Transcript Morgan Stanley & Co : Analysis of Apex Court Decision

Morgan Stanley & Co :
Analysis of Apex Court
Decision
Shri. Girish Dave IRS
Director of Incometax
International Taxation, Mumbai.
Morgan Stanley & Co (MS)
 Morgan Stanley & Co. (MS, the assessee) is a company
incorporated in U.S.A. and belongs to the Morgan Stanley Group.
 It provides global financial and consultancy services to its
institutional as well as individual clients.
 The Group has established a subsidiary company in India, Morgan
Stanley Advantage Services Pvt. Ltd. (MSAS) which has entered
into an agreement with the assessee for providing as many as
seventeen types of services.
 For these services, MS pays charges to MSAS at costs plus a mark
up and the risks for idle capacity are to be borne by MS.
 MS sends its staff to India for stewardship activities to maintain
standard of quality of the Morgan Stanley group and for monitoring
the overall outsourcing operations of MSAS.
Morgan Stanley & Co (Contd..)
 Further, MS sends its employees to MSAS who work
under the supervision and control of MSAS.
 These employees continue to be employed by MS and
their salaries are reimbursed by MSAS to MS.
 For determining the tax liability from this arrangement,
MS approached the Authority for Advanced Ruling (AAR)
for a ruling on the following questions:
Morgan Stanley & Co (Contd..)
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Whether the services to be rendered by MSAS constitute a PE
of the applicant under Article 5 of the India-US tax treaty?
Whether MSAS would be regarded as constituting a fixed PE
under article 5 (1) or an agency PE of the Applicant under Article 5
(4) of the Treaty?
Whether the Applicant would be regarded as having a PE in India
under Article 5(2)(l) of the Treaty if it were to send some of its
employees to India for undertaking certain Stewardship Activities or
on deputation?
Issues relating to transfer pricing.
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 the Applicant?
Arguments by the Applicant
 The applicant does not have a fixed
place of business.
 The services rendered by the applicant
do not constitute a service PE.
 MSAS is not a dependent agent of the
applicant under Article 5 (4) of the Treaty.
Arguments of the Department.
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The functions performed by MSAS are essential corefunctions for the enterprise and cannot be described as
preparatory and auxiliary in nature.
The agreement provides that MSAS is subject to detailed
instructions and control with respect to the conduct of the
business which shows that MSAS is a dependent agent.
MSAS is working for and on behalf of the applicant and is a
mere projection of the applicant and the group. Hence, MSAS is
a PE of the applicant under para 1 of article 5 of the treaty.
The services to be rendered by MSAS show it to be an
economically and legally dependent agent to the Morgan Stanley
customers exclusively, strictly following Morgan Stanley
procedures, policies and practices.
It also constitutes a PE under article 5 (2) (l) of the treaty.
MSAS also constitutes a PE under article 5 (4).
Ruling given by the AAR
 The AAR gave its ruling on 13th February, 2006.
 It held that MS will neither have a ‘basic rule’ PE under Article 5(1)
nor it will have an Agency PE under Article 5(4) of the DTAA
between India and USA nevertheless holding that there was virtual
projection of MS.
 The AAR, however, ruled that the provision of services by the
employees of MS would constitute a ‘Service PE’ under Article
5(2)(l) of the DTAA if the employees render service for more than 90
days.
 The AAR also ruled that if an Arm’s length remuneration is paid to an
Agency PE, then no further profits can be attributed to the Agency
PE.
 AAR declined to give any ruling on transfer pricing issues.
 As long as MSAS, being the PE of the applicant in India, is
remunerated for its services at arm’s length by the applicant/Morgan
Group 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.
After the AAR ruling…
 Since substantial questions of law were involved and the ruling of
the AAR would have a bearing on similar other cases with significant
revenue implications, the ‘Revenue’ decided to file a Special Leave
Petition (Civil) under Article 136 of the Constitution of India.
 Subsequently, the assessee also filed a SLP on issues decided
against it by the AAR.
Revenue’s Appeal (SLP No. 12907 of 2006)
1. Whether Permanent Establishment under Article 5(1) of the
Treaty exists and whether the activities of MSAS are
preparatory or auxiliary in nature?
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There are two basic requirements for having a PE, i.e., the
enterprise having a place at its disposal and the carrying out of
business activities from that place. Since MS has unrestricted
access to the premises of MSAS as per clause 9 of the service
agreement, the first requirement is satisfied.
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MSAS is doing the core business functions of MS. MSAS is
working under the total control and supervision of the MS. Even the
AAR observed that MSAS is nothing but a virtual projection of MS in
India. Therefore MSAS gets hypothesized as PE. The hypothesized
PE is not exactly the same as the subsidiary.
