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CASE NO.: Appeal (civil)  2914 of 2007

PETITIONER: M/s DIT (International Taxation), Mumbai

RESPONDENT: M/s Morgan Stanley & Co. INC

DATE OF JUDGMENT: 09/07/2007

BENCH: Dr. Arijit Pasayat & S.H. Kapadia

JUDGMENT: J U D G M E N T

CIVIL APPEAL No. 2914         OF  2007 (arising out of S.L.P. (C) No. 12907 of 2006) with CIVIL APPEAL No. 2915         OF  2007 (arising out of S.L.P. (C) No. 16163 of 2006) M/s Morgan Stanley & Co. INC.                   \005 Appellant            versus Director of Income Tax,  Mumbai                 \005Respondent

KAPADIA, J.

       Leave granted.

2.      In these civil appeals we are concerned with the articles  in Double Tax Avoidance Agreement ("DTAA") between India  and United States which have implication on transfer pricing  legislation.  The said Treaty either advocates application of  arm’s length principle or provides a mechanism for avoiding  double taxation on income.

3.      Morgan Stanley Group (MS Group) is one of the world’s  largest diversifying financial services companies.  It is a world  wide leader in investment banking and it is ranked amongst  the top institutions in merger and acquisitions, underwriting  of equity and equity and related transactions.  It has a major  presence in major securities market, with traders in numerous  countries around the world offering a unique distribution of  products.   It has three main lines of business, namely  securities investment management and investment banking   and credit services.   Morgan Stanley and Company (for short,  ’MSCo’) is an investment bank engaged in the business of  providing financial advisory services, corporate lending and  securities underwriting.  One of the group companies of  Morgan Stanley, Morgan Stanley Advantages Services Pvt. Ltd.  (for short, ’MSAS’) entered into an agreement for providing  certain support services to MSCo.  MSCo outsourced some of  its activities to MSAS.  The said MSAS was set up to support  the main office functions in equity and fixed income research,  account reconciliation and providing IT enabled services such  as back office operation, data processing and support centre to  MSCo.     

4.      On 19.5.2005 MSCo (Applicant) filed its advance ruling  application in Form 34-C inviting its advance ruling on the  points enumerated hereinbelow. The basic question relating to  the transaction between the applicant and MSAS on which

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advance ruling was sought was two fold namely, whether the  applicant was having a PE in India under Article 5(1) of the  DTAA on account of the services rendered by MSAS under the  Services Agreement dated April 14, 2005 entered into by MSAS  with the applicant and if so, the amount of income attributable  to such PE. 5.      By the impugned ruling delivered on 13.2.2006 by the  Authority for Advance Ruling (for short, ’AAR’) it was held,  inter alia, that the applicant cannot be regarded as having a  fixed place of business PE under Article 5(1) of the DTAA; that  MSAS cannot be regarded as an agency PE under Article 5(4)  of the DTAA; that the applicant would be regarded as having a  PE in India under Article 5(2)(l) if it were to send some of its  employees to India as stewards or as deputationists in the  employment of MSAS.  Against this ruling of the AAR the  applicant and the Department have come to this Court in   appeal by way of special leave petition. According to the  Department the applicant should be regarded as having a  fixed place in India under Article 5(1) as the applicant  proposes to carry on its business through MSAS in India.   According to the Department MSAS was the PE of the MSCo in  India.  They had a fixed place of business in Mumbai.   According to the Department the nature of the activities  proposed to be performed by MSAS in Mumbai indicated that  the said company represented the business presence of the  MSCo in India.  The Department also submitted that MSAS  was legally and financially dependent upon the  applicant and  consequently MSAS  constituted an agency PE of the applicant  under Article 5(4) of the DTAA.  Both these contentions were  rejected by the AAR vide the above impugned ruling.  However,  it has been ruled by the AAR that MSAS should be regarded as  constituting a service PE under Article 5(2)(l) as it proposed to  send its employees to India for undertaking stewardship  activities and for  undertaking to send some of its employees  to India as deputationists in the employment of MSAS.  It is  against this ruling of the AAR that the applicant has come to  this Court by way of appeal.  On the second question the AAR  ruled that the Transactional Net Margin Method (TNMM) was  the most appropriate method for the determination of the  Arm’s Length Price (ALP) in respect of the service agreement  dated 14.4.2005 between the applicant and the MSAS and as  the said method meets the test of arm’s length as prescribed  under Section 92-C of the 1961 Act, no further income was  attributable in the hands of MSAS in India.  The said ruling of  the AAR on the question of income attributable to the PE is the  subject matter of challenge by the Department.  EXISTENCE OF P.E. IN INDIA

