An analysis of taxability of BPOs in India

CA Rahul Dhawan

Introduction:-

Business Process Outsource (BPO) is a concept or business model which grows in India many folds; most of the multinational companies (MNC) have either setup their captive units in India or approach the Indian business entities to perform their business process from India.

Like MNCs have outsource the financial and administration (F&A) processes, human resources (HR) functions, call center and customer service activities and accounting and payroll.

Now, the question arises whether the Assessing officer can only tax the Indian entity for the fees received from the MNC or the MNC parent (which is outside India) can itself be taxed by the AO to the extent of income it earned globally from the operations attributable to the India entity.

Analysis of tax liability in the light of relevant provisions of Income Tax Act 1961:-

As per Section 9 (1)(i) of Income Tax Act 1961, all income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situate in India.

As per an explanation to Section 9(1)(i), ‘in the case of a business of which all the operations are not carried out in India, the income of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India subject to *force of attraction rule as explained below.

Further, the term business connection which has not been given any precise definition has been given view by Supreme Court in case of RD Aggarwal and co. and another, [56 I.T.R. 20]. In which question arises whether the non-resident has a ‘business connection’ in India from or through which income, profit or gains can be said to accrue or arise to him within the meaning of  section 9 of the Income Tax Act 1961, had to be determined on the facts of each case.

Also in CIT vs. Evans Medical Supplies Ltd, 1959, ITR 418), (Blue Star Engg. Co. (Bom.) Pvt. Ltd. Vs CIT (1969) 73 ITR 283 it was held that the expression “Business connection” is an expression of wide and indefinite import and has to be examined on the basis of facts of each case.

Other related cases

Commissioner of Income-tax v. Remington Typewriters Co. Bombay Ltd. L.R. 58 I.A. 42, Commissioner of Income-tax, Bombay Presidency and Aden v. Currimbhoy Ebrahim and Sons Ltd. L.R. 63 I.A. 1, Bangalore Woollen, Cotton and Silk Mills Co. Ltd. v. Commissioner of Income-tax Madras, (1950) 18 I.T.R. 423, Abdullabhai Abdul Kadar v. Commissioner ,of Income-tax Bombay City, (1952) 22 I.T.R. 241, Anglo-French Textile Company Ltd. v. Commissioner of Income-tax, Madras, [1953] S.C.R. 454 and Hira Mills Ltd. Cawnpore v. Income-tax Officer, Cawnpore, (1946) 14 I.T.R. 417, considered.

In this connection, CBDT has also issued a circular no. 5/2004 dated 28/9/2004 in which the relevant provisions related to taxability of non residents were explained as per below pointers:

1. A non-resident entity which has outsource certain services to a resident Indian entity then  If there is no business connection between the two, the non-resident entity will not be liable to tax under the Income Tax Act.

2. Where the non-resident entity has a business connection with the resident Indian entity, then the resident Indian entity should be treated as the Permanent Establishment of the non-resident entity and then the non-resident entity will be liable to tax in India.

3. The profit attributable to the business activities carried out in India by the Permanent Establishment is chargeable to tax in India.

(The phrase ‘profit attributable’ has wider meaning as has been decided in case of “Indian Leather Corporation Pvt. Ltd. vs. CIT” 227 ITR 552)

1. The profits °attributable to the Permanent Establishment in India will be determined as if the profit, it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar conditions and dealing, independently with the enterprises of which it is a Permanent Establishment as also defined as per article 7(2) of the OECD model convention 2010.

As per Para 16 of the OECD commentary on Article 7 further provides that profits that are attributable to the PE are to be determined under the fiction that PE is separate enterprise and that such an enterprise is independent from the rest of the enterprises of which it is a part as well as from any other person. The second part of the fiction corresponds to the arm length principle.

OECD 2010 report on the Attribution of profits to PE provides for a two step process to apply an arm’s length separate principle in attributing profits to PE:

Step 1: Undertake a functional analysis and factual analysis, which attributes to the PE the functions performed, assets used and risk assumed by the enterprise in respect of the business it carries on through the PE.

Step 2: Determine the pricing on an arm’s length basis, which determines on an arm’s length basis, which determine an arm’s length return for the functions performed, assets used and risk assumed attributed to the PE.

Thus, the OECD has developed working assumptions as regards the approach for attribution. It has examined the feasibility of treating a PE as a hypothetical distinct and separate enterprise and has reviewed ways in which transfer pricing principles could be applied by analogy in order to attribute profits to PE in accordance with the arm’s length principle.

° In case of ‘eFunds Corporation versus ADIT (Int’l Taxation) [2010] 42 SOT 165 (Delhi) instance of Ad hoc attribution formulated for taxability of Back office operations where PE looks after operations and marketing activities of overseas affiliates as follows:

–          Global adjusted profits X India assets/Global assets

1. It also states that in determining the profits of the Permanent establishment, there shall be allowed as deductions, expenses which are incurred for the Permanent establishment including executive and general administrative expenses so incurred, whether the state in which the Permanent establishment is situated or elsewhere. But those expenses are determined in accordance with the accepted principles of accountancy and the provisions of the Income Tax Act, 1961.

2. It further provides that the profit attributable to the Permanent establishment are those which that Permanent establishment would have made, if instead of dealing with its Head office, it had been dealing with an entirely separate enterprises under conditions and at prices prevailing in the ordinary market. This corresponds to “arm’s length principle.”

3. However, in determining the profits attributable to an IT enabled BPO unit constituting a Permanent Establishment, it will be necessary to determine the price of the services rendered by the Permanent Establishment to the Head office or by Head office to the Permanent Establishment on the basis of “arm’s length principle”.

