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Right arms length approach
July, 12th 2007

Mr Amitabh Singh, Tax partner, Ernst & Young

MNCs need to structure their inter-company assignments with care, taking into consideration the nuances of the Supreme Courts order in the Morgan Stanley case, says Mr Amitabh Singh, tax partner, Ernst & Young.

The reference is to the decision the apex court that back-office operations by a captive service provider for its parent would not per se create a permanent establishment (PE) of its foreign parent in India.

One highlight of the verdict is the discussion of the transactional net margin method (TNMM) as the appropriate transfer pricing (TP) approach to determine the arms length price between the foreign enterprise and the Indian captive service provider. As the pricing in Morgan Stanleys case was at arms length, no further profits could be attributable to the Indian captive unit on account of it being the foreign enterprises PE in India, said the court.

Mr Singh acknowledges that the verdict comes as a huge relief to the IT/ITES sector, particularly for units operating as captive off-shoring centres for their parent and affiliate companies overseas. I ndia is a popular hub for back-office operations.

Several MNCs have set up captive subsidiaries in India for carrying out back-office operations. Such captive service providers function as risk-mitigated entities and are normally remunerated on a cost-plus basis by their foreign parent or affiliates.

Captive service provider per se does not constitute a permanent establishment (PE) of their foreign parent or affiliates in India, he clarifies. However, even where there is a PE, the Court decision says that if the captive service provider is remunerated on an arms length basis taking into account the functions performed and risk undertaken by it, no further profits can be attributed to the PE in India.

Thus the profits attributable to the foreign enterprises PE would be subsumed in the arms length price paid to the captive service provider, says Mr Singh. The foreign parent would not bear any tax burden arising out of attribution of any additional profits over and above the arms length price paid to the captive service provider as long as the functions performed and risks undertaken by the captive service provider are the same as those of the PE.

The decision has settled a controversy raised by a Mumbai Tribunal order, says Mr Singh, citing the case of Set Satellite Singapore Pte Ltd. In that case, the Income-Tax Appellate Tribunal (ITAT) had adopted a dual entity concept, that is, the dependent agent and the dependent agent PE are two separate taxable entities. The Tribunal said that the tax liability of a taxpayer in respect of its PE in India was not extinguished by marking an arms length payment to the dependent agent.

While this ITAT order did not mean that a PE arising in India owing to a dependent agent will automatically result in profit attribution, it did create a sense of unease among the foreign investors, as regards its application during assessment proceedings.

Which is why the Supreme Court decision is significant, says Mr Singh. It clearly points out that there can be no further profit attribution if the pricing between the foreign enterprise and its PE in India the captive service provider is at an arms length. This will go a long way in boosting foreign investor confidence.

He reminds, however, that the functions performed and risks undertaken by the captive service provider should be the same as that of the PE. Since this is a matter of facts and circumstances, it would still be open to the tax authorities to make enquiries and satisfy themselves in this regard.

Arms length pricing is substantiated by TP studies and documentation. In general, taxpayers face a variety of technical and interpretive challenges in TP documentation and compliances in India, frets Mr Singh. Many taxpayers have adopted TNMM to defend their TP models. This method takes into consideration net margins as the base for comparisons.

Department takes to the CUP

How has the Department responded to the method adopted by the assessees? In some instances during past assessments, Transfer Pricing Officers (TPOs) have preferred to use the comparable uncontrolled price (CUP) method to assess TP compliance, says Mr Singh.

The usage of the inexact CUP creates challenges for taxpayers. Indian captive service centres are not subject to the same degree of market risks as independent third-party service providers. Therefore, application of industry benchmarks such as CUP, without reliable adjustments to neutralise differences in functions and risks, is not appropriate from a technical perspective, he feels.

It should come as a reprieve to MNCs operating in India that the apex court found the TNMM is an appropriate method for determining the arms length price for transaction between the foreign parent and its captive subsidiary in India.

The Personnel Angle

An interesting distinction that the Supreme Court drew was about the personnel: Between those sent to India by the foreign parent for stewardship activities (where they continue to work for the foreign parent), and employees deputed to India to function under the control and supervision of the captive service provider in India.

The court said that where an employee is deputed to India by the foreign parent and deployed by the captive service provider, a service PE would arise, because such a person retains his lien and on completion of his tenure he returns back to his job with the foreign parent. This finding appears to ignore the emerging distinction between legal employer and economic employer, opines Mr Singh.

While the foreign enterprise may be the legal or formal employer, if the individual is working under the control and supervision of the Indian entity, the Indian entity determines the number and qualifications of the individuals who will perform the work and the foreign enterprise is not accountable for the quality or outcome of the work performed by such individuals, he reasons. Such individuals should be deemed to have been employed by the Indian enterprise.

D. M.

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