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SC ruling may boost outsourcing
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July 10, 2007

In a significant decision on Monday, the Supreme Court ruled that foreign companies would not have to pay tax on their global income earned from business related to their outsourcing arms/units if these are done at existing market prices.

The Supreme Court ruling was in favour of Morgan Stanley's India-based BPO unit which had been served with tax notices by revenue officials asking the company to pay taxes on its global income.

The Supreme Court's ruling is important from a tax law principles point of view and also for captive outsourcing activities of foreign companies.

The case

Morgan Stanley Advantage Services Private Limited (MSAS) is an Indian company, the ultimate holding company of which is Morgan Stanley, USA. MSAS obtained registrations with the Software Technology Park of India (STP) for its Indian operations.

The STP units were engaged in the development of software and rendering of information technology enabled services (ITeS) such as back office operations, data processing, support centre and other related services to the Morgan Stanley group companies.

Morgan Stanley and Co Incorporated, USA (MSCo) (one of the group companies) entered into an agreement with MSAS, under which, MSAS was rendering support services to MSCo.

As part of the agreement, MSCo employees visited India to perform 'stewardship' functions/ activities to ensure that high standards of quality are met by MSAS. The stewardship function included briefing MSAS on expected standards of services, acquainting MSAS staff on various functions by conducting briefing sessions for effective transitioning and providing basic guidance such that the services meet overall global benchmark of Morgan Stanley group.

Although, the activities included monitoring overall outsourcing operations, it did not involve day-to-day management functions of MSAS.

MSCo also seconded its employees to MSAS on deputation (at MSAS' request) for a period up to two years. The deputed/seconded employees continued to be employees of MSCo and were compensated directly by MSCo.  MSAS reimbursed such costs to MSCo without any profit element or markup.

Further, in connection with certain services rendered by MSAS to MSCo, MSAS was compensated on its operating costs plus a suitable mark-up.

A transfer pricing study was conducted by MSAS using Transactional Net Margin Method (TNMM) with operating profit margin as the profit level indicator and was selected as the most appropriate method for determining the Arm's Length Price (ALP).

Based on functions, assets and risk (FAR) analysis, MSAS' margin for transactions with MSCo was determined at 29% based on a average margin of 28.33% determined as the average margin earned by comparable companies, providing similar services.

MSCo filed an application before the Authority for Advance Rulings (AAR) to seek ruling on the following:

Whether MSCo would be regarded as having a Permanent Establishment (PE) in India as per the provisions of India-USA Double Taxation Avoidance Agreement (treaty) in general, and specifically:

If the transactions between MSCo and MSAS were at arm's length, can any further income be attributed to the PE.

Decision of the AAR

The AAR held as follows:

In order to constitute a 'fixed place PE', an enterprise should undertake business through a fixed place of business (including machinery or equipment).

Although MSAS was rendering services to MSCo, it could not be said that MSCo, by utilising such services, was undertaking business activities through MSAS premises. Therefore, no 'fixed place PE' of MSCo was constituted in India.

Since MSAS did not have any authority to conclude contracts (on behalf of MSCo), no 'agency PE' was constituted.

MSCo employees deputed to India, including those performing stewardship functions were actively involved in key managerial activities of MSAS and hence, MSAS would constitute a 'service PE' of MSCo and Morgan Stanley group in India.

The question on appropriateness of transfer pricing methodology for determining the arm's length price and margin was not addressed since it was considered (by AAR) as outside its purview and jurisdiction

Since MSAS was remunerated on arm's length principle, no further income could be attributed to the PE.

MSCo and the Indian Revenue filed Special Leave Petitions before the Supreme Court against the AAR decision.

The Indian Revenue argued that MSCo had a 'fixed place PE' or 'agency PE' or 'service PE' in India and that the arm's length remuneration does not extinguish the possibility of attributing any further income to the PE.  MSCo in turn argued that the AAR decision to hold that it had a 'service PE' in India was incorrect.

Decision of the Supreme Court

The Supreme Court held:

Income attributable to PE

Despite AAR's reluctance to rule on appropriateness of methodology, the Court held that the TNMM methodology followed by MSAS is an appropriate methodology

With respect to attribution of profits to PE, the Court relying on Article 7(1) and Article 7(2) of UN Model convention held that since remuneration to MSAS was supported by a transfer pricing analysis, no further income can be attributed to the PE

The Supreme Court observed, though, in contextually, that determining taxability on the basis of 'economic nexus' would be an important feature in profit attribution.

Observations on the decision of Supreme Court

BMR & Associates, a professional tax advisory firm focussed on providing high quality services to its clients in the area of corporate and international tax, industry regulations, indirect taxes, M&A advisory and business process & it risk services.

It is led by Bobby Parikh, ex-CEO of Arthur Andersen and Ernst & Young in India.

The following are BMR's observations on the decision of Supreme Court:

* Circular No 23 of 1969 and Circular No 5 of 2004.

Nasscom reaction

Statement by the National Association of Software and Services Companies (Nasscom) on the SC ruling in Morgan Stanley case:

The ruling delivered on Monday by the Supreme Court in the matter of Morgan Stanley settles significant issues of principles in taxing the foreign entities who outsource their activities to their captive Indian companies.

The judgment and overall principles affirmed by the Supreme Court will provide reassurance to multinational companies with regard to the operation of their captive BPOs in India. It has also served to clear the unnecessary uncertainty on some of the taxation issues.

The court has clearly brought out that in determination of arms length compensation for the activities of the Indian captive company, the function and risk assumed must be duly considered.

In order to avoid the pitfalls that differing interpretations of this may cause, it is desirable that there be an Advance Pricing Mechanism, so that arms length compensation is determined in advance.

On an overall analysis, it is a very positive ruling for the BPO sector as it settles significant issues. As suggested by Nasscom in earlier representations, the ministry of finance should consider creating an Advance Pricing Mechanism procedure. The APA would allow taxpayers to disclose all relevant facts to tax authorities and obtain a binding ruling on the tax consequences.

Almost every other sizeable tax jurisdiction in the world provides an APA mechanism, including the United States, Canada and Mexico, almost every European country, China, Taiwan, Korea, Japan, Australia, etc. India too needs to immediately put in place an APA mechanism.

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