Attribution of Profits to an Agency PE: finding a middle ground

Before going for a short vacation, I take the opportunity to share with you a draft version of my forthcoming article “Attribution of Profits to an Agency PE: finding a middle ground”

Abstract
The definition of Permanent Establishment (PE), embodied in Article 5 of the OECD Model1 and the attribution of business profits to a PE, included in Art. 7 of the OECD Model are two essential provisions in the framework of international tax. This article deals with specific issues arising from the attribution of profits to an Agency PE. Before embarking in the discussion of the “quantum of taxation”, this article looks briefly into the concept of Agency PE and its recent developments with impact on Agency PE.

The concept of PE includes the situation of a dependent agent who has and habitually exercises an authority to conclude contracts in the name of a non-resident enterprise. This clause has proven over the years to be complex, ambiguous and empty of any guidance regarding the second step of the exercise, i.e. the attribution of profits.

In the last decade there have been certain developments that lead to consider that there is a push towards the expansion of the Agency PE concept. Various jurisdictions have been increasingly active challenging business operations that are structured in a cost effective manner, by asserting that local affiliates constitute an Agency PE of either their parent or other affiliated company. In the end, the consequences of such thrust mainly rest on the issue of correct attribution of profits to the Agency PE, created by the activities of the dependent agent.

Differing country practices may create not only volatility on the concept of Agency PE but also double taxation, requiring complex and enduring mutual agreement procedures, rulings or advanced pricing agreements in order to clarify such problem. In fact, even if jurisdictions would agree on the existence of a PE, they may be far from agreeing on the level of profits attributable to it.

In this context, the article starts by shortly examining the conditions necessary to decide upon whether a PE exists under Art. 5 (5) and (6) of the OECD Model. The second part discuses, in terms of attribution of profits, the consequences of finding that an Agency PE exists. The issue of attribution of profits to an Agency PE is discussed through examples, with special attention given to the new OECD approach towards the attribution of profits to PE’s.

Attempting to secure source taxation by determining the presence of an Agency PE

Once more, I address an Indian recent case dealing with permanent establishment (PE) issues. This case, contrary to the previous ones analysed, centres on the question whether certain activities performed in India by agents of a non-resident company gave rise to an Agency PE of the non-resident in India. According to the facts of the case, Western Union, a US incorporated company engaged in the business of rendering money transfer services (including cross-border transfer of monies) had certain activities carried out in India which could be said to amount to a PE under the Indian-US tax treaty.

Under Western Union business model, a person may use Western Union for transferring money abroad. Western Union provides a computer-generated code number. The recipient of the money, when he receives the code number approaches a Western Union representative/agent in the local jurisdiction (post offices, commercial banks, non-banking financial companies or tour operators). The code number is then fed into the computer with the help of specific software and the mainframe computer of Western Union is accessed by the representative/agent. The representative/agent matches the number and pays the money once the identity of the recipient is confirmed.

In order to enter into the business of international transfer of monies in India, Western Union appointed several local agents. Generally, agents, appointed for a 5 year period are remunerated at 30% (post offices) or 25% (others) of the money handed over by the agent in India. In case, Western Union assumes additional responsibility (advertising and promotion or call-centre) the commission may be reduced. A particular aspect of the business model is that money is first paid out by the agent and only thereafter reimbursed together with the commission due. Finally, an agent may be given the power to appoint sub-agents/representatives.

Western Union opened a liaison office (LO) in Mumbai (India), which acted as a communication link between the agents and Western Union. Accordingly, the LO was not designed to undertake any commercial, trading or industrial activity in India or sign any agreements. The LO was engaged in training and help installing local agents, communicated procedures and organized local marketing

The Indian tax authorities required Western Union to file a tax return of income and Western Union filed such return declaring "nil" income, claiming that it was not taxable in India. The tax authorities rejected that view by arguing that Western Union had a business connection in India (broader domestic PE test) and that it was carrying on business in India through a PE, in the form of various systems installed at the premises of various agents through which the business is carried on. In addition, the tax authorities argued that the agent’s commission was not at arm's length. Based on the fact that Western Union did not submit local accounts, the Indian tax authorities attributed to the PE of Western Union 10% of the gross commission earned by the agents in India, which was then taxed at the rate of 48%.

The case reached the New Delhi bench of the Income Tax Appellate Tribunal (ITAT) which analysed whether (i) Western Union had a business connection in India; (ii) Western Union had, under the treaty, a PE in India and if so what kind of PE and (iii) in case there is a PE in India, how much income is attributable to that PE. A decision, in favour of Western Union, was awarded on 10 March 2006.

