The uncertainty surrounding taxation of foreign companies setting up captive business process outsourcing units appears to have been resolved, at least to some extent. The Supreme Court, which delivered its eagerly awaited verdict in the Morgan Stanley case on Monday, has held that the income tax department cannot attempt to tax a part of the global income of a foreign company by attributing it to its India-based BPO.
The parent would thus not be at risk of being taxed in India as long as it is compensating its outsourcing unit on an arm’s length basis (Morgan Stanley US would send the Indian company the same payment as it would to an outside agency)
In such a situation, no part of the parent’s global income is attributable to the captive BPO, according to the SC ruling. Monday’s Supreme Court judgement is extremely complex and deals with several issues. Tax experts were mulling over the implications of the ruling late on Monday evening. BPOs ET spoke to were not willing to comment till they had digested the full impact of the ruling. Industry body Nasscom had also not issued a statement till late on Monday evening.
The apex court ruling also clarifies that income could be attributable to the outsourcing unit for independent functions and risks which have not been covered by the foreign company. Also what is arm’s length can always be challenged by the income tax department.
The ruling upheld the Authority for Advance Ruling’s (AAR) ruling that the business process outsourcing activities of Morgan Stanley’s India BPO, known as Morgan Stanley Advantage Services (MSAS), did not constitute a permanent establishment.
However, it has also upheld a part of the AAR ruling that MSAS was a service permanent establishment (PE). But the SC has gone on to rule that this was the case “only on account of services to be performed by the deputationists deputed by MSCo (the global investment bank) and not on account of stewardship activities.”
The service PE activities could not be taxed as the transactions between the parent and subsidiary were at arm’s length. The revenue had sought to tax investment bank Morgan Stanley's global income attibutable to the Indian BPO (MSAS).
If the court had upheld the plea of the income tax department, then the profit attributable to the PE in respect of the activities carried on in India would have been subject to tax in India at about 42% besides compliance requirements. The court further said that the economic nexus between the foreign parent company and their captive BPOs is an important aspect of the principle of attribution of profits.
“The situation would be different if the transfer pricing analysis does not adequately reflect the functions performed and risks assumed by the enterprise. In such a case, there would be need to attribute profits to the PE for those functions/risks that have not been considered,” the court said. The court said the object of the entire exercise is ultimately to ascertain whether the service charges payable or paid to the service provider (MSAS in this case) fully represents the value of the profits attributable to his service. In this connection, the revenue department has to examine whether the PE 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 regualtions, said the court.The object behind enactment of transfer pricing regulations is to prevent shifting of profits outside India, said the court.
Tax experts feel the decision will clear the air and end the uncertainty about taxation of captive BPOs. “The SC’s verdict will come as a huge relief to the captive IT/ITES units of overseas companies that offshore work on an arm’s length basis. Companies will, however, have to prove that their transactions are at an arm’s length. I am apprehensive on the ruling on deputation of personnel. It is a widely accepted and understood concept that a PE is not created if the deputed personnel is working under control and supervision of the subsidiary, with the risk, rewards and outcome of his work fully belonging to the subsidiary even though his payroll and legal employment continues with the overseas parent or affiliate company,” Amitabh Singh, tax partner, Ernst & Young said. The apex court’s ruling will be binding unlike in the case of the AAR’s decision. “The Supreme Court verdict provides certainty and stability with regard to BPO taxation in the country. The SC ruling would be binding and would provide certainty with regard to PE of an MNC in India.
There is a folly here, since, the service PE has nothing to do with Indian BPO and same is created solely by service of technicians of foreign company in favour of India BPOs. In a nutshell, there are no alarm bells for BPOs of foreign companies since status quo remains as Indian BPO of a foreign company does not per se create any PE,” Rahul K Mitra, executive director, PwC.