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Income from Business (Article 7)

Income from Business (Article 7). Vikram Vijayaraghavan, Advocate M/s Subbaraya Aiyar , Padmanabhan & RAMAMANI (SAPR) Advocates, Chennai. Agenda. Introduction to Article 7 The Model Conventions & Article 7 Article 7 in the MCs – A Deep Dive

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Income from Business (Article 7)

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  1. Income from Business(Article 7) Vikram Vijayaraghavan, Advocate M/s SubbarayaAiyar, Padmanabhan & RAMAMANI (SAPR) Advocates, Chennai

  2. Agenda • Introduction to Article 7 • The Model Conventions & Article 7 • Article 7 in the MCs – A Deep Dive • The Basic Rule (Article 7(1)) [with FoA & case studies] • PE - Computation Hypothesis (Article 7(2)) • PE – Computation of profits attributable (Article 7(3) and beyond) • Model Commentary on computation of profits attributable to PE • India’s DTAAs: Rubber hits the road! • An Example Indian DTAA’s Article 7 • Indian DTAA’s & Article 7 : Points to Note • Indian Income Tax Act & Attribution of profits to PE • S.9(1)(i), Explanation 1(a), Rule 10, Sec. 44C • Indian cases – Attribution to PE • Interplay between Article 7 and other Articles • Summary

  3. Introduction to Article 7

  4. Article 7 : Income from businessThe bulwark of a DTAA • An important Article which is the cornerstone of every DTAA - business profits is the engine driving most enterprises today. • This Article allocates taxing rights with respect to business profits of a Contracting State to the extent that these profits are not subject to different rules under other Articles of the Treaty. • Incorporates basic principle that unless an enterprise of a Contracting State has a Permanent Establishment situated in the other state, the business profits of that enterprise may not be taxed by that other State • This Article does not intend to trample upon other kinds of income such as dividends, immovable property rent etc.

  5. Introduction to Article 7 • Typically, where income is earned is called Source State and where the person who receives it is normally based is called Residence State • Bottomline: It’s a Source vs. Residence country power struggle i.e., “Where is my portion of the tax pie?” • Residence country typically has the right to tax the business profits subject to attribution of said profits to PE in Source State (Article 7 r.w. Article 5) : A logical proposition but the devil is in the details! Residence State? Source State?

  6. The Model Conventions & Article 7

  7. The Model Conventions & Article 7 • The 3 major Model Conventions – the OECD, the UN and the US - have a checkered history on Article 7. • It has evolved over time as globalization has rapidly increased • Prior to OECD 2010 MC, the OECD and UN/US differed always on the Force of Attraction concept; however other things were more or less on the same lines • Since the 2010 OECD MC, there is a divergence in the attribution of profits to PE with OECD very strongly advocating separate entity approach to arrive at ALP using only TP analysis : a marriage of Article 7 and 9 by OECD? • So we really need to study 5 combinations! • OECD MC 2008, OECD MC 2014 • UN MC 2011 • US MC 1996, US MC 2006

  8. Article 7 in the MC’s – A deep dive

  9. OECD Model ConventionThe Basic Rule - Article 7(1)

  10. UN Model ConventionThe Basic Rule - Article 7(1)

  11. US Model ConventionThe Basic Rule - Article 7(1)

  12. Article 7(1) Underlying principle • The principle which underlies Paragraph 1 has a long history and reflects international consensus that, as a general rule, until an enterprise as a State has a PE in another State, it should not be regarded as participating in the economic life of the other State to such an extent that the other State has taxing rights on its profits • Many types of PE’s possible (agency PE, supervisory PE, service PE etc.) • Exclusions to PE are usually when the operations in other State are in the nature of ancillary or preparatory activities (or) use of storage facility solely for delivery of goods (or) purchasing or info gathering activities (or) stock of goods maintenance for processing by another enterprise etc.

