TaxTMI 
TaxTMI 
2007 (7) TMI 201
X X X X Extracts X X X X
X X X X Extracts X X X X
....ities investment management and investment banking and credit services. Morgan Stanley and Company (for short, "MSCo") is an investment bank engaged in the business of providing financial advisory services, corporate lending and securities underwriting. One of the group companies of Morgan Stanley, Morgan Stanley Advantages Services Pvt. Ltd. (few short, "MSAS") entered into an agreement for providing certain support services to MSCo. MSCo outsourced some of its activities to MSAS. The said MSAS was set up to support the main office functions in equity and fixed income research, account reconciliation and providing IT enabled services such as back office operations, data processing and support centre to MSCo. On May 5, 2005, MSCo (applicant) filed its advance ruling application in Form No. 34-C inviting its advance ruling on the points enumerated hereinbelow. The basic question relating to the transaction between the applicant and MSAS on which advance ruling was sought was two fold namely, whether the applicant was having a P.E. in India under article 5(1) of the DTAA on account of the services rendered by MSAS under the services agreement dated April 14, 2005 entered into by MSA....
X X X X Extracts X X X X
X X X X Extracts X X X X
....to the P.E. is the subject matter of challenge by the Department. Existence of P.E. in India With globalization, many economic activities spread over to several tax jurisdiction. This is where the concept of P.E. becomes important under article 5(1). There exists a P.E. if there is a fixed place through which the business of an enterprise, which is a multi-national enterprise (MNE) , is wholly or partly carried on. In the present case MSCo is a multi-national entity. As stated above it has outsourced some of its activities to MSAS in India. A general definition of the P.E. in the first part of article 5(1) postulates the existence of a fixed place of business whereas the second part of article 5(1) postulates that the business of the MNE is carried out in India through such fixed place. One of the questions which we are called upon to decide is whether the activities to be undertaken by MSAS consist of back office operations of the MSCo and if so whether such operations would fall within the ambit of the expression "the place through which the business of an enterprise is wholly or partly carried out" in article 5(1). We quote herein below articles 5 and 7 of the DTAA: "Article....
X X X X Extracts X X X X
X X X X Extracts X X X X
....g goods or merchandise, or of collecting information, for the enterprise; (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 preparatory or auxiliary character, for the enterprise. 4. Notwithstanding the provisions of paragraphs 1 and 2, where a person-other than an agent of an independent status to whom paragraph 5 applies-is acting in a Contracting State on behalf of an enterprise of the other Contracting State, that enterprise shall be deemed to have a permanent establishment in the first- mentioned State if: (a) he has and habitually exercises in that first-mentioned State an authority to conclude contracts on behalf of the enterprise, unless his activities are limited to those mentioned in paragraph 3 which, if exercised through a fixed place of business, would not make that fixed place of business a permanent establishment under the provisions of that paragraph; (b) he has no such authority but habitually maintains in the first-mentioned State a stock of goods or merchandise from which he regularly delivers goods or merchandise. on behalf of the e....
X X X X Extracts X X X X
X X X X Extracts X X X X
....milar activities under the same or similar conditions and dealing wholly at arm's length with the enterprise of which it is a permanent establishment and other enterprises controlling, controlled by or subject to the same common control as that enterprise, in any case where the correct amount of profits attributable to a permanent establishment is incapable of determination or the determination thereof presents exceptional difficulties, the profits attributable to the permanent establishment may be estimated on a reasonable basis. The estimate adopted shall, however, be such that the result shall be in accordance with the principles contained in this article. 3. In the determination of the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the business of the permanent establishment, including a reasonable allocation of executive and general administrative expenses, research and development expenses, interest, and other expenses incurred for the purposes of the enterprise as a whole (or the part thereof which includes the permanent establishment), whether incurred in the State in which the permanent establishm....
X X X X Extracts X X X X
X X X X Extracts X X X X
....perty described in paragraph 3 (b) of article 12 (royalties and fees for included services)." In our view, the second requirement of article 5(1) of the DTAA is not satisfied as regards back office functions. We have examined the terms of the agreement along with the advance ruling application made by MSCo inviting the AAR to give its ruling. It is clear from a reading of the above agreement/application that MSAS in India would be engaged in supporting the front office functions of MSCo in fixed income and equity research and in providing IT enabled services such as data processing support centre and technical services as also reconciliation of accounts. In order to decide whether a P.E. stood constituted one has to undertake what is called a functional and factual analysis of each of the activities to be undertaken by an establishment. It is from that point of view, we are in agreement with the ruling of the AAR that in the present case article 5(1) is not applicable as the said MSAS would be performing in India only back office operations. Therefore to the extent of the above back office functions the second part of article 5(1) is not attracted. Lastly, as rightly held by the ....
