© Nishith Desai Associates 1 Shefali Goradia Nishith Desai Associates Legal and Tax Counseling...

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Nishith Desai AssociatesNishith Desai Associates

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September 12, 2007 www.nishithdesai.com

DIT, Mumbai v. Morgan DIT, Mumbai v. Morgan Stanley and Co. Inc.Stanley and Co. Inc.

© Nishith Desai Associates

Overview

Spotlight on the relevant articles Typical Structure Background Timeline Proceedings before AAR Supreme Court Ruling Points to ponder Take away


Spotlight – Article 5, India-US Spotlight – Article 5, India-US Tax TreatyTax Treaty

ARTICLE 5 - Permanent establishment – ARTICLE 5 - Permanent establishment –

1. For the purposes of this Convention, the term 1. For the purposes of this Convention, the term permanent establishment means a permanent establishment means a fixed place fixed place of businessof business through which the through which the business of an business of an enterpriseenterprise is wholly or partly carried on is wholly or partly carried on..


Service PEService PE

2. The term permanent establishment includes especially :2. The term permanent establishment includes especially :……………………………………....

(l)(l) the furnishing of services, other than included services as the furnishing of services, other than included services as defined in Article 12 (Royalties and Fees for Included defined in Article 12 (Royalties and Fees for Included Services), within a Contracting State by an enterprise Services), within a Contracting State by an enterprise through employees or other personnel, but only if:through employees or other personnel, but only if:

i.i. activities of that nature continue within that State for a activities of that nature continue within that State for a period or periods aggregating more than 90 days within period or periods aggregating more than 90 days within any twelve-month period ; orany twelve-month period ; or

ii.ii. the services are performed within that State for a related the services are performed within that State for a related enterprise within the meaning of paragraph 1 of Article 9 enterprise within the meaning of paragraph 1 of Article 9 (Associated Enterprises).(Associated Enterprises).


Exclusion from PEExclusion from PE

3. Notwithstanding the preceding provisions of this 3. Notwithstanding the preceding provisions of this Article, the term permanent establishment shall Article, the term permanent establishment shall be deemed not to include any one or more of the be deemed not to include any one or more of the following : following : ……………………

(e) the maintenance of a fixed place of business (e) the maintenance of a fixed place of business solely for the purpose of advertising, for the solely for the purpose of advertising, for the supply of information, for scientific research or supply of information, for scientific research or for other for other activities which have a preparatory or activities which have a preparatory or auxiliary characterauxiliary character, for the enterprise., for the enterprise.


Agency PEAgency PE4. 4. ….. where a person is acting in a Contracting State on behalf ….. where a person is acting in a Contracting State on behalf

of an enterprise of the other Contracting State, that of an enterprise of the other Contracting State, that enterprise shall be deemed to have a permanent enterprise shall be deemed to have a permanent establishment in the first-mentioned State, establishment in the first-mentioned State, if if ::

(a)(a) he has and habitually exercises in the first-mentioned State an he has and habitually exercises in the first-mentioned State an authority to conclude on behalf of the enterprise, unless his authority to conclude on behalf of the enterprise, unless his activities are limited to those mentioned in paragraph 3 which, if activities are limited to those mentioned in paragraph 3 which, if exercised through a fixed place of business, would not make that exercised through a fixed place of business, would not make that fixed place of business a permanent establishment under the fixed place of business a permanent establishment under the provisions of that paragraph ;provisions of that paragraph ;

(b) he has no such authority but habitually maintains in the first-(b) he has no such authority but habitually maintains in the first-mentioned State a stock of goods or merchandise from which he mentioned State a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the regularly delivers goods or merchandise on behalf of the enterprise, and some additional activities conducted in the State enterprise, and some additional activities conducted in the State on behalf of the enterprise have contributed to the sale of the on behalf of the enterprise have contributed to the sale of the goods or merchandise ; orgoods or merchandise ; or

(c) he habitually secures orders in the first-mentioned State, wholly or (c) he habitually secures orders in the first-mentioned State, wholly or almost wholly for the enterprise.almost wholly for the enterprise.