  13. Article 7(1)Escaping the Source Axe! • Two possibilities to escape source taxation prima facie #1 “….carries on business in the other Contracting State….” (lets attack the fundamentals!) #2 Carries on business in the other Contracting State but there is no PE there (Indian taxpayer’s usual refrain!)

  14. Article 7(1) Absence of “business” • Interesting Belgium case of Sogetra S.A.C.Etat Belge (1974) • Belgian company entered into JV with Dutch company to carry out harbour work in Netherlands; another Belgian company was brought in to raise finance which merely lent money and agreed to share of profit. • Lender argued that interest paid on loan was derived from PE and was therefore taxable only in The Netherlands. Cour de Cassation rejected this as the lender did not carry on business from a PE in The Netherlands • Transvaal Associated Hide & Skin Merchants (Pty) Ltd vs Collector of Taxes, Botswana (SATC 97) • Whether purchase of hides from abattoirs in Botswana and their preparation for sale and delivery constituted a business. Maisels J.A.’s referred to a dictum: “Anything which occupies the time and attention and labour of man for the purpose of profit is business”

  15. Article 7(1) Presence of business…Absence of PE • Payment to Singapore companies for letting out cranes to Malaysian company – no PE in Malaysia and not Roaylty – hence “business profits”– Walter Wright (Singapore) Pte Ltd vs. DGIR (3 M.L.J 186) • Per diem payment to Canadian owners of rail road freight cars for period of time those cars were used in US tracks classified as “rental income” and not “industrial and commercial profits” US Revenue Ruling 73-278 • Fees paid to French company for engineering services, the supply of machinery, erection and commissioning were not Royalties but “industrial and commercial profits” not taxable in India in absence of PE – Commr. Vs. Hindustan Paper Corp (77 Taxman 450 Calcutta HC)

  16. Article 7(1)“Force of Attraction” Principle • Principle of Force of Attraction primarily concerned with taxation of business profits in Source country • Prevent tax evasion/avoidance through artifical contracts & business arrangements • Identification of business txns. – source based taxation • Three kinds of FoA found in Treaties: • Pure force of attraction : all profits derived in source state taxable as profits of PE whether or not through PE • Limited force of attraction : profits derived through PE as well as profits from sale of goods/activities same or similar to PE directly by HO in source country taxable as profits of PE • No force of attraction : only profits derived through PE taxable • Article 7(1) of the UN MC includes a limited form of Force of Attraction principle

  17. Article 7(1)Pure Force of Attraction • Classic example of the Pure ‘Force of Attraction’ rule is Article III of the UK-USA Income-tax Convention, 1945 which read as follows: “(1) A UK enterprise shall not be subject to US tax in respect of its industrial or commercial profits unless it is engaged in trade or business in the United States through a PE situated therein. If it is so engaged, United States tax may be imposed upon the entire income of such enterprise from sources within the United States…” • In other words, if an enterprise of a contracting country had a PE in the other country, it was taxable not only in respect of the profits attributable to the PE, but in respect of the entire profits arising from sources in that country!

  18. Article 7(1)Limited FoA • The raison-d-etre of the modified ‘Force of Attraction’ principle is best understood from the Commentary on UN Model Convention which states thus (paragraph 46): “This para reproduces art. 7, para 1, of OECD Model Convention, with the addition of the provisions contained in cls. (b) and (c). In the discussion preceding the adoption by the Group of Experts of this para, several members from developing countries expressed support for the “force of attraction” rule, although they would limit the application of that rule to business profits covered by art. 7 of the OECD Model Convention and not extend it to income from capital (dividends, interest and royalties) covered by other treaty provisions. The members supporting the application of the “force of attraction” rule also indicated that neither sales through independent commission agents nor purchase activities would become taxable to the principal under that rule.

