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Two lessons for policymakers
July, 12th 2007
The decision affords the much desired stability and consistency, in relation to the vexed question of PE arising in specific circumstances.


The ruling of the Supreme Court in the Morgan Stanley case has far-reaching implications not only for captive Business Process Outsourcing units but also other sectors, says Mr Sudhir Kapadia, Head of Tax and Regulatory Practice - India, KPMG.

He adds that the decision affords the much desired stability and consistency, in relation to the vexed question of PE (permanent establishment) arising in specific circumstances, and also to the principle that the arms length remuneration to an associated enterprise should extinguish any further assessments to tax in the hands of the non-resident.

In arriving at this conclusion, the Supreme Court, as also the AAR (Authority for Advance Ruling) have impliedly confirmed the position enunciated by the Central Board of Direct Taxes (CBDT) way back in 1969 in relation to the sale of goods by a resident agent in India on behalf of a non-resident.

However, at the operational level, the question of determination of appropriate arms length remuneration in relation to associated enterprise will still be open to the Assessing Officer (AO) or the Transfer Pricing Officer (TPO), cautions Mr Kapadia.

There are two possible solutions which the Indian policymakers can consider to afford greater operational certainty to this question as well, he suggests.

One, APA or advance pricing arrangement (APA), under which advance ruling can be obtained in respect of the arms length pricing of goods or services, transacted between associated enterprise in advance, rather than be dependent upon an uncertain outcome at the end of two years post entering into a transaction (when the assessment of the tax return is taken up).

And, two, safe harbour rule. India can consider a safe harbour rule where under a cost plus appropriate mark-up can be set out to be followed by all players in the relevant industry, thus obviating the need of any advance ruling or litigation through assessments.

Background of the case

The case in focus is about Morgan Stanley and Company (MSCo), an investment bank engaged in the business of providing financial advisory services, corporate lending and securities underwriting.

Morgan Stanley Advantages Services Pvt Ltd (MSAS), Mumbai, a group company of Morgan Stanley, entered into an agreement for providing certain support services to MSCo.

Accordingly, MSCo outsourced to MSAS some of its activities, such as equity and fixed income research, account reconciliation and providing IT-enabled services such as back-office operation, data processing and support centre. MSAS charged a remuneration of cost plus 29 per cent to MSCo.

In 2005, MSCo had approached the AAR, with two questions: Whether MSCo had a PE in India, and whether there would be attribution of further profits, if any, in the hands of the PE of MSCo, where the transactions with MSAS were at arms length?

In February 2006, the AAR concluded that the activities of the MSAS in India neither constituted a fixed place PE of MSCo in India nor an agency PE.

However, the AAR ruled that by virtue of the fact that MSCo deputed employees to MSAS for undertaking stewardship and oversight activities, MSCo constitutes what is known as a service PE under the Indo-US Double Tax Avoidance Treaty (DTAT).

As regards the second question, the AAR ruled that the transactional net margin method (TNMM) followed by MSAS in charging MSCo for its services was the most appropriate method under the transfer pricing law.

The authority also said that since TNMM met with the test for arms length, no further income was attributable in the hands of MSCo in India.

Unhappy with the AARs ruling, the taxman approached the apex court.

The Supreme Court observed that MSAS was performing in India only back- office operations.

Therefore, it could not be said that MSCo carried out its own business through a fixed place in India, said the court.

It also noted that there is no agency PE in this case, because MSAS had no authority to enter into or conclude contracts in India.

To determine if there was a service PE, the court looked at the two kinds of activities involved, namely, stewardship and work to be performed by deputationists in India as employees of MSAS.

Stewardship activities involve briefing of the MSAS staff to ensure that the output meets the requirements of the MSCo. These activities include monitoring of the outsourcing operations at MSAS, elaborates Mr Kapadia.

The object is to protect the interest of MSCo. These stewards are not involved in day-to-day management or in any specific services to be undertaken by MSAS. The stewardship activity is basically to protect the interest of the customer.

A customer is entitled to protect its interest both in terms of confidentiality and in terms of quality control, he reasons.

In such case it cannot be said that MSCo has been rendering the services to MSAS. MSCo was merely protecting its own interests in the competitive world by ensuring the quality and confidentiality of MSAS services.

Accordingly, the Supreme Court did not agree with the ruling of the AAR that the stewardship activity would constitute a service PE.


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