Typical StructureTypical Structure

Service Provider

Captive BPO Unit

Customer

Su

pe

rvis

ion

&

Tra

inin

g

Sub

co

ntra

ct

paym

ent

payment

contract

Auxiliary services such as customer care, data collection etc

Core Business activity


BackgroundBackground

Circular 23 of 1969Circular 23 of 1969 – –

Extent of profit assessable under Section 9 - only that Extent of profit assessable under Section 9 - only that portion of the profit which can reasonably be attributed to portion of the profit which can reasonably be attributed to the operations of the business carried out in India the operations of the business carried out in India

Circular 5 of 2004Circular 5 of 2004 – –

If Indian BPO is paid “arm’s length price” for its services, If Indian BPO is paid “arm’s length price” for its services, there will be no further attribution of profits to the PE. there will be no further attribution of profits to the PE. Earlier Circular 1 of 2004 withdrawn (distinction between Earlier Circular 1 of 2004 withdrawn (distinction between “core” v. “incidental” activities not relevant?)“core” v. “incidental” activities not relevant?)


The PartiesThe Parties

Morgan Stanley and Company (“Morgan Stanley and Company (“MSMS”) is an investment bank ”) is an investment bank engaged in the business of providing financial advisory engaged in the business of providing financial advisory services, corporate lending and securities underwriting.services, corporate lending and securities underwriting.

Morgan Stanley Advantages Services Pvt. Ltd. (“Morgan Stanley Advantages Services Pvt. Ltd. (“MSASMSAS”) ”) entered into an agreement for providing certain support entered into an agreement for providing certain support services to MS.services to MS.

MS outsourced some of its activities to MSAS, which was set MS outsourced some of its activities to MSAS, which was set up to support the main office functions in:up to support the main office functions in:

equity and fixed income research, equity and fixed income research,

account reconciliationaccount reconciliation

providing IT enabled services such as, back office providing IT enabled services such as, back office operation, data processing and support centre to MS.operation, data processing and support centre to MS.


TIMELINETIMELINE19-05-200519-05-2005 MS filed an application before the AAR for obtaining a MS filed an application before the AAR for obtaining a

ruling.ruling.

13-02-200613-02-2006 The AAR pronounced its ruling.The AAR pronounced its ruling.

14-08-200614-08-2006 The Supreme Court of India issued notice in the SLP The Supreme Court of India issued notice in the SLP filed by DIT [International Taxation], Mumbai.filed by DIT [International Taxation], Mumbai.

31-08-200631-08-2006 SLP filed by MS along with leave for condonation of SLP filed by MS along with leave for condonation of delay (as limitation for filing SLP is 90 days from the delay (as limitation for filing SLP is 90 days from the date of original order from which SLP is sought).date of original order from which SLP is sought).

September September 20062006

MS filed a counter affidavit against the SLP filed by MS filed a counter affidavit against the SLP filed by the DIT.the DIT.

04-12-200604-12-2006 The DIT filed a rejoinder affidavit in response to MS’s The DIT filed a rejoinder affidavit in response to MS’s counter affidavit.counter affidavit.

09-06-200709-06-2007 Judgment of the Supreme Court pronounced.Judgment of the Supreme Court pronounced.


Questions raised before AARQuestions raised before AARMS sought advance ruling from the AAR on :MS sought advance ruling from the AAR on :

Whether MS had a PE in India under Article 5 of the DTAA Whether MS had a PE in India under Article 5 of the DTAA i.e.-i.e.- fixed place of businessfixed place of business dependent agent PEdependent agent PE service PEservice PE

Even if there were a PE no further profits could be attributed Even if there were a PE no further profits could be attributed if the fees paid to MSAS were on arm’s length.if the fees paid to MSAS were on arm’s length.

Whether the use of TNMM method was appropriate.Whether the use of TNMM method was appropriate.

If the transfer pricing mark-up of 29% determined by TNMM If the transfer pricing mark-up of 29% determined by TNMM method was appropriate.method was appropriate.


DIT’s SubmissionsDIT’s Submissions MSAS is basically a front office of MSMSAS is basically a front office of MS - -

which is wholly and exclusively dependent on MS; which is wholly and exclusively dependent on MS; It cannot function without the support of MS;It cannot function without the support of MS; It is a virtual projection of MS on the soil of India; It is a virtual projection of MS on the soil of India; MSAS performs essential and significant activities of the MSAS performs essential and significant activities of the

Morgan Stanley group, which are crucial and critical for the Morgan Stanley group, which are crucial and critical for the business being carried on by MS as well as the other business being carried on by MS as well as the other group companies.group companies.

The functions performed by the MSAS are The functions performed by the MSAS are core functionscore functions and not and not preparatory and auxiliarypreparatory and auxiliary

MSAS is an agent of MS. MSAS is an agent of MS. It is economically dependant on MS. It is economically dependant on MS. It is bound by the service / quality controls imposed by MSIt is bound by the service / quality controls imposed by MS

Employees of MS on Employees of MS on stewardship / deputationstewardship / deputation will constitute will constitute a a serviceservice PEPE as providing services to MSAS on behalf of MS. as providing services to MSAS on behalf of MS.