  19. Article 7(1)Limited FoA “Some members from developed countries pointed out that the “force of attraction” rule had been found unsatisfactory and abandoned in recent tax treaties concluded by them because of the undesirability of taxing income from an activity that was totally unrelated to the establishment and that was in itself not extensive enough to constitute a PE. They also stressed the uncertainty that such an approach would create for taxpayers. Members from developing countries pointed out that the proposed “force of attraction” approach did remove some administrative problems in that it made it unnecessary to determine whether particular activities were or were not related to the PE or the income involved attributable to it. That was the case especially with respect to transactions conducted directly by the home office within the country, but similar in nature to those conducted by the PE.

  20. Article 7(1)Limited FoA • However, after discussion, it was proposed that the “force of attraction” rule, should be limited so that it would apply to sales of goods or merchandise and other business activities in the following manner: if an enterprise has a PE in the other Contracting State for the purpose of selling goods or merchandise, sales of the same or a similar kind may be taxed in that State even if they are not conducted through the PE; a similar rule will apply if the PE is used for other business activities and the same or similar activities are performed without any connection with the PE.”

  21. Article 7(1)#NoFOA • Klaus Vogelexplains the preference for a system which did not adopt the ‘Force of Attraction’ rule in (3rd Edition, Vol I, page 410): “This distribution of taxation according to the economic connection of the profits concerned is preferable to the principle of ‘attraction force’ because the former method proceeds from the enterprise’s individual organizational structure and avoids restricting entrepreneurial freedom of disposition through fictitiously allocating profits by way of generalizing standards. While OECD committee on fiscal affairs recognized that such extensive freedom of entrepreneurial disposition might also involve the risk of being abused, it thought that this risk should not be given undue weight and that much more importance should be attached to ensuring, both for tax purposes and otherwise, that international business contacts can be shaped according to commercial requirement.”

  22. Article 7(1)Case Study #1 - FoA • DCIT vs. Roxon OY (106 ITD 489 Mumbai) • Finish assessee company entered into contract to “design, manufacture, deliver, erect, test and commission certain bulk handling facility at Nava Sheva Port Trust and to impart training to the NSPT” • Clearly assessee had PE in India : no dispute there • AO went one step further and held that assessee was required to supply the equipment (offshore equipment supply) and install it in India as part of a turnkey contract, thus the supply was linked to the installation and chargeable to tax under the ‘Force of Attraction’ principle.

  23. Article 7(1)Case Study #1 - FoA • Tribunal disagreed with Revenue and ruled in favour of assessee • Considered in detail the FoA clauses of the relevant Treaty and gave 3 reasons why profits from supplies did not fall within its ambit: • First is PE came into existence after supply transaction • Second reason was, if anything, PE is deemed to be buying at market value and selling at same value to customer; billing was direct with customer and the hypothetical purchase & sale by PE did not result in any profits to be taxable • Third reason is in offshore supply of equipments etc in a turnkey contract what can be taxed is only profits attributable to the work effectively carried out by PE

  24. Article 7(1)Case Study #2 - FoA • SNC-Lavalin vs. ACIT (110 TTJ Del 13) • Assessee entered into contract with NHPC for Chamera project. • Assesse claimed it had performed work relating to project even prior to setting up of PE but bills were raised after PE was established; claimed that profit not attributable to PE had to be excluded • Tribunal held limited FoA under India-Canada DTAA applies and FoA holds good even for rendering of services • It was held that as there was a composite contract for rendering services in connection with setting up of the Hydroelectric project, the work carried out outside India was deemed to have arisen in India as it was the same as the services rendered by the PE in India. • The fact that the invoices for the said off-shore work was raised through the PE in India and accounted for in the books of project office set up in India sealed the fate of the assessee.

