Indian Government drafts proposals for attribution of profits to permanent establishments (PEs) in India – Focus on India’s demand/market and deviation from TP principles

Prateek goyalThe attribution of profits to permanent establishment (PE) is one of the most litigated aspects of international tax in India. The Central Board of Direct Taxes (CBDT) had formed a committee to examine the existing scheme of profit attribution to PE and recommended changes.

The committee’s draft report has been released by the CBDT[1] and public comments on the report can be sent electronically till 18 May 2019 to the CBDT at

This blog makes an attempt to provide a brief overview of the draft proposals, rationale, views or opinions of the committee as provided in the draft report and some of the key observations and thoughts of the author.

A. Overview/key highlights of draft proposal

  1. With respect to the CBDT’s recently released draft proposal for providing PE attribution methodology, the most important and fundamental change is the deviation from Organisation for Economic Co-operation and Development (OECD) authorized approach [i.e., application of functional, assets and risk (FAR) based transfer pricing (TP) analysis] to a new methodology called as “fractional apportionment” to attribute profits to PE.
  2. This deviation is primarily on account of the opinion of the committee that FAR/TP principles do not account for supply side or market related factors in a country like India, where market or demand plays an important role in deriving profits.
  3. This proposed methodology of fractional apportionment provides that profits attributable to a PE will be arrived through an ad-hoc apportionment of profits derived from India, based on three factors, namely, sales, manpower (further bifurcated equally between number of employees and wages) and assets, each carrying an equal weightage.
  4. Sales represents demand/market. Manpower and assets (represent supply, including marketing activities). This approach is fairly similar (but with some modifications) to approach being discussed by European Union (EU) referred as Common Consolidated Corporate Tax Base (CCCTB) approach.
  5. However, in case of attribution to digital businesses or a significant economic presence, where business connection is primarily constituted by the existence of users beyond a prescribed threshold, the committee opined that an additional 4th factor should be considered. The committee believes that the users play an important role in any digital business model, and their contributions can be a substitute to either assets or employees, because users may supplement their role in contributing to profits of an enterprise.
  6. The committee recommended that in case of low and medium user intensity business models, 10% weightage shall be assigned to users and 30% to rest of the three factors. However, in case of high user intensity digital models, users shall be assigned a weightage of 20% and 25% to assets and employees, respectively, and 30% to sales.
  7. The proposed draft is silent on defining the low/medium or high user intensity and how it will be measured. It seems that it may be prescribed later, but the report on page 73 to 75 gives reference to 2018 OECD report on “tax challenges from digitization” and refers to a diagram that suggests that manufacturing and cloud computing businesses could probably have low intensity users; while e-commerce businesses may have medium user intensity. Collaborative consumption and social network businesses may also have high user intensity.
  8. I feel that these weights in so-called fractional apportionment are mechanical/standard and may not necessarily reflect the actual relative economic value addition/contribution.
  9. It will be interesting to see how will the intangible be covered in calculation of assets, especially the self-generated intangible property (IP).
  10. Further, to determine the profits derived from India, the committee recommends multiplying the revenues derived from India, with the actual global operational profit margin, but in case, global losses or profit margin turn out to be less than 2%, the committee recommends a deemed profit margin of 2%. This does not seem logical. This would basically mean taxing notional income whereas the real income is a loss. It may also go against the basic principle of taxation.
  11. Having said the above, the committee proposes to provide some relief as well. In case a business connection is due to the activities of a resident associate enterprise (AE) and the AE receives arm’s length payments of up to 10 lakhs, the committee said that in such a case, there will be no further attribution. However, in case payments exceed 10 lakhs, then profit attributable to the Indian operation will be derived by fractional apportionment but reduced by profits that have already been subjected to tax in the hands of the resident AE.
  12. Further, the committee also provides that the profits derived from Indian operations that have already been subjected to tax within India in the hands of a subsidiary should be deducted from the apportioned profits.
  13. The draft report also mentions that in cases where sales do not take place in India, and the profits that can be apportioned to the supply activities are already taxed in the hands of an Indian subsidiary, there may be no further taxes payable by the enterprise.
  14. The report also captures the views of academicians, experts and courts rulings, and it is claimed that these views also support the draft proposal.
  15. In terms of how these changes will be reflected in law, the report states that these amendments will either be through rules, possibly in Rule 10 or in the Indian Income Tax Act itself.

