1. AUTHORITY FOR ADVANCE RULINGS

1. Permanent Establishment – Article 5 of Dtaa with Usa

Morgan Stanley & Co. Inc., In re – (2006) 284 ITR 260 (AAR) : 201 CTR 67 (AAR) : 152 Taxman 1 (AAR New Delhi).

1. Company incorporated in India, which has agreed to render support services to the US based company (Applicant) and other group companies, cannot be said to be an agency PE of the applicant nor can it be said that the applicant is carrying on business through the place of business of Indian company; however Indian company would constitute PE of the Applicant under para 2(1) of Art. 5 of DTAA between India and USA when the applicant would send staff to the Indian company for stewardship and other similar activities and also on deputation and such staff would be working with the Indian company for more than ninty days.
    

2. So long as the US company doing business with an associated company (PE) in India complies with transfer pricing regulations and compensate the Indian entity at arm’s length, no portion of global profits of US company can be brought to tax in India.
    

3. Question of determination of arm’s length price is mandatorily required to be determined by the TPO in terms of s. 92C and the relevant instructions of the CBDT and, therefore, the question having already arisen and pending before the Assessing Officer, clause (i) of first proviso is applicable and the application for advance ruling has to be rejected; clause (ii) of the first proviso is also attracted as the Indian company has also to provide deliverables including hard-ware, intellectual property, software, etc., and all such deliverables fall within the meaning of property which are sought to be valued along with the services.

Facts

1. The Applicant, (MS) was an investment bank incorporated in USA. MSAS a wholly-owned subsidiary of the applicant group, incorporated in India, had entered into an agreement with the applicant to provide support services. The applicant had undertake to send staff to MSAS, for stewardship and other similar activities. The Applicant’s staff was 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. Salary cost of employees deputed was to be initially paid by the applicant and would be onwards recharged to MSAS.
    

2. Salary costs of employees sent to India for stewardship activities were borne by the applicant. For services rendered to the applicant MSAS charged on cost plus mark up basis.
    

3. Ruling was sought from the AAR as to inter alia :

1. Whether MSAS can be regarded as a Permanent Establishment (PE) of the applicant (MS) in India under the India-US Tax DTAA by virtue of MSAS being regarded as (a) its fixed place of business or (b) a dependent agent or (c) constituting a service PE on account of deputation of its employees in India?:
    

2. Even in the event MSAS constitutes a PE of the applicant in India, as long as MSAS was remunerated at arm’s length for its services, whether any further income could be attributed to the PE of the applicant (MS) ?
    

3. Whether Transactional Net Margin Method (TNMM) is the most appropriate method for the determination of the arm’s length price in respect of the transactions between the Applicant and MSAS?

Ruling

1. (a) MSAS cannot be regarded as a fixed place PE of the applicant since there was nothing to show that the business of the applicant was carried on through the place of business of the MSAS.

(b) Though MSAS was acting in India on behalf of the applicant, there was no material to show that MSAS was habitually exercising an authority to conclude contracts, maintaining stock of any goods or securing orders in India for the applicant. Therefore, MSAS cannot be considered as a dependent agent PE of the applicant under Article 5(4) of the DTAA.

(c) However, MSAS would constitute service PE of the applicant, since once the applicant would send staff on deputation for stewardship activities, they would be actively involved in the key managerial activities of MSAS. The AAR did not accept the argument that the staff would be working for the applicant only and hence there should not be a service PE. According to the AAR, while the benefit of the services of the staff working for the applicant may enure to the applicant, that would not be the same as the staff working for the applicant and hence according to AAR, all ingredients of Article 5(2)(I) were satisfied and MSAS would constitute PE of the applicant.

2. As long as MSAS, being the PE of the applicant, is remunerated for its services at arm’s length by the applicant, no further income can be attributed in the hands of the PE of the applicant.
    

3. AAR rejected the question regarding TNMM method on account of the following:

(a) The question was already pending before an income tax authority,

(b) It involved determination of the fair market value of property.