An analogy of a “Toll Manufacturer” and “Independent Contractor” is
most appropriate to understand this distinction.
Revenue’s Appeal (Contd…)
Analogy of a “Toll Manufacturer” and “Independent Contractor”.
 In the case of a toll manufacturer, it manufactures goods as directed
by a foreign principal using the technology owned by the Principal,
the entire cost incurred by it are reimbursed by the Principal with a
mark-up, the idle cost of the inventory, employees and space etc are
borne by the Principal. In such a case, the manufacturer’s activity of
manufacturing is on behalf of the Principal.
 However, in the case of an independent manufacturer, he uses his
own skills for manufacture, he takes the risks of idle inventory, idle
employee cost, idle capacity of machines etc. He performs
manufacturing functions independently without any interference in
the manner of production by the Principal. The Principal is
concerned only with the manufactured goods which is to be supplied
to him at predetermined prices. In such a case of independent
contractor, the Principal does not utilize any asset in India, does not
take any risk in India and does not perform any manufacturing
activity in India.
Revenue’s Appeal (Contd…)
 Another example could be of an Automobile
Manufacturer of Japan. He appoints three agents in India
for manufacture of parts, assembly of parts and sale of
automobiles. All three agents work under the direct
control and supervision of the Japanese Automobile
Manufacturer. The Agents are paid at cost plus five
percent basis since no significant risks are taken by such
agents. All the risks such as idle inventory, idle capacity
of employee, space and machines etc are borne by the
Japanese Manufacturer.
 Can it be said under such circumstances that the
Japanese do not have any business activity in India?
Revenue’s Appeal (Contd…)
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The MSAS does not take any significant risk in India. The MS
takes all the risks of idle capacity of employees, space etc. It utilizes
its Intellectual Properties provided to MSAS.
A detailed study of all the 17 services being performed by the
MSAS would clearly reveal that these are core and integral functions
of MS being done in India by MSAS on behalf of MS.
The question whether a foreign company chooses to do business in
the other country through a subsidiary or a branch is a question of
business model it chooses to follow.
The determining test is whether the business is of the foreign entity
or of the Indian company based on the terms of the agreement and
the FAR (Functions performed, Assets used, Risks taken) analysis.
Hence, it is concluded that MS has a ‘Basic Rule’ PE in India.
Revenue’s Appeal (Contd…)
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Whether Agency Permanent Establishment exists under Article
5(4) of the Treaty?
There are two basic requirements for establishing an Agency
PE, that is, Economic and Legal dependence of the agent and that
the agent concludes contracts on behalf of the principle.
The AAR has concurred with the revenue on the satisfaction of the
requirement of economic and legal dependence.
From the agreement, it is seen that the Indian subsidiary would be
merely a dependent agent working exclusively for the Morgan
Stanley Group. MSAS has been provided with the logo & brand
name of Morgan Stanley. The agreement clearly indicates that no
independent business distinct from the operations and services
rendered by MSAS to the MS customer would exist.
Another key factor, is the absence of entrepreneurial risk for MSAS,
which is an intrinsic feature for any independent business entity.
Revenue’s Appeal (Contd…)
 MSAS does not have any semblance of an independent contractor
in as much as it has to follow the detailed instructions, direction and
supervision by its principal as to the manner and method of carrying
out the activities assigned and thus, it is legally dependant on MS.
 On the basis of OECD Commentary and opinion of Klaus Vogel, the
question of an agent concluding the contract on behalf of the
principle has to be decided not only with reference to private law but
must also take into consideration the actual behavior of the
contracting parties.
 MSAS is interacting regularly with third parties and sub-contractors
for acquisition of various software, information and databases on
behalf of MS. The proprietary rights on such materials vests with the
MS only. Thus MSAS is concluding contracts on behalf of MS in
India. The activities of the agent are not confined to this only, as it
has many other activities including processing, analysis of the data
etc.
 In view of the above, MS has an Agency PE in India.
Revenue’s Appeal (Contd…)
 Whether 90 days requirement for service PE under
Article 5(2)(l) of the Treaty is fulfilled?
 A Service PE of MS would exist if MS renders services to
MSAS even for a day by sending employees in India as
per Article 5(2)(l)(ii) of the Indo-U.S Treaty.
Revenue’s Appeal (Contd…)
 Whether Any Profit is Attributable to Agency PE if payment to
Agent is at Arm’s Length Price?
 As per International practice most vividly brought out by the OECD
Report on Attribution of profits to a Permanent Establishment
published in December, 2006 after a two year world wide debate,
the host country will have taxing rights over two different legal
entities, The dependent agent enterprise (which is a resident of the
PE jurisdiction) and the dependent agent PE (which is PE of a non
resident enterprise).
