TMI Blog2007 (7) TMI 201X X X X Extracts X X X X X X X X Extracts X X X X ..... ld's largest diversifying financial services companies. It is a world wide leader in investment banking and it is ranked amongst the top institutions in merger and acquisitions, underwriting of equity and equity and related transactions. It has a major presence in major securities markets, with traders in numerous countries-around the world offering a unique distribution of products. It has three main lines of business, namely securities investment management and investment banking and credit services. Morgan Stanley and Company (for short, "MSCo") is an investment bank engaged in the business of providing financial advisory services, corporate lending and securities underwriting. One of the group companies of Morgan Stanley, Morgan Stanley Advantages Services Pvt. Ltd. (few short, "MSAS") entered into an agreement for providing certain support services to MSCo. MSCo outsourced some of its activities to MSAS. The said MSAS was set up to support the main office functions in equity and fixed income research, account reconciliation and providing IT enabled services such as back office operations, data processing and support centre to MSCo. On May 5, 2005, MSCo (applicant) filed its ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... net margin method (TNMM) was the most appropriate method for the determination of the arm's length price (ALP) in respect of the service agreement dated April 14, 2005. between the applicant and the MSAS and as the said method meets the test of arm's length as prescribed under section 92C of the 1961 Act, no further income was attributable in the hands of MSAS in India. The said ruling of the AAR on the question of income attributable to the P.E. is the subject matter of challenge by the Department. Existence of P.E. in India With globalization, many economic activities spread over to several tax jurisdiction. This is where the concept of P.E. becomes important under article 5(1). There exists a P.E. if there is a fixed place through which the business of an enterprise, which is a multi-national enterprise (MNE) , is wholly or partly carried on. In the present case MSCo is a multi-national entity. As stated above it has outsourced some of its activities to MSAS in India. A general definition of the P.E. in the first part of article 5(1) postulates the existence of a fixed place of business whereas the second part of article 5(1) postulates that the business of the MNE is carr ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... display, or occasional delivery of goods or merchandise belonging to the enterprise; (b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display, or occasional delivery; (c) the maintenance of a stock of goods, or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; (d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise; (e) the maintenance of a fixed place of business solely for the purpose of advertising, for the supply of information, for scientific research or for other activities which have preparatory or auxiliary character, for the enterprise. 4. Notwithstanding the provisions of paragraphs 1 and 2, where a person-other than an agent of an independent status to whom paragraph 5 applies-is acting in a Contracting State on behalf of an enterprise of the other Contracting State, that enterprise shall be deemed to have a permanent establishment in the first- mentioned State if: (a) he has and habitually exercises in that first-mentioned State an authority ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ate of the same or similar kind as those effected through that permanent establishment. 2. Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly at arm's length with the enterprise of which it is a permanent establishment and other enterprises controlling, controlled by or subject to the same common control as that enterprise, in any case where the correct amount of profits attributable to a permanent establishment is incapable of determination or the determination thereof presents exceptional difficulties, the profits attributable to the permanent establishment may be estimated on a reasonable basis. The estimate adopted shall, however, be such that the result shall be in accordance with the principles contained in this article. 3. In the determination of the profits of a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ith separately in other articles of the Convention, then the provisions of those articles shall not be affected by the provisions of this article. 7. For the purposes of the Convention, the term 'business profits' means income derived from any trade or business including income from the furnishing of services other than included services as defined in article 12 (royalties and fees for included services) and including income from the rental of tangible personal property other than property described in paragraph 3 (b) of article 12 (royalties and fees for included services)." In our view, the second requirement of article 5(1) of the DTAA is not satisfied as regards back office functions. We have examined the terms of the agreement along with the advance ruling application made by MSCo inviting the AAR to give its ruling. It is clear from a reading of the above agreement/application that MSAS in India would be engaged in supporting the front office functions of MSCo in fixed income and equity research and in providing IT enabled services such as data processing support centre and technical services as also reconciliation of accounts. In order to decide whether a P.E. stood cons ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... P.E. in the exhaustive sense under the DTAA. This analysis is important because it indicates the intention of Parliament in adopting an inclusive definition of P.E. so as to cover service P.E., agency P.E., software P.E., construction P.E., etc. There is one more aspect which needs to be discussed namely, exclusion of P.E under article 5(3). Under article 5(3)(e) activities which are preparatory or auxiliary in character which are carried out at a fixed place of business will not constitute a P.E. Article 5(3) commences with a non obstante clause. It states that notwithstanding what is stated in article 5(1) or under article 5(2) the term P.E. shall not include maintenance of a fixed place of business solely for advertisement, scientific research or for activities which are