The Hindu Business Line : How `permanent' the BPO units?

With the emergence of foreign Business Process Outsourcing units in India, the Government's stand on adopting a proper, fair and reasonable approach in taxing them, has been the subject matter of debate the last few years. In many cases, false alarms and apprehensions have been raised, in several others the Revenue has complicated things by issuing directions that have been interpreted differently, and in some Revenue Officers at the grassroots level have taken an unnecessarily aggressive stand. Typically, when a foreign company sets up a BPO unit in India, or for that matter, any country, the two primary issues of taxation are transfer pricing and creation of permanent establishment (PE). The latter issue has unfortunately and unnecessarily been blown out of proportion by the Revenue, probably out of aggressive thinking, when the actual focus should be in adopting a proper transfer pricing policy of the BPO units.

Partial resolution

In the midst of this, the Authority for Advance Ruling (AAR) recently pronounced in the Morgan Stanley case a ruling that has attracted the attention of the industry more than any other on foreign taxes passed in recent years. The ruling has been applauded for partially resolving the PE issue in favour of the taxpayers. However, in actual practice, the ruling creates more confusion than the relief it provides.

The brief facts of the case are that Morgan Stanley US (MS US) had outsourced IT development functions to its Indian subsidiary, Morgan Stanley India (MS India), against payment of fees. MS US sent, on a regular basis, its employees to the MS India business premises for carrying out stewardship activities. That is, supervise the functioning of MS India to ensure that the deliverables were to required quality and standard of MS US. The stewards, as such, did not appear to take part in any management functions of MS India. Though not specifically mentioned in the ruling, it appears (and quite logically) that MS India did not pick up the salary costs of the stewards. In other words, MS US continued to pay and bear the salary costs of the stewards.

There was another class of MS US employees who visited India. For them, MS India made specific requests to MS US to depute them to its business premises for providing services through training, etc. During such secondment, the technicians or secondees would remain on the payroll of MS US, which would initially pay their salaries in the US and thereafter recharge thee same from MS India on the basis of actuals, that is, without any mark-up. Further, the secondees would be under the direct control and supervision of MS India during the period of their stay in India.

The AAR ruling

In this background, several questions were referred to the AAR for consideration. Certain questions were not decided by the AAR as not falling within the scope and ambit of advance ruling. Fundamentally, the AAR gave a ruling inter alia on the following issues:

The BPO activities carried out by MS India per se did not create any fixed place of business PE or dependent agent PE of MS US; and

Both the stewards and the secondees resulted in MS India creating a service PE of MS US in India.

An analysis of the ruling would show that MS India is a separate company or entity compared to MS US. Therefore, as such, outsourcing of BPO activities on a principal-to-principal basis by MS US in favour of MS India per se could never result in MS India creating a fixed place of business, PE of MS US in India. The position on this is very clear, as also clarified in the OECD model commentary. To this extent, the AAR merely stated the obvious while giving relief to the taxpayer.

It may be noted that though the AAR ruled in favour of the assessee on this point, it made observations to the effect that MS India was a projection of MS US or Morgan Stanley worldwide group. It is submitted that there is no such concept of projection, whether virtual or actual. MS India, again being a separate entity compared to MS US, could have created a PE of MS US through the dependent agency clause, provided it solicited or concluded contracts on behalf of MS US (soliciting of orders constitutes creation of agency PE under majority of the Indian treaties, as opposed to the OECD model, where only conclusion of contracts creates an agency PE). The facts of the case clearly suggested that MS India never solicited or concluded contracts on behalf of MS US, as it only carried out IT development work under outsourcing model on principal-to-principal basis. The AAR also quite correctly ruled that MS India did not create any such agency PE of MS US. This was again stating the obvious.

It may be noted that though the AAR held that MS India did not create a dependent agency PE of MS US, since it did not solicit or conclude contacts on behalf of MS US, it nonetheless held that MS India was otherwise an agent of MS US and it was only due to the fact that it did not carry out such specific functions of soliciting or concluding contracts, which are the prerequisites under the tax treaty for creating agency PE, it did not create the dependent agency PE. Though these remarks did not have any adverse bearing on the outcome of the ruling, it is difficult to fathom the rationale of treating a contractor (working under a principal-to-principal contract of outsourcing) as an agent of the foreign company.

(To be concluded)

(The author is Executive Director, PricewaterhouseCoopers.)