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INTERNET LAW - Do Outsourcing Companies Constitute Permanent Establishment in India?
June, 05th 2008

Supreme Court of India ruled on the issue of whether foreign companies with business process outsourcing companies in India were deemed to have permanent establishment for taxation purposes.  European and United States companies are increasingly opting for business process outsourcing companies (BPO) in India.  Reduction on production costs is the main reason for this corporate shift.  Besides, India is an English speaker nation with high quality professionals in information technology and accounting.  It is fair to say that India is to corporate services as China is to manufacturing.  Thus far since India follows the corporate establishment principles for taxation purposes, the obvious question for any foreign company is what is my company's tax liability for BPOs in India?  Are those BPOs creating permanent establishment for my foreign company?  These questions were answered by the India Supreme Court ruling in DIT v. Morgan Stanley & Co.

Even though the ruling on DIT v. Morgan Stanley and Co., [(2007) 292 ITR 416 (SC)] is rendered for the specific facts the case posted, this Indian Supreme Court decision is extremely important for any foreign company holding BPOs in India.  This case rules on how Indian tax authorities may tax BPO companies and whether BPO companies constitute permanent establishment.

Facts

Morgan Stanley & Co. (hereafter MSCo) is a United States (US) company providing financial services, mainly investment banking, investment management, credit services, and mergers and acquisition services, at an international  scale.  MSCo is a subsidiary of Morgan Stanley, a US, Delaware Company.  MSCo established a wholly-owned subsidiary in India called Morgan Stanly Advantage Services Private Limited (MSAS).  MSAS was function was to provide services and support MSCo' offices and infrastructure units around the world.

The relationship between MSCo and MSAS (even though the later was a subsidiary of the former) was delimited by a specific agreement.  MSAS was to provide support to MSCo on IT, accounting, and research matters.  Under the agreement, MSCo would send its supervisory staff to MSAS to create a global consistent and uniform high quality standard as required by MSCo.  MSCo staff did not get involved in day-to-day activities at MSAS but in monitoring activities.  MSCo staff was paid by MSCo, not by MSAS; concretely, MSAS paid them and MSAS got reimbursed by MSCo.  MSAS activities were merely operational; indeed, MSAS did not engaged in any client relationship with MSCo's clients.  The consideration for this contractual agreement was the following: MSCo would pay MSAS a percentage for the services MSAS performed.  This percentage was calculated by the sum of the service costs and a mark-up of certain percentage of these costs.

Questions of Law

The applicable law in this case was the Agreement for Avoidance of Double Taxation and Prevention of Fiscal Evasion between India and the United States (the Treaty).

After MSCo entered into this agreement with its Indian subsidiary MSAS, MSCo sought a private ruling form the Indian tax authority in light of the treaty rules.   MSCo asked several specific questions; among others, it asked the Indian tax authority whether MSAS services under its agreement with MSCo constitute permanent establishment; whether MSAS would be considered an Agency permanent establishment (PE) of MSCo; whether MSCo would be deemed having PE in India by MSCo sending its staff to India for specific monitory tasks; and whether MSCo would have PE in India for any other reason and as per Indian legislation.

The Indian tax authority held (among other issues not coved in this article) that MSAS services constitute service PE of MSCo in India under Article 5(2)(I) of the Treaty, when MSCo sends its monitoring staff  to India.  However, the Indian tax authority leaned on MSCo side by adding that not income would be attributed to MSAS as long as MSAS is reimbursed by MSCo at arm's length.

Supreme Court Ruling

The specific question entertained by the Supreme Court of India was whether the activities performed by MSAS were back office operations of MSCo; and if so, whether they typify Art. 5(1) expression when defining PE: "the place through which the business of an enterprise is wholly or partly carried out."

The Supreme Court held confirmed the tax authority private ruling; it held that MSAS was only performing back office operations under Art. 5 (3) of the Treaty and these operations did not constitute a fixed place PE under Art. 5(1).  Thus, MSCo did not have PE in India through MSAS activities.  The Supreme Court added that the term PE does not include having a fixed place of business for advertisement, scientific research, or for preparatory or auxiliary activities, despite the statements in Art. 5(1) and Art. 5(2).

To the issue of whether MSAS constitute Agency PE, the Supreme Court ruled (confirming the private ruling) that MSAS services did not constitute Agency PE because MSAS had not authority to enter into contracts on behalf of MSCo.  Contracts would be entered by MSCo and only 'implemented' by MSAS back office operations in India.

Regarding Service PE of MSCo through MSCo staff sent to India, the Court held that MSCo, as a recognized multinational company, was merely protecting its services and interests in the competitive international market by trusting these back operational functions to MSAS.  MSCo, the Court said, is looking for quality control and confidentiality from MSAS as its service provider of secondary activities. MSCo staff sent to MSAS was not performing day-to-day activities. The Supreme Court held that MSCo may have PE in India by 'deputationists' sent by MSCo to MSAS India but not for 'monitoring' staff.  Thus, the Court overruled the tax authority ruling that MSCo staff sent to India constituted Service PE.   
 
The Supreme Court also ruled on the method used by MSCo and MSAS to pay the consideration for this contract (Transactional Net Margin Method).  The Court considered this was an appropriate method to determine the arm's length price for the services rendered by MSAS. 

 
 
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