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INTRODUCTORY OBSERVATIONS

65. The question of allocation is still in its initial stage. It was not only the great increase in the levies during and after the war which made the taxation problems more and more the centre of public interest,1 but also the considerable expansion of the tax department, and the affiliated tax-accountancy department, which have brought the problem of the apportionment of profits to the fore. The international interest taken in these questions, especially from the viewpoint of the prevention of double taxation, has roused the taxpayers to greater activity. They in turn have made the taxation experts enter more deeply into the study of the problems which must be settled by the administration. Although it is impossible to give positive answers to the questions on apportionment, they will be treated from the viewpoint of practical experience, which is still in a state of constant growth and change. Needless to say, the viewpoint is bound to vary with these changes.

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66. Basic Principles for allocating Profits. — Foreign enterprises are taxable on the profits derived from carrying on an enterprise — i.e., a business or industry, in this country (Company-Tax Ordinance, Article I, paragraph I, sub-head 30). According to the official theory liability arises if the foreign enterprise maintains economic relations with N.E.I., and is delimited by the extent of these economic relations. It is evident that tax liability is not restricted to profits from business activities taking place within the boundaries of N.E.I. On the contrary, the business unit in N.E.I. is taxable on income from all its activities even if some of such activities are carried outside N.E.I. If the non-resident enterprise has, however, a permanent establishment in the other countries to which the activities of the N.E.I. business extend, then the profits attributable to such establishment are not taxable in N.E.I.

There is no statutory or administrative rule as to which method should be applied for a proper apportionment of the profits, or which factor should be taken into account. The circumstances and conditions of each enterprise have to be studied individually in order to arrive at an equitable apportionment. The study of the nature of the business will show the value of the profit-making factors inherent therein, and will furnish an answer to the other question — viz., whether and to what extent profits should be attributed to business activities outside the N.E.I., and therefore excluded from the assessment. The Court of Tax Appeals has repeatedly upheld the administration in refusing to reduce the assessment when the taxpayer contended that a part of the profits should be allocated to activities outside N.E.I., when such activities were, in fact, non-productive of profits — e.g., book-keeping and technical supervision. In due time, certain general principles will emerge, and the Court of Tax Appeals will doubtless assist in establishing them.

67. Allocation of Income from Reserves. — A corollary of the above principle is that all income derived from capital set aside by a foreign enterprise for carrying on economic relations with N.E.I. is taxable. Consequently, income is allocated to N.E.I. for tax purposes, whether it is in the form of income derived from using the capital in the business in N.E.I., or placing capital temporarily unemployed for such purposes on deposit in a bank in N.E.I. or abroad, or investing it in bonds or stocks in N.E.I. or abroad.

68. The amount of money needed in the carrying on of the business in N.E.I. fluctuates from time to time, especially in the case of agricultural enterprises, and the funds temporarily unemployed or waiting to be used in the business obviously cannot be separated from the business itself. Consequently, when directors have set aside a part of the profits as a reserve, these funds really belong to, and fulfil a function in the business here, even though they are deposited in a bank abroad or invested in foreign securities. If placed on deposit, there is no essential difference whether the funds are deposited by the branch of the enterprise in the N.E.I. branch of a bank or by the head office of the enterprise in the principal establishment of the bank abroad. It is also immaterial whether the bonds or stocks purchased are kept by the head office or the branch, and whether the income is received abroad or in N.E.I.

69. Similarly, income from securities used as collateral on loans to be employed in the business here is considered a part of the earning of the N.E.I. business. The cardinal test is whether the funds belong to or are destined for use in the N.E.I. business, regardless of what they are called. Such funds include, inter alia, funds to pay cost of leave of employees, depreciation reserves or repair funds, pension reserves, reserves for taxes or for other purposes.