6.      With globalization, many economic activities spread over  to several tax jurisdiction.  This is where the concept of P.E.  becomes important under Article 5(1).  There exists a P.E. if  there is a fixed place through which the business of an  enterprise, which is multinational enterprise (MNE), is wholly  or partly carried on.  In the present case MSCo is a multi- national entity.  As stated above it has outsourced some of its  activities to MSAS in India. A general definition of the P.E. in  the first part of Article 5(1) postulates the existence of a fixed  place of business whereas the second part of Article 5(1)   postulates that the business of the MNE is carried out in India  through such fixed place. One of the questions which we are  called upon to decide is whether the activities to be  undertaken by MSAS consists of back office operations of the  MSCo and if so whether such operations would fall within the  ambit of the expression "the place through which the business  of an enterprise is wholly or partly carried out" in Article 5(1).

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7.      We quote herein below Articles 5 and 7 of the DTAA :

"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 wholly or partly  carried on.

2.      The term "permanent establishment"  includes especially:

(a)     a place of management; (b)     a branch; (c)     an office; (d)     a factory; (e)     a workshop; (f)     a mine, an  oil or gas well, a quarry or  any other place of extraction of natural  resources;

(g)     a warehouse, in relation to a person  providing storage facilities for others;

(h)     a farm, plantation or other place where  agriculture, forestry, plantation or related  activities are carried on;

(i)     a store or premises used as a sales outlet;

(j)     an installation or structure used for the  exploration or exploitation of natural  resources, but only if so used for a period  of more than 120 days in any twelve  month period;

(k)     a building site or construction,  installation or assembly project  or  supervisory activities in connection  therewith, where such site, project or  activities (together with other such sites,  projects or activities, if any) continue for  a period of more than 120 days in any  twelve month period;

(l)     the furnishing of services other than  included services as defined in Article 12  (Royalties and Fees for Included  Services),  within Contracting State by an  enterprise through employees or other  personnel, but only if;

(i)     activities of that nature continue  within that State for a period or  periods aggregating more than 90  within any twelve-month period; or

(ii)    the services are performed within  that State for a related enterprise  (within the meaning of paragraph 1

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of Article 9 (Associated Enterprise).

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 :

(a)     the use of facilities solely for the  purpose of storage, display or  occasional delivery of goods or  merchandise belonging to the  enterprise;

(b)     the maintenance of a stock of goods  or merchandise belonging to the  enterprise solely for the purpose of  storage, display, or occasional  delivery;

(c)     the maintenance of a stock of goods,  or merchandise belonging to the  enterprise solely for the purpose of  processing by another enterprise;

(d)     the maintenance of a fixed place of  business solely for the purpose of  purchasing goods or merchandise,  or of collecting information, for the  enterprise;

(e)     the maintenance of a fixed base of  business solely for the purpose of  advertising, for the supply of  information, for scientific research,  or for other activities which have  preparatory or auxiliary character,  for the enterprise.   4.      Notwithstanding the provisions of  paragraphs 1 and 2, where a person  other than an agent of an independent  status to whom paragraph 5 applies is  acting in a Contracting State on behalf of  an enterprise of the other Contracting  State other Contracting State, that  enterprise shall be deemed to have  permanent establishment in the first- mentioned State if:

(a)     he has an habitually exercises in  that first-mentioned State an  authority to conclude contracts 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, would not make  that fixed place of business a  permanent establishment under the  provisions of that paragraph;

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(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 that 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.

5.      An enterprise of a Contracting State shall  not be deemed to have a permanent  establishment in the other Contracting  State merely because it carries on  business in that State through a broker,  general commission agent or any other  agent of an independent status, provided  that such persons are acting in the  ordinary course of their business.  However, when the activities of such an  agent are devoted wholly or almost wholly  on behalf  of that enterprise and the  transactions between the agent and the  enterprise and the transactions between  the agent and the enterprise are not  made under arm’s length conditions, he  shall not be considered an agent of  independent status within the meaning of  this paragraph.

