important role in generating an enterprise’s profits.

Until 2010, the OECD and UN model tax treaties treated profit attribution under Article 7 (business profits) and allowed sales to be taken into account, both in the direct accounting method as well as in the indirect apportionment method. However, the revised Article 7 in the 2010 update of the OECD model tax treaty (which was based on the OECD’s 2008 report on the attribution of profits) approximated profit attribution with TP and omitted the option of apportionment, thereby ostensibly undermining sales and contributions made by market jurisdictions toward the profits of an enterprise. Article 7 was modified to the extent of taking away the formulary apportionment option and inserting the condition that profits should be attributed using a functions, assets, and risks (FAR) analysis considering the arm’s length principles under TP regulations.

Before 2010, Article 7 had remained largely unchanged since the introduction of the OECD model tax treaty in 1963, and a large number of treaties retain the earlier version of this article in the OECD or UN model tax treaty versions, both of which allow formulary apportionment, and do not impose a FAR-based approach. Hence, generally, three standard versions of Article 7 exist today – the pre-2010 and the 2010 versions of Article 7 in the OECD model tax treaty and the Article 7 version of the UN model tax treaty.

The UN model treaty provides relatively greater taxation rights to the source country in the form of force of attraction rules and restrictions on deduction of certain expenses. Apart from these differences, this article in the two model treaties was somewhat similar until the OECD 2008 report, and sought to tax only those profits of the PE that it would be expected to make if it were considered an independent and separate entity. This would normally be achieved by maintaining separate accounts for the permanent establishment (separate accounting or direct method). However, in the absence of separate accounts, both conventions provided in paragraph 4 for attribution of profits by way of apportionment as may be customary in the pertinent state (fractional apportionment or indirect method).

India has strongly dissented from the FAR-based approach, considering the lack of economic justification and the potential adverse consequences to India, a net importer of capital and technology, with a large talent pool and a high consumption capacity. Given its strong disapproval, this approach was neither accepted in Indian tax treaties nor adopted in its domestic law.

Indian tax treaties, domestic law (Rule 10 of the Indian Income Tax Rules), and several court decisions (such as eFunds Corporation v ADIT [(2010) 42 SOT 165 (Del)] and Convergys Customer Management Group Inc v ADIT [2013-TII-88-ITAT-DEL-INTL]) have affirmed and upheld the apportionment method as permissible. However, an objective method was not prescribed in the existing scheme. Therefore, wide discretion was accorded to the assessing officers and thereby different methodologies seem to have been adopted in different cases, leading to litigation due to uncertainty.

Recognising the significance of issues regarding the attribution of profits to a PE, as well as the need to bring greater clarity and predictability in the applicable tax regime, the CBDT recently issued its report on the attribution of profits to PEs, inviting stakeholders to comment.

The proposal

The report is an exhaustive draft that provides insights into the economic basis for the allocation of taxing rights in respect of business profits by looking at how economies contribute to business profits of multinational enterprises. It also documents various international practices for profit attribution.

The report recommends the use of the fractional apportionment method for profit attribution, which is a method permissible under paragraph 4 of Article 7 of tax treaties and Rule 10 of the India Income Tax Rules. The fractional apportionment method differs from formulary apportionment (which is followed by the US states and has been proposed by the EU) in that it does not necessitate consolidation of profits of the enterprise from different tax jurisdictions, and can be determined by considering only those profits that have been derived by the enterprise in India, and thereafter apportioning them on the basis of certain factors.

In essence, the formulary apportionment method allocates profits from intra-firm transactions on the basis of a formula that reflects contributions made by each sub-unit (group member) to the overall profit of the corporation (MNE group).

The report suggests a "three-factor" method to attribute profits, as discussed below.

Three-factor approach

The report proposes a formula-driven methodology for profit attribution in India that gives weight to three factors:

  1. Sales

  2. Manpower (employees and wages); and

  3. Assets.

In a way, this three-factor approach takes into account both demand and supply-side factors that contribute to the profits of the enterprise. The possible reasons for including these three factors in the formula may be:

  • The sales factor could capture high consumption in India;

  • The manpower factor (i.e. the product of the number of employees and their wages) could capture the large, cost-effective talent pool available in India; and

  • The asset factor could balance the formula, as most Indian operations follow contractual business models that have a weak assets base.

The report suggests assigning equal weight to all the factors and highlights that international practices (as embodied by the European Union’s common consolidated corporate tax base proposal) and tax literature support the assignment of equal weight to each of the factors.

The committee recommended adopting the following formula to determine the profits derived from India:

Profits attributable to operations in India = Profits derived from India x [India Sales/3xGlobal sales+ (Indian employees/6xGlobal employees) + (Indian wages/6xGlobal wages) + (Indian assets/3xGlobal assets)]

Further, the report suggested the inclusion of a fourth factor (users) in the formula in the case of digital businesses, in light of the “significant economic presence” concept legislated by India for digital businesses.