Cases referred to

1. ABC, In re (1996) 136 CTR (AAR) 451 : (1997) 223 ITR 416 (AAR)

2. Abc, In re (2005) 193 CTR (AAR) 328 : (2005) 274 ITR 501 (AAR)

3. CIT vs. Visakhapatnam Port Trust (1984) 38 CTR (AP) 1 : (1983) 144 ITR 146 (AP)

4. Dun & Bradstreet Espana, S.A., In re (2005) 193 CTR (AAR) 9: (2005) 272 ITR 99 (AAR) 161 : (2005) 272 ITR 416 (AAR)

5. XYZ, In re (1999) 156 CTR (AAR) 583 : (2000) 242 ITR 208 (AAR)

Circulars referred to

Circular No.23 of 1969, dt. 23rd July, 1969.

Board’s Instruction No.3 of 2003, dt. 20th May, 2003

Circular No. 5 of 2004, dt. 25th Sept., 2004

2. TRIBUNAL

2. Fees for technical services – Article 7 of Dtaa with Uk r.w.s 44D and 115a

Limitation on deduction for expenses as set out in section 44D will not apply in a case where income in question, is not in nature of fees for technical services within the meaning of said expression under DTAA with UK but which could on the test laid down under Explanation 2 to section 9(1)(vii), be treated as fees for technical services,
Jt CIT vs. Essar Oil Ltd. (2006) 7 SOT 216 (Mum)

Facts

The issue involved in the instant case was whether or not the limitation on deduction for expenses as set out in section 44D would apply in a case where the related income was not in the nature of fees for technical services so far as the meaning of the said expression under the applicable bilateral tax treaty was concerned, but on the test laid down under Explanation 2 to section 9(1)(vii) such an income could be treated as fees for technical services.

Decision

1. The terms of Article 7 of the DTAA between India and UK are similar to the terms of Article 7 of the DTAA between India and Singapore considered by the Tribunal in the case of Dy. CIT vs. Boston Consulting Group (P.) Ltd. [2005] 94 ITD 31 (Mum.). In that case, the assessee was receiving income through its PE in India by providing strategy consultancy services such as marketing and sales strategy, business strategy and portfolio strategy, etc. to its clients in India and abroad. The Tribunal, after discussing the terms of Article 7 of the DTAA and referring to the provisions of sections 44D and 115A, held that such services clearly rule out the applicability of clauses (a) and (c) to Article 12(4) of the DTAA. As regards clause (b) of Article 12(4), the Tribunal held that only such services as are technical in nature are covered which may enable the recipient of services to apply the technology and not consultancy services. In case receipts through PE in respect of which profits are computed under Article 7(3) of the DTAA are not fee for technical services, section 44D is not to be applied for the purposes of deduction of expenses. The Tribunal held that the receipts by the assessee – Singapore-company through its permanent establishment in India chargeable to tax under Article 7(3) of the DTAA between India and Singapore, being from strategy consultancy services, were not from technical services as referred to in Article 12(4)(d) of the DTAA. Hence section 44D, and for that matter, Explanation 2 to section 9(1)(vii), did not apply and, therefore, the limitation for deduction under section 44D was not attracted. The Tribunal also held that even if a contrary view was possible the one favourable to the assessee has to be preferred. Similar is the view taken by the Tribunal in the case of Raymond Ltd. vs. Dy. CIT [2003] 80 TTJ (Mum.) 120.
    

2. The Tribunal therefore held that :limitation on deduction for expenses as set out in section 44D will not apply in a case where income in question is not in nature of fees for technical services within the meaning of said expression under DDTA with UK but on the test laid down under Explanation 2 to section 9(1)(vii), could be treated as fees for technical services under the DTAA with UK though it may so be under Explanation 2 to S. 9 (1) (vii)