On the domestic law issue (business connection test), the ITAT mentioned that the expression (business connection) presupposes an element of continuity between the business of the non-resident and the activity in India. Such continuity can take several forms, such as carrying on a part of the main business or activity incidental to the non-resident through an agent or merely facilitating or assisting the carrying on of that business. Taking into account the facts, the ITAT considered that the receiving aspect of the transaction was interrelated with the paying aspect by the local agent. (i.e. they could not be segregated). As such, the ITAT held that there was a business connection. Since the business connection test was a wider concept than a PE, the issue needed to be assessed under the treaty between the US and India.

The PE issue was subdivided in four sub-issues, namely: (i) Physical PE: (ii) LO as PE (iii) software as PE or (iv) Agency PE.

Physical PE. Since Western Union, besides a LO, lacked any kind of place of business in India, the first issue addressed was whether the agents premises constituted a fix place of business through which the business of an Western Union is wholly or partly carried on. On this point the ITAT promptly stated that there was no evidence that Western Union could enter and make use of the premises of any agents (i.e. department of Posts, commercial banks, non-banking financial companies and tour operators) for its business and therefore there was no fixed place of Western Union in India.

Liaison Office as a fixed place of business. Tacking into account the limited activities (i.e. no trading activity) which the LO was authorized to carry on in India, the second issue was whether the LO could still be considered to be the fixed place of business of the Western Union in India. On this point the ITAT held that the LO could not be considered to be the fixed place PE since it carries out activities which are of a preparatory or auxiliary character (i.e. the maintenance of a fixed place of business solely for the purpose of advertising, for the supply of information, for scientific research or for other activities which have a preparatory or auxiliary character cannot be considered to a PE).

Software as a PE of Western Union. The tax authorities held that Western Union business was being carried out through the software, which was installed in all the fixed premises of the agents. Accordingly, the software itself would be considered an “installation” at a fixed place through which the business is carried on and would, as such, constitute a PE. The ITAT said that although under the treaty an installation may, in fact, amount to a PE, such installation couldn’t be treated as a PE since it was not used for exploration or exploitation of natural resources.

Perhaps on this point, the ITAT could have added more elements to the discussion. Although the treaty definition in the context of e-commerce has over the time raised some doubts, the OECD has recently clarified that an Internet web site, which is a combination of software and electronic data, does not in itself constitute tangible property and therefore does not have a location that can constitute a “place of business” as there is no “facility such as premises or, in certain instances, machinery or equipment” as far as the software and data constituting that web site is concerned (paragraph 42.2 of the OECD Commentaries to Art. 5). In the same way, software of Western Union, even if installed in the Agents computers, could not constitute a PE of Western Union. This case is of course different from the situations where, instead of software, a server is located in the source jurisdiction. For example, recently the Indian tax authorities concluded that server of the internationally known firm VISA, through which its Indian business operations were transacted, did constitute a fixed place of business within India.

Agency PE. The more difficult issue was to determine whether the agents "independent agents" or "dependent agents" under the terms of the treaty. The ITAT started by analysing whether the agents were independent (Art. 5(6) OECD Model) and only later considered if the Agents could be considered dependent (Art. 5(5) OECD Model).

On the independence test, the tax authorities held that the agents should not be considered independent since (i) they are not carrying on the activity for Western Union in the ordinary course of their business, (ii) they were authorized to appoint sub-agents and (iii) they are precluded to carry on the same business for any other entity.

On the first point the ITAT stated that in order to qualify as an independent agent, the agent must: (1) be acting in the ordinary course of his business; (2) his activities should not be devoted wholly or almost wholly exclusive and (3) the transactions between the foreign enterprise and the agent should be at arm's length.

The ITAT first considered that for the agents in question, dealing with money belonging to others and the activity of paying out monies on behalf of the Western Union should be viewed as part of their business activity. In the case of the tour operators, acting as agents of an established firm engaged in the international money transfer business, may be even considered favourable to their business (I am now imagining the stranded kid somewhere in Goa without a penny!).

Secondly, the ITAT pointed out that there was no evidence demonstrating that the agents activities for Western Union, compared to all remaining activities, was so large that it could be said that the agents were (economically) dependent on Western Union. In addition, the agents had their own businesses or activities. As the ITAT said, “just because they are not carrying on money transfer for any other company it cannot be said that their activities are wholly or almost wholly devoted to Western Union”.

The tax authorities supported their case on paragraphs 36 to 38.8 of the revised commentary on the OECD Model. The ITAT understanding of paragraphs 38.6 was nevertheless, that to consider the agents economically dependent the agent's activities for the foreign enterprise must constitute a large chunk of all his activities taken together. Since no facts suggest such economic dependence, the agents should be considered independent.

