Hon’ble Supreme Court of India (‘SC’) in Morgan Stanley’s case on India-USA Double Taxation Avoidance Agreement (‘DTAA’)

Morgan Stanley, USA (‘MSCo’) is an investment bank and a tax resident of USA. Morgan Stanley Advantage Services Private Limited (‘MSAS’) an Indian company and a group entity of Morgan Stanley Group (MS Group), is engaged in the rendition of support services like Information Technology Enabled Services (‘ITeS’) and other back office services to MSCo, another group entity of MS Group. An application to Authority for Advance Ruling (‘AAR’) was first made by MSCo seeking its ruling on possible tax implications which may arise to it under the DTAA from stewardship and deputation arrangement etc. Thereafter, both MSCo and Indian Tax Authorities approached SC by way of a Special Leave Petition (‘SLP’) challenging the ruling of AAR, on respective aggrieved grounds. SC finally disposing both the SLP ‘s had addressed various controversial issues relating to Permanent Establishment (‘PE’), Attribution of Income to PE, Relevance of Arm’s Length Price etc, which are of special relevance to Indian ‘BPO’ sector

Introduction

In view of increasing Foreign Direct Investment (‘FDI’) in India by Multinational Enterprises (‘MNE’s) from various overseas jurisdictions and growing number of complex international tax issues being faced by these MNE’s in relation to their Indian taxation, interpretation and application of Double Taxation Avoidance Agreements has become an important facet of cross-border taxation in India.

In above context, one important development which has taken place in relation to taxation of MNE’s having footprints in India (particularly ‘BPO’ sector) is the recent SC ruling in Morgan Stanley’s case (supra). In this ruling, SC has dealt with issues relating to existence of Permanent Establishment (‘PE’) under Article 5 of DTAA, attribution of Income under Article 7 of DTAA, sanctity of Arm’s Length Price (‘ALP’) etc.

Factual Matrix of the case

MSCo agreed to outsource certain support services like IT support services, account reconciliation, equity research, maintaining industry database, etc. to MSAS in India vide agreement dated 14 April; 2005. Further, MSCo proposed to send its staff to ‘MSAS’ in India on stewardship activities. Further, MSCo proposed to send its staff on deputation at specific request from MSAS and without shifting ‘pay roll’ of deputed employees, MSCo transferred the control and supervision over the deputed employees to MSAS.

In aforesaid background, MSCo first made an application to AAR inviting its ruling on potential tax implications which may arise under DTAA, in view of subject service arrangement, stewardship activities in India and deputation arrangement. Broadly speaking, AAR (152 Taxman 1) held that although MSCo is having no fixed place PE and agency PE in India but MSCo is having service PE constituted in India due to stewardship activities and deputation arrangement, under Article 5 of DTAA. Further, AAR having held that MSCo is having service PE in India, concluded that since MSAS stands remunerated at Arm’s Length Price (‘ALP’), no further attribution and taxability can be made to ‘service PE’ of MSCo in India under Article 7 of DTAA. Further, AAR declined to give its ruling on the question whether mark-up of 29% offered by MSCo to MSAS (applying Transactional Net Margin Method or ‘TNMM’) in relation to subject ‘outsourced services’ complies with transfer pricing provisions contained in Chapter X of Income Tax Act (‘Act’), in view of the bar provided in first proviso to section 245R(2) of the Act.

Challenging aforesaid AAR ruling, both MSCo (on AAR’s ruling constituting MSCo’s ‘service PE’ in India under Article 5 of DTAA) and Revenue (On ARR’s ruling holding i) no fixed place PE and agency PE of MSCo in India under Article 5 of DTAA ii) remuneration at ALP will extinguish any further assessment under Article 7 of DTAA), moved to SC by way of Special Leave Petiton (‘SLP’) under Article 136 of Indian constitution.

Supreme Court’s ruling on existence of ‘PE’ under Article 5 of DTAA

3.1 Fixed place PE under Para 1 of Article 5 of DTAA (Refer Para 6 & 8 of the SC ruling)

In relation to captioned issue, revenue challenging AAR ruling, contended before SC that on facts, MSCo is having fixed place PE in India as it proposes to carry on its business through MSAS in India and has a fixed place of business in the form of MSAS.

SC initially noted that in order to constitute ‘fixed place PE’, it is sine qua non to fulfil i) there is a fixed place of business of MNE in source country and ii) the business of MNE is being carried through that ‘fixed place’. But later on, SC while holding that ‘outsourced activities’ performed by MSAS remain confined to ‘back office’ operations supportive to ‘front office’ operations of MSCo, upheld the views of AAR that MSCo is not carrying any business in India.

In so holding, SC gave an important principle that “In order to decide whether a PE stood constituted one has to undertake what is called as a functional and factual analysis of each of the activities to be undertaken by an establishment.”