Cases referred to

1. General Electric Technical Services Co. Inc. [IT Appeal No. 3328 (Bom.) of 1986]

2. Dy. CIT vs. Boston Consulting Group Pte. Ltd. [IT Appeal No. 447 (Mum.) of 2001]

3. Dy. CIT vs. Boston Consulting Group Pte. Ltd. [2005] 93 TTJ (Mum.) 293

4. Dy. CIT vs. Boston Consulting Group Pte. Ltd. [2005] 94 ITD 31 (Mum.)

5. Raymond Ltd. vs. Dy. CIT [2003] 80 TTJ (Mum.) 120

3. Tds u/s 195 – Payment for purchase of software from Non- Resident parties is not royalty and is therefore not liable for Tds u/s. 195

Payment made for purchase of software from non resident parties does not amount to ‘royalty’ within ambit of section 9(1)(vi) and in such case assessee has no liability to deduct tax at source under section 195 and as such the provisions of section 40(a)(i) cannot be applied

Sonata Information Technology Ltd. vs. Dy C.I.T. (2006) 7 S.O.T. 465 (Mum)

Facts

The assessee-distributor of software products purchased some software from various non-resident parties and claimed the amount paid in that regard as revenue expenditure. The AO, treated the said amount as payment on account of ‘royalty’ under section 9(1)(vi) and since no tax was deducted at source by assessee at the time of making payments, he disallowed the same as revenue expenditure under section 40(a)(i). On appeal, the CIT(A) also held that the assessee was under the obligation to deduct the tax at source under section 195 and, hence, the provisions of section 40(a)(i) were attracted.

Decision

On appeal to the Tribunal, it was held that the issue had already been concluded by the decision of the Tribunal in assessee’s own case wherein the Tribunal, had held that payment made by the assessee for purchase of software did not amount of ‘royalty’ within the ambit of section 9(1)(vi) and, therefore, assessee was not liable to deduct tax at source under section 195. It was further held that, as a necessary corollary, the provisions of section 40(a)(i) could not be applied to the case of assessee.

4. Section 10a of the Income-tax Act, 1961, read with Article 7 of Dtaa with Usa

Since assessee (which was engaged in the development of software) was an establishment of a company incorporated in USA, chargeability of income-tax on operations of assessee was subject to provisions of DTAA. Assessee had worked out total value of software transferred to its head office on the basis of man hour put in for manufacture of computer software at rates prescribed in the contract note executed by head office in USA. Since there seemed to be a conflict between provisions of paragraph 2 of Article 7 of DTAA and basis on which foreign exchange remittances had been made from head office, business profits attributed to assessee were required to be determined afresh in accordance with Article 7 of DTAA as well as the arms length principle and only thereafter the claim of deduction u/s 10A could be properly considered.

Virage Logic International vs. Asst. Director of I.Tax (2006) 7 S.O.T 263 (Ca)

Facts

1. Assessee-company was engaged in development of software and was a permanent establishment in India of a U.S. company. The assessee, disclosed an income of Rs. 1,08,77,823 but claimed the same as exempt under section 10A. The assessee had worked out the total value of the software transferred to its head office on the basis of fixed rate of man-hour put in for manufacture of such software. On this basis the value of software transferred during the year was worked out at US $ 4,83,950 on which, after deducting the expenses incurred by the branch office, a profit of Rs. 1,08,77,823 was worked out.
    

2. The AO denied the exemption under section 10A on certain grounds. He further held that from the perusal of global accounts of the assessee it was seen that the gross profit of the assessee was almost four times of the cost incurred by it, that in the consolidated accounts the amounts paid to assessee must have been treated as cost, that even if the software supplied by the assessee was further processed in the United States, the profit from such supply had to be in the same proportion as the full cost incurred in the USA bore to the profits of VLC, (i.e., the assessee company) and that as per the invoices raised, the cost of the U.S. company from its Indian branch supply was US $ 4,83,950. The Assessing Officer, therefore, estimated the sale consideration to be four times of the cost i.e., US $ 19,35,800 or Rs. 8,98,79,194 and after reducing cost of Rs. 2,34,21,524 worked out the profits of the assessee at Rs. 6,64,57,670.
    