preparatory or auxiliary in character. In the present case we are of the view that the abovementioned back office functions proposed to be performed by MSAS in India fall under article 5(3)(e) of the DTAA. Therefore, in our view in the present case MSAS would not constitute a fixed place P.E. under article 5(1) of the DTAA as regards its back office operations. However, the question which arises for determi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ality and confidentiality of MSAS services. We do not agree with the ruling of the AAR that the stewardship activity would fall under article 5(2)(1). To this extent we find merit in the civil appeal filed by the appellant (MSCo) and accordingly its appeal to that extent stands partly allowed. As regards the question of deputation, we are of the view that an employee of MSCo when deputed to MSAS does not become an employee of MSAS. A deputationist has a lien on his employment with MSCo. As long as the lien remains with MSCo the said company retains control over the deputationist's terms and employment. The concept of a service P.E. finds place in the U.N. Convention. It is constituted if the multinational enterprise renders services through its employees in India provided the services are rendered for a specified period. In this case, it extends to two years on the request of MSAS. It is important to note that where the activities of the multinational enterprise entails it being responsible for the work of deputationists and the employees continue to be on the payroll of the multinational enterprise or they continue to have their lien on their jobs with the multinational enterpri ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... eeping in mind the principle of arm's length price. Charges paid or payable by MSCo to MSAS under the service contract have to be accounted as income at arm's length price. There are different methods for determining appropriate transfer pricing. Under section 92C(1) of the Income-tax Act, arm's length price in relation to international transactions has to be determined by any of the following methods: (a) Comparable uncontrolled price method (CUPM) (b) Resale price method (RPM) (c) Cost plus method (CPM) (d) Profit split method (PSM) (e) Transactional net margin method (TNMM) (f) Such other method as may be prescribed by the Central Board of Direct Taxes The taxpayer is required to compute arm's length price for a transaction(s) using one of the five methods stipulated in the Income-tax Rules. Rule 10C(1) of the Income-tax Rules defines the most appropriate method as the method which is best suited to the facts and circumstances of each particular international transaction. As per rule 10C(2) the most appropriate method has to be selected having regard to a number of factors which are enumerated therein. The arm's length price has to be computed by the application of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... clude rules 10A to 10E in the Income-tax Rules. Sections 92A and 92B provide meanings of the expressions "associated enterprise" and "international transaction" respectively with reference to which the income is to be computed under section 92 of the Income-tax Act. We quote hereinbelow sections 92A and 92B of the Income-tax Act: "Section 92A. Meaning of associated enterprise.- (1) For the purposes of this section and sections 92, 92B, 92C, 92D, 92E and 92F, 'associated enterprise', in relation to another enterprise, means an enterprise- (a) which participates, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise; or (b) in respect of which one or more persons who participate, directly or indirectly, or through one or more intermediaries, in its management or control or capital, are the same persons who participate, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise. (2) For the purposes of sub-section (1), two enterprises shall be deemed to be associated enterprises if, at any time during the previous year,- (a) one enter ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ndivided family, the other enterprise is controlled by a member of such Hindu undivided family, or by a relative of a member of such Hindu undivided family, or jointly by such member and his relative; or (l) where one enterprise is a firm, association of persons or body of individuals, the other enterprise holds not less than ten per cent. interest in such firm, association of persons or body of individuals; or (m) there exists between the two enterprises, any relationship of mutual interest, as may be prescribed. Section 92B. Meaning of international transaction.- (1) For the purposes of this section and sections 92, 92C, 92D and 92E, 'international transaction' means a transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature or purchase, sale or lease of tangible or intangible property, or provision of services, or lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises and shall include a mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of, or any contribution to, any cost or expense ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... han one price is determined by the most appropriate method, the arm's length price shall be taken to be the arithmetical mean of such prices, or, at the option of the assessee, a price which may vary from the arithmetical mean by an amount not exceeding five per cent. of such arithmetical mean. (3) Where during the course of any proceeding for the assessment of income, the Assessing Officer is, on the basis of material or information or document in his possession, of the opinion that- (a) the price charged or paid in an international transaction has not been determined in accordance with sub-sections (1) and (2); or (b) any information and document relating to an international transaction have not been kept and maintained by the assessee in accordance with the provisions contained in sub-section (1) of section 92D and the rules made in this behalf; or (c) the information or data used in computation of the arm's length price is not reliable or correct; or (d) the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub-section (3) of section 92D, the Assessing Officer may proceed ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... services provided in the international transaction; (b) resale price method, by which,- (i) the price at which property purchased or services obtained by the enterprise from an associated enterprise is resold or are