  25. Article 7(1)Case Study #3 - FoA • Sumitomo Corp. vs. DCIT (114 ITD 61 Del.) • The assessee, a Japanese company, secured several contracts for supply of various equipment's to Maruti Udyog Ltd for its car project and also undertook to supervise the installation of the equipment's. • The contracts were independent and not commercially a coherent whole. • The period of supervision in the case of individual contracts did not exceed 180 days. • The Department argued that there was a supervisory PE on the basis that the period of all contracts had to be aggregated. • It was also argued that as the supervisory services were “effectively connected” with the PE, Article 12(5) applied and the fees thereof had to be assessed as business profits and not as fees for technical services

  26. Article 7(1)Case Study #3 - FoA • Tribunal held that as far as Article 12(5) was concerned, the State where the PE was located was entitled to tax only those profits which were economically attributable to the PE and arose as a result of activities of PE • ITAT held that Article 12(5) adopted the “No Force of Attraction Principle”. It held that Article 12(5) made a distinction between income which was the result of activities of the PE and income which arose by reason of direct dealings by the enterprise from the head office without the aid or assistance of the PE. • The term “effectively connected” was held not to be the opposite of “legally connected” but as being “really connected”. It was held that the connection had to be seen not in the form but in real substance. • ITAT also repelled aggregation argument by Department with regard to FoA rule and held that different contracts were not part of a coherent whole and aggregating them would violate the FoA rule

  27. Article 7(1)Case Study #4 – FoA • ITO vs. LinkLaters LLP (40 SOT 51 Mum.) • Whether services rendered by UK law firm from outside India to Indian clients was taxable in India given that assessee had a PE? • India-UK DTAA does not have standard “Force of Attraction” clause in the usual format but merely provides that if enterprise of one Contracting State carries on business in other Contracting State through PE, “the profits of the enterprise may be taxed in the other State but only so much of them as is directly or indirectly attributable to that permanent establishment“ • The Tribunal held that connotation of the phrase “profits indirectly attributable to permanent establishment” incorporated FoA rule. • It held that in addition to taxability of income in respect of services rendered by the PE in India, ANY income in respect of the services rendered to an Indian project (similar to the services rendered by the PE) is also taxable in India irrespective of fact whether such services are rendered through PE or directly by the general enterprise.

  28. Article 7(1)Case Study #4 - FoA • Tribunal held that this indirect attribution, in view of the specific provisions of the India-UK tax treaty, was enough to bring the income from such services within the ambit of taxability in India. • The Tribunal emphasized that the twin conditions that had to be satisfied for taxability of related profits are (i) the services should be similar or relatable to the services rendered by the PE in India; and (ii) the services should be ‘directly or indirectly attributable to the Indian PE’ i.e. rendered to a project or client in India. • The effect of the judgement is that the entire profits relating to services rendered by the assessee, whether rendered in India or outside India, in respect of Indian projects became taxable in India!! • This ruling has been struck down (thankfully!) restored by subsequent Mumbai Special Bench in ADIT vs. Clifford Chance (TS-194-ITAT-2013 Mum)

  29. Article 7(1)FoA - Points to Ponder • Around 30 of ~85 Indian DTAA’s contain some form of FoA. • Many DTAA’s Limited FoA (Canada, Belgium, USA, Italy, Denmark) • Some DTAA’s limited Limited FoA!! (NZ, Indonesia) • Some adopt UN Model with “Right to Prove otherwise” (Sri Lanka, Cyprus, Germany) • Some adopt OECD Model with variation (directly or indirectly attributable to PE) (Japan, Singapore, UK, Malta, Oman) • Can we take refuge under the Indian Income Tax Act which has only attribution to PE concept and no FoA?

  30. OECD MC - Article 7(2) PE : Computation Hypothesis

  31. UN MC - Article 7(2)PE : Computation Hypothesis Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were 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 permanent establishment.

  32. US MC – Article 7(2)PE - Computation Hypothesis

  33. Article 7(2)PE – Computation Hypothesis • Approach to determine profit of the PE. Historically two approaches: • Relevant business activity (or) • Functionally separate entity • OECD recommends “functionally separate entity” approach • Profit should be determined by applying arm’s-length principle – OECD TP Guidelines should be applied • Clear movement towards Article 7(2) and Article 9 being closely tied together : ALP is fundamental to the mix!