70. When the funds lose their character as a reserve for the N.E.I. business, the income therefrom ceases to be taxable. Such is the case when the “reserves” have grown so large that they are more than adequate for the possible need of the business in N.E.I., and the directors give this excess the character of a permanent investment outside the local business. For example, such an investment is constituted when the money is invested in another business in N.E.I. or abroad, through organising a subsidiary company or buying the shares of an existing company.

71. Allocation between Netherlands and N.E.I. — Between the Netherlands, where the assessment of companies is based on distributed dividends, and N.E.I., where the tax is on profits, difficulties on account of double taxation arise repeatedly. These difficulties also arise in connection with the difference in the rate of tax. Article 27 of the Netherlands Law on Dividends and Percentages Tax only allows remission for two-thirds, when the profits, out of which the dividends are paid, have been made in N.E.I. The so-called Indian profits are therefore taxed at one-third of the normal rate. Moreover, there is often a difference of opinion between the Dutch and N.E.I. tax authorities on the question of what should or should not be considered as (so-called) Indian profits. Double taxation is, therefore, not only the result of the difference between legal provisions, but also of this discrepancy in opinion. In order to avoid such double taxation, the authorities of N.E.I. are in constant consultation with those of the mother country. As a result of this collaboration, a satisfactory solution, or at any rate an approximate solution, is to be expected for the problem of the apportionment of profit between the two jurisdictions.

(a) BOOK-KEEPING AND ACCOUNTING REQUIREMENTS

72. According to Article 13 of the Company-Tax Ordinance of 1925, foreign companies working in this country must arrange their book-keeping in such a way as to show all the data necessary for calculating the profits made by the enterprise in N.E.I. The taxpayers are expressly informed that, in the checking of their return, their book-keeping will be taken as a starting-point.

73. The dealings of companies incorporated in N.E.I. must be recorded in such a manner that the profit made through the carrying on of the business, or from the capital employed or invested outside, can be ascertained through the books. Companies incorporated abroad must keep their books in such a manner as to show, not only the profit made through the business in N.E.I., but also income from reserve funds belonging to that business, regardless of where such funds may be invested. The books must be kept in either Dutch, Malay or Chinese, or in another language approved of by the director of finance (French, English, German). The book-keeping must include a continuous record of the cash position, and a statement of debtors, creditors and stocks, which must be kept up regularly and closed off annually, and, furthermore, a balance-sheet must be made up every year. The books and documents relating thereto must be kept for ten years.

(b) METHODS OF ALLOCATION

74. It is clear that different methods will have to be applied for the various categories of enterprises. A careful study of the peculiarities of each separate enterprise will lead to a better understanding of the value of the various factors which contribute to the making of profits. Some of the factors which will always receive careful consideration in the course of the checking of the taxpayers’ returns are: the fact whether the activities of the business are industrial or agricultural, or exclusively buying and selling; the turnover; the analysis of the costs; the fixed capital and the fluid capital used in N.E.I.

75. Practically all the great industries producing raw material or staple products operate exclusively in N.E.I, and therefore raise no problems of apportionment. Problems arise, however, in the case of enterprises whose products for some reason or other have no regular quotation in the world market, and have to undergo more or less intensive treatment before being ready for consumption. Up to the present, it has been possible to arrive at a reasonable assessment by making a comparison with the proceeds from the sale of raw material by other enterprises, or by an estimate of the influence of the manufacturing process on the sale price. But the fact that many difficulties have to be faced cannot be denied. For instance, many point out that, as a result of increasing competition or of other causes, the organisation of the sales outside the N.E.I. territory is a factor of ever-growing importance for the making of profits. This makes it urgent to study more intensively the structure of the business, so as to be able to decide whether a part of the total profit may be attributed to this sales organisation, because of its having a permanent influence in making the profit.