X X X X Extracts X X X X
X X X X Extracts X X X X
....te a P.E. Article 5(3) commences with a non obstante clause. It states that notwithstanding what is stated in article 5(1) or under article 5(2) the term P.E. shall not include maintenance of a fixed place of business solely for advertisement, scientific research or for activities which are preparatory or auxiliary in character. In the present case we are of the view that the abovementioned back office functions proposed to be performed by MSAS in India fall under article 5(3)(e) of the DTAA. Therefore, in our view in the present case MSAS would not constitute a fixed place P.E. under article 5(1) of the DTAA as regards its back office operations. However, the question which arises for determination in the present case is the nature of activities performed by stewards and deputationists deployed by MSCo to work in India as employees of MSAS. Under article 5(2)(1) furnishing of services through the fixed place in India can constitute a P.E. The AAR in the impugned ruling has held that the stewards and deputationists are proposed to be sent by MSCo from the U.S. According to the AAR there is a flow of service from MSCo to MSAS when the former deputes its own employees to work in Ind....
X X X X Extracts X X X X
X X X X Extracts X X X X
....ng as the lien remains with MSCo the said company retains control over the deputationist's terms and employment. The concept of a service P.E. finds place in the U.N. Convention. It is constituted if the multinational enterprise renders services through its employees in India provided the services are rendered for a specified period. In this case, it extends to two years on the request of MSAS. It is important to note that where the activities of the multinational enterprise entails it being responsible for the work of deputationists and the employees continue to be on the payroll of the multinational enterprise or they continue to have their lien on their jobs with the multinational enterprise, a service P.E. can emerge. Applying the above tests to the facts of this case we find that on request/requisition from MSAS the applicant deputes its staff. The request comes from MSAS depending upon its requirement. Generally, occasions do arise when MSAS needs the expertise of the staff of MSCo. In such circumstances, generally, MSAS makes a request to MSCo. A deputationist under such circumstances is expected to be experienced in banking and finance. On completion of his tenure he is rep....
X X X X Extracts X X X X
X X X X Extracts X X X X
....hod (CPM) (d) Profit split method (PSM) (e) Transactional net margin method (TNMM) (f) Such other method as may be prescribed by the Central Board of Direct Taxes The taxpayer is required to compute arm's length price for a transaction(s) using one of the five methods stipulated in the Income-tax Rules. Rule 10C(1) of the Income-tax Rules defines the most appropriate method as the method which is best suited to the facts and circumstances of each particular international transaction. As per rule 10C(2) the most appropriate method has to be selected having regard to a number of factors which are enumerated therein. The arm's length price has to be computed by the application of methods mentioned in section 92C(1) of the income-tax Act. In the present case, the applicant has taken the opinion of Earnest and Young (for short, "E & Y"), consultants, as experts who have suggested, keeping in mind the various activities undertaken by MSCo and MSAS in India, TNMM as the most appropriate method for determination of arm's length price in respect of transactions between MSCo and MSAS. The applicant sought a ruling from the AAR on the appropriateness of the said method. On the adequacy o....
X X X X Extracts X X X X
X X X X Extracts X X X X
....ise, means an enterprise- (a) which participates, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise; or (b) in respect of which one or more persons who participate, directly or indirectly, or through one or more intermediaries, in its management or control or capital, are the same persons who participate, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise. (2) For the purposes of sub-section (1), two enterprises shall be deemed to be associated enterprises if, at any time during the previous year,- (a) one enterprise holds, directly or indirectly, shares carrying not less than twenty-six per cent. of the voting power in the other enterprise; or (b) any person or enterprise holds, directly or indirectly, shares carrying not less than twenty-six per cent. of the voting power in each of such enterprises; or (c) a loan advanced by one enterprise to the other enterprise constitutes not less than fifty-one per cent. of the book value of the total assets of the other enterprise; or (d) one enterprise guarantees not less than ten pe....
X X X X Extracts X X X X
X X X X Extracts X X X X
....Meaning of international transaction.- (1) For the purposes of this section and sections 92, 92C, 92D and 92E, 'international transaction' means a transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature or purchase, sale or lease of tangible or intangible property, or provision of services, or lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises and shall include a mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to anyone or more of such enterprises. (2) A transaction entered into by an enterprise with a person other than an associated enterprise shall, for the purposes of sub-section (1), be deemed to be a transaction entered into between two associated enterprises, if there exists a prior agreement in relation to the relevant transaction between such other person and the associated enterprise; or the terms of the relevant transaction ar....