B. Rationale, views or opinion of committee as provided in the draft report

  1. The draft proposal essentially means that the committee believes that authorized OECD approach (AOA) or TP and arm’s length principles do not capture the contribution of a jurisdiction like India i.e., demand or market side factors.
  2. The committee believes that while AOA may be favorable to the interests of certain countries which are net exporters of capital and technology, it is likely to have a significant adverse impact on developing economies like India, which are primarily the importers of capital and technology.
  3. The report states that draft proposals are based on the premise that profits are contributed by demand also in a jurisdiction, in addition to supply. By contribution towards demand means the contribution in terms of facilitating the economy, ability of their residents to pay, maintenance of the markets that enables the sales, etc. Hence, given the contribution towards demand and supply, taxation of a PE in that jurisdiction should also be done in a mixed way as contributed by that jurisdiction i.e., considering both demand and supply side factors.
  4. The committee believes that the revised Article 7 of OECD model tax convention in 2010 and its clarified FAR analysis-based attribution through TP principles, have not been incorporated in Indian tax treaties and therefore, the additional guidance issued by the OECD with reference to AOA approach does not apply to India’s tax treaties.
  5. The committee also believes that one of the primary implications of the revisions introduced in Article 7 of the OECD model tax convention (MTC) and the adoption of AOA approach (which we believe was merely clarification in substance) for profit attribution, excluding the option of apportionment, was that, in cases where business profits could not be readily determined, on the basis of accounts, the same were required to be determined by taking into account FAR. However, in the committee’s view, such an approach completely ignores the sale receipts derived from the source tax jurisdiction, i.e., India. The committee opined that it’s a major deviation from the generally applicable accounting standards for determining business profits, where business profits cannot be determined without taking “sales” into account.
  6. Further, India has consistently communicated and shared its view that since business profits are dependent on the sales revenue and costs, and since the sale revenue depends on both demand and supply, it is not appropriate to attribute profits exclusively on the basis of FAR. 

    C. Key observations and thoughts on draft proposal

  7. The proposed change seems to completely discard TP principles by replacing the economic concept of value creation/contribution, with the mechanical definition of business profits, in order to build a case for demand side factors for attributing profits, even if FAR does not exists to create that demand. This may result in unfair treatment to taxpayers. For example:
    • If a company sets up a subsidiary to do business viz.-à-viz. a branch, the taxable profits according to proposed law, would be different. This may not make economic logic and may not be fair.
    • Also, where the FAR and development, enhancement, maintenance, protection and exploitation (DEMPE) analysis support a simple cost-plus mark-up or net margin analysis, a compulsory fractional apportionment like a profit split method approach may not be fair.
  8. To respectfully counter CBDT’s argument that FAR and current TP principles do not capture demand side factors, we wish to highlight that profits of comparable companies may cover the sales side factors and/or any location savings. Also, any unique contribution towards market in India, can be evaluated and addressed through profit split method. Hence, it is unfair to say that FAR analysis and TP law in India does not address the demand/market side factors.
  9. The concern is that the proposed methodology may result in double taxation if the residence country of the taxpayer does not consider the approach to be consistent with the tax treaty. There will need to check how the dispute resolution of such cases will work in MAP. The APAs anyway seems to be out of picture, given the proposed law.
  10. As far as the viewpoint of the committee with respect to Article 7 is concerned, it is believed that common wordings of Article 7 of the OECD model tax convention before 2010; and also that of the UN; along with Indian model tax treaties clearly provide that profits, for the purposes of attributing to the PE, would be those, which a PE might be expected to make if it was 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.
  11. Now, determination of such profits under the hypothesis of a PE being a distinct and separate enterprise, dealing wholly independently with the enterprise of which it is a PE, is nothing but adhering to arm’s length principles under TP, i.e., analyzing as to how third-parties would have dealt in uncontrolled conditions, being the very fundamental concept of TP.
  12. This also supported the revised commentary to Article 7 of the OECD MTC. The OECD stated that the separate entity or arm’s length principles were already there in the pre-2010 OECD MC; and that OECD considered to only clarify those principles that had slight modifications.
  13. It is believed that the concept of arm’s length principle under TP, for the purposes of attribution of profits to PEs, was merely made explicit, in the revised version of Article 7 of the OECD MC, i.e., post 2010, while it already remained implicitly there in the earlier version of Article 7 of the OECD, i.e., before 2010, which matches with both the UN and Indian model tax treaties.
  14. Further, section 92F(iiia) also recognizes PE as an enterprise for the purpose of subjecting the same to the provisions of TP. Therefore, the Indian TP law India itself acknowledges the applicability of arm’s length principles under TP to PEs of the foreign enterprises. The report is silent on why the committee has discarded the same.
  15. This is also supported by the fact the APA frequently asked questions (FAQs) released by the CBDT also stated that PE attribution cases will be covered by APA, although lately CBDT started giving a different impression that FAQs need further clarification and arm’s length price may not necessarily mean no further attribution.
  16. Unfortunately, given the consistent stand of Indian authorities and the recent CBDT report, it seems that the report may not be completely discarded, despite representations. One can only hope that a middle path is found to blend the principles of TP/FAR analysis with the supply/market side factors, and India does not end up doing something domestically which overrides tax treaties and creates double taxation for MNCs operating in India.
  17. Groups with business operations in India should review the implications of the recommendations on their business models as well consider any risk of double taxation. It is important for companies to continue to monitor the developments in this area and to consider an active engagement with policymakers.


The author of the blog is Prateek Goyal, Senior Manager – International Tax and Transfer Pricing Services at EY India

(Views are personal)