The AAR ruledThe AAR ruled

On existence of PE of MS :On existence of PE of MS : No No fixed place of business PEfixed place of business PE -under -under Article 5(1)Article 5(1);; MSAS not a MSAS not a dependent agentdependent agent under under Article 5(4)Article 5(4);; Service PE triggered – Service PE triggered – underunder Article 5(2)(l) Article 5(2)(l)

• Employees of MS sent to India – for stewardship or on Employees of MS sent to India – for stewardship or on deputation in the employment of MSAS – If such presence deputation in the employment of MSAS – If such presence exceeded 90 days;exceeded 90 days;

Even if MSAS a PE of MS in India – As per Circular 5 / 2004 – no Even if MSAS a PE of MS in India – As per Circular 5 / 2004 – no further profits attributable if arm’s length price has been paid;further profits attributable if arm’s length price has been paid;

No ruling on use of TNMM - as proceedings had already been initiated. No ruling on use of TNMM - as proceedings had already been initiated. ( (AAR had also taken preliminary objection that it is not permitted to AAR had also taken preliminary objection that it is not permitted to determine the fair market value of propertydetermine the fair market value of property))


Special Leave Petition to Special Leave Petition to the Supreme Courtthe Supreme Court

Director International Tax – SLP to the Director International Tax – SLP to the Supreme CourtSupreme Court

MS files counter to SLP & a fresh SLP as MS files counter to SLP & a fresh SLP as a cross-petitiona cross-petition


Grounds taken by DITGrounds taken by DIT Grounds relating to fixed place of business PEGrounds relating to fixed place of business PE

MSAS is nothing but a projection of MS.MSAS is nothing but a projection of MS.

Many of the observations in the AAR ruling are contrary to the Many of the observations in the AAR ruling are contrary to the contention that there is no fixed place of business for MSAS.contention that there is no fixed place of business for MSAS.

The AAR has found that MS would be in a position to exercise close The AAR has found that MS would be in a position to exercise close control and supervision on the working of MSAS - shows that the control and supervision on the working of MSAS - shows that the business of MSAS was inextricably linked with the business of MS.business of MSAS was inextricably linked with the business of MS.

Grounds relating to dependant agency PEGrounds relating to dependant agency PE

The AAR has not discussed how the condition relating to authority to The AAR has not discussed how the condition relating to authority to conclude contract in Article 5(4) of the DTAA has not been satisfied and conclude contract in Article 5(4) of the DTAA has not been satisfied and such non-consideration vitiates the decision on this point.such non-consideration vitiates the decision on this point.

The AAR has not appreciated the commercial realities and its The AAR has not appreciated the commercial realities and its judgement is contrary to the views of Klaus Vogel which have been judgement is contrary to the views of Klaus Vogel which have been approved by the Authority in its ruling which is reported in 237 ITR 230. approved by the Authority in its ruling which is reported in 237 ITR 230.

The decision of the AAR is contrary to the rulings reported in 274 ITR The decision of the AAR is contrary to the rulings reported in 274 ITR 501 and 237 ITR 230.501 and 237 ITR 230.


Grounds relating to Service PEGrounds relating to Service PE

The AAR has wrongly held that the PE would be constituted only if the The AAR has wrongly held that the PE would be constituted only if the services rendered by the employees exceed 90 days.services rendered by the employees exceed 90 days.

The decision of the AAR is contrary to Article 5(2)(l) which does not prescribe The decision of the AAR is contrary to Article 5(2)(l) which does not prescribe any such restriction of 90 days.any such restriction of 90 days.

Grounds relating to attribution of profits in the hands of PEGrounds relating to attribution of profits in the hands of PE

The AAR has wrongly held that in case MSAS is remunerated at arm’s length The AAR has wrongly held that in case MSAS is remunerated at arm’s length by MS then no further income can be attributed in the hands of the PE by MS.by MS then no further income can be attributed in the hands of the PE by MS.

A strict adherence to the arm’s length principle would make the dependent A strict adherence to the arm’s length principle would make the dependent agent PE completely meaningless.agent PE completely meaningless.

Cited recent OECD report on attribution of profits.Cited recent OECD report on attribution of profits.

