Apportionment of Income Under Income Tax Act, 1961 (India)

Apportionment, in the context of income tax, refers to the allocation of income between different taxing jurisdictions (states or countries) when a business operates in more than one such jurisdiction. This allocation is crucial to determine the taxable income in each jurisdiction, ensuring that income is taxed fairly and to avoid double taxation. In India, the Income Tax Act, 1961 (the Act) provides provisions and principles for the apportionment of income, particularly for non-residents or businesses with operations spanning multiple states.

Understanding the Need for Apportionment

When a business generates income from activities conducted in multiple locations, determining which portion of that income is attributable to each location becomes essential for tax purposes. Without a clear method of apportionment, companies could face the risk of being taxed on the same income by multiple jurisdictions, leading to an unfair tax burden. Conversely, the absence of apportionment rules could enable businesses to manipulate their operations to shift profits to lower-tax jurisdictions, thus avoiding their fair share of tax.

Legal Basis for Apportionment under the Income Tax Act, 1961

The Income Tax Act, 1961, and its associated rules, particularly Rule 10 of the Income Tax Rules, deal with the computation of income taxable in India for non-residents. These provisions implicitly address apportionment by specifying methods for determining the portion of income that is deemed to accrue or arise in India, thus becoming taxable here.

• Section 5 of the Income Tax Act: This section defines the scope of total income. It specifies that income received or deemed to be received in India, or income accruing or arising in India, or income accruing or arising outside India but received in India, is taxable in India. The concept of 'accruing or arising' in India is crucial for apportionment, as it determines which income is considered to have a sufficient nexus with India to be taxable here.

• Section 9 of the Income Tax Act: This section deals with income deemed to accrue or arise in India. It lists several situations where income is considered to accrue or arise in India, regardless of where it is actually received. This includes:

  • Income through business connection in India: Income attributable to operations carried out in India through a business connection is deemed to accrue or arise in India.
  • Income from property in India: Income derived from any property situated in India.
  • Income from any asset or source of income in India: Income derived from any asset or source of income located in India.
  • Income from transfer of a capital asset situated in India: Gains arising from the transfer of a capital asset situated in India.
  • Salary earned in India: Salary earned for services rendered in India.
  • Interest, royalty, and fees for technical services: In certain circumstances, interest, royalty, and fees for technical services are deemed to accrue or arise in India.

• Rule 10 of the Income Tax Rules: While not directly titled "Apportionment," Rule 10 provides the methods for computing the income of non-residents from business activities. It indirectly addresses apportionment by prescribing how the income attributable to Indian operations should be determined. This rule is often used in conjunction with judicial pronouncements to determine the appropriate apportionment method.

Methods of Apportionment

There is no single, universally applicable formula for apportionment of income. The appropriate method depends on the specific facts and circumstances of each case, including the nature of the business, the location of assets, and the activities performed in each jurisdiction. Some commonly used methods include:

1. Bookkeeping Method: This method involves maintaining separate books of account for the Indian operations. Income and expenses directly attributable to the Indian operations are recorded in these books. This method is suitable when the Indian operations are relatively independent and can be clearly distinguished from the rest of the business.

   • Advantages: Simple to implement and understand if the businesses are clearly independent.
   • Disadvantages: Can be subjective if transactions are interdependent, and may lead to manipulation.

2. Proportional Apportionment Method: This method involves allocating income based on a predetermined ratio or formula. The formula typically considers factors such as:

   • Turnover: Apportioning income based on the ratio of turnover in India to total global turnover.
   • Assets: Apportioning income based on the ratio of assets located in India to total global assets.
   • Payroll: Apportioning income based on the ratio of payroll expenses in India to total global payroll expenses.
   • Composite Formula: Combining two or more of the above factors to arrive at a weighted average.
   • Advantages: Provides a systematic way to allocate income across jurisdictions.
   • Disadvantages: Choice of formula can be subjective, and may not accurately reflect the economic reality of the business.

3. Specific Allocation Method: This method involves directly allocating specific items of income and expense to the jurisdiction where they are generated or incurred. For example, if a non-resident company sells goods to an Indian customer, the profit from that sale would be directly allocated to India.

   • Advantages: Provides a direct link between income and the jurisdiction where it is earned.
   • Disadvantages: Difficult to apply to income that is jointly earned or that cannot be easily traced to a specific jurisdiction.

4. Arm's Length Principle: Section 92 of the Income Tax Act deals with transfer pricing and the arm's length principle. Although primarily applicable to transactions between associated enterprises, the arm's length principle can also be relevant in determining the appropriate apportionment of income. The principle requires that transactions between related parties should be priced as if they were conducted between independent parties dealing at arm's length. This helps ensure that profits are not artificially shifted to lower-tax jurisdictions.