Separately, the committee endorsed assigning a relatively lower weight of 10% to users in low and medium user intensity models, and 20% in high user intensity models at this stage, with the corresponding reduction in the weight of employees and assets, except that sales are assigned 30% weight in apportionment in both fact patterns.

Calculating profits derived from Indian operations

In the absence of separate accounts of Indian operations for calculating profits derived therefrom, the report recommended determining such profit by applying the global profit margin on the revenue generated from customers in India.

Profits derived from India = Revenue derived from India x global operational profit margin

The global operational profit margin is the earnings before interest, taxes, depreciation and amortisation (EBITDA) margin.

Further, a floor rate of 2% of the gross revenue or turnover derived from India operations is deemed as “profits derived from India”, in cases in which an enterprise has global losses or a global operational profit margin of less than 2% and has operations in India.

Step-by-step mechanism to implement proposed model

The committee’s recommendation would be implemented by following these steps:

  1. Determining the profits derived from the Indian operations of the enterprise;

  2. Apportioning the profits from Indian operations of the enterprise on the basis of the three/four factors mentioned above, depending on the business model; and

  3. Deducting profits from Indian operations of the enterprise that may have already been taxed in India.

Illustration on how profit attribution would work under the proposed approach







 1 million





 10 million



2 million 






 Weight as per the proposed approach





 Total percentage attribution under the proposed three-factor approach


 Total percentage attribution as per judicial precedents

26% to 50%


An analysis of pertinent case laws indicate that the courts have upheld the application of the apportionment method, which is permissible under Indian tax treaties and Indian rules. However, the courts have not insisted on a universal and consistent approach for the apportionment of profits.

In most court decisions, ad hoc percentages ranging from 26% to 50% of the profits derived from Indian sales are attributed to activities undertaken by the enterprise through a PE in India. If profits were to be attributed using the proposed three-factor approach, the enterprises that have a lower proportion of these factors would as a result be attributed lower profits than under the courts’ decisions.

Therefore, from an Indian perspective, the enterprises in India that contribute heavily through their supply side (manpower and assets) and demand side (sales) activities in India would likely see a higher share of their profits attributed to their operations in India, and consequently would pay higher taxes.

In the case of digital enterprises that undertake activities through a digital platform, the attribution of profits using the method recommended by the committee would almost always result in a higher attribution of profits to the Indian entity than in the case of non-digital companies because of the addition of the fourth factor in profit attribution (10% or 20% of weight based on user intensity – these ratios are constant).

While the committee deliberated on the significance of digitalisation and the role of users in value creation and profit of an enterprise, the report does not define the term “users” and the threshold of users for including them in the formula. Rather, it discusses only the various kinds of users (active and passive, depending on the level of participation) and assigns two weights depending on the level of intensity.

Disengaging from the FAR-based apportionment and yet hanging on to it

The report explores the option of attributing profits on the basis of supply-side factors by resorting to FAR, along with demand-side factors represented by sales. This has application in the case of a PE that comes into existence through the presence of an Indian subsidiary, which is separately taxed in India on its own income. An example of this situation would be a dependent agent PE or a service PE that comes into existence on the basis of stewardship provided by the employees of the foreign enterprise while on secondment to the Indian entity. When such a PE maintains separate accounts from which taxable profits can be determined, that would suffice. However, when the PE does not maintain separate accounts, the report recommends the following approach:

  • To the extent that the Indian subsidiary is remunerated for its contributions on an arm’s-length basis, the profits of that Indian subsidiary may be considered to represent the profits derived from the contribution of supply-side factors in India.

  • To the extent that those profits are already taxed in India (in the hands of the Indian subsidiary) they need not be included again in the PE’s profits. Thus, in such a case, where the activities of an Indian subsidiary contributing to the business of the foreign enterprise leads to the creation of a PE in India, the profits need to be attributed to the PE only in respect of demand-side factors, or sales, because the supply-side factors have already been taken into account in the taxable income of the Indian entity.

  • To the extent there are no sales in India (or if Indian sales are less than INR 1 million ($14,000)), and only the supply-side activities are carried out by the Indian subsidiary, which has been remunerated for such activities on an arm’s-length basis, using a FAR analysis, no additional profits may be subject to tax. Although this concept has been upheld by the Indian courts, this explicit recommendation should come as a welcome relief to development centres that are Indian branches of overseas entities and hence PEs in their own right.


Upon cursory review, the report’s suggested approach appears to factor in both demand- and supply-side factors by assigning weights to the factors that contribute to the business profits of the enterprise, and thereby gives rise to a valid justification of taxation of the profits to which their economies have contributed. The profits derived by the enterprise from its operations in India are defined objectively using a simple formula. Accordingly, the subjectivity of the existing scheme and the resulting litigation are intended to be mitigated once the recommendations find their way into legislation. At its core, the committee has only sought to improve on the existing Rule 10, rather than exorcising a rule that has outlived its utility.

