Landmark ruling on permanent establishment
A recent ruling on the interpretation of provisions of Double Tax Avoidance Agreements is a landmark decision on the concept of a permanent establishment, which is the bedrock on which business profits can be taxed in a contracting state. When there is a close and continued relationship between a resident and non-resident business, the latter becomes liable to tax in India.
The Income-Tax Act, 1961 deals with the concept of a business connection between a resident and a non-resident. Where there is an intimate and a real relationship between the two on a continued basis, the non-resident becomes liable to tax in India in respect of income earned pertaining to a business connection that is deemed to accrue in India.
Section 9 of the Act, which deals with business connection, stands superseded where the non-resident is residing in a country with which India has entered into a Double Tax Avoidance Agreement (DTAA).
Under such an agreement, business profits are taxable under Article 7, provided such profits are attributable to the permanent establishment (PE), defined by Article 5 of the DTAA.
A reading of Article 5 of the DTAA shows that Para 1 thereof applies where an enterprise carries on a business, whether wholly or partly, through a fixed place of business.
The commentary of OECD on Article 5 states that there must be a fixed place of business which takes in not only fixed premises but also machinery or equipment. The expression "a fixed place" indicates a certain degree of permanence. It is necessary that the business of the enterprise be carried on through a fixed place. Para 2 of Article 5 of the DTAA is an inclusive provision that takes in various places and services enumerated in clauses (a) to (l). A number of places are specified in Clauses (a) to (k) whereas clause (l) postulates provision of services by an enterprise within a contracting state through employees or other personnel.
Landmark case
These points were considered in a landmark ruling in the case of Morgan Stanley and Co., US, (2006; 152 Taxman 1). The facts in this case were that the applicant, M group, a non-resident company incorporated in the US, provided financial advisory services, corporate lending and securities underwriting.
The diverse activities of the applicant were undertaken by various divisions.
One of the group companies, MSAS, incorporated in India, was set up by the applicant to manage the group members' front office and infrastructure functions of its global operations, including services such as IT support, account reconciliation and research.
MSAS entered into a service agreement with the applicant. Under the agreement, it undertook to provide M group the aforesaid support services. To enable MSAS provide those services it was agreed between the parties that the applicant would send staff to MSAS (India) for stewardship and similar activities.
The applicant group agreed to pay MSAS the actual sum of all costs, together with an appropriate mark-up, mutually agreed on.
From an employment perspective, the staff would continue to be employed or engaged and their salaries and fees would be paid directly by the applicant.
Net margin method
A company `E' conducted a transfer pricing study for MSAS. The transactional net margin method (TNNM) was selected as the most appropriate, with operating profit margins being the profit level indicator in respect of the services rendered by MSAS to the applicant.
The average margin earned by comparable companies providing similar services was worked out at 28.33 per cent and under the existing arrangement, MSAS charged the applicant a margin of 29 per cent on the costs it incurred.
MSAS agreed to develop computer software including customised electronic data or computer programmes of critical relevance for the various divisions of the applicant such as equity research, fixed income division, equity finance service divisions and investment banking divisions.
It also agreed to provide research reports, data analysis, industry- and company-specific analysis, earning models of companies as an on-going process so as to help various divisions of the applicant formulate their business strategies.
MSAS would use the brand name, trade name as well as computer hardware of M. Whatever was produced or developed by it would be passed on to the M group and the former would have no right or interest in the said products.
The staff deputed to MSAS would be on the payroll of the applicant and the remuneration paid by it would be reimbursed by MSAS.
According to the AAR, MSAS had a fixed place of business but there was nothing to show that the business of the applicant was carried on through the place of business of MSAS.
The contention that rendering of the aforementioned services by MSAS to the applicant and other group companies which may be utilised by them in running their business, amounts to carrying on business through the fixed place of business of MSAS was not accepted by the AAR.
The germane condition of carrying on business through a fixed place of business of MSAS, not being fulfilled, Article 5 (1) would not be attracted. Therefore, MSAS cannot be treated as the PE of the applicant.
According to the AAR, for the purpose of Para 4, it is not necessary that MSAS should be an agent of the applicant/M group. It is enough if it satisfies the two requirements which are cumulative.
So far as the first requirement is concerned, that was satisfied as MSAS would be acting in India on behalf of the applicant/M group. Regarding the second requirement, MSAS is not an agent and, according to the commissioner, it was not an agent of independent status. Thus, admittedly, this requirement is also satisfied.
Having considered the facts and contentions of the parties both oral and written, the AAR ruled that MSAS could not be held to be a PE of the applicant/M group.
As regards the question whether the applicant would be regarded as having a PE in India under Article 5(2)(1) if it were to send some of its employees to India for undertaking stewardship activities or on deputation in the employment of MSAS, the AAR ruled that the ingredients of Para (2)(1) of Article 5 have to be considered.
From the terms of agreement, it is clear that the employees of the applicant are to be sent to MSAS whether for stewardship activity or on deputation basis for more than 90 days.
The applicant's contention that the staff would be working for the applicant was not accepted by the AAR. It may be that the benefit of services of the staff would be ensured to the applicant but it would not be the same as working for the applicant.
Once employees are sent by the applicant on deputation for stewardship activities, they would be actively involved in the key managerial activities of MSAS.
It follows that the ingredients of para (2)(1) of Article 5 are satisfied. Therefore, the AAR ruled that MSAS would constitute a PE.
This ruling is a landmark decision on the interpretation of provisions of Double Tax Avoidance Agreements, on the concept of a permanent establishment, which is the bedrock on which business profits can be taxed in a contracting state
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