In this regard, further useful reference may be made to following rulings

  a) Delhi ITAT Special Bench in the case of Motorola 95 ITD 269 (In relation to ‘fixed place PE’ under India-Sweden DTAA, India-USA DTAA, India- Finland DTAA)

  b) AAR in the case of Sutron 138 Taxmann 87 ( In relation to ‘fixed place PE’ under India-USA DTAA)

  c) APHC in the case of Vishakhapatnam Port Trust 144 ITR 146 (exposition of ‘PE’ concept in DTAA)

3.2 Agency PE under Para 5 of Article 5 of DTAA (Refer Para 9 of the SC ruling)

In relation to captioned issue, SC rejecting the argument of revenue that MSCo is ‘agency PE’ for MSAS in India and upholding AAR’s ruling on the point, specifically concluded that there is no agency PE in India for MSCo as MSAS holds no authority to enter into/conclude contracts in India MSCo in India. In this context, SC also noted that the contracts in present case would be entered and concluded in USA. In this regard, further useful reference may be made to following rulings:

   d) AAR in the case of Indian JV 143 Taxman 71 (In relation to agency PE under India-USA DTAA)

   e) AAR in the case of Al Nisr Publishing 239 ITR 879 (In relation to agency PE under India-UAE DTAA)

    f) AAR in the case of TVM 237 ITR 230 (In relation to agency PE under India-UK DTAA) g) Delhi ITAT Special Bench in the case of Motorola 95 ITD 269 (In relation to agency PE under India- Sweden DTAA)

3.3 Implication of exclusion provided for ‘preparatory or auxiliary activities’ as provided in Para 3 of Article 5 of DTAA (Refer Para 12 of the SC ruling)

In relation to captioned issue, SC besides already holding that MSCo is having no ‘fixed place PE’ in India under Para 1 of Article 5 of DTAA, further held that subject ‘outsourced activities’ proposed to be undertaken by MSAS in India being in the nature of ‘back office operations’, falls under the exclusion of ‘preparatory or auxiliary activities’ and hence do not give rise to ‘fixed place PE’ for MSCo in India. In this connection, it is worth noting here that ‘preparatory and auxiliary’ clause of a DTAA has been considered and applied for the first time by SC. In this regard, further useful reference may be made to following rulings:

   a) Delhi ITAT in the case of Western Union Financial Services 104 ITD 84 (In relation to preparatory and auxiliary activities under India-USA DTAA)

   b) Delhi ITAT Special Bench in the case of Motorola 95 ITD 269 (In relation to preparatory and auxiliary activities under India-USA DTAA)

   c) AAR in the case of UAE Exchange Centre 139 Taxman 82 In relation to preparatory and auxiliary activities under India-UAE DTAA)

3.4 Service PE under Para 2(I) of Article 5 of DTAA qua subject stewardship and deputation arrangement (Refer Para 13,14,15 of the SC ruling)

In relation to captioned issue, SC initially noted that in order to invoke Para 2(I) of Article 5 of DTAA, there are twin conditions which must be simultaneously fulfilled:

   a) MNE furnishes services within India and

   b) that too through its employees

Taking first the issue of ‘service PE’ qua subject stewardship activities, SC allowing MSCo’s appeal and overruling AAR’s ruling creating ‘service PE’ due to stewardship activities, held that MSCo is merely protecting its own interests in the competitive world by ensuring the quality and confidentiality of MSAS support services and it cannot be said that MSCo has been rendering any services to MSAS. Hence, it was concluded by SC that as regards stewardship activities, no ‘service PE’ stood constituted of MSCo in India, under Para 2(I) of Article 5 of DTAA.

Then coming to the issue of ‘service PE’ qua subject deputation arrangement, SC noted in the facts of the instant case that i) on deputation of employees by MSCo to MSAS in India, they do not become employees of MSAS (i.e payroll remained with MSCo) ii) employees are sent on deputation on specific request and need for ‘expertise’ of MSAS in India and iii) employees retained the lien over the their employment with MSCo. Further, in this context, SC laid down a principle that in case MNE continues to be responsible for work of deputationist and deputationists remain on the payroll of MNE (here MSCo) or employees continues to have lien over their employment with MSCo, then a service PE can emerge. Applying the aforesaid principle to the facts of instant case, SC concluded that MSCo is having service PE in India qua deputation arrangement and so upheld the AAR ruling on the point.

