India has today become synonymous with outsourcing of services, and significant cost savings is the key driver for this phenomenon. That being said, it cannot be denied that among the key factors that companies consider carefully before outsourcing their operations to India are the tax issues. Associated with these issues are the costs of such a move and the level of certainty provided to corporate boards.
Increased outsourcing of services has, among other issues, led to
Flow of consideration for services from the overseas jurisdiction, and vice versa, between the recipient and the service provider; and
Movement of personnel to India from an overseas jurisdiction, and vice versa.
The following are some of the relevant issues in the context of the two streams of transactions mentioned above:
Inter-company pricing should comply with the arm's-length price requirement under the transfer pricing law in the Indian Income Tax Act 1961; and
Movement of personnel could expose the employer entity to taxation in the other jurisdiction by way of creation of a presence through a permanent establishment (PE). Such a PE created by the employees is generally referred to as a service PE.
The judiciary in India has recently passed two landmark judgments, the decision of the Supreme Court in the case of Morgan Stanley & Co (decision dated July 9 2007) and the decision of the Special Bench of the Income Tax Appellate Tribunal (ITAT) in the case of Aztec Software and Technology (decision dated July 12 2007).
While the decision of the Supreme Court deals with issues relating to the exposure of foreign companies in India, the ITAT decision deals with certain issues germane to the transfer pricing law.
Supreme Court's decision in the case of Morgan Stanley
The taxpayer, Morgan Stanley (MS), a US tax resident, established a group company in India [Morgan Stanley Advantage Services Private (MSAS)]. MSAS provided back office operations, data
MS had proposed to send its employees to India for the following:
To acquaint MSAS with the global standards and requirements of the services expected of MSAS, in other words for providing stewardship services to MSAS; and
On deputation to MSAS, at the latter's request.
It was however proposed that such employees would remain on the payroll of MS and the actual cost (without profit element) of these employees was to be reimbursed by MSAS to MS.
For its support services, MSAS was to be remunerated by MS on costs plus mark-up basis. The mark-up arrived at was 29% on the basis of a transfer pricing study, using the transactional net margin method (TNMM).
Based on the advance ruling application filed by MS, the Authority for Advance Ruling (AAR) had held that:
MS would be regarded as having a service PE in India under article 5(2)(l) of the India-USA tax treaty as it proposed to send its employees to India for undertaking stewardship activities or on deputation; and
As MSAS was remunerated at arm's-length, no further income could be attributable to the Indian PE of MS.
Issues before the Supreme Court and decision
Whether MS had a PE in India?
The Supreme Court held that one had to undertake a functional and factual analysis of each of the activities to be undertaken by an establishment to decide whether there was a PE or not. MSAS was performing only back office operations in India. Accordingly, MSAS did not constitute a fixed place PE [under aticle 5(1) of the treaty] as regards its back office functions.
Independent of the above, the court also observed that MSAS would not constitute a fixed place PE as the functions performed by MSAS would fall within the excluded category of preparatory and auxiliary services, as provided under article 5(3)(e) of the treaty.
The court ruled out the possibility of MSAS creating an agency PE [article 5(4) of the treaty] for MS in India because the MSAS had no authority to enter into or conclude contracts on behalf of MS.
The court said that the stewardship activity was to protect the interest of MS itself, and it could not be said that MS was rendering services to MSAS in this respect. Against this background, it was held that the stewardship activity would not attract the service PE provisions under article 5(2)(l) of the treaty. On this point, the Supreme Court differed with the decision earlier given by the AAR.
As regards the deputation of employees, it was held that the employees on deputation could be considered as constituting a service PE in India for the foreign company in a case where:
the foreign company is responsible for the work of the deputed employees; and
such employees continue to be on the payroll of the foreign company or continue to have a lien on their jobs with the foreign company.
The court held that employees on long-term deputation to MSAS constituted a service PE of MS under article 5(2)(l) of the treaty.
Whether after making payment at arm's length, any further income was attributable to such PE, if any?
The Supreme Court has in principle concurred with the ruling of the AAR that an associated enterprise (that also constitutes a PE) was remunerated on an arm's-length basis taking into account all the risk-taking functions of the enterprise. Having made the observation, the court decided that there should be no additional profits attributable to such a PE in India.
It observed further that the situation would be different if transfer pricing analysis does not adequately reflect the functions performed and the risks assumed by the enterprise. In such a situation, there would be a need to attribute profits to the PE for those functions/risks that have not been considered.
The court also observed that TNMM is the appropriate method in the case of a service PE as it apportions the total operating profit arising from the transaction on the basis of sales, costs, assets and so on.