  34. Article 7(2)Authorized OECD approach Step1: Hypothesising the PE as a distinct and separate enterprise Determining the profits of a PE Step 2: determining the profits of the PE Functional / factual analysis to determine the Activities and conditions of the PE Functions performed Comparability analysis Applying transfer pricing methods to attribute profits Assets used Risk assumed Capital and funding Recognition of dealings Source: ICAI Article 7 Webinar: 24 May 2014

  35. Article 7(2) PE - Separate Entity Approach • Difficulty in this approach is simply that PE is not a separate entity • It cannot enter into legally binding contracts with remainder of enterprise of which it is part • It cannot borrow funds or pay interest or royalties to the remainder of the enterprise • Thus to apply these guidelines developed in context of separate enterprises means creating functionally separate enterprise as an artificial construction i.e., a separate enterprise fiction

  36. Article 7(2)Expenses of a PE: the bird’s-eye view! • Three kinds of expenses for the PE: • expenses that PE itself incurs in India • expenses that the foreign company incurs at head office level exclusively for the Indian PE and • expenses that the foreign company incurs at head office level generally for its business which also benefits the PE being a part of the legal entity. • With respect to direct expenditure i.e., clause (a) there is little dispute; it is always deductible by PE • Attribution of exclusive expenditure & apportionment (by key) of general HO expenditure is always contentious – especially the latter i.e., apportionment .

  37. Article 7(3)….and beyondComputation of profits attributable to PE • A bit of history…. • OECD MC 2008 (i.e., prior to 2010), UN MC 2001 & 2011, US MC 1996 & 2006 were all along on the same lines – few differences such as FoA, • Attribution to Permanent Establishment Report 2008, OECD changed things! • OECD MC 2010 made significant differences to Article 7 • In other words, US & UN Model follow the old OECD Model. Indian treaties typically follow these too • New OECD Model Article 7 framework reflects the growing trend of using ALP as the backbone and integrating everything under the TP umbrella • What were the changes in OECD Model post 2008 ? • OECD Model modified Article 7(2) to incorporate F.A.R, removed the old OECD MC’s Article 7(3), 7(4), 7(5) and 7(6). New Article 7(3) relating to corresponding adjustment introduced

  38. Article 7(3)….Computation of profits attributable to PE

  39. Article 7(3)….Computation of profits attributable to PE

  40. Article 7(3)….Computation of profits attributable to PE

  41. Article 7(3)….Computation of profits attributable to PE

  42. Article 7(3)….Computation of profits attributable to PE

  43. UN Model Commentary on Computation of expenses attributable to PE • The UN MC specifically excludes certain deductions by PE in Art. 7(2), the UN Model Commentary provides the rationale: “41. The treatment of interest charges raises particular issues. First there might be amounts which, under the name of interest, are charged by a head office to its permanent establishment with respect to internal “loans” by the former to the latter. Except for financial enterprises such as banks, it si generally agreed that such internal “interest” need not be recognized. This is because: • From a legal standpoint, the transfer of capital against payment of interest and an undertaking to repay in full at due date is really a formal act incompatible with the true legal nature of a PE • From the economic standpoint, internal debts and receivables may prove to be non existent, since if an enterprise is solely or predominantly equity funded it ought not to be allowed to deduct interest charges that it has manifestly not had to pay….” 42. For these reasons, the ban on deductions for internal debts and receivables should continue to apply generally, subject to special situation of banks….

  44. OECD Model Commentary 2014 on Computation of expenses attributable to PE • OECD MC 2014 Commentary deleted a number of paragraphs from Article 7 of previous versions of its MC. The rationale is explained in detail in its Model Commentary as follows: “38. Article 7, as it read before 2010, included the following paragraph 3: “In determining the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the permanent establishment, including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere.” Whilst that paragraph was originally intended to clarify that paragraph 2 required expenses incurred directly or indirectly for the benefit of a permanent establishment to be taken into account in determining the profits of the permanent establishment even if these expenses had been incurred outside the State in which the permanent establishment was located, it had sometimes been read as limiting the deduction of expenses that indirectly benefited the permanent establishment to the actual amount of the expenses.

