Safe Harbour Rules Vs Permanent Establishment

Safe harbour Rules Vs Permanent Establishment

Government has notified Safe Harbour rules (SHR) to provides certainty to Indian associate enterprise of MNC group in its Transfer Pricing Assessment

The bigger question is that whether safe harbour will really provide certainty to MNC group as whole in connection with taxation in India

To bang upon the subject, I have considered the case of Software Development Services, as provided in safe Harbour rule

An enterprise engaged in Software Development services, can avail the benefits of SHR, if it is engaged in either of following activities relating to:

a)      Business Application software and information system development using know methods and existing software tools

b)      Support for existing systems

c)       Converting or translating computer languages

d)      Adding user functionality to application programmes.

e)      Debugging of Systems

f)       Adaptation of Existing Software

g)      Preparation of User Documents

Further to avail, benefits under the SHR, for enterprise engaged in software development services, following FAR should be satisfied, as under:-

Particulars	Foreign Principle	Indian Associated Enterprise
Functions	Critical functions – Conceptualisation and design of Product, providing strategic direction and framework and entire Supervision of Indian Associated Enterprise	Perform the work assigned under the supervision of Foreign Principle
Asset	Capital, funds and other significant assets including intangibles are provided by Foreign principle	No ownership right, legal or economic on any intangibles generated during the course of rendering services
Risk	Assume all economically significant Risk	Do not assume any significant risk.

Though by subjecting itself to SHR, Indian associate enterprise will be protected from uncertainty and high pitch transfer pricing adjustments

But there is other side of the story also.

Based on activities enumerated, aforesaid FAR analysis and other incidental factors, analysed hereinafter below, will the foreign principle be liable to taxation in India on account of presence of PERMANNET ESTABLISHMENT.

To elucidate the concept, Consider a case where Foreign Holding Company (H) is having wholly owned Subsidiary (S) in India and S is engaged in Software Development services and it has availed the SHR.

Further I have considered here UN model of DTAA, since Indian most of DTAA are based on this model only

The question for consideration is whether S will be considered as PE of H and if so, whether S reporting margins (20%/22% of operating expenses) as mandated in safe harbour rules, will be sufficient attribution of profit of H to PE under Article 7(2) or their needs further attribution of profits of H to PE.

Existence of Permanent Establishment -Analysed

1.       In instant case, Existence of PE is to be evaluated from fixed PE (Article 5(1) ) and agency PE (Article 5(5)(a)) perspective.

2.       Fixed PE- For Fixed PE, following test to be satisfied:-

a)      Place of Business Test

b)      Power of Disposition Test

c)       Permanence Test

d)      Business test

3.       In circumstances of Instant case, Place of business test and Permanence test can be easily be satisfied, only remaining other tests need to be satisfied.

4.       Power of Disposition Test

a)      Test is satisfied when place of business of S is at the disposal of H or should be freely available to H for the purpose of business activities of H.

b)      Since it is condition of SHR that employee of S has to work under the supervision of H and if it is a case where employees of H are freely using the S’s place of business for supervision of S employee for business purpose, power of disposition test can be deemed to be satisfied.

5.       Business Test

a)      Business test is satisfied when foreign enterprise is carrying core of peripheral activities in India, excluding the activities of auxiliary or preparatory in nature

b)      Based on list of activities enumerated in ‘”Software Development Services”, possibility of satisfying the business test is established in following cases.

Activities	Business Test
Business Application software and information system development using know methods and existing software tools	Core Activity- Business Test satisfied
Support for existing systems	Auxiliary Activities – Business Test not satisfied
Converting or translating computer languages	Peripheral Activities – Business Test satisfied
Adding user functionality to application programmes.	Peripheral Activities – Business Test satisfied
Debugging of Systems	Peripheral Activities – Business Test satisfied
Adaptation of Existing Software	Peripheral Activities – Business Test satisfied
Preparation of User Documents	Auxiliary Activities – Business Test not satisfied

6.       Conclusion- Fixed PE- Thus if power of disposition test is satisfied, there is possibility that AO may hold that H has PE in India, for the afore-said core or peripheral activities being carried out by S.

