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India’s fractional apportionment proposals are an ‘invitation to chaos’
Taxpayers are concerned that India’s proposal to introduce a fractional apportionment model could lead to double taxation and a subsequently higher number of mutual agreement procedure cases.

The Central Board of Direct Taxes (CBDT) has concluded its consultation on a proposal to move towards fractional apportionment. If
implemented, India would join the growing list of countries like France and
Italy trying to outflank the OECD on digital tax reform because the proposal is
a step up from the country’s significant economic presence (SEP) concept.
This increases the risk of double taxation and disputes for
taxpayers at the worst possible time and, therefore, any foreign multinational
with a permanent establishment (PE) in India might have to rethink its position
if the proposal is implemented.
“These [proposals] do not seem workable since they paint all
transactions with the same brush,” said Jimmy Spencer, CFO at Chemtex Group.
“They’ve not considered how different businesses operate. Each one has a
different set of parameters.”
Spencer described the proposed rules as a “fresh invitation
to chaos”.
“The international tax infrastructure in India is
ill-equipped for this,” Spencer told TP
Week. “There are too many transfer pricing legacy cases pending in the
courts.”
Fractional apportionment is different to the standard
formulary model that applies in India today because the former does not require
the global profits of multinational companies to be consolidated in order to determine
the local tax base.
Much like formulary apportionment, however, the new
allocation model will use key factors, such as sales, employees and assets, as
part of its profit attribution rules to cover both supply and demand.
The FAR controversy
Although the proposal may widen the tax net, the amendments
would keep India outside international treaty norms, thus risking double
taxation.
The OECD and the UN have designed their tax treaty models to
include the function, asset and risk (FAR) analysis as a condition for
formulary models.
However, the Indian authorities have long been sceptical of
the FAR analysis and left it out of their tax treaties, but the latest proposal
explores the possibility of using this analysis in a unique way for the
supply-side factors (employees and assets), establishing a hybrid analysis
between fractional apportionment and the FAR analysis.
“What they’ve done – because they think the OECD approach is
insufficient – is come up with their own way of attributing profit which is not
like the FAR analysis,” said Amit Maheshwari, managing partner at Ashok
Maheshwari and Associates.
“The aim is to assign equally to each of these factors, but
there will likely be a fourth factor, namely users,” Maheshwari told TP Week. “We’ll have to see if it’s
high-user intensity or low-user intensity.”
The problem is that these factors might not cover every
business model perfectly. Some fear that the implementation will lead to a
series of trial and error situations.
“Not every business model correlates with the sales,
manpower and assets model since each company has a different dynamic,” Spencer
explained. “These guidelines are a non-starter.”
“In my
forty-plus years in industry, I’ve seen overseas companies bear most of the
risk and liabilities of everything from technology licenses to operational cost
guarantees rather than pass it on to the Indian entity,” he said.
In the past, the Indian government was concerned that the
FAR analysis would work against Indian businesses because of the country’s
dependence on capital imports. The authorities hope is that the demand-side
weights (sales and users) will counteract this impact.
“It will be interesting to see how the FAR analysis of the
depreciation and amortisation would be distinguished to attribute profits
towards the dependent agent permanent establishment [DAPE] by following the
dual entity approach,” said Amit Gupta, director of tax at Dell in Singapore.
However, Gupta is concerned that the changes to profit
attribution rules are a step towards formulary apportionment in all but name.
“This could result in more MAPs under existing tax treaties to avoid double
taxation,” he said.
Any change to profit attribution rules can raise the threat
of double taxation. In the case of fractional apportionment, it may lead to
mismatches of profit allocation on cross-border operations. This could lead to
taxpayers losing their tax credits in their country of residence.
Silver lining
Although taxpayers are generally worried about the proposals
and the new issues it may create, Gupta would address the imbalance in the OECD
digital tax proposals that only takes the supply-side into account, and also “one
silver-lining” in India’s proposal.
There is an exception for cases where the company has no
sales in India and the Indian subsidiary is compensated for its losses at an
arm’s-length rate.
As such, Arvind Singal, head of tax at RBS India, alongside
Nitin Kapoor, associate director at the company, argue the new rules could help
reduce the number of disputes.
“Given the complexity around attribution of income to PEs in
India, the Indian government’s efforts to bring uniformity in the approach are
commendable,” the duo write in an article for the May/June double issue of International Tax Review.
“This will not only bring certainty but will also help to
curtail the arbitrary modes adopted by the tax authorities when attributing
income to a multinational company’s Indian PEs.”
If the proposals spell more controversy for taxpayers, the
next obvious question is how to mitigate the risk of disputes. Lengthy TP disputes are one of the biggest
challenges facing multinationals operating
in India, and the launch of the APA programme was a conscious effort to reduce the amount of controversy.
Taxpayers may engage in
APAs because they are worried about the introduction of the earnings
before interest, taxes, depreciation and amortisation (EBITDA) clause that
conflicts with arrangements based on the cost-plus method or the transactional
net margin method (TNMM).
“The APAs agreed with the Indian tax authority on either
cost-plus or TNMM may be higher than the EBITDA margins obtained by the
overseas company,” Spencer explained.
“After considering all of the above, I can’t see how the
EBITDA clause is going to be useful except for loss-making companies open to
controversy on 2% of their notional EBITDA,” Spencer said.
But the APA process has “completely
slowed down”, Spencer added.
The tax authority is likely
to struggle to fast track APA talks and prevent further disputes once
India adopts fractional apportionment.
The Indian government
has taken BEPS as its starting point and set the SEP as its own standard. It is
now moving towards a controversial apportionment model while the world searches for a clear road-map on
taxing the online economy. These rules may clear the way for new challenges for
taxpayers in India, but they might also set a problematic global precedent.
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