6.      The fact that a company which is a  resident of a Contracting State controls or  is controlled by a company which is a  resident of the other Contracting State, or  which carries on business in that other  State (whether through a permanent  establishment or otherwise), shall not of  itself constitute either company a  permanent establishment of the other.

xxxxx

Article 7

BUSINESS PROFITS

1.      The profits of an enterprise of a  Contracting State shall be taxable only in  that State unless the enterprise carries  on business in the other Contracting  State through a permanent establishment  situated therein. If the enterprise carries  on business as aforesaid, the profits of  the enterprise may be taxed in the other  State but only so much of them as is  attributable to (a) that permanent  establishment; (b) sales in the other State  of goods or merchandise of the same or

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similar kind as those sold through that  permanent establishment; or (c) other  business activities carried on in the other  State of the same or similar kind as those  effected through that permanent  establishment.

2.      Subject to the provisions of paragraph 3,  where an enterprise of a Contracting  State carries on business in the other  Contracting State through a permanent  establishment situated therein, there  shall in each Contracting State be  attributed to that permanent  establishment the profits which it might  be expected to make if it were a distinct  and independent enterprise engaged in  the same or similar activities under the  same or similar conditions and dealing  wholly at arm’s length with the enterprise  of which it is a permanent establishment  and other enterprises controlling,  controlled by or subject to the same  common control as the enterprise, in any  case where the correct amount of profits  attributable to a permanent   establishment is incapable of  determination or the determination  thereof presents exceptional difficulties,   the profits attributable to the permanent  establishment may be estimated on a  reasonable basis. The estimate adopted  shall, however, be such that the result  shall be in accordance with the principles  contained in this Article.

3.      In the determination of the profits of a  permanent establishment, there shall be  allowed as deductions expenses which  are incurred for the  purposes of the  business of the permanent  establishment, including a reasonable  allocation of executive and general  administrative expenses, research and  development expenses, interest and other  expenses, incurred for the purposes of  the enterprise as a whole (or the part  thereof which includes the permanent  establishment), whether incurred in the  State in which the permanent  establishment is situated or elsewhere, in  accordance with the provisions of and  subject to the limitations of the taxation  laws of that State.  However, no such  deduction shall be allowed in respect of  amounts, if any, paid (otherwise than  towards reimbursement of actual  expenses) by the permanent  establishment to the head office of the  enterprise or any of its other offices, by  way of royalties, fees or other similar  payments in return for the use of patents,  know-how or other rights, or by way of  commission or other charges for specific  services performed or for management, or

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except in the case of banking enterprise,  by way of interest on moneys lent to the  permanent establishment.  Likewise, no   account shall be taken, in the  determination of the profits of a  permanent establishment, for amounts  charged (otherwise than toward  reimbursement of actual expenses), by  the permanent establishment to the head  office of the enterprise or any of its other  offices, by way of royalties, fees or other  similar payments in return for the use of  patents, know-how or other rights, or by  way of commission or other charges for  specific services performed or for  management, or, except in the case of a  banking enterprise, by way of interest on  moneys lent to the head office of the  enterprise or any of its other offices.

4.      No profits shall be attributed to a  permanent establishment by reason of  the mere purchase by that permanent  establishment of goods or merchandise  for the enterprise.

5.      For the purposes of this Convention, the  profits to be attributed to the permanent  establishment as provided in paragraph 1  (a) of this Article shall include only the  profits derived from the assets and  activities of the permanent establishment  and shall be determined by the same  method year by year unless there is good  and sufficient reason to the contrary.

6.      Where profits include items of income  which are dealt with separately in other  Articles of the Convention, then the  provisions of those Articles shall not be  affected by the provisions of this Article.

7.      For the purposes of the Convention, the  term "business profits" means income  derived from any trade or business  including income from the furnishing of  services other than included services as  defined in Article 12 (Royalties and Fees  for Included Services)  and including  income from the rental of tangible  personal property other than property   described in paragraph 3 (b) of Article 12  (Royalties and Fees for Included  Services)."