7.       Agency PE – Agency PE is satisfied when following conditions are met:-

a)      S is acting on behalf of H

b)      S has authority to CONCLUDE contracts on behalf of H.

c)       S is not an independent agent, satisfying the following conditions:-

                                       i.      The activities of S are devoted exclusively on behalf of H

                                      ii.      The transactions between S & H are not at ALP

8.       Authority to Conclude contracts – in the instant case, S can be deemed to have authority to conclude contracts on behalf of H, where S is engaged in following activities, rendering services to Indian Customers on behalf of H:-

a)      Adding user functionality to application programmes.

b)      Debugging of Systems

c)       Adaptation of Existing Software

9.       Independent Agent – In the instant case, S status of being independent agent is doubtful on account of following:-

a)      The entire activities of S are wholly devoted on behalf of H

b)      Whether adoption of margin by S stated in SHR, will deem that transaction will between S & H will be at ALP, is not free from doubt.

10.   Conclusion- Agency PE- There is possibility that S , being treated as agency PE of H.

Attribution of Profit to Permanent Establishment

Article 7(2) regulates the attribution of Profit of H to PE and provides that profit be attributed based on following assumptions:

a)      The PE is separate distinct enterprise.

b)      It was dealing wholly ad independently with foreign enterprise of which it is PE.

Critical Point

If PE is found to exist based on afore-said reasoning, the important point for consideration is whether adoption of stipulated margin by S as per SHR is sufficient attribution of profit to S, being PE of H or further attribution of profit of H to PE is required.

Analysis

1.       As per decision of Hon’ble Supreme Court in Morgan Stanley (2007) 292 ITR 416, if the transactions with PE are at ALP, then there is no need to further attribute the profit to PE.

2.       As per afore-said FAR analysis, S is only performing low risk functions, without ownership of any asset and in that scenario SHR mandated that S should earn 20%/22% of its operating expenses and based on that it will deemed that transaction between S & H are at  ALP

3.       All important functions, major assets and risk are on the part of H. If it is established that H is having PE in India in the business of S, then there is every possibility that AO will further attribute the profit of H, for functions performed, assets owned and risk taken relating to business of S in India.

4.       Further under rule 10, AO may attribute the profit of H to S based on assets, revenue etc. if unable to attribute profit based on FAR analysis.

5.       Thus in spite of opting for safe harbour rules, based on function profile as stated in said rules, there is every possibility of AO invoking PE existence in the hands of H and levying tax in the hands of H on Profits attributable to S less than profits of S.

6.       I think it is high time that Government should come up with clarity on this aspect, otherwise  objective of carving SHR will be defeated , since Income Tax department always try to prove the existence of PE, whenever they  see business connection of Foreign Enterprise in India.

Analysis- Judgement -Sudhir Menon HUF case - Section 56(2)(vii)- Issue of shares at less than FMV

Analysis of Mumbai Tribunal Judgement in Sudhir Menon HUF (ITA No. 4887/Mum/2013)- AY 2010-11- Section 56(2)(vii)

Facts:-

1.       Assessee was shareholder in a company and was allotted right shares (1,94,000) at face value of Rs. 100 each on 28.01.2010

2.       The book value (FMV) of shares on 31/3/2009 was Rs. 1538.

3.       AO apply the provisions of section 56(2)(vii)(c) and held that since assessee receive property at less than FMV, the FMV less than consideration is taxable in the hands of assessee. Accordingly AO calculated additional income of assessee at Rs. 27.82 Cr (1,94,000 x (1538-110))

Held

1.       Section 56(2)(vii) apply where company issue shares at less than FMV- Thus where existing company issues shares to new shareholders at less than FMV, then provision of section 56(2)(vii) will be attracted in the hands of shareholders.

2.       Implication on Right Issue- As long as, therefore, there is no disproportionate allotment, i.e., shares are allotted pro-rata to the shareholders, based on their existing holdings, there is no scope for any property being received by them on the said allotment of shares; there being only an apportionment of the value of their existing holding over a larger number of shares. Thus on proportionate right share to existing shareholders at less than FMV, section 56(2)(vii) will not be attracted in the hands of shareholders and based on that AO order is set aside.