As to the claim that the Agents remuneration was not arm’s length the ITAT pointed out that no prove was given to consider that the commission fees were not arm’s length.

Even though the ITAT considered that the agents to be independent, it further considered whether such Agents may be consider to habitually exercise an authority in India to conclude contracts in the name of Western Union (i.e. if they are dependent agents).

The tax authorities held that such agents had authority to conclude contracts on behalf of Western Union, based on their power to appoint sub-agents and the lack of active involvement by Western Union in the transactions. Western Union acknowledged that it authorized the agents to appoint sub-agents, but that was only for the purpose of enabling the agent to carry on his part of the transaction. In fact, Western Union was not obliged to remunerate such sub-agents. Western Union contended that there was no evidence to show that the agents had as a matter of fact the authority to conclude contracts on behalf of the PE, nor that the agent was habitually exercising such authority.

On this point the ITAT noted that Art. 5 uses two expressions: "has" and "habitually exercises" the authority to conclude contracts on behalf of the foreign enterprise. The first refers to the legal existence of such authority and the second to a systematic course of conduct by the agent. The ITAT held that no express authority was given to in the agreement between Western Union and the Agents. From the simple power to appoint sub-agents cannot be inferred that the agents either have the authority to conclude the contracts or have habitually exercise the authority without any protest from Western Union.

The ITAT apparently relied on paragraph 33 of the Commentary to Art. 5, which says "the authority to conclude contracts must cover contracts relating to operations which constitute the business paper of the enterprise. It would be irrelevant, for instance, if the person had authority to engage employees for the enterprise to assist that person's activity...."

In addition, the ITAT considered that there was no evidence that the agents "habitually" exercised the authority to conclude contracts. The ITAT mentioned that the Agents merely execute the payment part in India (after determining the genuineness of the transaction and the identity of the beneficiary). By executing the last leg of a contract concluded outside India, the Agents cannot be said to be concluding contracts for Western Union. The payment by the Agent should be considered part of his duty (for which a remuneration is awarded) under the Agreement with Western Union and not an authority to conclude contracts on behalf of Western Union.

In conclusion, the ITAT rejected all arguments by the tax authorities and concluded that no PE of Western Union was deemed to exist in India. Since no PE in India was deemed to exist, there was no issue of attributing profits under Art. 7.

Final note
I found the argumentation on the Agency PE element very interesting. First, not everyday a case dealing with Agency PE reaches a court of law. Secondly, the argumentation presented by the (non-OECD) tribunal demonstrates a degree of sophistication in the interpretation of treaties that should set an example to other countries (even OECD members).

A final note to point out that the ITAT, although not addressing explicitly the interrelationship between Art. 5(5) and (6) OECD Model, seems to apply the more widely accepted “Main Rule/Exception Theory”.

As regards the relationship between Art. 5(5) and (6) OECD Model, two main theories may be said to exist. According to the “Main Rule/Exception Theory” (see John Avery Jones, David A. Ward et al., European Taxation, 5, 1993), Art. 5(5) constitutes the main rule, while Art. 5(6) constitutes the exception to this rule. Under this theory, when one of the conditions of Art. 5(6) is not met, the conditions of Article 5(5) (namely the conclusion of contracts binding on the principal) must always be met in order to deem a PE to exist. Conversely, according to the “Two Separate Rule Theory” or ““Grey Area Theory”(See Sidney Roberts, Intertax, 9 and 10, 1993) Art. 5(5) refers to cases of direct representation and Art. 5(6) to cases of indirect representation. The effect is that when one of the conditions of Art. 5(6) is not met, the existence of a PE is implied. In short, Avery Jones & Ward position attempts to reconcile the application of the Agency concept in both common and civil law countries, concluding that paragraph 5 provides the general rule and paragraph 6 provides the exception, i.e., the agents who do not fall under paragraph 6 are covered by paragraph 5. For Roberts, paragraphs 5 and 6 simple concern two different situations (direct and indirect representation) and therefore there is no rule exception relationship between those paragraphs.

A third theory (Kroppen/Huffmeier) argues, on the basis that the criterion of “concluding contracts in the name of” the foreign principal is not even mentioned under paragraph 6, that it is immaterial, in order to qualify under paragraph 6, in whose name the independent agent is acting. Under this third view, independent agents will not constitute a PE, whether or not they bind their principal, provided they are legally and economically independent and they act in the ordinary course of their business.