8.      In our view, the second requirement of Article 5(1) of  DTAA is not satisfied as regards back office functions.  We  have examined the terms of the Agreement along with the  advance ruling application made by MSCo inviting the AAR to  give its ruling.  It is clear from reading of the above Agreement  /application that MSAS in India would be engaged in  supporting the front office functions of MSCo in fixed income  and equity research and in providing IT enabled services such  as data processing support centre and technical services as

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also reconciliation of accounts.  In order to decide whether a  P.E. stood constituted one has to undertake what is called as  a functional and  factual analysis of each of the activities to be  undertaken by an establishment.  It is from that point of view,  we are in agreement with the ruling of the AAR that in the  present case Article 5(1) is not applicable as the said MSAS  would be performing in India only back office operations.    Therefore to the extent of the above back office functions the  second part of Article 5(1) is not attracted.   

9.      Lastly, as rightly held by the AAR there is no agency PE  as the PE in India had no authority to enter into or conclude  the contracts.  The contracts would be entered in the United  States. They would be concluded in US.  The implementation  of those contracts only to the extent of back office functions  would be carried out in India, and therefore, MSAS would not  constitute an Agency PE as contended on behalf of the  Department.   

10.     In the DTAA, the term P.E. means a fixed place of  business through which the business of an MNE is wholly or  partly carried out. The definition of the word P.E. in Section  92(F)(iii) is inclusive, however it is not under Article 5(1) of the  Treaty.  It is for this reason that Article 5(2) of the DTAA herein  refers to places included as P.E. of the MNE. One such place is  mentioned in Article 5(2)(l) which deals with furnishing of  services.

11.       The concept of P.E. was introduced in 1961 Act as part  of the statutory provisions of transfer pricing by the Finance  Act of 2001.  In Section 92-F (iii) the word "enterprise" is  defined to mean "a person including a P.E. of such person who  is proposed to be engaged in any activity relating to the  production\005. ".  Under the CBDT circular No.14 of 2001 it has  been clarified that the term P.E. has not been defined in the  Act but  its meaning may be understood with reference to the  DTAA entered into by India. Thus the intention was to rely on  the concept and definition of P.E. in the DTAA.  However, vide  Finance Act, 2002 the definition of P.E. was inserted in the  Income Tax Act, 1961 (for short, ’I.T. Act’) vide Section 92-F  (iiia) which states that the P.E. shall include a fixed place of  business through which the business of the MNE is wholly or  partly carried on. This is where the difference lies between the  definition of the word P.E. in the inclusive sense under the I.T.  Act as against the definition of the word P.E. in the exhaustive  sense under the DTAA.  This analysis is important because it  indicates the intention of the Parliament in adopting an  inclusive definition of P.E. so as to cover service P.E., agency  P.E., software P.E., Construction PE etc.

12.     There is one more aspect which needs to be discussed  namely, exclusion of P.E under Article 5(3).  Under Article 5(3)  (e) activities which are preparatory or auxiliary in character  which are carried out at a fixed place of business will not  constitute a P.E. Article 5(3) commences with a non obstante  clause. It states that notwithstanding what is stated in Article  5(1) or under Article 5(2) the term P.E. shall not include  maintenance of a fixed place of business solely for  advertisement, scientific research or for activities which are  preparatory or auxiliary in character. In the present case we  are of the view that the above mentioned back office functions  proposed to be performed by MSAS in India falls under Article  5(3) (e) of the DTAA.  Therefore, in our view in the present case  MSAS would not constitute a fixed place P.E. under Article

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5(1) of the DTAA as regards its back office operations.

13.     However, the question which arises for determination in  the present case is the nature of activities performed by  stewards and deputationists deployed by MSCo to work in  India as employees of MSAS.  Under Article 5(2)(l) furnishing of  services through the fixed place in India can constitute a P.E.   The AAR in the impugned ruling has held that the stewards  and deputationists are proposed to  be sent by the MSCo from  U.S.  According to the AAR there is a flow of service from the  MSCo to the MSAS when the former deputes its own  employees to work in India in MSAS.  Therefore, according to  the AAR the service Agreement between MSCo and MSAS  dated 14.4.2005 would fall under Article 5(2)(l) and  consequently the transfer pricing regulation would apply  for  evaluating the charges payable by MSCo to MSAS in India for  such service contract.  This ruling has been challenged by the  applicant.  