3.       Bonus Issue - Issue of bonus shares is by definition capitalization of its profit by the issuing-company. There is neither any increase nor decrease in the wealth of the shareholder (or of the issuing company) on account of a bonus issue, and his percentage holding therein remains constant. In other words, there is no receipt of any property by the shareholder, and what stands received by him is the split shares out of his own holding. Thus section 56(2)(vii) will not apply in case of bonus issue.

Critical comments

A)     Section 56(2)(vii) deal with deeming income in the hands of Individual and HUF as under:

a)      Where these entities receives property without consideration and FMV value of property is more than Rs. 50,000, then FMV of property will be deemed income in the hands of Recipient entities.

b)      Where these entities receive property for consideration and difference between FMV and consideration is more than Rs. 50,000, then such difference will be deemed income in the hands of recipient entities.

c)       Property among other things includes shares of listed and unlisted entities.

B)      Section 56(2)(viia) deals with deeming income in the hands of unlisted companies and firm  where conditions as mentioned above at (a) or (b) are met but property is defined to include only shares of unlisted companies

C)      Implications- From operation of above-said judgement

1)      Right Issue by Listed Company –

a)      Suppose upon right issue by Listed Company at less than FMV, the individual shareholders renounce the right in favour on New shareholder, being firm. As a result firm applied and was allotted shares by listed company. This has resulted in disproportionate allotment. However firm will not be taxable on receipt of property at less than FMV, since section 56(2)(vii) does not apply to firm and under section 56(2)(viia), listed company’s share are not covered.

b)      Suppose in above case, individual shareholders renounce their right in favour of new shareholder, being Individual. In such case going by above said Tribunal Judgement, the new Individual shareholder, getting disproportionate allotment, will be subjected to provision of section 56(2)(vii).

c)       Operation of above-said judgement will create dichotomy in taxation treatment in the hands of Individual and company & Firm.

2)      Cost of shares in the hands of New Shareholder – Suppose a person in whose favour right was renounce, apply and allotted right shares. He acquired right for Rs. 5/share and amount paid for acquisition is Rs. 10/share. Book value of share is Rs. 50. Going by above Judgment, there will be inconsistency in the operation of following two provisions as under:-

a)      Section 49(4) – Where FMV of property is treated as income in the hand of person u/s 56(2)(vii)/(viia), then as per section 49(4), cost of acquisition of said property in hands of said person will be FMV of property. Thus in instant example, the cost of acquisition will be Rs. 40/share (Rs. 50-10)

b)      Section 55(2) – In case where person has buy the right and then apply for right share, the cost of acquisition of shares will be aggregate of amount paid for purchase of right and shares. In the instant example, it will be Rs. 15/share

c)       Operation of above-said judgement will created inconsistency in the operation of section 49(4) and 55(2).

3)      Issue of Shares at Premium, issue price being more than FMV based on DCF –

a)      Section 56(2)(viib) provides that where unlisted company issues shares at premium, but the issue price is more than FMV, then excess of issue price over FMV will be taxable in the hands of company

b)      Rule 11UA(2) provides that FMV will be either book value or value arrived at on the basis of DCF, at the option of assessee.

c)       Suppose face value of share is Rs. 10, premium Rs. 50. Book value – Rs. 80. Valuation based on DCF – Rs. 60.

d)      Investor will always prefer valuation of company based on DCF, as DCF methodology is better reflection of value of company over book value.

e)      For the purpose of section 56(2)(viib), Company will considere the FMV, as its option to be Rs. 60, so that issue price is at par with FMV ( 60 = 60) and a result that nothing is taxable in its hands.

f)       FMV for purpose of section 56(2)(vii)/(viia)  is book value – Rs. 80. As a result Rs. 20/share will be taxable in the hands of investor u/s 56(2)(viii)/(viia).

g)      Thus investor investing on the basis of actual/potential worth of company, will be forced to pay tax in the instant case.