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Ganges River in Varansi |
Clarity on profits
The Indian government and the Central Board of Direct Taxes (CBDT) have tried to clarify the extent of global profits earned by a non-resident enterprise that could be attributed to the activities of its captive service units in India. This ruling will definitely provide clarity on the issue by providing that no income needs to be further attributed to India if the transactions are at arm's length, taking into account the functions performed and the risks assumed by the Indian enterprise.
The ruling clearly reinforces the importance of robust transfer pricing documentation and economic analysis of the functions and risks assumed by the entities.
Though the ruling affords the much desired stability and clarity on the matter, at the operational level, the question of determination of appropriate arm's-length remuneration is still open to tax officers to decide. The determination of arm's-length remuneration is necessarily a subjective criterion that revolves around the facts and circumstances of each case. It is for this reason that many countries have introduced alternative arrangements such as advance pricing arrangement (APA) and safe harbor rules to afford greater operational certainty in specific cases. It is desirable that India also introduces such provisions at the earliest.
One would have to wait and see how the tax authorities interpret and implement the ruling. At ground level, it is expected that the comment of the Supreme Court that TNMM is the appropriate method will become a subject matter of debate. Furthermore, the assessing officers could also be influenced by the fact that MSAS had offered the price at a cost plus 29% mark-up as the arm's-length price. Though the functions, assets and risks assumed in all cases could be different, tax officers could consider this accepted rate of 29% as a benchmark and seek to apply it universally
over other taxpayers. It would however be premature to make a finer comment on this aspect.The Mumbai Tribunal, in the case of SET Satellite (Singapore) Pte [2007] 106 ITD 175 (Mumbai) had held that dependent agent and dependent agent PE are two different entities which can be taxed in India, and mere payment of an arm's-length price to the dependent agent cannot extinguish the tax liability of the foreign company in India.
One could argue that the decision of the Supreme Court has now superseded this decision of the Mumbai Bench of the Tribunal, the court has held that payments of arm's-length price to the Indian entity would curtail any further attribution of profits to India. However, one needs to be cautious before such a conclusion can be reached as the matter dealt with by the Supreme Court relates to a service PE, whereas a dependent agent PE operates in a different context.
As regards deputation/movement of employees, MNCs typically adopt a mix of the following modes:
Employees come to India to provide stewardship activities;
Employees are sent to India with their payroll still being administered in the overseas jurisdiction; and
Employees are sent to India with the transfer of their employment/ payroll to the Indian company.
In its decision, the Supreme Court ruled out any service PE exposure being created in India of the stewardship method pointed out above. The method pointed out in the transfer to an Indian company method was not in question before the Supreme Court.
It is only with regard to the second method that the court has indicated that there could be a PE exposure for the foreign company. To create any PE exposure in India, the court has clearly laid down the twin conditions that
the foreign company should be responsible for the work of the deputed employees; and
such employees continue to be on the payroll of the foreign company or continue to have a lien on their jobs with the foreign company.
One
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One however wonders why the court did not consider the argument of preparatory and auxiliary services in the context of a service PE, even in situations where there is a deputation of employees from the foreign company. The
judgement and the overall principles laid down by the court will reassure MNCs with regard to their captive service providers in India. However, a lot of work still needs to be done to cement the clarity.
The Income Tax Appellate Tribunal in the case of Aztec Software and Technology Services (
Aztec Software decision
The taxpayer, Aztec Software & Technology Services (Aztec), is a company registered in India, engaged in the business of development and export of software. Aztec was entitled to claim income-tax benefit on its profits, under section 10A of the Act.
The company had set up a subsidiary, Aztec Software (Aztec Inc) in the US for providing marketing and onsite software development services. For its services, Aztec Inc was remunerated by Aztec on a cost plus 10% and on a cost plus 5% basis, respectively.
The transfer pricing officer (TPO) passed his order in the case of Aztec and recommended an adjustment on the basis that the service fee paid to Aztec Inc was excess. On receipt of the order from the TPO, Aztec was given an opportunity of hearing by the assessing officer (AO). Finally, the AO passed the assessment order confirming the adjustment proposed by the TPO.
The taxpayer challenged the order of the AO before the Commissioner of Income Tax (Appeals) [CIT(A)] on several grounds, which covered issues relating to:
The jurisdiction and procedure for making a reference to the TPO;
Arguments on the merit of the case.
The CIT(A) subsequently passed an order deciding the issues in appeal partly in favour of the taxpayer. The comment that the transfer pricing provisions could be invoked only if there was sufficient material before the AO that the conditions set out in clauses (a) to (d) of section 92C(3) of the Act were being satisfied or an opinion could be formed that it was necessary or expedient to refer the computation of the arm's length price to the TPO.
