Chand, V.

Das, P.

English

Serveur académique lausannois

1Kluwer International Tax Blog - 1 / 5 - 04.11.2021Kluwer International Tax BlogFrom  a  FAR  to  a  FARM  Analysis  with  respect  to  ProfitAttribution  to  the  Indian  Significant  Economic  Presence(SEP)  TestVikram Chand  (Managing  Editor)  (Tax  Policy  Center  of  the  University  of  Lausanne,Switzerland) and Pitambar Das (Tax Policy Division, Ministry of Finance, India) · Monday,July 9th, 2018The Existing Framework: Nexus and Profit Attribution RulesUnder the current Double Taxation Avoidance Agreement (DTAA) framework, businessprofits are in principle taxable in the State of residence of the enterprise. However,the source (market) jurisdictions may tax the profits if a permanent establishment (PE)is triggered therein. A PE arises when the non-resident operates in the market Statethrough  a  physical  presence  such  as  a  fixed  place  of  business  (e.g.  office  orconstruction  site)  or  through  dependant  agents  (e.g.  employees).  Thus,  when  atraditional business operates through a tangible presence in the market State (andsubject to certain conditions) a PE is constituted unless the activities carried outthrough the fixed place or by the dependant agents fall under the list of exceptions.However, State practice varies with respect to profit attribution to such a nexus.States could allocate profits by resorting to the authorized OECD approach (AOA) orby deploying formulary or deemed profit  allocation methods.  With respect to theformer, profit allocation to the PE depends on tangible factors in the market statesuch as significant people functions, assets and risks (FAR) linked to the PE. Withrespect to the latter, States may allocate profits to the PE based on elements linked toturnover  derived  from  the  market  States  (total  net  profit*local  turnover/totalturnover). Typically, developed States (OECD or EU Member States such as Austria,Germany or Netherlands) apply the AOA whereas developing States (India or China)usually apply formulary or deemed profit methods.[1]The Policy Debate Triggered by Highly Digitalized BusinessesHighly digitalized businesses may operate in  the market  State through online ordigital  means and derive  substantial  revenues from that  State.  For  example,  thefollowing digitalized businesses may operate and commercialize in the market Statewithout any physical presence, primarily,  due to their heavy reliance on softwarerelated intangibles: i) businesses that provide an online marketplace for the sale ofgoods  and  services  such  as  eBay,  Booking.com,  Uber  and  Airbnb;  ii)  businesses2Kluwer International Tax Blog - 2 / 5 - 04.11.2021providing  online  services  such  as  online  advertising:  Facebook,  online  gaming:PartyPoker  or  online  payment  services:  PayPal;  iii)  businesses  selling  digitalizedproducts and content through an online platform such as Netflix or Spotify; and iv)businesses providing online solutions such as cloud computing solutions as providedby Microsoft Azure or SalesForce.com. Accordingly, the question arises as to how canmarket States tax (in particular highly) digitalized businesses as the current treatyrules are not equipped to tax such businesses since they focus on physical presence.Currently, policy makers (OECD and EU Commission) are discussing two possibilitiesto  solve  the  issue  at  stake.  The  first  option,  an  interim  measure,  involves  theintroduction of turnover taxes (a discussion on this option is beyond the scope of thiscontribution). The second option, a longer-term measure, involves modifying the PEdefinition and profit attribution rules, in particular, the AOA framework. With respectto the latter option,  the current debate revolves around whether such new rulesshould  be  targeted  only  for  digitalized  businesses  or  for  traditional  as  well  asdigitalized businesses?New  Rules  Targeted  only  at  Digitalized  Businesses  –  The  Issue  of  RingFencingIn relation to taxing digitalized businesses, in the BEPS Action 1 Final Report (2015),the OECD discusses the possibility that States may introduce a significant economicpresence (SEP) test. This test proposes creating a new nexus or presence based oneither revenue,  digital  or user related factors,  or a combination thereof.  The EUCommission also follows a similar approach in its recent draft directive on SignificantDigital Presence. According to the Commission, a Digital PE arises in a Member Statewhen the digital services provided through a digital interface exceeds either (i) arevenue threshold of Euro 7 Million or ii) the number of users availing the digitalservices exceed 100,000 users or; iii) the number of business contracts for digitalservices concluded by users in a Member State exceeds 3,000 contracts.Both OECD and the EU Commission recognize that the profit  allocation rules,  inparticular, the AOA framework needs modification in order to attribute profits to thenew nexus. While the OECD has not elaborated on the potential modification, the EUCommission has made a proposal, especially, with respect to digitalized businessesthat depend on user participation. According to the EU Commission: functions, assetsand risks that relate to data or users in the market State shall be attributed to thedigital PE even if (all of) these activities are performed at the level of the head office.Moreover, the profit attribution principles should take into account the development,enhancement,  maintenance,  protection  and  exploitation  of  intangible  assets.Furthermore,  the draft  directive  states  that  taxpayers  should use the profit  splitmethod as a default method to allocate profits to such a digital presence unless anduntil the application of another method is put forward. The draft directive indicatesthat further guidance on the application of such rules will be developed in the duecourse of time.The rules proposed by the EU Commission are based on amending the AOA. However,as argued by Spinosa and Chand in a recent publication in the June/July issue ofIntertax, the AOA is itself unsettled and unclear. Therefore, building new rules on anunstable foundation will surely cause tax uncertainty for businesses and open the3Kluwer International Tax Blog - 3 / 5 - 04.11.2021doors  for  more  tax  disputes.  