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1. Shefali Goradia Nishith Desai Associates Legal and Tax Counseling Worldwide Mumbai  Silicon Valley  Bangalore  Singapore DIT, Mumbai v. Morgan Stanley and Co. Inc. September 12, 2007 www.nishithdesai.com

2. Overview • Spotlight on the relevant articles • Typical Structure • Background • Timeline • Proceedings before AAR • Supreme Court Ruling • Points to ponder • Take away

3. Spotlight – Article 5, India-US Tax Treaty ARTICLE 5 - Permanent establishment – 1. For the purposes of this Convention, the term permanent establishment means a fixed place of business through which the business of an enterprise is wholly or partly carried on.

4. Service PE 2. The term permanent establishment includes especially : ………………….. (l) the furnishing of services, other than included services as defined in Article 12 (Royalties and Fees for Included Services), within a Contracting State by an enterprise through employees or other personnel, but only if: • activities of that nature continue within that State for a period or periods aggregating more than 90 days within any twelve-month period ; or • the services are performed within that State for a related enterprise within the meaning of paragraph 1 of Article 9 (Associated Enterprises).

5. Exclusion from PE 3. Notwithstanding the preceding provisions of this Article, the term permanent establishment shall be deemed not to include any one or more of the following : ………… (e) the maintenance of a fixed place of business solely for the purpose of advertising, for the supply of information, for scientific research or for other activities which have a preparatory or auxiliary character, for the enterprise.

6. Agency PE 4. ….. where a person is acting in a Contracting State on behalf of an enterprise of the other Contracting State, that enterprise shall be deemed to have a permanent establishment in the first-mentioned State, if : • he has and habitually exercises in the first-mentioned State an authority to conclude on behalf of the enterprise, unless his activities are limited to those mentioned in paragraph 3 which, if exercised through a fixed place of business, would not make that fixed place of business a permanent establishment under the provisions of that paragraph ; (b) he has no such authority but habitually maintains in the first-mentioned State a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the enterprise, and some additional activities conducted in the State on behalf of the enterprise have contributed to the sale of the goods or merchandise ; or (c) he habitually secures orders in the first-mentioned State, wholly or almost wholly for the enterprise.

7. Core Business activity Service Provider Customer contract payment Sub contract Supervision & Training payment Auxiliary services such as customer care, data collection etc Captive BPO Unit Typical Structure

8. Background Circular 23 of 1969 – • Extent of profit assessable under Section 9 - only that portion of the profit which can reasonably be attributed to the operations of the business carried out in India Circular 5 of 2004 – • If Indian BPO is paid “arm’s length price” for its services, there will be no further attribution of profits to the PE. Earlier Circular 1 of 2004 withdrawn (distinction between “core” v. “incidental” activities not relevant?)

9. The Parties • Morgan Stanley and Company (“MS”) is an investment bank engaged in the business of providing financial advisory services, corporate lending and securities underwriting. • Morgan Stanley Advantages Services Pvt. Ltd. (“MSAS”) entered into an agreement for providing certain support services to MS. • MS outsourced some of its activities to MSAS, which was set up to support the main office functions in: • equity and fixed income research, • account reconciliation • providing IT enabled services such as, back office operation, data processing and support centre to MS.

10. TIMELINE

11. Questions raised before AAR MS sought advance ruling from the AAR on : • Whether MS had a PE in India under Article 5 of the DTAA i.e.- • fixed place of business • dependent agent PE • service PE • Even if there were a PE no further profits could be attributed if the fees paid to MSAS were on arm’s length. • Whether the use of TNMM method was appropriate. • If the transfer pricing mark-up of 29% determined by TNMM method was appropriate.

12. DIT’s Submissions • MSAS is basically a front office of MS - • which is wholly and exclusively dependent on MS; • It cannot function without the support of MS; • It is a virtual projection of MS on the soil of India; • MSAS performs essential and significant activities of the Morgan Stanley group, which are crucial and critical for the business being carried on by MS as well as the other group companies. • The functions performed by the MSAS are core functions and not preparatory and auxiliary • MSAS is an agent of MS. • It is economically dependant on MS. • It is bound by the service / quality controls imposed by MS • Employees of MS on stewardship / deputation will constitute a servicePE as providing services to MSAS on behalf of MS.