76. Similar difficulties arise, when the producing department has been formed into a separate corporation, and the sales are entrusted to another company, which forms part of the same world concern. The relation between the sales corporation and that concern may be similar to that of a branch and a parent company, or it may be that the production and the sales corporations are both subsidiary companies of another company which holds their capital stock. When such is the case, the N.E.I. tax administration is naturally not tied to any juridical limits. Endeavours will have to be made to determine the profits realised by the company working in this country — i.e., the profits derived from the production of the raw material, and this, if necessary, independently of the data furnished by the parties interested. In some instances, it may be necessary to examine the results obtained by the entire composite body, so as to obtain a correct idea of the profits made in this country.

77. With regard to companies whose activities in N.E.I. are limited entirely to the buying of produce, the assessment of the profits offers many divergent points of view. In such cases, the books are often inconclusive, because the concern abroad looks upon the organisation in this country as only an item of expense, and does not recognise that buying as well as selling are factors in the making of profits. When the buying is carried on wholesale, there will often be arguments for fixing the gross profits at the same amount as the buying commission which would be paid to a third party. When there is an extensive organisation for buying transactions, a different procedure will have to be found for the determination of the Indian profits (see paragraphs 109 and 110).

78. It also occurs — and apparently these difficulties are found throughout the world — that the books and accounts of a branch, however complete and perfect, cannot be taken as the basis for the calculation of the profit derived in this country. This is the case, for example, when it is impossible to verify the invoicing of the head office or the branches abroad to the branch in this country. In these cases taxable income is estimated, as a rule, on the basis of a presumed yield at the prevailing rates of interest on the capital invested, or on the turnover. As this method does not assure accuracy, the results may be further verified by examining the invoices showing the cost to the head office or the branch shipping the goods to N.E.I.

1. Method of Separate Accounting

79. In general, the fiscal authorities start from the principle that the profit made by the N.E.I. part of the enterprise must be proved by the book-keeping carried on in this country. The annual statements sent in with returns, and containing the data for the so-called East Indian profits, will serve as a basis of assessment. This procedure is just; bona-fide taxpayers, who have arranged their book-keeping in such a way that it gives a clear insight into the profit made by the “branch”, need not have their entire book-keeping examined. Of course, the taxpayer may at all times be asked to give any information with regard to the book-keeping of the branch, its relation to the chief book-keeping and to that of other branches, the manner of invoicing, the calculation of compensation for services rendered by the other branches to the Indian branch. This procedure has also practical advantages, because the Company-Tax Ordinance imposes on the taxpayer an obligation the ignoring of which will place him in the position of a defaulter. The administration may then estimate the taxable income.

80. A considerable number of the enterprises working in N.E.I. are resident in the Netherlands. A few years ago a branch of the N.E.I. tax-accountancy service was instituted in the Netherlands; this enables the administration to examine the chief book-keeping of those bodies established in the Netherlands, with their consent. Up to the present, no objections have been raised by the taxpayers against this examination. It goes without saying that there is a perfect co-operation between the two services, the one in N.E.I., the other in the mother country. In a few instances, the N.E.I. authorities have examined the principal book-keeping of businesses established in other countries with the consent, of course, of the taxpayer.

2. Empirical Methods

81. When the book-keeping and other detailed evidence regarding the business in N.E.I. are insufficient, 50 that it is impossible to calculate the local profits on the basis thereof, some other method of allocation must be employed. Efforts are made to collect as much data as possible, so as to obtain a reasonable basis to start from. When the gross receipts, or turnover figures, are known (and, as a rule, they are), a gross profit may be computed by applying to the gross receipts a percentage based on data obtained from similar enterprises. From the gross profit thus estimated, the expenses of the local establishment are deducted in order to arrive at the taxable net profit. As a rule, valuation of the net profit with reference to gross receipts is not to be recommended, as this method is not exact enough, and is apt to neglect differences in costs of doing business in the various countries where the enterprise has branches. The book-keeping of the local branch should show the actual expenditures in N.E.I. The problem of the extent to which the general expenditure of the enterprise is deductible from the profits of the local branch is not be solved along general lines, but depends on the circumstances of the particular kind of business.