Factors Considered in Determining the Appropriate Method

The tax authorities and courts in India consider various factors in determining the appropriate method of apportionment, including:

• Nature of Business: The nature of the business activities, such as manufacturing, trading, services, or a combination thereof.
• Extent of Operations in India: The scale and scope of the business operations conducted in India.
• Interdependence of Operations: The degree to which the Indian operations are integrated with the rest of the business.
• Availability of Data: The availability of reliable data for applying different apportionment methods.
• Industry Practices: Prevailing industry practices for apportionment of income in similar businesses.
• Judicial Pronouncements: Decisions of the courts and tribunals on similar cases.

Important Considerations and Challenges

• Business Connection: Establishing whether a "business connection" exists in India is a critical issue in determining the taxability of income. A business connection implies a real and intimate relation between the non-resident and the business activities in India, contributing directly or indirectly to the earning of income. The mere purchase of goods in India for export outside India does not, by itself, constitute a business connection.
• Attribution of Profits: Once a business connection is established, the next step is to determine the profits attributable to that business connection. This requires a careful analysis of the functions performed, assets used, and risks assumed by the non-resident in India.
• Transfer Pricing Regulations: Transactions between associated enterprises are subject to transfer pricing regulations under Section 92 of the Income Tax Act. These regulations require that transactions be priced at arm's length, which can impact the apportionment of income between the related entities.
• Permanent Establishment (PE): Under tax treaties, the concept of a permanent establishment (PE) is relevant. A PE is a fixed place of business through which the business of an enterprise is wholly or partly carried on. If a non-resident has a PE in India, the profits attributable to that PE are taxable in India. The rules for attributing profits to a PE are often similar to the rules for apportioning income based on a business connection.
• Double Taxation Avoidance Agreements (DTAAs): India has entered into DTAAs with many countries to avoid double taxation of income. These agreements often provide specific rules for determining the taxable income in each country, which may override the general apportionment principles under the Income Tax Act.

Case Laws and Judicial Pronouncements

Several court cases have dealt with the issue of apportionment of income under the Income Tax Act. Some notable examples include:

• CIT v. R.D. Aggarwal & Co. [1965] 56 ITR 20 (SC): This case established the principles for determining whether a business connection exists in India and the extent to which income is attributable to that business connection. The Supreme Court held that a business connection must be real and intimate, and that the income must be directly or indirectly attributable to the operations carried out in India.
• CIT v. Mitsui & Co. Ltd. [2003] 263 ITR 263 (SC): This case clarified the scope of Section 9(1)(i) of the Income Tax Act, dealing with income deemed to accrue or arise in India through a business connection. The Supreme Court emphasized the need to establish a clear nexus between the business activities in India and the income sought to be taxed.
• Formula used for apportioning income in the case of multinational corporations: Court have generally upheld the use of a composite formula, considering factors like turnover, assets, and payroll, to apportion income of MNCs, ensuring a fair reflection of their economic activities in India.

Practical Examples

Example 1: Turnover-Based Apportionment

A non-resident company sells goods to customers in India and other countries. Its total global turnover is INR 100 crore, and its turnover in India is INR 20 crore. If the company's global profit is INR 10 crore, the income attributable to India, using the turnover-based apportionment method, would be:

(INR 20 crore / INR 100 crore) * INR 10 crore = INR 2 crore

Therefore, INR 2 crore would be taxable in India.

Example 2: Asset-Based Apportionment

A non-resident company has assets located in India and other countries. The total value of its global assets is INR 50 crore, and the value of its assets in India is INR 10 crore. If the company's global profit is INR 5 crore, the income attributable to India, using the asset-based apportionment method, would be:

(INR 10 crore / INR 50 crore) * INR 5 crore = INR 1 crore

Therefore, INR 1 crore would be taxable in India.

Conclusion

Apportionment of income is a complex issue under the Income Tax Act, 1961. It requires a careful analysis of the facts and circumstances of each case, as well as a thorough understanding of the relevant legal provisions and judicial pronouncements. Businesses operating in multiple jurisdictions must carefully consider the apportionment rules to ensure compliance with the tax laws and to avoid double taxation. The choice of apportionment method should be reasonable and justifiable, considering the nature of the business, the extent of operations in each jurisdiction, and the availability of data. Consulting with tax professionals is highly recommended to navigate these complexities and ensure accurate and compliant tax reporting.