  45. OECD Model Commentary 2014 on Computation of expenses attributable to PE “39. This was especially the case of general and administrative expenses, which were expressly mentioned in that paragraph. Under the previous version of paragraph 2, as interpreted in the Commentary, this was generally not a problem since a share of the general and administrative expenses of the enterprise could usually only be allocated to a permanent establishment on a cost-basis. 40. As now worded, however, paragraph 2 requires the recognition and arm’s length pricing of the dealings through which one part of the enterprise performs functions for the benefit of the permanent establishment (e.g. through the provision of assistance in day-to-day management). The deduction of an arm’s length charge for these dealings, as opposed to a deduction limited to the amount of the expenses, is required by paragraph 2. The previous paragraph 3 has therefore been deleted to prevent it from being misconstrued as limiting the deduction to the amount of the expenses themselves.

  46. OECD Model Commentary 2014 on Computation of expenses attributable to PE “That deletion does not affect the requirement, under paragraph 2, that in determining the profits attributable to a permanent establishment, all relevant expenses of the enterprise, wherever incurred, be taken into account. Depending on the circumstances, this will be done through the deduction of all or part of the expenses or through the deduction of an arm’s length charge in the case of a dealing between the permanent establishment and another part of the enterprise. 41. Article 7, as it read before 2010, also included a provision that allowed the attribution of profits to a permanent establishment to be done on the basis of an apportionment of the total profits of the enterprise to its various parts. That method, however, was only to be applied to the extent that its application had been customary in a Contracting State and that the result was in accordance with the principles of Article 7. For the Committee, methods other than an apportionment of total profits of an enterprise can be applied even in the most difficult cases. The Committee therefore decided to delete that provision because its application had become very exceptional and because of concerns that it was extremely difficult to ensure that the result of its application would be in accordance with the arm’s length principle.”

  47. OECD Model Commentary 2014 on Computation of expenses attributable to PE “42. At the same time, the Committee also decided to eliminate another provision that was found in the previous version of the Article and according to which the profits to be attributed to the permanent establishment were to be “determined by the same method year by year unless there is good and sufficient reason to the contrary.” That provision, which was intended to ensure continuous and consistent treatment, was appropriate as long as it was accepted that the profits attributable to a permanent establishment could be determined through direct or indirect methods or even on the basis of an apportionment of the total profits of the enterprise to its various parts. The new approach developed by the Committee, however, does not allow for the application of such fundamentally different methods and therefore avoids the need for such a provision” • Bottomline: OECD has clearly moved to a separate entity model driven by ALP analysis using its Transfer Pricing Guidelines

  48. India’s DTAA’s

  49. India’s DTAAsRubber hits the road! • We saw the Model Conventions; what do India’s negotiated DTAAs with various Countries? • Most of India’s DTAA’s follow the UN MC and the old OECD MC (2008) • Have limited Force of Attraction (FoA) rule • Deductions of expenses allowed for purpose of PE including executive and general administrative expenses • Have clause which subjects allowability of expenses to domestic laws of the State in which PE is situated • Allow apportionment wherever necessary/applicable

  50. ARTICLE 7 - BUSINESS PROFITS 1. The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to (a) that permanent establishment; (b) sales in that other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment; or (c) other business activities carried on in that other State of the same or similar kind as those effected through that permanent establishment. 2. Where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall be attributed to such permanent establishment the profits which it might be expected to derive if it were an independent enterprise engaged in the same or similar activities under the same or similar conditions and dealing at arm's length with the enterprise of which it is a permanent establishment. India’s DTAA’s: An exampleIndia-Belgium DTAA

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