provided to an unrelated enterprise, is identified; (ii) such resale price is reduced by the amount of a normal gross profit margin accruing to the enterprise or to an unrelated enterprise from the purchase and resale of the same or similar property or from obtaining and providing the same or similar services, in a comparable uncontrolled transaction, or a number of such transactions; (iii) the price so arrived at is further reduced by the expenses incurred by the enterprise in connection with the purchase of property or obtaining of services; (iv) the price so arrived at is adjusted to take into account the functional and other differences, including differences in accounting practices, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market; (v) the adjusted price arrived at under ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... evaluated under sub-clause (ii); (iv) the profit thus apportioned to the assessee is taken into account to arrive at an arm's length price in relation to the international transaction: Provided that the combined net profit referred to in sub-clause (i) may, in the first instance, be partially allocated to each enterprise so as to provide it with a basic return appropriate for the type of international transaction in which it is engaged, with reference to market returns achieved for similar types of transactions by independent enterprises, and thereafter, the residual net profit remaining after such allocation may be split amongst the enterprises in proportion to their relative contribution in the manner specified under sub-clauses (ii) and (iii), and in such a case the aggregate of the net profit allocated to the enterprise in the first instance together with the residual net profit apportioned to that enterprise on the basis of its relative contribution shall be taken to be the net profit arising to that enterprise from the international transaction; (e) transactional net margin method, by which,- (i) the net profit margin realized by the enterprise from an international t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... g into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from such transactions in the open market; or (ii) reasonably accurate adjustments can be made to eliminate the material effects of such differences. (4) The data to be used in analyzing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into: Provided that data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared." "Rule 10C. Most appropriate method.- (1) For the purposes of sub-section (1) of section 92C, the most appropriate method shall be the method which is best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an arm's length price in relation to the international transaction. (2) In selecting the most appropriate method as specified in sub-rule ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ate. In our view, apart from the orders passed by the Assessing Officer and the Transfer Pricing Officer, the said method (TNMM) is the appropriate method in the case of service P.E. as the TNMM apportions the total operating profit arising from the transaction on the basis of sales, costs, assets, etc. As regards determination of profits attributable to a P.E. in India (MSAS) is concerned on the basis of arm's length principle we have quoted article 7(2) of the DTAA. According to the AAR where there is an international transaction under which a non-resident compensates a P.E. at arm's length price, no further profits would be attributable in India. In this connection, the AAR has relied upon Circular No. 23 of 1969 issued by the Central Board of Direct Taxes as well as Circular No. 5 of 2004 also issued by the Central Board of Direct Taxes. This is the key question which arises for determination in these civil appeals. To answer the above question we quote article 7 of the U.N. Model Convention which reads as under: "Article 7 ATTRIBUTION OF BUSINESS PROFITS Article 7 of the UN Model Convention states as under: Business profits. The profits of an enterprise of a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ilar payments in return for the use of patents or other rights, or by way of commission for specific services performed or for management, or, except in the case of a banking enterprise by way of interest on moneys lent to the head office of the enterprise or any of its other offices. 4. In so far as it has been customary in a Contracting State to determine the profits to be attributed to a permanent establishment on the basis of an apportionment of the total profits of the enterprise to its various parts, nothing in paragraph 2 shall preclude that Contracting State from determining the profits to be taxed by such an apportionment as may be customary; the method of apportionment adopted shall, however, be such that the result shall be in accordance with the principles contained in this article. 5. For the purposes of the preceding paragraphs, the profits to be attributed to the permanent establishment shall be determined by the same method year-by-year unless there is good and sufficient reason to the contrary. 6. Where profits include items of income which are dealt with separately in other articles of this Convention, then the provisions of those articles shall not be affec ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... that also constitutes a P.E., has been remunerated on an arm's length basis taking into account all the risk-taking functions of the enterprise. In such cases nothing further would be left to be attributed to the P.E. 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 P.E. for those functions/risks that have not been considered. Therefore, in each case the data placed by the taxpayer has to be examined as to whether the transfer pricing analysis placed by the taxpayer is exhaustive of attribution of profits and that would depend on the functional and factual analysis to be undertaken in each case. Lastly, it may be added that taxing corp orates on the basis of the concept of economic nexus is an important feature of attributable profits (profits attributable to the P.E.). Conclusion : To conclude, we hold that the AAR was right in ruling that MSAS would be a service P.E. in India under article 5(2)(1), though only on account of the services to be performed by the deputationists deployed by MSCo and not o ..... X X X X Extracts X X X X X X X X Extracts X X X X
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