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..) • 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. • The functions performed by MSAS are essential core-functions 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? · 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. • 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…) • 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 itchooses 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…) 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. .