DIT (International Taxation), Mumbai V. Morgan Stanley & Co. Inc. (2007) 292 ITR 416 (SC)

1. Case Title and citation:

       DIT (International Taxation), Mumbai V. Morgan Stanley & Co. Inc. (2007) 292 ITR 416 (SC)

2. Court, Bench and Date of judgment:

       Court: The Supreme Court of India

       Bench: Justice S.H Kapadia and Justice Arijit Pasayat

Date of the Judgment: 9^th July,2007

3. Parties to the case:

Appellant: Director of Income Tax (International Taxation), Mumbai

Respondent: Morgan Stanley & Co. Inc.

4. Introduction:

The landmark judgment of Director of Income Tax (International Taxation), Mumbai V. Morgan Stanley & Co. Inc. stands as one of the most significant legal milestones in the cross-border corporate taxation in India. The case revolves around the India-US Double Taxation Avoidance Agreement (DTAA) and the factors which define the technical contours of a Permanent Establishment (PE) under this agreement.

The case specifically highlights the issue whether utilization of an Indian group captive entity by a foreign entity for its support operations and deploying international staff for oversight and short-term assignments triggers a taxable corporate presence in India.

5. Facts of the case:

Morgan Stanley & Co. Inc. (MSCo) is one of the world’s largest investment banks based in the United States of America which provides various services like financial advisory and corporate lending. It belongs to the renowned global financial service firm, The Morgan Group. The Morgan Stanley Group established an indirect subsidiary in India which was named as Morgan Stanley Advantages Services (MSAS).

It was established to provide a range of back-office support and specialized information technology enabled operations. In April 2005, the MSCo entered into an agreement with the MSAS, that the MSAS must support the front-office operations of the MSCo.

The MSCo. sent its trained senior employees to India to monitor the standard of quality and efficiency maintained by the MSAS. During this several technical experts where simultaneously sent to India to for short-tern assignment work while their employment was still under the MSCo.

The MSCo. anticipated that there might be a hefty cross-border tax implication and to prevent that the MSCo approached the Authority for Advanced Ruling (AAR) under the Section 245Q (1) of the Income Tax Act,1961.

6. Issues Raised:

The primary legal issues before the Supreme Court of India were:

1. Whether the MSAS’s office in India constituted to a fixed place of business as per the definition of ‘Permanent Establishment’ under Article 5 (1) of the India -US DTAA.
2. Whether MSAS could be considered an ‘Agency Permanent Establishment’ under the Article 5 (4) of the India-US DTAA.
3. Whether the activities performed by the MSCo’s employees amount to stewardship or merely a quality management as a part of rendering service.
4. Whether sending the employees to India constitutes to an establishment of a PE in India.
5. Whether the payment of Arm’s Length Price by a foreign enterprise to its associate entity extinguishes the tax liability completely in India.

7. Arguments of the parties:

Arguments advanced by the Appellant

Existence of a Fixed Place Permanent Establishment:

The revenue department contended that the MSAS represented the permanent business presence of the MSCo in India. The operations carried out by the MSAS where a core component of the MSCo’s global investment banking architecture and acted as a fixed place of business for MSCo, thus, it satisfied the definition of Permanent Establishment under Article 5 (1).

Existence of Agency PE:

The MSAS was argued to be completely dependent, both financially and operationally. Its existence relied on the service provided to MSCo only and acted solely under its control. The MSAS being controlled by a foreign parent company meets the economic threshold of an Agency under the Article 5(4).

Creation of a service PE:

The treaty specifies the period for which foreign employees can render their services in the territory of India. It was argued that both the stewards and the deputed personnel where the employees of the MSCo and the ARTICLE 5 (4) of the Treaty does not differentiate between the types of employees. Therefore, a service PE was formed.

Inadequacy of Arm’s Length Payment:

The Revenue department contested that the payment of an arm’s length price by MSCo to MSAS absolved it from any taxable liability. It further contended that even if MSAS received an arm’s length price for performing its local activities economic presence of MSCo in India through PE created another pool of profits separately identifiable as having been earned through the PE under Art. 7 of the Treaty. Therefore, global profits needed allocation in India through a profit split method.

Arguments advanced by the Respondent:

Absence of Fixed Place PE:

 MSCo contested that to constitute a Fixed Place PE under Article 5(1) the enterprise must have the legal and operational control over the place (“right of disposal”). MSAS owned and controlled its premises. The main activity of MSCo, that is investment banking was not performed from Mumbai only the back-office work for such activities was conducted in Mumbai.

Agency Relationship Not Established:

MSCo highlighted that MSAS never had any kind of authority to make business or financial commitments on behalf of MSCo and that it was merely dependent economically or financially as a captive service unit and that it did not negotiate terms or enter into binding relationships with MSCo.

Difference in Roles of Personnel:

MSCo contended that such personnel had been assigned by MSCo only to safeguard MSCo’s own brand, data protection and service delivery norms. The employees did not provide any services to MSAS they just performed the role of quality checking on behalf of MSCo.

 MSCo further contended that from the moment the employee becomes a deputed one he/she operates as an employee of MSAS, subject to the supervision and management of MSAS.