In aforesaid context of ‘service PE’, further useful reference may be made to following previous rulings

:  a) AAR in 105 Taxman 218/242 ITR 205 (interalia dealing with ‘service PE’ in India-USA DTAA)

   b) AAR in AT&S 157 Taxman 198/287 ITR 421 (dealing with ‘deputation’ of employees and consequential ‘fees for technical services’ under India-Austria DTAA)

   c) AAR in Teckniskil Berhard 88 Taxman 439/222 ITR 551 (dealing with provision of labour/ manpower and related ‘PE’ issue under India- Malaysia DTAA)

   d) Delhi High Court ruling in the case of HCL Info System 144 Taxman 492/282 ITR 263 and underlying Delhi ITAT ruling reported at 76 TTJ 505 (dealing with ‘deputation’ and tax withholding under section 192 or section 195 of the Act)

In relation to captioned issue, SC upheld AAR’s views that in case MSAS stands remunerated at ALP, no further attribution of income may be made to MSCo’s service PE in India and further held that it will hold good in case subject ALP covers all the risk taking functions of the Indian entity (here MSAS). In so holding, SC laid stress on the adequacy of transfer pricing analysis conducted for determining ALP qua services provided by Indian entity and observed that in case aforesaid transfer pricing analysis do not reflect all the functions performed and risk assumed by Indian entity in India, there would be a need for further attribution of Income to Indian entity. It may be worth noting here that SC in reaching to aforesaid conclusion duly recognized and considered CBDT Circular No. 23 of 1969 and Circular No. 5 of 2004, which have advocated same line of thought on the subject.

In aforesaid context, further useful reference may be made to following rulings:

   a) Mumbai ITAT in Set Satellite 106 ITD 175 (dealing with attribution beyond ALP under India- Singapore DTAA etc.)

   b) SC in Ishikawajima Harima Heavy Industries Limited 158 Taxman 259 (attribution of income to ‘PE’ under India-Japan DTAA)

   c) SC in Hyundai Heavy Industries 161 Taxman 191 (attribution of income to ‘PE’ under India- Korea DTAA)

Supreme Court’s ruling on appropriate transfer pricing (‘TP’) method and adequacy of mark-up

In relation to captioned issue, even though AAR declined to answer on adequacy of mark-up of 29% as offered by MSCo to MSAS in lieu of ‘outsourced services’ rendered to it as per section 245R(2) of the Act, SC going ahead with its plenary powers under Article 136 of Indian Constitution, held in the particular facts of MSCo and MSAS that i) TNMM is appropriate method in case of ‘service PE’ and ii) mark-up of 29% arrived through ‘TNMM’ is correct and appropriate. In this regard, further useful reference may be made to 5 Member Special Bench ruling of ITAT in the case of Aztec Software 107 ITD 141, which has comprehensively dealt with catena of issues surrounding ‘TP’ provisions and recent Delhi ITAT ruling in the case of Mentor Graphics dated 2 November 2007.

Conclusion

   6.1 As regards ‘PE’ issue under Article 5 of DTAA considered and decided by SC in the instant ruling is concerned, it seems that conclusion of SC is based on facts and same may be distinguished from facts to facts. Further, as regards SC ruling on non constitution of ‘service PE’ qua stewardship activities is concerned, it seems that its conclusion is in line with principle underlying ‘service PE’ as codified in UN Model Convention. Further, as regards SC ‘s ruling on ‘service PE’ qua deputation is concerned, it seems that same needs to considered/examined carefully while going for cross border ‘deputation’ in future.

   6.2 As regards issue relating to ‘attribution beyond ALP’ is concerned, it seems that SC has given a landmark ruling by affirming the views taken by CBDT in its Circular No. 23 of 1969 and Circular No. 5 of 2004 and by upholding AAR’s views. In this context, SC has affirmed that once an Indian entity is remunerated at ALP covering all the functions and risks undertaken by it, then no further attribution of income may be made to ‘PE’ of MNE in India. Having said that, subject SC ruling has beautifully highlighted the underlying role played by ‘TP’ analysis in attribution of income and related taxability under Article 7 of DTAA., by holding that ‘TP’ analysis should be wholesome and reflect all risks and functions undertaken by Indian entity in order to avoid any additional attribution.

   6.3 As regards mark-up of 29% which was offered by MSCo to MSAS for ‘outsourced services’ is concerned, it seems that same is restricted to facts of MSCo and MSAS and may get changed from year to year on the basis of respective ‘TP’ study.

   6.4 Broadly speaking, this ruling is a landmark and reverberating in relation to Indian cross-border taxation and particularly for ‘BPO’ sector as it has touched and addressed various issues like existence of ‘fixed place PE’ ‘service PE’ ‘agency PE’ under Article 5 of DTAA, ‘preparatory or auxiliary clause’, extinguishments of any further assessment after remuneration at ALP to captive BPO etc.

   Further, very recently as reported in The Hindu Business Line dated October 28, 2007, revenue authorities have moved a review petition before SC seeking its review on aforesaid ‘assessment beyond ALP issue’ and hence all eyes on this move of revenue are on SC now ..…