However, the following points merit consideration in adoption of the suggested approach:

  1. When a taxpayer has access to an income tax treaty with India, most treaties mandate the attribution of income to a PE on the basis that the PE is a “single, distinct and separate” enterprise (Article 7(2)). However, the treaty further states that nothing in paragraph 7(2) will preclude attribution to a PE based on a country’s customary approach (Article 7(4)) and the result of such apportionment is in conformity with the principle of Article 7. In India, whether this customary approach is the apportionment-based Rule 10 or whether it is the arm's-length principle (after the introduction of TP provisions in the Income Tax Act in 2001 (along with CBDT Circular No. 14 of 2001 and Circular No. 5 of 2004) is a matter of debate that requires careful consideration.

  2. The fractional apportionment method will not produce an allocation of profits that would be the same as that under separate accounting and arm’s-length pricing. Such a method tends to disregard market conditions as well as particular circumstances of the individual enterprises, and ignores management’s own allocation of resources, thus producing an allocation of profits that may bear no sound correlation to economic facts. Inherently, it runs the risk of allocating profits to an entity that in reality is making losses based on what third parties would realistically do in similar circumstances.

  3.  The enterprise’s global operational profit margin may not always be commensurate with the functions and risks attributable to the PE, and would therefore lead to an imbalanced attribution of profits.

  4. The report does not provide any reasoning or impact analysis for assigning equal weight to all the factors.

  5. Given that manpower is one of the factors in the proposed apportionment formula, the scope of the definition reasonably would extend to include contract workforce as well, but the report does not address this issue.

  6. The report’s approach completely ignores intangible property, which is often the crown jewel of some enterprises, especially in the technology and pharmaceutical sectors. Accordingly, intangible property will not have any impact on profit attribution. This might be because fair value for self-generated intangibles is not being recognised. Because ownership of intangible property is not a significant factor in India, such an exclusion may be seen as deliberate.

  7. The proposed formula cannot adequately address the movement of exchange rates.

  8. The multiplicity of taxes in the digital context, particularly owing to withholding on royalty payments, the equalisation levy and significant economic presence (SEP) can lead to multiple taxation with no credits available because the bases are different under each levy (gross in case of withholding tax and the equalisation levy, net in the case of SEP).

  9. The transition to the suggested approach would present enormous political and administrative complexity and require a level of international consensus that is unrealistic in the field of international taxation. Further, apportionment does not provide a complete solution to the allocation of profits of an MNE group unless it is applied to the whole enterprise. That in turn would render this a unilateral measure, prone to causing double taxation, and the likely disagreements destined to eventual resolution under the mutual agreement procedure (MAP) of tax treaties.

As an alternative, the proposed formula-based method could be, at most, applied selectively and used alongside a FAR-based approach based on the arm’s-length principle. The proposed formula would be resorted to only when the traditional transfer pricing methods are unsatisfactory.

Another possible solution would be to allocate taxing rights to routine profits to countries in which functions and activities take place, and allocate the right to tax the residual profit to the market or destination country where sales to third parties take place. This approach would use TP methods to achieve an arm’s-length outcome and then reap the benefit of the unitary approach when they do not (i.e. for allocation of residual profit). This would be similar to the proposal regarding marketing intangibles the OECD has put forward in the context of the digital economy, and is intended to move from a FAR to a FARM approach that would add a market component to the FAR analysis. Thus, the market state shall also obtain the right to tax part of the profit linked to sales in the other state that represents a more inclusive nexus orientation.

Way forward

Profit attribution has always been a problematic issue, and it has been litigated in several forums. The CBDT’s publication of the report for public consultation is a welcome move, and it allows the government to test the waters as to the public’s receptiveness. It remains to be seen what changes the CBDT makes to its recommendation after comments from the various stakeholders are reviewed now that the consultation period has ended. However, we would suggest that the formulary methodology be once and for all abandoned in favour of a realistically available alternative methodology to align transfer pricing and profit attribution principles.

This article was written by Suchint Majmudar and Vishweshwar Mudigonda of Deloitte India. 

Phil Fortier - Portrait

Suchint Majmudar


Mudigonda Vishweshwar_DeloitteIndia

Vishweshwar Mudigonda

Suchint Majmudar, Partner
Deloitte India

Vishweshwar Mudigonda, Partner
Deloitte India

© 2019. For information, contact Deloitte Touche Tohmatsu Limited. This communication contains general information only, and none of Deloitte Touche Tohmatsu Limited, its member firms or their related entities (collectively, the “Deloitte network”) is, by means of this communication, rendering professional advice or services. Before making any decision or taking any action that may affect your finances or your business, you should consult a qualified professional adviser. No entity in the Deloitte network shall be responsible for any loss whatsoever sustained by any person who relies on this communication.

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