2007 (7) TMI 201 - SC - Income Tax

Service permanent establishment found via deputationists; transactional net margin method applied with 29% cost-plus remuneration

SC upheld AAR's finding that the foreign enterprise had a service P.E. in India due to deputationists, not stewardship. For attribution of income to that ... Existence of Permanent Establishment (P.E.) in India - taxability of income attributable to the P.E. - business of providing financial advisory services, corporate lending and securities underwriting - Double Tax Avoidance Agreement ('the DTAA') between India and United States - Appropriateness of TNMM for determination of arm's length - HELD THAT:- We hold that the AAR was right in ruling that MSAS would be a service P.E. in India under article 5(2)(1), though only on account of the services to be performed by the deputationists deployed by MSCo and not on account of stewardship activities. As regards income attributable to the P.E. (MSAS) we hold that the transactional net margin method was the appropriate method for determination of the arm's length price in respect of transaction between MSCo and MSAS. We accept as correct the computation of the remuneration based on cost plus mark-up worked out at 29 per cent. on the operating costs of MSAS. This position is also accepted by the Assessing Officer in his order dated December 29, 2006 (after the impugned ruling) and also by the Transfer Pricing Officer vide order dated September 22, 2006. As regards attribution of further profits to the P.E. of MSCo where the transaction between the two are held to be at arm's length, we hold that the ruling is correct in principle provided that an associated enterprise (that also constitutes a P.E.) is remunerated on arm's length basis taking into account all the risk-taking functions of the multinational enterprise. In such a case nothing further would be left to attribute to the P.E. The situation would be different if the transfer pricing analysis does not adequately reflect the functions performed and the risks assumed by the enterprise. In such a case, there would be need to attribute profits to the P.E. for those functions/risks that have not been considered. The entire exercise ultimately is to ascertain whether the service charges payable or paid to the service provider (MSAS in this case) fully represent the value of the profit attributable to his service. In this connection, the Department has also to examine whether the P.E. has obtained services from the multinational enterprise at lower than the arm's length cost. Therefore, the Department has to determine income, expense or cost allocations having regard to arm's length prices to decide the applicability of the transfer pricing regulations. Accordingly, both the civil appeals filed by the applicant (MSCo) and by the Department are partly allowed with no order as to costs. Issues Involved:1. Existence of Permanent Establishment (P.E.) in India2. Income Attributable to P.E.3. Appropriateness of Transactional Net Margin Method (TNMM) for determining Arm's Length Price (ALP)4. Attribution of Further Profits to P.E. when Transactions are at Arm's LengthDetailed Analysis:1. Existence of Permanent Establishment (P.E.) in IndiaThe primary issue was whether the applicant, MSCo, had a Permanent Establishment (P.E.) in India as per Article 5(1) of the Double Tax Avoidance Agreement (DTAA) between India and the United States. The court examined whether the activities undertaken by MSAS in India, which included back office operations, constituted a P.E. under Article 5(1). It was held that back office functions performed by MSAS did not satisfy the second requirement of Article 5(1) as these functions were preparatory or auxiliary in nature, falling under Article 5(3)(e) of the DTAA. Therefore, MSAS did not constitute a fixed place P.E. under Article 5(1).The court also addressed whether MSAS could be considered an agency P.E. under Article 5(4). It was determined that MSAS did not have the authority to enter into or conclude contracts on behalf of MSCo, and thus, did not constitute an agency P.E.However, the court agreed with the Authority for Advance Rulings (AAR) that MSAS constituted a service P.E. under Article 5(2)(1) due to the presence of stewards and deputationists sent by MSCo to work in India. The stewards' activities were deemed to be for quality control and confidentiality purposes, which did not constitute services rendered to MSAS. However, deputationists retained their lien with MSCo and provided services to MSAS, thus constituting a service P.E.2. Income Attributable to P.E.The court examined the taxability of income attributable to the P.E. under Article 7 of the DTAA. It was held that the income attributable to the P.E. is the income from the foreign company's operations in India. The court emphasized that the transfer pricing analysis must reflect the functions performed and risks assumed by the enterprise. If the transfer pricing analysis does not adequately reflect these aspects, further profits must be attributed to the P.E. The court upheld the AAR's ruling that if MSAS is remunerated at arm's length, no additional profits need to be attributed to the P.E. However, this is contingent upon the transfer pricing analysis being exhaustive of the functions and risks involved.3. Appropriateness of Transactional Net Margin Method (TNMM) for determining Arm's Length Price (ALP)The court evaluated whether the TNMM was the most appropriate method for determining the arm's length price (ALP) for transactions between MSCo and MSAS. The court noted that the TNMM was suggested by consultants E&Y and agreed upon by the Transfer Pricing Officer and the Assessing Officer. The court found TNMM appropriate for service P.E. as it apportions total operating profit based on sales, costs, and assets. The court accepted the computation of the remuneration based on a cost-plus mark-up of 29% on the operating costs of MSAS.4. Attribution of Further Profits to P.E. when Transactions are at Arm's LengthThe court addressed whether further profits should be attributed to the P.E. when transactions are at arm's length. The court upheld the AAR's ruling that if an associated enterprise, which also constitutes a P.E., is remunerated on an arm's length basis, taking into account all risk-taking functions, no additional profits need to be attributed. However, if the transfer pricing analysis does not adequately reflect the functions performed and risks assumed, further profits must be attributed to the P.E. The court emphasized the importance of economic nexus in the principle of attribution of profits.ConclusionThe court concluded that MSAS would be a service P.E. in India under Article 5(2)(1) due to the deputationists but not due to stewardship activities. The TNMM was deemed the appropriate method for determining the ALP, and the remuneration based on a 29% mark-up was accepted. The court upheld that no additional profits need to be attributed to the P.E. if the transfer pricing analysis is exhaustive of the functions and risks involved. The ruling by the AAR was modified to reflect these conclusions, and both civil appeals were partly allowed.