Setback to concept of Advance Ruling & Foreign Investment

AIT News Network

NEW DELHI. What may perhaps result in a major setback to concept of Advance Ruling in Income Tax, Customs, Central Excise & Service Tax matters is the filing of SLP by the Income Tax Department against the ruling of Authority for Advance Rulings(Income Tax)  AIT-2006-74-AAR  in case of Morgan Stanley. In a hearing held on 14^th August 2006 ; Supreme Court Bench of Mr Justice S.H. Kapadia and Mr Justice R.V. Raveendran has issued notice on SLP filed by DIT(International Taxation),Mumbai. 

The Income Tax Department had taken an unprecedented step of filing Petition in Supreme Court  against a ruling of Authority for Advance Ruling Authority.

Section 245 S of Income Tax Act stipulates as under:  

(1) The advance ruling pronounced by the Authority under section 245R shall be binding only

        (a)        on the applicant who had sought it;

        (b)        in respect of the transaction in relation to which the ruling had been sought; and

        (c)        on the Commissioner, and the income-tax authorities subordinate to him, in respect of the applicant and the said transaction.

(2) The advance ruling referred to in sub-section (1) shall be binding as aforesaid unless there is a change in law or facts on the basis of which the advance ruling has been pronounced.

T H E  F A C T S:

The applicant a non-resident company was incorporated in USA under the General Corporate Law of the State of Delaware and it is a tax resident of USA;  described as “Morgan Stanley & Co., U.S.” and is shown as wholly owned subsidiary of Morgan Stanley, US.   It is a leading investment Bank having a number of group companies in various parts of the world.   The applicant, inter alia, provides financial advisory services, corporate lending and securities underwriting.  The diverse activities of the applicant are undertaken by various divisions.  One of the group companies is a Morgan Stanley Advantage Services Private Limited (“MSAS”) which is incorporated in India and is set up by the Morgan Stanley Group to support  the Group Member’s front office and infrastructure unit functions in their global operations for providing support services.  MSAS is a wholly owned subsidiary of  Morgan Stanley International Holdings Inc., (U.S.) in which 80% shares are held by Morgan Stanley U.S. and 20% shares are held by Morgan Stanley International Corporated US which is a wholly owned subsidiary of Morgan Stanley, US.  MSAS renders support services such as IT support, account reconciliation, research etc.  Under an agreement dated 1.12.2003, the applicant has out-sourced support services specified in Schedule-II thereto as amended from time to time.  MSAS does not undertake the important revenue generating functions of the applicant  nor does it bear any significant market risk with respect to its transactions with the applicant. The client’s interaction is done entirely by the employees/personnel of the applicant.   The applicant proposes to send it’s staff to India for stewardship activities and other similar activities to ensure that the high standards of quality are met as Morgan Stanley group entities are to be satisfied that the services received by them from other group companies  meet the Morgan Stanley standards.  Like any other customer, the applicant has to undertake certain stewardship and similar activities such as briefing MSAS on the standard of services expected, acquainting the staff on various aspects of the functions by conducting briefing sessions for effective transitioning of various functions and providing basic guidance so that services provided  meet the overall global value benchmarks of the Morgan Stanley Group.   The stewardship activities include monitoring the overall outsourcing operations at MSAS.  Firm management and infrastructure personnel travel to India for a very short term to ensure that the establishment and operations of MSAS proceed without any material exposure from the investors’ perspectives but they are not involved in any day-to-day management or other specific services to or for MSAS.    The applicant’s staff is also sent on deputation on the request of  MSAS for  periods ranging between several months to a couple of years to work under its control and supervision.   From an employment contract perspective, the staff will continue to be employed or engaged and their salaries and fees will be directly paid by the applicant.   MSAS is required to reimburse the compensation cost to the applicant with no profit element.  The consideration paid to MSAS by  the applicant for the services rendered will be the sum of the costs and a mark-up of a certain percentage of the costs as agreed upon between the parties.  The term ‘costs’ is defined in Schedule 3 of the agreement to include direct and indirect costs incurred by MSAS in providing the services, including all costs relating to under-utilization of capacity, such as idle time cost of employees, rent for vacant space, etc.  MSAS shall allocate indirect costs amongst the customers on a reasonable basis.   For the financial year 2003-04, M/s Ernst & Yong Private Limited has conducted a transfer pricing study for MSAS.  The Transactional Net Margin Method (TNMM) was selected as the most appropriate method with operating profit margin being the profit level indicator in respect of services rendered by MSAS to the applicant.  The average margin earned by the comparable companies providing similar services is worked out to 28.33% and under the existing arrangement MSAS charges the applicant a margin of 29% on the costs it incurs. 

