24 July 2008
The landmark decision of the Supreme Court in the Morgan Stanley case has laid down a few guiding principles regarding taxability of captive BPO (business process outsourcing) operations, says Dr Suresh Surana, a Mumbai-based chartered accountant and founder of RSM-Astute Group. Taxability of BPO operations in India needs to be analysed at two levels, he says, speaking to Business Line.
“First, taxability of the Indian unit performing the services; and secondly, the taxability of the foreign enterprise engaging the Indian unit for the services.”
Generally, the Indian units are liable to tax on business profits at the normal tax rate viz. 33.99 per cent for Indian companies and partnership firms, and 42.23 per cent in case of branches of foreign companies.
“However, most units are eligible for deduction either under Section 10A or Section 10AA of the Income Tax Act, 1961,” he says. These provisions offer tax sops to STPs (software technology parks) and SEZs (special economic zones).
Corporate tax
As such, most units do not end up paying any corporate tax except MAT (minimum alternative tax) introduced by the last Budget for STP units, observes Dr Surana.
However, it is important that the business profits must be determined by using ‘arm’s length pricing’.
The phrase ‘arm’s length pricing’ connotes a price that an independent person would charge for the same service.
Transfer pricing regulations of our tax regime provide for several methods for determination of the arm’s length price.
TNM method
Of these, the Supreme Court stated that the transactional net margin (TNM) method is the most appropriate in the Morgan Stanley case.
Dr Surana is hopeful that the clarity regarding the use of TNM method will help resolve many a contentious issue before the transfer pricing authorities.
“However, the operating margin of 29 per cent claimed by Morgan Stanley appears to be on the higher side as most units have an operating margin of 12 to 15 per cent,” he points out.
Foreign enterprise
The determination of taxability of foreign enterprise engaging the Indian unit is more complex, according to Dr Surana.
“The primary issues here are whether the foreign enterprise has a permanent establishment (PE) in India and if so, whether any further income needs to be attributed to India assuming that the foreign enterprise has already paid an arm’s length price to the Indian unit.”
It is here that the principles laid down the court should be helpful.
The mere rendering of ‘back office services’ are in the nature of preparatory or auxiliary services; and in case the Indian unit has no authority to conclude contracts for the foreign enterprise, the foreign enterprise will not be regarding regarded as having a permanent establishment in India, ruled the court.
Second, the taxability of foreign enterprise on account of presence of personnel in India depends upon the functions performed, said the court.
“In case the functions are in the nature of stewardship functions such as quality control or confidentiality aspects, it would not amount to PE. However, deputation of personnel for rendering services from India would amount to PE.”
Arm’s length pricing
And third, in case the profits of Indian unit are taxed based on arm’s length pricing, no further profits need to be attributed, adds Dr Surana.
The BPO industry, with exports in 2006-07 of about $8.4 billion, has been attracting good amount of foreign investment from MNCs and the Morgan Stanley decision is very likely to have a favourable effect on this investment trend, he expects.
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