X X X X Extracts X X X X
X X X X Extracts X X X X
....on has not been determined in accordance with sub-sections (1) and (2); or (b) any information and document relating to an international transaction have not been kept and maintained by the assessee in accordance with the provisions contained in sub-section (1) of section 92D and the rules made in this behalf; or (c) the information or data used in computation of the arm's length price is not reliable or correct; or (d) the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub-section (3) of section 92D, the Assessing Officer may proceed to determine the arm's length price in relation to the said international transaction in accordance with sub-sections (1) and (2), on the basis of such material or information or document available with him: Provided that an opportunity shall be given by the Assessing Officer by serving a notice calling upon the assessee to show cause, on a date and time to be specified in the notice, why the arm's length price should not be so determined on the basis of material or information or document in the possession of the Assessing Officer. (4) Where an arm....
X X X X Extracts X X X X
X X X X Extracts X X X X
....ction, or a number of such transactions; (iii) the price so arrived at is further reduced by the expenses incurred by the enterprise in connection with the purchase of property or obtaining of services; (iv) the price so arrived at is adjusted to take into account the functional and other differences, including differences in accounting practices, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market; (v) the adjusted price arrived at under sub-clause (iv) is taken to be an arm's length price in respect of the purchase of the property or obtaining of the services by the enterprise from the associated enterprise; (c) cost plus method, by which,- (i) the direct and indirect costs of production incurred by the enterprise in respect of property transferred or services provided to an associated enterprise, are determined; (ii) the amount of a normal gross profit mark-up to such costs (computed according to the same accounting norms) arising from the transfer or provision of the same or similar property ....
X X X X Extracts X X X X
X X X X Extracts X X X X
....ofit remaining after such allocation may be split amongst the enterprises in proportion to their relative contribution in the manner specified under sub-clauses (ii) and (iii), and in such a case the aggregate of the net profit allocated to the enterprise in the first instance together with the residual net profit apportioned to that enterprise on the basis of its relative contribution shall be taken to be the net profit arising to that enterprise from the international transaction; (e) transactional net margin method, by which,- (i) the net profit margin realized by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base; (ii) the net profit margin realized by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base; (iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, b....
X X X X Extracts X X X X
X X X X Extracts X X X X
....ar may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared." "Rule 10C. Most appropriate method.- (1) For the purposes of sub-section (1) of section 92C, the most appropriate method shall be the method which is best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an arm's length price in relation to the international transaction. (2) In selecting the most appropriate method as specified in sub-rule (1), the following factors shall be taken into account, namely:- (a) the nature and class of the international transaction; (b) the class or classes or associated enterprises entering into the transaction and the functions performed by them taking into account assets employed or to be employed and risks assumed by such enterprises: (c) the availability, coverage and reliability of data necessary for application of the method; (d) the degree of comparability existing between the international transaction and the uncontrolled transaction and between the enterprises entering into such transact....
X X X X Extracts X X X X
X X X X Extracts X X X X
.... further profits would be attributable in India. In this connection, the AAR has relied upon Circular No. 23 of 1969 issued by the Central Board of Direct Taxes as well as Circular No. 5 of 2004 also issued by the Central Board of Direct Taxes. This is the key question which arises for determination in these civil appeals. To answer the above question we quote article 7 of the U.N. Model Convention which reads as under: "Article 7 ATTRIBUTION OF BUSINESS PROFITS Article 7 of the UN Model Convention states as under: Business profits. The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to (a) that permanent establishment; (b) sales in that other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment; or (c) other business activities carried on in that other State of the same or similar kind as those effected thro....
X X X X Extracts X X X X
X X X X Extracts X X X X
....n apportionment as may be customary; the method of apportionment adopted shall, however, be such that the result shall be in accordance with the principles contained in this article. 5. For the purposes of the preceding paragraphs, the profits to be attributed to the permanent establishment shall be determined by the same method year-by-year unless there is good and sufficient reason to the contrary. 6. Where profits include items of income which are dealt with separately in other articles of this Convention, then the provisions of those articles shall not be affected by the provisions of this article. Note: The question of whether profits should be attributed to a permanent establishment by reason of the mere purchase by that permanent establishment of goods and merchandise for the enterprise was not resolved. It should therefore be settled in bilateral negotiations." Article 7 of the U. N. Model Convention inter alia provides that only that portion of business profits is taxable in the source country which is attributable to the P.E. It specifies how such business profits should be ascertained. Under the said article, a P.E. is treated as if it were an independent enterprise ....
X X X X Extracts X X X X
X X X X Extracts X X X X
....by the taxpayer is exhaustive of attribution of profits and that would depend on the functional and factual analysis to be undertaken in each case. Lastly, it may be added that taxing corp orates on the basis of the concept of economic nexus is an important feature of attributable profits (profits attributable to the P.E.). Conclusion : To conclude, 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 prof....