A very good reading on this topic is Giuseppe Persico “Agency permanent establishment under Article 5 of the OECD Model Convention” (Intertax, 2000/02, p. 66–82), which discusses interpretation and terminology issues of the Agency PE rule.

Tax Evasion can be bad for your health!

Check out the video and see how tax evasion can be bad for your health! You cannot say anymore I didn’t warn you!

Indian outsourcing activities: from finding a PE to determining its remuneration

India has established itself as a leading jurisdiction for outsourcing software and IT enabled services. Nevertheless, the outsourcing of services does not come without tax implications. This note is about a recent Indian Advance Ruling involving outsourcing activities of Morgan Stanley (February 2006) that sheds some light on some issues regarding the taxability of business process outsourcing units in India.

As a background note, the Indian tax authorities were very active during 2004 on attempting to establish guidelines on the taxation of business process outsourcing (BPO). In that regard, they first issued a highly controversial Circular 1/2004, which some months later was withdrawn and released as Circular 5/2004. According to the final Circular, if a non-resident entity outsources certain services to a resident Indian entity and there is no business connection between the two entities, the resident entity is not treated as a permanent establishment (PE) of the non-resident entity. Basically, an outsourcing agreement will have tax implications for the outsourcer if such outsourcer is deemed to have a PE in India.

Background of the Ruling

This recent ruling involves the well-known Morgan Stanley, a US investment bank that provides worldwide financial advisory services, corporate lending and securities underwriting. For its business in India, US Morgan Stanley incorporated an Indian subsidiary (MSAS) in order to support the Morgan Stanley front office and infrastructure unit functions in their global operations.

In short, Morgan Stanley outsourced or was planning to outsource certain support services (i.e. non-important revenue generating functions) to MSAS, namely IT support, account reconciliation, research and other back office services. In order to ensure high standards of quality, Morgan Stanley staff was to be sent (for short periods of time) to India for stewardship activities and other similar activities (i.e. monitoring the overall outsourcing operations at MSAS). Morgan Stanley staff was also to be sent to India, on the request of MSAS, for periods ranging between several months to a couple of years, to work under its control and supervision. MSAS was reimbursed employment costs to Morgan Stanley without a mark-up. The consideration for the outsourced services was to be based on a cost plus. On the basis of a local transfer pricing study, the “arms length” mark-up for similar services was set at 29% on the costs incurred.

In order to ascertain the tax implications of its future activities in the Indian territory, Morgan Stanley asked for an advance ruling to the local tax authorities as to whether its activities would give rise to PE in India, under the tax treaty between India and the US, and if yes which profits would be attributable to such PE.

The PE issues dealt on the ruling were not limited to the outsourced services rendered by MSAS, but also included the possibility of deeming MSAS a dependent agent PE of Morgan Stanley, the issue of US employees sent to India to undertake stewardship activities and employees seconded to MSAS.

To set its arguments, Morgan Stanley defended that:
(i) it had no fixed place of business in India through which it could be said to carry on its business;
(ii) the premises of MSAS in India were being solely used for carrying on the business of MSAS;
(iii)the outsourced services rendered by the MSAS do not constitute service PE within the Treaty;
(iv) the staff to be sent to MSAS for certain stewardship functions, it is only to ensure quality benchmarks and other requirements;
(v) briefing and basic training provided to MSAS staff was only to ensure best output of MSAS and to minimize the risk arising from the outsourcing services to MSAS.
(vi) In regard to a potential agency PE, MSAS is independent of Morgan Stanley since it is not an agent of Morgan Stanley, does not act on behalf of the Morgan Stanley, does not maintain stock of goods on behalf of the Morgan Stanley nor does it secure orders in India wholly or almost wholly for Morgan Stanley.

The tax authorities, on the other hand, contended that MSAS was a fixed PE under Art. 5(1), a service PE under Art. 5(2)(l) as well as a dependent agent under Art. 5(4) of the treaty. The tax authorities argued that:
(i) MSAS performs essential and significant activities for Morgan Stanley, such as research support, quantitative modelling and account reconciliation. Such functions are essential core-functions for the Morgan Stanley and cannot be described preparatory and auxiliary in nature.
(ii) As for the agency PE, the tax authorities reasoned that by virtue of the agreement, MSAS would render service wholly and exclusively to the applicant and its group. The agreement also provides that MSAS is subject to detailed instructions and control with respect to conduct of the business, which shows that MSAS is a dependent agent. In addition, the service agreement clearly indicate that services are to be rendered by MSAS as economically and legally dependent agent to the Morgan Stanley customers exclusively, strictly following Morgan Stanley procedures, policies and practices. As to the contention that MSAS does not have any authority to conclude any contract on behalf of the Morgan Stanley ignores the commercial reality of the situation and all these facts show that MSAS should not be viewed as an independent agent.