Moreover,  such  rules  clearly  ring-fence  digitalizedbusinesses.New Rules Targeted for all Enterprises: The Indian SEP TestIn  order  to  avoid ring-fencing concerns for  digitalized businesses,  we are of  theopinion that international tax principles for conventional businesses as well  as e-commerce should be similar. The new nexus and profit attribution rules should applyto ‘all enterprises’ in a neutral, efficient, simple & certain, fair & equal and flexiblemanner. In this regard, the introduction of the SEP test in the Indian domestic tax lawapplicable to “all enterprises” is clearly a step in the right direction. A SEP arises forall  non-resident  enterprises  if  they  exceed either  a  revenue or  a  user  threshold(although one of the author’s to this blog believes that the user threshold should be apart of the revenue threshold and not an independent threshold per se). This beingsaid, the SEP test will apply to treaty partners only when the new provisions areincorporated in tax treaties. Undoubtedly, getting OECD Member States to agree onthis test will  be a daunting task for the Indian treaty negotiators unless this testbecomes the new global standard (similar to the equalization levy – a turnover typemeasure). Even if the SEP test, as implemented in India, becomes the global standard,the key issue that will then need to be solved pertains to profit attribution.Profit Attribution: The Migration from a FAR to FARM AnalysisConsider the following situation where an entity in State R sells goods or services on aremote basis into State S. Let us further assume that the turnover from State S is USD500 and this amount also represents the total turnover of the entity. Moreover, thetotal operating costs of the entity amount to USD 400. Thus, the entity makes ataxable net profit of USD 100.If State S applies the AOA framework as it currently stands, the profit will only not betaxable in State S. This is because the Functions, Assets and Risks (FAR) are onlyperformed,  deployed  or  assumed  in  State  R.  Put  differently,  the  existing  AOAframework, primarily, takes into account only production side factors whereas demandside factors represented by sales are completely ignored.The question then arises as to how should the taxable net profit be divided betweenthe residence and source States? At the outset,  we are of the opinion that “full”formulary  approaches should  not  be used as  they conflict  with  the arm’s  lengthstandard. A possible solution could be to introduce a new interpretation on profitattribution in Article 7 or introduce a market apportionment key within the AOAframework.  Both approaches will  take into consideration not only residence statefactors (FAR) but also source state factors (the market or M). However, the outcomewould be different under both scenarios as illustrated below.Under the new interpretation approach, the Functions, Assets and Risks linked to thesale in the Market State could be allocated to the new nexus. Essentially, the SEPwould be allocated the sales as reduced by the expenses in relation to those sales.Therefore, the entire profit of USD 100 could be allocated to the SEP.Under the market apportionment key approach, once a new nexus is established, the4Kluwer International Tax Blog - 4 / 5 - 04.11.2021market State will obtain a right to tax a part of that profit linked to sales in State S.For instance, based on facts and circumstances, an equal weight could be allocated toFunctions (25%), Assets (25%), Risks (25%) and Market (25%). Consequently, as themarket reflects a 25% weight, the new nexus will be attributed USD 25 as profits onwhich the non-resident taxpayer will have to pay taxes in the market State.This market apportionment key approach, in our opinion, is far less radical than theaforementioned interpretation approach or a destination based cash flow approach ora sales based formulary apportionment mechanism under which the market State willreceive the entire or a substantial part of the profit on which it may levy its tax.Of course, both proposals can only be viable internationally if there is internationalconsensus on the new interpretation or the weights that can be allocated to Functions,Assets, Risks and Market.It should be noted that the purpose of the contribution was only to throw up ideas tosolve the profit attribution issue at stake if a SEP test is introduced for all enterprises.The authors do identify that there are several shortcomings in these proposals, Thus,the authors welcome comments from the international tax community on such an idea.________________________To make sure you do not miss out on regular updates from the Kluwer InternationalTax Blog, please subscribe here.References[+]This entry was posted on Monday, July 9th, 2018 at 10:40 am and is filed under BEPS,Digitalization, Permanent Establishments, Value CreationYou can follow any responses to this entry through the Comments (RSS) feed. You canleave a response, or trackback from your own site.5Kluwer International Tax Blog - 5 / 5 - 04.11.2021

From a FAR to a FARM Analysis with respect to Profit Attribution to the Indian Significant Economic Presence (SEP) Test

https://serval.unil.ch/resource/serval:BIB_131EE8E84AD8.P002/REF.pdf

From a FAR to a FARM Analysis with respect to Profit Attribution to the Indian Significant Economic Presence (SEP) Test

Abstract

Similar works

Full text

Available Versions

Serveur académique lausannois