14.     Article 5(2)(l) of the DTAA applies in cases where the MNE  furnishes services within India and those services are  furnished through its employees.  In the present case we are  concerned with two activities namely stewardship activities  and the work to be performed by deputationists in India as  employees of MSAS.  A customer like an MSCo who has world  wide operations is entitled to insist on quality control and  confidentiality from the service provider. For example in the  case of software P.E. a server stores the data which may  require confidentiality.  A service provider may also be  required to act according to the quality control specifications  imposed by its customer. It may be required to maintain  confidentiality.  Stewardship activities involve briefing of the  MSAS staff to ensure that the output meets the requirements  of the MSCo.  These activities include monitoring of the  outsourcing operations at MSAS.  The object is to protect the  interest of the MSCo.  These stewards are not involved in day  to day management or in any specific services to be  undertaken by MSAS.  The stewardship activity is basically to  protect the interest of the customer.  In the present case as  held hereinabove the MSAS is a service P.E.  It is in a sense a  service provider. A customer is entitled to protect its interest  both in terms of confidentiality and in terms of quality control.   In such a case it cannot be said that MSCo has been rendering  the services to MSAS.  In our view MSCo is merely protecting  its own interests in the competitive world by ensuring the  quality and confidentiality of MSAS services.  We do not agree  with the ruling of the AAR that the stewardship activity would  fall under Article 5(2)(l).  To this extent we find merit in the  civil appeal filed by the appellant (MSCo) and accordingly its  appeal to that extent stands partly allowed.

15.     As regards the question of deputation, we are of the view  that an employee of MSCo when deputed to MSAS does not  become an employee of MSAS.  A deputationist has a lien on  his employment with MSCo.  As long as the lien remains with  the MSCo the said company retains control over the  deputationist’s terms and employment.  The concept of a  service PE finds place in the U.N. Convention.  It is constituted  if the multinational enterprise renders services through its  employees in India provided the services are rendered for a  specified period.  In this case, it extends to two years on the  request of MSAS.  It is important to note that where the  activities of the multinational enterprise entails it being  responsible for the work of deputationists and the employees  continue to be on the payroll of the multinational enterprise or

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they continue to have their lien on their jobs with the  multinational enterprise, a service PE can emerge.  Applying  the above tests to the facts of this case we find that on  request/requisition from MSAS the applicant deputes its staff.   The request comes from MSAS depending upon its  requirement.  Generally, occasions do arise when MSAS needs  the expertise of the staff of MSCo.  In such circumstances,  generally, MSAS makes a request to MSCo.  A deputationist  under such circumstances is expected to be experienced in  banking and finance.  On completion of his tenure he is  repatriated to his parent job.  He retains his lien when he  comes to India.  He lends his experience to MSAS in India as  an employee of MSCo as he retains his lien and in that sense  there is a service PE (MSAS) under Article 5(2)(l).  We find no  infirmity in the ruling of the ARR on this aspect.  In the above  situation, MSCo is rendering services through its employees to  MSAS.  Therefore, the Department is right in its contention  that under the above situation there exists a Service PE in  India (MSAS).  Accordingly, the civil appeal filed by the  Department stands partly allowed.

Income Attributable to PE 16.     Under Article 7, the taxability is of the MNE. What is to  be taxed under Article 7 is income of the MNE attributable to  the P.E. in India. The income attributable to the said P.E. is  the income attributable to foreign company’s operations in  India, which in term, implies the income attributable to the  activities carried on by the MNE through its P.E. in India.  Therefore, there is a difference between the taxability of the  P.E. in respect of its income earned by it in India which is in  accordance with the Income-Tax Act, 1961 and which has  nothing to do with the taxability of the MNE, which is also  taxable in India under Article 7, in respect of the profits  attributable to its P.E.. Under Article 7, the taxability is of the  MNE. What is taxable under Article 7 is profits earned by the  MNE. Under the said IT Act, the taxable unit is the foreign  company, though the quantum of income taxable is income  attributable to the P.E. of the said foreign company in India.   