82. In certain cases it is assumed that a certain amount may be allowed for the buying office as buying commission, and that it should be equal to the usual buying commission paid to a third person. But this method has the drawback that profit is always attributed to the country where the buying is done, without taking into consideration the total results of the business. Hence, preference is given, on practical and theoretical grounds, to the method of expressing the N.E.I. profits as a fraction of the total profits.

3. Method of Fractional Apportionment

83. If the accounts of the head office show the total net profit of the foreign enterprise, an analysis of the structure of the activities of such an enterprise and of its possibilities for making profit in N.E.I., as compared with those in the other countries in which the enterprise operates, will indicate which part of the total profit should be taken as a minimum to represent the so-called N.E.I. profit. The fixing of this proportion may be facilitated by making a comparison with other enterprises. Another method is to take the net results of the entire enterprise as a basis and calculate how much should be allocated to the part of the enterprise abroad and therefore excluded from the assessment. In some cases, an apportionment of profit in accordance with the turnover figures will be the most practical method.

84. On the part of the taxpayers, repeated efforts have been made to arrive at an apportionment of profits on the basis of wages paid for labour performed in obtaining the profits. In order to have a reliable basis of comparison, it may be necessary to correct these figures, so as to take into account the difference in the wage standard prevailing in different countries. This reasoning is based on the thesis that the carrying on of a business consists of the organic use of the means of production — viz., labour, soil and capital; and that the two latter elements ought not be taken into consideration for the allotment of profits. The N.E.I. authorities have rejected, in principle, this basis for the apportionment of profits, and they have been upheld by the Court of Tax Appeals. The primary reasons for rejecting this basis are that the wage-scale varies so greatly from country to country that it cannot be taken as a common basis for comparing the profit-earning capacity of the branches in the different countries, and also that, in the case of many enterprises producing raw materials, their very life is due to the soil, climate and other circumstances peculiar to N.E.I. For example, this country in 1931 produced 90 per cent of the world supply of cinchona from which quinine is made, and the tobacco of Sumatra has a certain quality which is not found elsewhere.

85. It has therefore been definitely settled that the amount of wages paid out in the different countries cannot be taken as a basis for the apportionment of the profits. There remains the difficulty of selecting a guiding principle for apportionment. Happily, certain opinions are developing, and these are carefully watched, both by the taxpayer and the administration. For instance, for enterprises which buy at their head office in Europe and sell in N.E.I., the profits are apportioned in the ratio of 25 per cent to the buying office and 75 per cent to N.E.I. These figures may vary, however, for each individual concern.

86. The international trade in raw products offers particular difficulties, because it is frequently carried on by enterprises with their head office in Amsterdam, London, New York or elsewhere, and with purchasing branches in N.E.I., and selling branches in other countries. The N.E.I. branch is instructed by cable to make purchases, sometimes for subsequent sale abroad, sometimes to cover sales already made, sometimes for a mere speculation. It is often impossible to determine the results obtained by the various transactions, because buying and selling are intermingled in such a way that the value, or at any rate the result of each transaction, cannot be traced separately. And, even if the result could be traced, there remains the difficulty of deciding to whose initiative, or to which other activities, the profit derived from the buying or selling is to be attributed, and whether these factors are within or without N.E.I. The total or general results will have to be found in the annual accounts. In practice, the taxpayers have always shown great willingness in supplying the authorities with the information desired, and the profits are allocated as described under the heading “Buying Establishments” (paragraphs 109-114).

87. On the whole, the verification of general results should be restricted to a written explanation of the items in the annual accounts and written answers to certain questions about the system of valuation of stock, depreciation, overhead and running expenses, reserves, etc. Delicate questions are always presented by the manner in which the head office charges the local branch with supplies, services and overhead expenses. The examination of the principal book-keeping is usually only possible in the case of Dutch companies operating in N.E.I. Although it must be admitted that this is an unsatisfactory state of affairs, it is plain that a satisfactory solution is hard to find.

