2007 (7) TMI 201 - SC - Income Tax

AAR was right in ruling that MSAS would be a service P.E. in India under article 5(2)(1), though only on account of the services to be performed by the deputationists deployed by applicant, MSCo and not on account of stewardship activities. As regards income attributable to the P.E. (MSAS), held that the transactional net margin method was the appropriate method for determination of the arm s length price in respect of transaction between MSCo and MSAS

Summary

Issues Involved:
1. Existence of Permanent Establishment (P.E.) in India
2. Income Attributable to P.E.
3. Appropriateness of Transactional Net Margin Method (TNMM) for determining Arm's Length Price (ALP)
4. Attribution of Further Profits to P.E. when Transactions are at Arm's Length

Detailed Analysis:

1. Existence of Permanent Establishment (P.E.) in India
The primary issue was whether the applicant, MSCo, had a Permanent Establishment (P.E.) in India as per Article 5(1) of the Double Tax Avoidance Agreement (DTAA) between India and the United States. The court examined whether the activities undertaken by MSAS in India, which included back office operations, constituted a P.E. under Article 5(1). It was held that back office functions performed by MSAS did not satisfy the second requirement of Article 5(1) as these functions were preparatory or auxiliary in nature, falling under Article 5(3)(e) of the DTAA. Therefore, MSAS did not constitute a fixed place P.E. under Article 5(1).

The court also addressed whether MSAS could be considered an agency P.E. under Article 5(4). It was determined that MSAS did not have the authority to enter into or conclude contracts on behalf of MSCo, and thus, did not constitute an agency P.E.

However, the court agreed with the Authority for Advance Rulings (AAR) that MSAS constituted a service P.E. under Article 5(2)(1) due to the presence of stewards and deputationists sent by MSCo to work in India. The stewards' activities were deemed to be for quality control and confidentiality purposes, which did not constitute services rendered to MSAS. However, deputationists retained their lien with MSCo and provided services to MSAS, thus constituting a service P.E.

2. Income Attributable to P.E.
The court examined the taxability of income attributable to the P.E. under Article 7 of the DTAA. It was held that the income attributable to the P.E. is the income from the foreign company's operations in India. The court emphasized that the transfer pricing analysis must reflect the functions performed and risks assumed by the enterprise. If the transfer pricing analysis does not adequately reflect these aspects, further profits must be attributed to the P.E. The court upheld the AAR's ruling that if MSAS is remunerated at arm's length, no additional profits need to be attributed to the P.E. However, this is contingent upon the transfer pricing analysis being exhaustive of the functions and risks involved.

3. Appropriateness of Transactional Net Margin Method (TNMM) for determining Arm's Length Price (ALP)
The court evaluated whether the TNMM was the most appropriate method for determining the arm's length price (ALP) for transactions between MSCo and MSAS. The court noted that the TNMM was suggested by consultants E&Y and agreed upon by the Transfer Pricing Officer and the Assessing Officer. The court found TNMM appropriate for service P.E. as it apportions total operating profit based on sales, costs, and assets. The court accepted the computation of the remuneration based on a cost-plus mark-up of 29% on the operating costs of MSAS.

4. Attribution of Further Profits to P.E. when Transactions are at Arm's Length
The court addressed whether further profits should be attributed to the P.E. when transactions are at arm's length. The court upheld the AAR's ruling that if an associated enterprise, which also constitutes a P.E., is remunerated on an arm's length basis, taking into account all risk-taking functions, no additional profits need to be attributed. However, if the transfer pricing analysis does not adequately reflect the functions performed and risks assumed, further profits must be attributed to the P.E. The court emphasized the importance of economic nexus in the principle of attribution of profits.

Conclusion
The court concluded that MSAS would be a service P.E. in India under Article 5(2)(1) due to the deputationists but not due to stewardship activities. The TNMM was deemed the appropriate method for determining the ALP, and the remuneration based on a 29% mark-up was accepted. The court upheld that no additional profits need to be attributed to the P.E. if the transfer pricing analysis is exhaustive of the functions and risks involved. The ruling by the AAR was modified to reflect these conclusions, and both civil appeals were partly allowed.