SKP Tax Alert
30 December 2014 | Volume 7 Issue 16
Creation of PE due to employee deputation, however salary costs are deductible towards attribution of profits

Recently, the Income Tax Appellate Tribunal of Mumbai (ITAT) has in  the case of M/s Morgan Stanley International Incorporated (MSI) (ITA no. 6882/Mum/2011) held that the recharge of salary cost of seconded employees by a foreign company to an Indian company would create a Permanent Establishment (PE) of the foreign company.  Accordingly the reimbursement of salary cost received by the foreign company would be taxable in India under Article 7 of the India-USA Double Taxation Avoidance Agreement (DTAA).  It also held that the salary cost would be considered an allowable deduction while computing the income of the foreign company. Further, it held that such reimbursement would not constitute Fees for Technical Services (FTS) under Income Tax Act, 1961 (the Act) and / or Fees for Included Services (FIS) under DTAA.  While adjudicating the instant case, the ITAT also discussed the recent ruling of the Delhi High court in the case of Centrica India Offshore Pvt Ltd (Centrica)[1]  and the decision of the Supreme Court in the case of Morgan Stanley and Co (Morgan Stanley)[2]  in detail.

Facts of the case:
  • MSI, a tax resident of USA (Taxpayer), was in the business of rendering support services to its group companies around the world.
  • During the year, the tax payer had seconded employees to two Indian subsidiary companies, namely, Morgan Stanley Advantages Services Pvt Ltd (MSAS) and MISM Global Support and Technology Services Pvt Ltd (GSTS).
  • The salary of the seconded employees was paid by the taxpayer. Further, requisite taxes under section 192 of the Income Tax Act, 1961 (the Act) on such salary was withheld by the taxpayer and deposited with the Indian Government Treasury.
  • The entire salary cost of the seconded employees was recharged by the taxpayer to MSAS & GSTS on a cost-to-cost basis (i.e. no mark-up was charged by the tax payer).
  • The Assessing Officer (AO) held it to be in the nature of FTS under the ACT  as well as FIS under the DTAA.
  • The Commissioner of Income Tax (Appeal) (CIT (A)) confirmed the findings of the AO.
Key Issues before ITAT:
  • Whether the taxpayer by way of deputing employees to Indian companies had rendered any services to MSAS & GSTS?
  • Whether the salary recharge by MSI to MSAS & GSTS amounted to FTS under the Act and/ or FIS under the India-USA DTAA?
  • Whether presence of taxpayer's employees in India resulted in formation of a Service Permanent Establishment (PE) of the tax payer in India as per Article 5 of the DTAA?
Taxpayer's contentions:
  • Seconded employees were under the supervision and control of the Board of Directors of the Indian companies and the employees were accountable only to the Indian companies.
  • The tax payer had not rendered any service to the Indian companies but had merely seconded its employees. Payment of salary was for administrative convenience and the salary had been reimbursed by the Indian companies without any mark-up.
  • Reimbursement of salary cost without mark-up had been accepted to be at arm's length by the Transfer Pricing Officer (TPO) in his order for the same assessment year.
  • Since there was no income element in the transaction, the reimbursement can not be taxed under section 9(i)(vii) of the Act. It also relied on various decisions to contend that reimbursement of salary of seconded employees did not constitute FIS under the DTAA.
  •  Alternatively, it was contended by the taxpayer that if seconded employees were considered to be its employees, they would constitute a Service PE in India as per Article 5 of the DTAA. Accordingly, taxability should be governed by Article 7 which talks about Business Profits of the DTAA and not by Article 12 which deals with FIS.  Therefore, no tax would be payable in India since salary cost would have to be allowed as a deduction under Article 7 against the reimbursement of salary cost received.
Revenue's contention:
  • The taxpayer was in the business of providing support services to its group companies.
  • Seconded employees were highly qualified technical personnel rendering managerial and consultancy services and hence services rendered by them   were in the nature of FTS under the Act and FIS under the DTAA.
  • As far as Service PE is concerned, since the matter was neither examined by the AO nor by the CIT (A), it needed to be sent back to the lower authorities to examine the amount of income  attributable to PE.
  • Also, there was no one-to-one correlation between the salary payment made by the taxpayer and the amount remitted by the subsidiaries.
ITAT ruling:
  • On perusal of TDS certificates and details of amount payable, it was held by the ITAT that there  was no discrepancy in the amount of the cost which had been reimbursed by the subsidiaries to taxpayer.
  • The ITAT held that reimbursement of salary cost would not constitute FIS within the meaning of India US DTAA by virtue of PE being created due to presence of taxpayer's employees in India.  It observed that the Delhi High Court in case of Centrica and all other decisions relied on by the revenue have nowhere discussed  Para 6 of Article 12 of DTAA for determining the taxability of such payments.  On perusal of this Article, it was clear that the clause of Royalty or FIS would not apply when the taxpayer was carrying on business in other Contracting State through PE and such FIS was attributable to such PE. As far as Service PE was concerned, the ITAT proceeded on the premise that seconded employees were really the employees of the taxpayer who had come to India to render services and once they were rendering services on behalf of the taxpayer in India, they constituted service PE in India.  Thus, ITAT did not get into the controversy as to whether the taxpayer was the real or legal employer or the Indian entities were the real employer.  In arriving at this conclusion, it drew support from the decision of the Supreme Court in the case of Morgan Stanley and the decision of the Delhi High court in the case of Centrica.
  • Further, according to Article 7, the taxpayer can claim all costs relating to earning such income, the salary cost paid to seconded employees by the taxpayer should be allowed as a deduction towards the income received by it as it was a cost to the taxpayer.

[1] 364 ITR 336 (2014)
[2] 292 ITR 416 (2007)
SKP's Comments
This is a welcome judgement by the Mumbai ITAT and it should help foreign groups reduce exposure on account of taxability of employee secondment arrangements, even in cases where it constitutes a Service PE. However, appropriate documentation and complying with withholding tax provisions as per Indian tax law with respect to salary payments is a must and would help in safeguarding the tax position adopted.
The Mumbai ITAT has adopted a different position as compared to the Delhi High court by relying on  Para 6 of Article 12 of the DTAA. Thus, whenever any MNC is structuring the secondment arrangement, it would have to keep in mind whether the relevant treaty contains such para in the Article dealing with Royalty and FTS. However, it is important  to note that the ITAT has not discussed Para (2)(l) of Article 5 (i.e. Service PE clause) of the DTAA which mentions that Service PE is not constituted when the amount paid to overseas entities fall within the meaning of FIS. Accordingly, whether one still needs to examine the exact nature of services from the stand-point of FIS and, the inter-play of Para (2)(l) of Article 5 and Para (6) to Article 12 are open questions not dealt with by the ITAT in this case. 

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