3. The CIT(A) upheld the disallowance under section 10A. He further held that the assessee was branch office of the parent company in the USA and, therefore, as per Article 5 para (2)(b) of DTAA it was a Permanent Establishment (PE) of the U.S. Company in India; that being so the income of the assessee-company was to be computed in accordance with the provisions of Article 7 of the DTAA. The profit of the PE was the income earned from the sale of software that was prepared in India. The assessee had not provided the actual sale consideration of the software. The amount which had been paid by the HO was not the sale consideration of the software. The payments were lump sum amounts. Therefore, in the absence of requisite details the AO was justified to estimate the realizable sale value as four times of the invoice value. However, as per Article 7 only the profit attributable to PE could be taxed in India. The software had been prepared in India and sold outside. In the business of software the main profit was because of preparation of software. Therefore, it would be appropriate on the facts of the case to attribute 75 per cent of net profit to the PE in India. The CIT(A), therefore, estimated the income at 75 per cent of the net income determined by the AO and, thus, worked out the income at Rs. 4,98,43,260 as against Rs. 6,64,57,670 determined by the Assessing Officer.

Decision

1. On Second Appeal to the Tribunal, it was held that the assessee-company was an establishment of a company incorporated in the U.S.A. and, therefore, chargeability of income-tax on the operations of the assessee was subject to the DTAA. It was not in dispute that the assessee was a PE in India of the US company. Business profits attributable to this PE, if any, were required to be determined in accordance with Article 7 of the DTAA. Paragraph 2 of Article 7 lays down the basis that the profits attributable to the PE in India shall be the profits which it might be expected to make if it was a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly at arm’s length from the enterprise of which it is a PE. However, in case the correct amount of profits attributable is incapable of determination or the determination thereof presents exceptional difficulties, the profits attributable to the PE might be estimated on the reasonable basis.
    

2. Provisions of section 10A, on the other hand, grant deduction of such profits and gains as are derived by an undertaking from the export of articles or things or computer software. Sub-section (3) of section 10A further stipulates that the deduction is available to the undertaking, if the sale proceeds of articles or things or computer software exported out of India are received in, or brought into, India by the assessee in convertible foreign exchange within a period of six months from the end of the previous year or within such further period as the competent authority may allow in this behalf. In the instant case, the sale proceeds were worked out by the assessee on the basis of man-hour put in for manufacture of computer software at the rates prescribed in the contract not executed by the head office in the USA. There seemed to be an apparent conflict between the provisions of paragraph 2 of Article 7 and the basis on which foreign exchange remittance had been made from the head office. If the contention of the assessee was taken to its logical conclusion, it would amount to seeking assessment in India of the business profits allowed to the PE in India at the discretion of the head office based in USA, whereas the profits were required to be attributed according to paragraph 2 on the basis that the Indian branch was distinct, separate and completely independent of the head office and was dealing with head office at arm’s length. For such working, the control, influence or supervision of the head office with respect to its transactions or commercial relations with the PE had to be ignored. These transactions were required to be evaluated and their effects ascertained on the doctrine of arm’s length as between two independent organizations. For that purpose the taxing authorities in India were free to determine the amount of sale proceeds irrespective of the alleged contract notes which were nothing but unilateral documents in the absence of existence of two parties. Rectification, according to the arm’s length principle is necessary if goods are invoiced from the head office to the PE or vice versa at prices which may not be consistent with the arm’s length principle
    

3. Therefore, the first issue to be resolved in the instant case was determination of transfer pricing on an independent basis. No such exercise had been attempted in the orders of the authorities below. It is only where the correct amount of profits attributable to the PE in India is incapable of determination on such basis or the determination thereof presents exceptional difficulties that the profits attributable to the PE may be estimated on some other reasonable basis. But for taking recourse to any other reasonable basis there has to be certain diligence for determination of the profits attributable to the PE on arm’s length principle. Hence, this issue was liable to be restored to the Assessing Officer for determination of the profits attributable to the assessee in accordance with paragraph 2 of Article 7 of the DTAA. It was only thereafter that the assessee’s claim of deduction under section 10A could be properly considered.

Case referred to

Infotech Enterprises Ltd. vs. Joint CIT [2003] 85 ITD 325 (Hyd.)