Hardev Singh, senior manager, KPMG global transfer pricing services, reports on a key ruling by the Delhi Tax Tribunal.
The Delhi Tax Tribunals ruling in the Rolls Royce Plc (RRPLC) case, has dwelled into attribution of business profits to a permanent establishment undertaking marketing activities. It has dealt with various factual aspects in determining the existence of a permanent establishment (PE). The tribunal ruled that 35% of the global profits of the company in respect of sales effected in India would be attributable to the activities of its PE in India.
The brief facts of the case are as follows:
RRPLC, a tax resident of the UK, supplied aero-engines and spare parts to its Indian customers which, among others, included Hindustan Aeronautics Ltd, the Indian Navy and the Indian Air Force. RRPLC had a subsidiary, Rolls Royce India Ltd (RRIL). RRIL entered into an agreement with RRPLC to provide certain services to the latter. RRIL was compensated by RRPLC for providing such services
During the survey operations carried out by the tax authorities, it was found that the activities of RRIL also included marketing and liaison services, market analysis, technical support, customer relationship interface, strategic planning, and so on, on behalf of RRPLC.
Based on these survey findings, the tax authorities alleged that RRPLC was having a business connection under section 9(1)(i) of the Act, as well as a PE under article 5 of the DTAA between India and UK. It was held that:
- the premises of RRIL constituted a fixed place PE of RRPLC under Article 5(1) of the DTAA;
- the premises of RRIL was a PE under article 5(2)(f) of the DTAA, since it was used for receiving or soliciting orders for RRPLC;
- RRIL was a dependant agent of RRPLC under article 5(4)(c) of the DTAA, as it was routinely securing orders for RRPLC.
The Delhi tribunal confirmed the findings and conclusions of the tax authorities based on the following:
- RRILs premises was a fixed place of business at the disposal of RRPLC through which RRPLC conducted its business in India (no formal legal right required for using the premises);
- The activities carried on through the fixed place was not preparatory or auxiliary, but a core activity of marketing, negotiating the contracts and selling of products;
- RRIL almost acted like a sales office of RRPLC in India;
- RRIL solicited and received orders wholly and exclusively on behalf of RRPLC; and
- RRIL was a projection of RRPLC in India.
Attribution of business profits to a permanent establishment
On the question of attribution of profits to India, the tribunal relied on the decision of the Supreme Court in the Ahmedbhai Umarbhai case.
The tribunal said that:
- The profits are to be computed as if the PE is a distinct and separate enterprise and dealing wholly independently with the enterprise of which it is a PE. Such profits are treated as directly attributable to the PE and are brought to tax.
- Where a PE takes an active part in negotiating, concluding or fulfilling contracts, notwithstanding that other part of the enterprise have also participated in those transactions, the proportion of the profit arising out of those contracts shall be treated as profit indirectly attributable to the PE and will be taxable in such contracting state where the PE is situated. Thus, the direct as well as indirect income attributable to the PE is chargeable to tax.
- The total profits of the enterprise has to be apportioned on the basis of various factors affecting accrual of income.
- The first of that approach requires the identification of activities carried on through the PE. This should be done through a factual and functional analysis. Under the first step, the economically significant activities and responsibilities undertaken through the PE will be identified. This analysis should to the extent relevant consider the activities and responsibilities undertaken through the PE in the context of activities and responsibilities undertaken by the enterprise as a whole.
- Under the second step, the remuneration of any such dealing would be determined by applying, the principles developed for the application of the arm's length principle between associated enterprises, by reference to the functions performed, assets used and risk assumed by the enterprise through the PE and through the rest of the enterprise, that is by comparative FAR analysis.
- It was observed that the manufacturing of the goods dealt or traded in India are not manufactured in India. The manufacturing operation is carried on outside India.
- Manufacturing is one of the important and integral part of the total activities which contributes to the earning of income.
- The extent of assets used are irrelevant as in the present case, the activity comprises of manufacturing and marketing.
- The marketing is in India. Therefore, the profit accruing directly or indirectly in respect of the marketing activities in India shall be taxable in India under the Income-tax Act, 1961 read with rule 10 of Income-tax rules 1962.
- It was held that in a case in which the revenue is of the opinion that actual amount of the income accruing or arising directly or indirectly through or from any business connection in India cannot be definitely ascertained, for the purpose of assessment the same may be calculated at such percentage of the turnover so accruing or arising as may be considered reasonable, or in such other manner as the revenue may deem suitable.
- The Supreme Court, in the case of CIT vs. Ahmed Bhai Umar Bhai & Co., 18 ITR 472, held that where the manufacture and sale of the goods were not carried out in the same state, the profit of a part of business, that is relating to manufacture of goods accrued at a place where manufacturing activities are carried out and hence, not assessable in the other state where only trading activities are carried on.
- The tribunal, therefore, allocated 50% of the profits towards manufacturing activity which cannot be taxed in India as no such manufacturing activity is carried out in India.
- In respect of other activities apart from marketing of goods in India, the assessee has also carried out research and development activity outside India. In a product in which the assessee deals in Research and Development activities are as important as manufacture. R&D activities are on an ongoing basis which results into development of newer products. 15% of the profits were allocated to such R&D activities.
- Balance of the profit could be attributable to the marketing activities which are in India. Held that though contracts are signed outside India yet the negotiations and other discussions are in India and hence, all other profits can be said to accrue or arise into directly or indirectly through the operations of PE in India.
After allocating 50% to the manufacturing operations and 15% to research and development carried outside India, the tribunal attributed 35% of the global profits in respect of Indian sales as income taxable in India. Looking at the approach to attribution, the tribunal has, in a way, followed the global apportionment adopted in the landmark case of the Special Bench in the Motorola case.
One of the arguments put before the tribunal was that since RRIL was being remunerated at arms length price (ALP) and the said ALP was accepted by the transfer pricing officer (TPO), no further attribution could be done. Hence, the payment of ALP to RRIL should extinguish the assessment of RRPLC in India. Though the tribunal acknowledged that determination of ALP is a relevant step for attribution of income, no conclusions were drawn thereon. It would pertinent to highlight here that it was the revenues contention that there are many activities carried out by RRIL which are not part of its agreement and hence, it cannot be said that the entire profit accruing to the RRPLC is in the form of remuneration paid to RRIL.
The take away summary from this case is the need for multinationals to critically examine the nature and extent of operations in India, in terms of actual operations and documenting the same. Further the mere payment of ALP to dependant agent does not extinguish tax liability of the foreign company in India, unless the dependent agent is being compensated for all the functions performed, assets employed and risks undertaken. Else, revenue authorities would always be tempted to claim a share of the global profit