The Advance Ruling

As to the fixed PE issue, the ruling states that, although the place of business of MSAS is no doubt fixed, there is nothing to show that the business of the Morgan Stanley is carried on through the place of business of MSAS. As such, MSAS cannot be treated as the PE of Morgan Stanley group.

As to the question of whether MSAS is a dependent agent and therefore gives rise to an Agency PE of Morgan Stanley in India, the ruling starts by determining that it has to be demonstrated that (i) MSAS is acting in India on behalf of Morgan Stanley; (ii) MSAS is a person other than an agent of independent status; (iii) MSAS (a) has and habitually exercises an authority to conclude contracts on behalf of the applicant ; (b) has no such authority but habitually maintains a stock of goods or merchandise from which it regularly delivers goods on behalf of the applicant; or (c) habitually secures orders in India wholly or almost wholly for Morgan Stanley.

Although it was held that MSAS was acting in India on behalf of Morgan Stanley and that MSAS should not be viewed as an agent of independent status, the ruling states that none of the 3 pre-requirements (iii above), to find that an Agency PE of Morgan Stanley exists, are satisfied. namely, it was not proven that MSAS exercises an authority to conclude contracts; maintains a stock of goods or merchandise or secure orders in India. As such, MSAS cannot be held to be a dependent agent of Morgan Stanley.

Finally, as to the issue of whether the presence of personnel in India, the ruling stated that if employees were to be sent o India for undertaking stewardship activities for a period beyond ninety days, MSAS would be regarded as a service PE of Morgan Stanley.

The ruling, in addition to the PE issues, also addresses the problem of attribution of profits. Morgan Stanley questioned whether, even in the event MSAS constitutes a PE in India, as long as MSAS is remunerated for its services at arm's length, whether any further income can be attributed in the hands of the PE of Morgan Stanley. More specifically, if Morgan Stanley is deemed to have a PE in India as a result of sending its employees to India, whether given the function which would be performed and risks that could be undertaken by such a PE, would a remuneration based on a margin on total operating cost of the PE be the appropriate profit attributable to such a PE?

On this point, Morgan Stanley referred to Circular 23 of 1969 and the more recent Circular 5 of 2004 in order to argue that the amount taxable in India would be only that much as is attributable to operations of MSAS. The tax authorities, on the other hand, contends that Art. 7 of the treaty adopts the force of attraction rule and, as such, the scope of profits of the Morgan Stanley liable to be taxed in other contracting state would get expanded if Morgan Stanley has any business activity in India which is in any manner connected with the PE. More specifically, if Morgan Stanley would carry on in India any activity connected with shares, derivatives, bonds, debentures etc. even if such transaction are carried out directly, income would be liable to be taxed in India in view of the force of attraction rule.

The ruling states that it is difficult to accept a position (force of attraction), which would run counter to Art. 7(1) of the treaty and it would be enough if MSAS is remunerated for its services at an arm's length price.

In conclusion, in case there is a PE, as long as MSAS is remunerated for its services at arm's length by Morgan Stanley and as long as all its actual income is brought to tax, no further income can be attributed in the hands of the PE of the applicant. Unfortunately, the ruling did not address the further issue of whether a remuneration based on a margin on total operating cost of the PE would, in this case, be appropriate.

Note

After reading this advance ruling, I remained with a feeling (which is somewhat common to other cases throughout the world) that, although on the PE issues the arguments and points are well debated and developed, the same does not happen on the issue of allocation of profits to a PE. In this case, we would have a situation where a subsidiary would give rise to a service PE and the allocation issue is left, perhaps consciously, a bit undeveloped.

Several authors, have outlined the necessity to clarify the application of Art.7 on those situations (service PE) since its is not clear whether the arm’s length price paid for the services would be sufficient to determine the profits attributable to a PE. This issue can also be linked to the ongoing discussion on the “dual taxpayer approach” vs the “single taxpayer approach” as regards Agency PE’s.

Under the first view, when attributing profits to an Agency PE is important to distinguish between the two different taxpayers (Dependent Agent and the Agency PE), which ultimately may have different functions assets and risks and, therefore, different taxable profits. Under the single taxpayer approach, the profit attributable to an Agency PE would be merely the arm's length profit remuneration of the dependent agent and, as such, the profit of agency PEs would correspond, by definition, to zero.

On this topic last topic there would be much to be said. I would leave it to another opportunity.