Extinguishing Further Profits from Attribution:  According to MSCo, as per transfer pricing principles once an Associated Enterprise (PE) has been remunerated at arm’s length based on the FAR analysis no more profit can be attributed to PE. To attribute any more would cause economic double taxation against the very spirit of Article 7 of the DTAA.

8. Court’s Reasoning and Analysis:

1. Analysis of Fixed Place PE (Article 5(1))

It was noted by the Court that three structural requirements need to be met for the Fixed Place PE to arise:

• There should exist a physical place (a “place of business”).
• This place must have some permanent character (“fixed”).
• The enterprise of the non-resident must conduct its business “wholly or partly through” this fixed place.

In this case, the Supreme Court stated that although MSAS possessed a fixed place of business in India, MSCo did not conduct its business of investment banking from this place. MSAS merely conducted its back office, processing and research activities that were supportive in nature. MSCo did not have any unrestricted rights to dispose of MSAS’s office facilities. Therefore, there was no existence of Fixed Place PE.

2. Analysis of Agency PE (Article 5(4))

The Court examined the provisions related to the agency and found that an Agency PE is constituted if the agent has the continuous right to act on behalf of the principal in negotiating and making contracts or stocks of goods in which deliveries are made. In this case, MSAS did not enjoy any power to bind MSCo in terms of financial and investments contracts.

3. Analysis of Service PE under Article 5(2)(l)

The court categorized the movement of personnel into two separate categories as follows:

Stewardship Activities: It was held by the Court that the movement of stewards by the MSCo was done merely for protecting the investor’s business and compliance of data security. The stewards did not provide managerial, technical or consultancy services to MSAS. They were auditors observing the quality of service rendered. Thus, it stewardship activities do not amount to Service PE.

Deputation Activities: The court observed that during deputation the employees work for MSAS but still maintain employment, seniority and social security with MSCo. In case of default or any loss suffered by the employee, MSCo will be structurally liable. MSCo renders the skilled services of its employees to MSAS for conducting its business operations. Since, the services are being rendered by the employees of MSCo in India the Court ruled that presence of deputed employees gives rise to the Service PE under Article 5(2)(l) of the India-US DTAA.

4. Relationship between Transfer Pricing and Profit Attribution (Article 7)

The Supreme Court of India has adopted the principle of the Single Entity approach along with a detailed analysis of Functions, Assets, and Risks (“FAR”).

The Court has held that Profits of a PE are to be determined under Article 7 based on what the PE would have made assuming that it was an independent enterprise performing its own operations. In the case where a transfer pricing analysis shows that the Indian subsidiary, constituting the PE has been remunerated fully and on an arm’s length basis by the foreign subsidiary then no further profit can be attributable to the foreign corporation through the PE in India.

Therefore, since the risks were entirely borne by MSCo and the functions performed by MSAS were fully remunerated at market rates, the tax liability of the PE stood completely extinguished.

9. Judgment and Ratio Decidendi:

Judgment:

The Supreme Court of India held that the MSCo did not have a fixed place PE neither an Agency PE in India nor the stewardship activities constituted to a Service PE. However, the deputation of the MSCo employees at MSAS created a Service PE in accordance to the provisions of Article 5(2) (1) of the India-US DTAA.

The MSAS was remunerated at the Arm’s Length Price through the TNMM system and no additional profits were left to be attributed to the Service PE in India.

      Ratio Decidendi:

The court observed that a foreign entity does not have a fixed place PE in the territory of India unless it exercises the direct operational control over the premise and stewardship activities by the parent company which are done to monitor the quality of task do not amount to furnishing of services.

When the associated enterprise constituting a PE is fully remunerated at an Arm’s Length Price capturing all functions, assets and risks the tax liability extinguishes.

10. Critical Analysis:

Significance of the Judgment:

The judgment of the case is an essential pillar of Indian international tax laws. The adoption of the Arm’s Length Price eliminates any chances of further allocation of the profit.

Implications and Impact:

This judgment served to reassure foreign enterprises that any outsourcing of jobs to India would not result in their profit being taxed in India long as they paid the arm’s length price to the Indian firm.

III. Critical Analysis:

Although this ruling was helpful for protecting the foreign corporations against the legal claims made by the state, it opened up a huge loophole for tax claims. This is because the tax exemption will not be applicable unless and until the corporation makes a very thorough review of the FAR of the concerned business.

This is why it is very important for tax authorities to scrutinize the activities of the Indian back offices. If they manage to prove that the Indian back-office is involved in managing hidden risks or creating intellectual property and not simply carrying out support operations, the tax exemption will not be applicable to such corporations.

11. Conclusion

The judgment by the court in this case represented a balance between strictness of legalities required in the maintenance of sovereignty of tax system in India and an open economic atmosphere for foreign investments.

The confirmation of the rule that a payment made on arm’s length basis under transfer pricing eliminates further profit allocation helped unify Indian case law with the global standards set by the OECD (Organisation for Economic Co-operation and Development). It continues to be a benchmark for dealing with tax disputes among multinational corporations to this very day.

12. Reference(S):

• Double Taxation Avoidance Agreement (DTAA)
• Income-Tax Act,1961: Section 9(1) (i), 92C and 245 Q
• OECD Model Tax Convention on Income and on Capital, Commentary on Article 5 (Permanent Establishment) and Article 7 (Allocation of Profits).