Grounds taken by DITGrounds taken by DIT


Supreme Court JudgmentSupreme Court Judgment MS MS does notdoes not have a have a fixed placefixed place PE in India under Article 5(1) PE in India under Article 5(1)

MS MS does notdoes not have an have an dependant agency PEdependant agency PE under Article 5(4) under Article 5(4)

MS MS does notdoes not have a have a Service PEService PE on account of employees on account of employees performing performing stewardshipstewardship activities activities

MS MS would createwould create a a Service PEService PE on account of on account of deputationdeputation of of employees to MSASemployees to MSAS

Transactions are at arm’s lengthTransactions are at arm’s length - - no further attributionno further attribution to the to the PE, provided the payments made to the PE take into account all the PE, provided the payments made to the PE take into account all the risk-taking functions of the Multi-national enterprise (MNE)risk-taking functions of the Multi-national enterprise (MNE)


Analysis of the JudgmentAnalysis of the Judgment

A functional and factual analysis of each of the activities to be A functional and factual analysis of each of the activities to be undertaken by an establishment.undertaken by an establishment.

MSAS in India would be engaged in supporting the front office MSAS in India would be engaged in supporting the front office functions of MS.functions of MS.

Provision of services by a subsidiary to its parent/ group does not by Provision of services by a subsidiary to its parent/ group does not by itself constitute that subsidiary, a PE of its parent/group company.itself constitute that subsidiary, a PE of its parent/group company.

Business of the foreign enterprise is not carried out through the place Business of the foreign enterprise is not carried out through the place of business of the subsidiary.of business of the subsidiary.


Analysis of the JudgmentAnalysis of the Judgment

Deputation of employees by MS to MSAS held to constitute a Deputation of employees by MS to MSAS held to constitute a service PE in India under Article 5(2)(l), though only on account service PE in India under Article 5(2)(l), though only on account of the services to be performed by the deputees deployed by MS of the services to be performed by the deputees deployed by MS and not on account of stewardship activities.and not on account of stewardship activities.

TNMM accepted as the appropriate method for determination of TNMM accepted as the appropriate method for determination of the arm's length price in respect of transaction between MS and the arm's length price in respect of transaction between MS and MSAS.MSAS.

The computation of the remuneration based on cost plus mark-up The computation of the remuneration based on cost plus mark-up worked out at 29% on the operating costs of MSAS is accepted worked out at 29% on the operating costs of MSAS is accepted and approved by the Supreme Court. and approved by the Supreme Court.


Points to Ponder

Relevance of back office activities for determination of PERelevance of back office activities for determination of PE

Service PE - Service PE - stewardship v deputationstewardship v deputation

Implications if the applicable DTAA does not have a Implications if the applicable DTAA does not have a Service PE RuleService PE Rule

Implications if no DTAA situationImplications if no DTAA situation

Would the foreign company have a “business connection” in Would the foreign company have a “business connection” in India on account of deputation of personnel?India on account of deputation of personnel?


Points to Ponder

Attribution of profits to PE : Single entity v. Dual Attribution of profits to PE : Single entity v. Dual entityentity

Transfer pricing: Can the AAR rule on it?Transfer pricing: Can the AAR rule on it?

Is TNMM and the 29 percent mark up here to stay?Is TNMM and the 29 percent mark up here to stay?


Power of Review: SCPower of Review: SC

Article 137 of the Constitution provides that the Supreme Article 137 of the Constitution provides that the Supreme Court has the power to review any judgment pronounced Court has the power to review any judgment pronounced by it. by it.

Time limit to file review application is within 30 days from Time limit to file review application is within 30 days from the date of judgment or order the date of judgment or order

The grounds for review under the civil procedure code The grounds for review under the civil procedure code are:are:

On the On the discovery of new and important matter or evidencediscovery of new and important matter or evidence

On account of some On account of some mistake or error apparent on the face of mistake or error apparent on the face of the recordthe record or or for any other sufficient reasonfor any other sufficient reason


TakeawaysTakeaways Back-office activities are not to be construed “the Back-office activities are not to be construed “the

business of the MNE” - It is the business of the service business of the MNE” - It is the business of the service providerprovider

SC has brought to fore the fine distinction between a SC has brought to fore the fine distinction between a secondment and deputation.secondment and deputation.

Approved the Single Entity Approach for attribution?Approved the Single Entity Approach for attribution?

Implicitly accepted that the AAR can rule on Transfer Implicitly accepted that the AAR can rule on Transfer Pricing?Pricing?

SC keen on emphasizing on “economic nexus” as pre-SC keen on emphasizing on “economic nexus” as pre-requisite for taxation of non-resident. Recent requisite for taxation of non-resident. Recent International tax decisions by Supreme Court reiterate International tax decisions by Supreme Court reiterate this principle (Ishikawagima / Hyundai)this principle (Ishikawagima / Hyundai)


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