17.     An important question which arises for determination is  whether the AAR is right in its ruling when it says that once  the transfer pricing analysis is under taken there is no further  need to attribute profits to a PE.  Computation of income  arising from international transactions has to be done keeping  in mind the principle of arm’s length price.  Charges paid or  payable by MSCo to MSAS under the service contract have to  be accounted as income at arm’s length price.  There are  different methods for determining appropriate transfer pricing.   Under Section 92C(1) of the I.T. Act, arm’s length price in  relation to international transaction has to be determined by  any of the following methods: (a)     Comparable Uncontrolled Price Method (CUPM) (b)     Resale Price Method (RPM) (c)     Cost Plus Method (CPM) (d)     Profit Split Method (PSM) (e)     Transactional Net Margin Method (TNMM) (f)     Such other method as may be prescribed by CBDT

18.     The taxpayer is required to compute arm’s length price  for a transaction(s) using one of the five methods stipulated in  the Income Tax Rules.  Rule 10C(1) of Income Tax Rules  defines the most appropriate method as the method which is  best suited to the facts and circumstances of each particular  international transaction.  As per Rule 10C(2) the most  appropriate method has to be selected having regard to

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number of factors which are enumerated therein.  The arm’s  length price has to be computed by the application of methods  mentioned in Section 92C(1) of the I.T. Act.   

19.     In the present case, the applicant has taken the opinion  of Earnest and Young (for short, ’E & Y’), Consultants, as  experts who have suggested, keeping in mind the various  activities undertaken by MSCo and MSAS in India, TNMM as  the most appropriate method for determination of arm’s length  price in respect of transaction between MSCo and MSAS.  The  applicant sought a ruling from the ARR on the  appropriateness of the said method.  On the adequacy of the  mark-up  the applicant relied upon a transfer pricing review  undertaken by E & Y, an independent consultant, for  benchmarking the transaction between the applicant and  MSAS and as per that review, the average mark-up (on costs)  of comparable companies providing similar services, was taken  into account at 29%.  This was agreed upon by MSAS and the  applicant (MSCo).  It has been accepted by the Transfer Pricing  Officer and by the Assessing Officer.  It has not been disputed  by T.N. Chopra & Associates, consultants appointed by the  Department.  

20.     Accordingly, the applicant (MSCo) preferred an applicant  to the AAR on the following issues: (i)     Appropriateness of TNMM for determination of  arm’s length in respect of transaction between  MSCo and MSAS. (ii)    Adequacy of the mark-up charged by MSAS for  provision of service to MSCo based on arm’s length  principle. (iii)   Attribution of further profits in the hands of PE of  MSCo where the transaction is at arm’s length. (iv)    Appropriateness of remuneration based on margin  on total operating cost of PE for determining profit  attributable to service PE.

21.     As stated above, one of the main points which arises for  determination in the present case is : whether the AAR was  right in ruling that as long as MSAS was remunerated for its  services at arm’s length, there should be no additional profits  attributable to the applicant or to MSAS in India.

22.     To answer the above question one has to examine the  provisions of the I.T. Act as well as the provisions of DTAA  between India and U.S.A.

23.     Sections 92 to 92E of the I.T. Act contains transfer  pricing provisions in the I.T. Act with effect from the financial  year commencing from 1.4.2001.  With the enactment of the  said sections the rules for the interpretation and  implementation of the said provisions were also amended so  as to include Rules 10A to 10E in the Income Tax Rules.   Sections 92A and 92B provide meanings of the expressions  "Associated Enterprise" and "International Transaction"  respectively with reference to which the income is to be  computed under Section 92 of I.T. Act.

24.     We quote hereinbelow Sections 92A and 92B of the I.T.  Act: "Meaning of associated enterprise. Section 92A.    (1) For the purposes of this section and  sections 92, 92B, 92C, 92D, 92E and 92F, "associated  enterprise", in relation to another enterprise, means an  enterprise \026

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(a)     which participates, directly or indirectly, or through  one or more intermediaries, in the management or  control or capital of the other enterprise; or  (b)     in respect of which one or more persons who  participate, directly or indirectly, or through one or  more intermediaries, in its management or control or  capital, are the same persons who participate, directly  or indirectly, or through one or more intermediaries, in  the management or control or capital of the other  enterprise.