88. Subsidiary companies of large concerns have sometimes caused difficulties when the annual statements of the parent company were subjected to a closer examination. The taxpayer argued that it is not necessary to examine the results of the other subsidiary companies abroad for the sake of verifying the profits of the subsidiary company here, once they have — in their opinion — provided sufficient data for the latter.

4. Requirements for the Selection of Methods and Value of the Various Methods

89. The Ordinances in force do not lay down any rules for the application of one or another method. The authorities have perfect liberty in selecting any method of apportionment. Foreign concerns may not demand the application of a certain method. However, as the Company-Tax Ordinance requires foreign concerns to keep their books in such a way as to show the East Indian profits, the authorities first examine the separate accounting. They will only deviate from this method when they find that the figures actually fail to show clearly the profits made by the enterprise in N.E.I., or when this method is precluded by the nature of the business. The Ordinance makes an exception only for insurance companies which may choose between separate accounting and fractional apportionment (see paragraph 33).

90. It cannot be said positively which method is considered the most practical and satisfactory from the viewpoint of normal use and of prevention of tax evasion, because the circumstances of one concern will point to one method, and those of another concern to a different one, or even to a combination of various methods. Generally speaking, it may be stated that, for the great agricultural and mining concerns, it is possible to arrange their accountancy in this country in such a way that the figures give a clear idea of the financial results. At the same time, it will be necessary to verify the branch accounts in the light of annual accounts, invoices and compensation accounts of the head office, and, as a rule, this can easily be done. The export and import concerns present the real difficulties, and there is a growing tendency to fix the Indian profits at a certain portion of the total result.

(c) APPORTIONMENT BETWEEN BRANCH AND PARENT ENTERPRISE

1. Apportionment of Gross Profits of Local Branch to Real Centre of Management abroad

91. The mere fact that the management of a business is not established in N.E.I., whereas the business itself is carried on entirely in N.E.I., cannot be considered of sufficient importance to justify holding that part of the profits have been made in the country where the management is situated. This standpoint is due to the fact that the enterprises in N.E.I. are primarily agricultural and mining enterprises. The former might be called agricultural-industrial concerns, because they turn the raw material into the product fit for the international market in their own factories on their own estates. For staple produce (sugar, tea, coffee, pepper, copra, tin and rubber), world market prices exist, and many of these products are sold by tender or sealed bids.1 Consequently, the work of the directors with regard to the selling is of very little importance in the making of profits. Moreover, the fact that a corporation is established outside of the N.E.I. is often of a purely formal nature.

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92. Sometimes the management abroad performs services to which part of the profits may be attributed; but, in principle, no special part of the profits is to be apportioned to the management as such. Practice will, no doubt, reveal that, in many concerns, it is impossible to keep strictly separate the management as such and its activities with regard to the making of profit.

2. Apportionment of Expenses of Real Centre of Management to Branch

Interest Charges

93. When only the real centre of management is established outside N.E.I., while the entire business of the foreign enterprise is carried on in this country, the total interest carried by the centre of management on behalf of the enterprise will be charged to the account of the profits taxable in this country. When, on the other hand, the foreign company has several branches, the interest will have to be divided among them. We take, for example, an English rubber company operating exclusively in Sumatra. One day it decides to open rubber estates in Liberia. For the financing of the latter, it is compelled to negotiate a loan. In such case the interest on the loan will not be charged against the East Indian profits. When, however, an import firm has branches in different countries, it will be pretty well impossible to assign loans to any particular branch, and the apportionment of the interest charged will be made according to the degree of importance of each branch in the business complex. As a rule, the turnover figure may be taken as a basis of apportionment.

General Overhead

94. A similar reasoning is applied for the overhead expenses, on the understanding that, for these expenses, the importance of the branch in the business complex is always the basis for the apportionment. When the enterprise in India is the only business of the foreign company, so that only the management has its seat outside this country (a form which is found very generally in agricultural and mining enterprises), the overhead expenses are, as a general rule, deducted from the profits. Then the profits are put down in total as N.E.I. profits.

