The Central Board of Direct Taxes had endeavoured to provide certainty in respect of the taxation of BPO units through its circular 5/2004 dated September 28, 2004, on the basis of attribution of income to a Permanent Establishment (PE) on an arms length basis.
In the landmark decision in DCIT versus Morgan Stanley & Co Inc., the Supreme Court rendered its judgement on the taxation of captive outsourcing activities, whether they qualify as a PE and the amount of income, which may be attributed to profits from the BPO unit.
The Supreme Court undertook a functional and factual analysis of each back-office activity undertaken by Morgan Stanleys captive BPO. The Court held that these activities were in the nature of preparatory or auxiliary services, which though carried out at fixed place, do not qualify as a PE. The Supreme Court also held that, as long as the activities were in the nature of back-office operations and no contracts were concluded by the BPO independently, there was no agency PE.
Whilst pronouncing its judgement, the Supreme Court held that definition of PE, as adopted by India, is an inclusive definition which covers, among others, service PEs, agency PEs, software PEs, etc. In passing, the Supreme Court made reference to software PEs, where service providers may be required to act according to quality control specifications of their customers. However, this does not assist in determining the scope of software PEs and has in fact left room for uncertainty.
Though the Supreme Courts ruling has provided some relief to the BPO industry, on account of broad acceptance of the principle that as long as the transfer pricing analysis takes into consideration functions and risks undertaken by the BPO unit, no further profits will be attributable to taxation of such unit. However, the statement made by the Supreme Court in passing in relation to software PEs, may be used by the tax authorities as a garb to examine the potential tax incidence of such BPOs.