 The Australian Guidelines on Attribution of profits to a dependent
agent PE provides a number of examples as to how profits can be
attributed to a dependent agent PE.
Revenue’s Appeal (Contd…)
 Where a dependent agent PE is found to exist, to attribute profits to the PE,
under the first step of the authorized OECD approach, a functional and
factual analysis determines the functions undertaken by the dependent
agent enterprise both on its own account and on behalf of the non-resident
enterprise.
 On the one hand, the dependent agent enterprise will be rewarded for the
services it provides usually by means of a fee from the non-resident
enterprise.
 On the other hand, the dependent agent PE will have attributed to it the
assets and risks of the non-resident enterprise relating to the functions
performed on its behalf by the dependent agent enterprise, together with
sufficient free capital to support those assets and risks.
 The OECD thus concluded that profits may be attributed to the dependent
agent PE after an arm’s length reward has been given to the dependent
agent enterprise.
 Such attribution of profits will depend on facts and circumstances of the
case and some countries such as Australia have issued detailed guidelines
for the same.
Revenue’s Appeal (Contd…)
 Thus, the International practice and the OECD approach
suggest that in case of an agency PE, there are two
different entities to be assumed for the purpose of
taxation in the host country as (i) Dependent Agent, and
(ii) Hypothesized Agency PE.
 In the present case, the activities of MS in India through
MSAS constitute a hypothesized agency PE and a basic
FAR analysis indicates that profits over and above the
arm’s length reward to MSAS can be attributed to it.
 In view of the above, when attributing profits to the
dependent agent PE, there are likely to be profits (or
losses) over and above the arm’s length reward paid to
the dependent agent enterprise.
Ruling by the Apex Court
 Under Article 5 (1) of the DTAA between India
and US, there exists a PE if there is a fixed
place through which the business of an
enterprise, which is an MNE, is wholly or partly
carried on. Article 5(1) is not applicable to MSAS
as it performs only back office operations.
 There is no agency PE as the PE in India has no
authority to enter into or conclude the contracts.
The contracts would be entered in the US. They
would be concluded in US.
Ruling by the Apex Court(Contd..)
 The ruling of the AAR that the stewardship
activity would fall under Article 5(2)(l) is not
accepted by the SC.
 On the other hand, persons on deputation have
lien on employment with MS and MS retains
control over the deputationists’ terms and
employment. The employees continue to be on
the payroll of the MNE. In such a case, a service
PE can emerge.
 As the above conditions are satisfied in this
case, there exists a Service PE in India (MSAS).
Ruling by the Apex Court(Contd..)
 Agreed with the AAR in principle that if an
associated enterprise, which also constitutes a
PE, has been remunerated at arm’s length basis
taking into account all the risk-taking functions of
the enterprise, then no further income could be
attributed to the PE (MSAS).
 The Transactional Net Margin Method (TNNM) is
the most appropriate method for determination
of arms’ length price in the case of a ‘service
PE’.
Interpretation of Apex Court Ruling
 One possible interpretation is that if a transfer
pricing analysis is done, no further profits can be
charged in the hands of MS and
 if any adjustment has been made by the transfer
pricing officer, then further profits can be
charged only in the hands of MSAS i.e the
Indian company.
 Nothing can be taxed in the hands of the foreign
company, the MS, and it is not required to file a
return of income even if transfer pricing officer
determines a higher arms’ length price.
 This is suggestive of a single point taxation.
Interpretation of Apex Court Ruling
 The other possible view and which appears to be more
correct, is that if the transfer pricing officer determines
that the transfer pricing analysis does not adequately
reflect the functions performed and risks assumed by the
enterprise, then the extra income attributable to India
should be taxed in the hands of the foreign company,
that is, MS.
 MS has to file its return of income in India.
 In the present case, since the transfer pricing analysis
has not taken into consideration the functions performed
by the ‘deputationists’ and the risks assumed by the
enterprise MS on account of those functions, MS may be
required to file its return of income in India.
Summary
 The functions of MSAS in India are substantive
and core functions of the Morgan Stanley Group
and are not just ‘back office functions’. The
MSAS is, therefore, a PE of MS under Article
5(1) of the DTAA.
 The functions performed by MSAS in India
clearly indicate that in substance they have an
authority to conclude contracts and thus MSAS
is a PE of MS under Article 5(4) of the DTAA.
Summary(Contd..)
 The functions of MSAS in India are substantive
and core functions of the Morgan Stanley Group
and are not preparatory or auxiliary in nature
and thus the exclusion clause of Article 5(3)(e) of
the DTAA will not be applicable.
 The ‘deputationists’ working on behalf of MSCo.
constitute a service PE of MS in India.
 Payment of an arm’s length remuneration to a
dependant agent PE or to a service PE does not
extinguish the tax liability of the principal in India.
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Thank You.