95. Some concerns contend that the charges, commissions, etc., made for services to the branch should be deducted from the East Indian profits, but the Court of Tax Appeals has confirmed the opinion of the administration that such deductions should not be allowed. Although it might be fair to allow such deductions in the case of banks and import and export enterprises, it will never be easy in their case to settle the question directly in figures.

3. Apportionment of Net Profits

96. It is impossible to lay down a general rule in connection with the apportionment of part of the net profits of the branch to the deficitary parent, or vice versa.

When an enterprise operates at a total loss, no profit will be allocated to the Indian branch if, for instance, the enterprise consists only of a buying establishment outside N.E.I., and a selling organisation in this country. If, however, there is only one buying establishment outside this country, but several selling establishments in N.E.I. and various other countries, it is quite possible that some profits will be allocated to the East Indian branch, even when the whole enterprise has been working at a loss. This is perfectly logical in view of the fact that possibilities for making profits vary considerably in the different markets. In cases like these, the only way to arrive at satisfactory conclusions is to make an exhaustive analysis of the business itself and a careful comparison with similar enterprises carrying on their business in this country. The above problem is still in its initial stages of development.

97. When the enterprises concerned possess only a wholesale buying organisation within N.E.I., whose profit is calculated by considering a certain commission on the buying as East Indian profit because a more reliable method is lacking, it is conceivable that a certain amount of profit is assessed as having been realised in this country, while the total result of the enterprise would be negative. This gives an example of the undesirable consequences to which this system may lead.

98. With regard to foreign enterprises carrying on agricultural or mining activities in this country, which manufacture the raw products into finished articles and sell them in foreign countries, the East Indian profit can justly be taxed where the business in its entirety is working at a total loss on account of losses sustained in the manufacture abroad of the raw material, or in the sale abroad of the finished product. The East Indian profit would be delimited by the price obtainable for the raw product in the world markets.

(d) APPORTIONMENT BETWEEN PARENT ENTERPRISE AND SUBSIDIARIES

99. The present trend of the practice is to determine, as much as possible, the profits made by the subsidiary as if the latter existed independently of the parent company. This has always been done where the parties concerned have maintained separate accounts for the “dummy” and have declared as its profits the full profits of agricultural or mining enterprises. In many cases, however, serious problems have been presented by the fact that the book-keeping of the parent company does not treat the “dummy” as a separate entity, and represents the holding company as the exploiter. Sometimes, from an economic viewpoint the subsidiary enjoys no independent existence, and is, in fact, entirely merged with the parent company.

100. The fiscal authorities are not bound by any settled rule, and if the intention to evade taxation is plain, they have the right to assess the parent company, notwithstanding the representations which the parties concerned may make. Such cases will, however, always remain exceptional, as the authorities are able, in most instances, to respect the legal fiction and still make the necessary corrections in order to arrive at a fair assessment.

101. The word “dummy” has a special significance in N.E.I., resulting from the fact that the agrarian and mining laws forbid companies, organised elsewhere than in the Netherlands or N.E.I., to acquire long lease rights, or mining concessions, or even prospecting licences. Consequently, foreign (not Dutch) companies can only carry on agricultural or mining enterprises in this country through the intermediary of a representative, which, as a rule, is a subsidiary company organised in the Netherlands or in N.E.I. The subsidiary, as a rule, has little capital and holds the long lease titles, etc. The fiscal administration of N.E.I. has always adhered to the point of view that these subsidiary companies are the exploiters of the land or concessions concerned, and are therefore assessable on the income derived from such properties. If companies take an unfair advantage of this viewpoint, it may be necessary to go a step further, and treat part of the income allotted to the holding company as taxable profits. It will then be necessary for the administration to take into account the profits of the holding company in order to arrive at a proper valuation of the profits of the subsidiary.

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