T H E  Q U E S T I O N S   B E F O R E   A U T H O R I T Y:

The applicant sought advance rulings of the Authority on the following questions:-

• Whether on the facts and in the circumstances of the case, Morgan Stanley & Co. incorporated (“the Applicant”) would be regarded as having a Permanent Establishment (“PE”) in India under the provisions of Article 5 of the Agreement for Avoidance of Double Taxation and Prevention of Fiscal Evasion with Respect to taxes on Income and Capital Gains entered into between the Government of the Republic of India and the Government of the United States of America (hereinafter referred to as the “Treaty”), and specifically:-

(a)   Whether the Applicant would be regarded as  having a PE in India under Article 5 of the Treaty on account of the services rendered by Morgan Stanley Advantage Services Private Limited (“MSAS”) under the Draft Services Agreement proposed to be entered into by it with the Applicant (”Agreement”)?

(b)  Whether MSAS would be regarded as constituting an agency PE of the Applicant under Article 5(4) of the Treaty?

(c) 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 as described in paragraph 3 in Annexure II?

(d) Whether the Applicant would be regarded as having a PE in India under Article 5(2)(I) of the Treaty if it were to send some of its employees to India on deputation in the employment of MSAS?

(e)  Whether the Applicant would have a PE in India for any other reason?

• Whether, on the facts and in the circumstances of the case and in light of the provisions of Section 92C of the Income Tax Act, 1961 (“ITA”) read with Rules 10B and 10C of the Income-tax Rules, 1962 (“the Rules”), the ‘Transactional Net Margin Method’ (“TNMM”) is the most appropriate method for the determination of the arm’s length price in respect of transactions between the Applicant and MSAS?

• Whether on the facts and in the circumstances of the case, a mark-up of 29% (using the TNMM for the benchmarking analysis) on the operating costs incurred by MSAS for providing services to the Applicant would meet the arm’s length test as prescribed under Chapter X of the ITA?

• Based on the facts and in the circumstances of the case, even in the event MSAS constitutes a PE of the Applicant in India, 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?

• Based on the facts and in the circumstances of the case, in the event the Applicant is deemed to have a PE in India as a result of sending employees to India or due to deputation of employees to MSAS, whether given the function which would be performed and risks that could be undertaken by such a PE, would a remuneration based on a margin on total operating cost of the PE be the appropriate profit attributable to such a PE?

R U L I N G    O F   A U T H O R I T Y :

Authority for Advance Rulings had ruled:
1. a. that MSAS is not the PE of the applicant in India under the provisions of article 5(1) of the Treaty;
1. b. that MSAS would not constitute an agency PE of the applicant under article 5(4) of the Treaty;
1.c. that MSAS would be regarded as the PE of the applicant in India under Article 5(2)(l) of the Treaty if it were to send some of its employees to India for undertaking stewardship activities as described in paragraph 3 in Annexure II for a period beyond ninety days;
1.d. that MSAS would be regarded as the PE of the applicant in India under Article 5(2)(l) of the Treaty if it were to send some of its employees to India on deputation in the employment of MSAS for a period beyond ninety days;
2. that the question is liable to be rejected in view of the  first proviso to  sub-section (2) of Section 245R of the Act;

3. that as this question is dropped, we decline to pronounce any ruling on it.
4. that based on the facts and circumstances of the case, 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.
5. that  as the first part of the question which is  consequential to question nos. 1(c) & (d) is the premise for  the second part which is in fact the real question and  is nothing but  an alternate formulation of question nos. (2) & (3);  in  as much as question no. (2) is rejected and question no. (3) is dropped, no ruling need  be given on this question.

(Click here for full text of ruling of Authority AIT-2006-74-AAR )