Monday, May 01, 2006

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 In that regard, they first issued a highly controversial Circular 1/2004, which some months later was withdrawn and released as Circular 5/2004.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.


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.



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