The CIT(A), in his order also commented that instruction No 3 dated May
Revenue filed an appeal before the Bangalore Tribunal (ITAT) against the order of the CIT(A).
Arm's-length price
The table on the next page
Based on the factual matrix of the case, and the legal issues decided by the ITAT, the order of the CIT(A) has been set aside and the matter has been restored to the files of the AO. As such, the AO will now again refer the matter to the TPO for determination of the arm's length price.
First test and provisions
The Aztec decision is the first of the decisions of the Appellate Tribunal on the issues emanating from the transfer pricing provisions. The decision assumes significance as it has been given by a special five-member bench, and is binding on all the other tribunals.
The ITAT has covered a wide range of legal issues and, wherever relevant, it has followed the principles laid down by the Delhi High Court in the case of Sony India (P) Limited [2006] 157 Taxman 125 (Del).
The decision is being perceived as a shot in the arm of the revenue, with most of the issues being decided in its
favour . This could serve as a serious blow to the industry, which is already struggling with the high pitched transfer pricing assessments being made by tax officers. However, it only signifies a long tussle between the revenue and the tax payers.The ITAT has remanded the matter back to a tax officer to give Aztec another chance to prove that its transactions with group companies are at arm's length. What is interesting to note is that if the TPO again determines that the international transactions of the company are not at arm's length, then Aztec might again have to appeal against the order. This would mean that whole factual process would need to be re-examined and re-determined by the CIT(A) and so on, leading to a multiplicity of proceedings.
This would only lead to more uncertainty and lack of finality on this matter for a significant period to come.
It is feared that the decision will set a bad precedent and could lead to transfer pricing appeals being remanded back to the tax officer. This will only result in redoing the entire transfer pricing assessments and stifling the appellate proceedings.
In parallel, until there is finality on the matter, the tax department will be churning out the annual assessment orders, raising significant tax demands.
Issue |
Decision/observations of the Tribunal |
Should the AO demonstrate that there is tax avoidance for invoking the transfer pricing provisions? |
The provisions can be invoked by the AO where he either finds the existence of the circumstances mentioned in clauses (a) to (d) of section 92C(3) of the Act or he considers it expedient or necessary to do so. There is no other requirement mentioned in the Act and the AO need not demonstrate the existence of tax avoidance. This answer would apply even |
Whether it is a legal requirement that the AO should demonstrate that the circumstances set out in clauses (a) to (d) of section 92C(3) of the Act are satisfied, before making a reference to the TPO? |
The circumstances mentioned in section 92C need not be necessary for invoking provisions of section 92CA. |
Whether the AO is required to record his opinion before seeking an approval from the CIT for making a reference to the TPO? |
Collection of information and material from the taxpayer at this stage and then recording the opinion is not mandatory. However, the AO must have some material on record as the same is essential in obtaining an approval from the CIT. |
Whether the AO has to grant an opportunity to the assessee before making a reference to the TPO? |
There is no requirement for giving an opportunity to the taxpayer before a reference is made. |
What is the legal effect of Instruction No 3 of 2003 dated May |
There is no fault or illegality in the Instruction. |
What is the role of the AO after receipt of the order from the TPO? |
The words having regard to in section 92CA(4) convey strong meaning and are strong enough to enjoin upon the AO to pass the order and adopt the transfer pricing ordered by the TPO. Thus, only if the AO has recorded reasons, can he take an arm's length price other than the one proposed by the TPO. |
Whether multiple year data can be used? |
However, after the amendment brought in by the Finance Act 2007, with effect from June |
Whether NASSCOM rates can be considered as a comparable uncontrolled price (CUP) for conducting a comparability analysis? |
The Tribunal made a passing reference to the revenue's objection by saying that if it is not shown that data pertaining to previous two years influences the determination of arm's length price, the same cannot be used for benchmarking the international transactions. |
Robust compliance
These two decisions clearly reinforce the importance of robust compliance with the transfer pricing provisions in the Act. There can be no debate that transfer pricing is not an exact science and the arm's-length price for any transaction can be scientifically and arrived at accurately. This is the reason why it has emerged as one of the top most concerns for industry leaders operating in India.
Having said that, one should not lose sight of one of the canons of taxation – certainty. To move towards this direction, the Indian government should introduce concepts such as advance pricing arrangement and safe
KR Girish is head of tax for KPMG in South India krgirish@kpmg.com, Rohit Jain, manager rohitjain@kpmg.com.