The “arm’s length price” would have the same meaning as in the definition in Section 92F (ii) of the Income Tax Act 1961 (hereinafter, called as an Act). The arm’s length price would have to be determined in accordance with the provisions of Section 92 to 92F of the Act.

Relevance of Permanent establishment in case of Non-resident taxation: – an extension of concept of Business connection:

Article 5.1 of DTAA defines that the term ‘permanent establishment’ to mean a fixed place of business through which the business of an enterprise is wholly or partly carried on. Thus, the conditions so prescribed under Article 5(1) are as follows:

– There must be a place of business;

– The place of business must be fixed; and

– The business of the enterprise must be carried on through that place of business.

In case of Steel Authority of India Ltd. v. Asstt. CIT [2007] 105 ITD 679 (Delhi) it has been said that fixed place of business should be that of the assessee. It may be owned, rented out to the assessee or the assessee might have obtained facility by way of license to carry out business from that fixed place. But, the assessee should have some kind of domain or control over the place of business either wholly or partly.

Similarly in case of Ericsson Radio Systems A.B. v. Dy.CIT [IT Appeal No. 815 (Delhi) of 2001] reported in as ITD 269, ITAT Special Bench held as under:

“The OECD commentary on Double taxation refers to a “fixed place” as a link between the place of business and a specific geographical point. It has to have a certain degree of permanency. It emphasized that to constitute a “fixed place of business”, the foreign enterprise must have at its disposal certain premises or a part thereof.

The conception of PE is important to determine the right of contracting state to tax the business profits of an enterprise of another contracting state. The business profits of an enterprise of one contracting state are taxable in the other state if the enterprise maintains a PE in the latter state and only to the extent the business profits are attributable to such PE.

* Role of Force of attraction (FOA) rule:

The underlying principle of the ‘Force of Attraction’ rule, in its pure form, envisages that when an enterprise is said to have a permanent establishment (PE) in another country, it exposes itself to taxation the entire gamut of income that it earns from carrying on activities in that other country, whether or not through that PE.

Few instances where the rule of FOA in DTAA treaties has been explained

‘Force of attraction rule’ as explained in Article 7(3) of India-UK DTAA

Where a permanent establishment takes an active part in negotiation, concluding or fulfilling contracts entered into by the enterprise, then, notwithstanding that other parts of the enterprise have also participated in those transactions, that proportion of profits of the enterprise arising out of these contracts which the contribution of the permanent establishment to those transactions bears to that of the enterprise as a whole shall be treated for the purpose of paragraph 1 of this Article as being the profits indirectly attributable to that permanent establishment.

–    On the contrary another case considered for analysis when Multinational companies establish captive operation in India and such captive Indian entity exclusively services the parent MNC for which it gets paid appropriate fees.

Now the same question arises that whether the Indian revenue authorities can only tax the captive Indian entity for the fees that it receives from the MNC parent or whether the MNC parent (that is outside India) can itself be taxed by the Indian authorities to the extent of the income it has derived internationally from operations attributable to the captive Indian entity.

This was the subject matter of litigation before the Authority for Advance Ruling (AAR) in the Morgan Stanley Case. In February 2006, the AARs ruled that even if the captive Indian BPO operation was treated as a “permanent establishment” of the MNC, only the income received by the Indian entity from the MNC parent would be taxed in India. It also held that the MNC parent itself would not be liable to be taxed in India to the extent of profits attributable to the Indian operations so long as the Indian entity was remunerated by the MNC parent on an arm’s length basis.

With the AAR ruling being in favor of the assessee, it was naturally the subject-matter of an appeal preferred by the revenue before the Supreme Court.

The gist of the ruling is as follows:

(a) it is first necessary to determine whether the Indian captive BPO is a “permanent establishment” of the MNC parent. If not, then the MNC’s profits are not taxable in India;

(b) if the Indian captive BPO is determined to be a “permanent establishment”, then the MNC parent’s income (attributable to the Indian operations) will be taxable in India only if its remuneration of the captive Indian BPO is not on an arm’s length basis.

The logic of the Supreme Court decision seems to be to ensure that there is no tax leakage through outsourcing. In other words, if the transaction between the MNC parent and the Indian captive BPO is on an arm’s length basis, then the Indian entity receives sufficient revenue on which it pays taxes in India. However, if the services of

the Indian entity are undervalued (and not on an arm’s length basis) resulting in less revenue to the Indian entity, that would in turn result in less taxes being paid in India and hence revenue leakage.

It is therefore important for all captive BPO entities to have proper transfer pricing arrangements with their MNC parents such that the transactions are conducted on an arm’s length basis.

It is believed that this ruling from the Supreme Court will put to rest the ambiguity that existed in the interpretation of the Income Tax Act and various circulars issued by the Central Board of Direct Taxes (CBDT).

As also held in case of Rolls Royce Singapore Pte Ltd. vs. ADIT that while in principle it is correct that if a fair price is paid by the assessee to the agent for the activities of the assessee in India through the Dependent agent PE and the said price is taxed in India at the hands of the agent, then no question of taxing the assessee again would arise, this is subject to a transfer pricing analysis being undertaken u/s 92.

In case of SET Satellite (Singapore) Pte Ltd. (218 CTR 452), Hon’ble Bombay high court had held that in case the agent is remunerated at arm’s length by the foreign principal, the tax liability of foreign principal, (which would arise in case it is regarded to have PE in India) would stand extinguished.

Conclusion:-

In the light of above provisions and discussion it can be said that while determining the tax liability of a non resident entity in India it is essential to examine whether such a non-resident entity has business connection through permanent establishment in India as well as the transaction value at which the business transaction has been finalized i.e. if the transaction between the associated enterprises is at the arm length price then the fees given to Indian BPO shall only be taxable in India.

(Republished With Amendments)