13. The AAR ruled • On existence of PE of MS : • No fixed place of business PE -under Article 5(1); • MSAS not a dependent agent under Article 5(4); • Service PE triggered – under Article 5(2)(l) • Employees of MS sent to India – for stewardship or on deputation in the employment of MSAS – If such presence exceeded 90 days; • Even if MSAS a PE of MS in India – As per Circular 5 / 2004 – no further profits attributable if arm’s length price has been paid; • No ruling on use of TNMM - as proceedings had already been initiated. (AAR had also taken preliminary objection that it is not permitted to determine the fair market value of property)

14. Special Leave Petition to the Supreme Court • Director International Tax – SLP to the Supreme Court • MS files counter to SLP & a fresh SLP as a cross-petition

15. Grounds taken by DIT • Grounds relating to fixed place of business PE • MSAS is nothing but a projection of MS. • Many of the observations in the AAR ruling are contrary to the contention that there is no fixed place of business for MSAS. • The AAR has found that MS would be in a position to exercise close control and supervision on the working of MSAS - shows that the business of MSAS was inextricably linked with the business of MS. • Grounds relating to dependant agency PE • The AAR has not discussed how the condition relating to authority to conclude contract in Article 5(4) of the DTAA has not been satisfied and such non-consideration vitiates the decision on this point. • The AAR has not appreciated the commercial realities and its judgement is contrary to the views of Klaus Vogel which have been approved by the Authority in its ruling which is reported in 237 ITR 230. • The decision of the AAR is contrary to the rulings reported in 274 ITR 501 and 237 ITR 230.

16. Grounds taken by DIT • Grounds relating to Service PE • The AAR has wrongly held that the PE would be constituted only if the services rendered by the employees exceed 90 days. • The decision of the AAR is contrary to Article 5(2)(l) which does not prescribe any such restriction of 90 days. • Grounds relating to attribution of profits in the hands of PE • The AAR has wrongly held that in case MSAS is remunerated at arm’s length by MS then no further income can be attributed in the hands of the PE by MS. • A strict adherence to the arm’s length principle would make the dependent agent PE completely meaningless. • Cited recent OECD report on attribution of profits.

17. Supreme Court Judgment • MS does not have a fixed place PE in India under Article 5(1) • MS does not have an dependant agency PE under Article 5(4) • MS does not have a Service PE on account of employees performing stewardship activities • MS would create a Service PE on account of deputation of employees to MSAS • Transactions are at arm’s length - no further attribution to the PE, provided the payments made to the PE take into account all the risk-taking functions of the Multi-national enterprise (MNE)

18. Analysis of the Judgment • A functional and factual analysis of each of the activities to be undertaken by an establishment. • MSAS in India would be engaged in supporting the front office functions of MS. • Provision of services by a subsidiary to its parent/ group does not by itself constitute that subsidiary, a PE of its parent/group company. • Business of the foreign enterprise is not carried out through the place of business of the subsidiary.

19. Analysis of the Judgment • Deputation of employees by MS to MSAS held to constitute a service PE in India under Article 5(2)(l), though only on account of the services to be performed by the deputees deployed by MS and not on account of stewardship activities. • TNMM accepted as the appropriate method for determination of the arm's length price in respect of transaction between MS and MSAS. • The computation of the remuneration based on cost plus mark-up worked out at 29% on the operating costs of MSAS is accepted and approved by the Supreme Court.

20. Points to Ponder • Relevance of back office activities for determination of PE • Service PE - stewardship v deputation • Implications if the applicable DTAA does not have a Service PE Rule • Implications if no DTAA situation • Would the foreign company have a “business connection” in India on account of deputation of personnel?

21. Points to Ponder • Attribution of profits to PE : Single entity v. Dual entity • Transfer pricing: Can the AAR rule on it? • Is TNMM and the 29 percent mark up here to stay?

22. Power of Review: SC • Article 137 of the Constitution provides that the Supreme Court has the power to review any judgment pronounced by it. • Time limit to file review application is within 30 days from the date of judgment or order • The grounds for review under the civil procedure code are: • On the discovery of new and important matter or evidence • On account of some mistake or error apparent on the face of the record or for any other sufficient reason

23. Takeaways • Back-office activities are not to be construed “the business of the MNE” - It is the business of the service provider • SC has brought to fore the fine distinction between a secondment and deputation. • Approved the Single Entity Approach for attribution? • Implicitly accepted that the AAR can rule on Transfer Pricing? • SC keen on emphasizing on “economic nexus” as pre-requisite for taxation of non-resident. Recent International tax decisions by Supreme Court reiterate this principle (Ishikawagima / Hyundai)

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