4.       With due respect to afore-said judgement, I think it is not the mandate of law to cover issue of shares u/s 56(2)(vii)/(viia) on account of following:-

a)      Section 56(2)(vii) was bought into the status upon repeal of Gift Tax Act, whereby on incidence of gift, the tax burden has been shifted from Donor to Donee. Erstwhile Gift Tax Act, did not contain any provision for treating the difference between FMV and Issue price as gift in the hands of Company. So on similar analogy, the said differential should not be taxable in the hands of Investor u/s 56(2)(vii)

b)      Had mandate of law to treat the difference between FMV and issue price of shares as taxation incidence in the hands of investor u/s 56(2)(vii), then it would have come up with more elaborate definition of FMV, which is currently restricted to book value, as against prescribed under section 56(2)(viib). In real world, for investment perspective, valuation of company is rarely done on book value; rather it is based on discounted cash flow or Comparable Companies method.

c)        On operation of section 56(2)(vii), cost in the hands of recipient of property is governed by section 49(4). Had the intention of law to cover the issue of share at less than FMV as taxable event in the hands of investor, it would have made consequential amendments in section 55 and other incidental provisions, which is not done.

Section 115BBD vs Section 115O- Impact of Interim Finance Act 2014.

Section 115BBD vs Section 115O- Impact of Interim Finance Act 2014.

1.       U/s 115BBD Parent Domestic Company is required to pay tax of 15% on dividend income received from foreign subsidiary, provided dividend is received in FY 13-14. The said dividend is taxable on Gross basis, without allowing any deduction for expenses.

2.       The said benefit has not been extended in interim Finance Act, 2014 , as a result dividend received from foreign subsidiary  in FY 14-15 will be chargeable to tax @ 30% on net basis.

3.       Section 115O, provides that in computing the Dividend Distribution Tax (DDT) on dividend declared by Domestic company, the following amount shall be deducted from said dividend:-

a)      Amount of dividend received from domestic subsidiary company, on which subsidiary company has paid DDT.

b)      Amount of dividend received from Foreign subsidiary company, on which recipient company has paid tax u/s 115BBD

4.       Section 115BBD will become non-operational w.e.f 1/4/2014. Now question for consideration is

·         Whether parent company which will received dividend from  foreign subsidiary in FY 14-15, on which parent co will pay tax @ 30%, can claim deduction of such dividend while calculating DDT on dividend which will be declared by it (Parent)

5.       On plain reading of section 115O, it appears that benefit of reduction of dividend received from Foreign subsidiary will not be available to parent company from 1/4/2014.

6.       On logical reasoning and intention behind the beneficial provision of section 115O, one can claim the benefit of deduction of dividend from foreign subsidiary on following grounds:-

a)      Domestic subsidiary is required to pay 15% DDT on dividend declared by it. Parent company is entitled to reduce the said dividend while calculating DDT on dividend declared by it.

b)      Present section 115BBD requires parent company to pay 15% tax on dividend from foreign subsidiary, before parent company can claim the deduction of  said dividend while calculating the dividend declared by it

c)       Now on section 155BBD becoming non-operational from 1/4/2014, Parent company will be required to pay 30% tax on dividend received from foreign subsidiary. When present law is allowing benefit u/s 115O on payment if 15% tax on foreign dividend,  the said benefit should be continue on payment of tax  of 30% on foreign dividend.

7.       However if reasoning given at point 6 above is accepted, there will be practical difficulties in implementing section 115O, explained as under:-

a)      U/s 115BBD, tax on dividend is required to be paid @ 15% on gross basis without allowing any deduction for expenses

b)      In the absence of section 115BBD, tax on dividend will be paid @ 30%, net of expenses

c)       Considered a case, where parent company incurred expense of Rs. 50,000 in earning dividend of Rs. 60,000 from subsidiary company.

d)      Parent company will pay tax of 30% of net dividend of Rs. 10,000 (60,000-50,000)

e)      Question for consideration is how amount of such dividend shall be deducted by parent company while calculating DDT on dividend declared by it i.e Rs. 60,000 or Rs. 10,000

Hope that Final Finance Act, 2014 will definitely throw clarity on these aspects