(2)     For the purposes of sub-section (1), two enterprises  shall be deemed to be associated enterprises if, at any  time during the previous year,

(a)     one enterprise holds, directly or indirectly, shares  carrying not less than twenty-six per cent. of the  voting power in the other enterprise; or (b)     any person or enterprise holds, directly or indirectly,  shares carrying not less than twenty-six per cent. of  the voting power in each of such enterprises; or  (c)     a loan advanced by one enterprise to the other  enterprise constitutes not less than fifty-one per cent.  of the book value of the total assets of the other  enterprise; or (d)     one enterprise guarantees not less than ten per cent.  of the total borrowings of the other enterprise; or (e)     more than half of the board of directors or members of  the governing board, or one or more executive  directors or executive members of the governing board  of one enterprise, are appointed by the other  enterprise; or  (f)     more than half of the directors or members of the  governing board, or one or more of the executive  directors or members of the governing board, of each  of the two enterprises are appointed by the same  person or persons; or (g)     the manufacture or processing of goods or articles or  business carried out by one enterprise is wholly  dependent one the use of know-how, patents,  copyrights, trade-marks, licences, franchises or any  other business or commercial rights of similar nature,  or any data, documentation, drawing or specification  relating to any patent, invention, model, design, secret  formula or process, of which the other enterprise is the  owner or in respect of which the other enterprise ha  exclusive rights; or (h)     ninety per cent. or more of the raw materials and  consumables required for the manufacture or  processing of goods or articles carried out by one  enterprise, are supplied by the other enterprise, or by  persons specified by the other enterprise, and the  prices and other conditions relating to the supply are  influenced by such other enterprise; or  (i)     the goods or articles manufactured or processed by  one enterprise, are sold to the other enterprise or to  persons specified by the other enterprise, and the  prices and other conditions relating thereto are  influenced by such other enterprise; or (j)     where one enterprise is controlled by an individual, the  other enterprise is also controlled by such individual  or his relative or jointly by such individual and relative  of such individual; or (k)     where one enterprise is controlled by a Hindu

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undivided family, the other enterprise is controlled by  a member of such Hindu undivided family, or jointly  by such member and his relative; or  (l)     where one enterprise is a firm, association of persons  or body of individuals, the other enterprise holds not  less than ten per cent. interest in such firm,  association of persons or body of individuals; or (m)     there exists between the two enterprises, any  relationship of mutual interest, as may be prescribed.

Meaning of international transaction. Section 92B. (1)        For the purposes of this section and  sections 92, 92C, 92D and 92E, "international  transaction" means a transaction between two or more  associated enterprises, either or both of whom are  non-residents, in the nature or purchase, sale or lease  of tangible or intangible property, or provision of  services, or lending or borrowing money, or any other  transaction having a bearing on the profits, income,  losses or assets of such enterprises and shall include a  mutual agreement or arrangement between two or  more associated enterprises for the allocation or  apportionment of, or any contribution to, any cost or  expense incurred or to be incurred in connection with  a benefit, service or facility provided or to be provided  to any one or more of such enterprises.

(2)     A transaction entered into by an enterprise with  a person other than an associated enterprise shall, for  the purposes of sub-section (1), be deemed to be a  transaction entered into between two associated  enterprises, if there exists a prior agreement in relation  to the relevant transaction between such other person  and the associated enterprise; or the terms of the  relevant transaction are determined in substance  between such other person and the associated  enterprise."  (emphasis supplied) 25.     Section 92B defines "International Transaction" to mean  a transaction between two or more associated enterprises  which are, either or both of whom are non residents.  The said  transaction covers purchase, sale or lease of tangible or  intangible property or provision of services or lending or  borrowing money or any other transaction having an impact  on the profits, income, losses or assets of such enterprises and  shall include a mutual arrangement between two or more  associated enterprises for the allocation or apportionment of  any cost or expense incurred in connection with the benefit,  service or facility provided to anyone or more of associated  enterprises.   

26.     Determination of arm’s length price in relation to  international transaction is provided for in Section 92C to the  I.T. Act read with Rule 10B.  We quote herein below Section  92C of the I.T. Act read with Rules 10B and 10C of the Income  Tax Rules which reads as under: "Computation of arm’s length price. Section 92C.    (1)     The arm’s length price in relation to  an international transaction shall be determined by  any of the following methods, being the most  appropriate method, having regard to the nature of  transaction or class of transaction or class of  associated persons or functions performed by such

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persons or such other relevant factors as the Board  may prescribe, namely:-

(a)     comparable uncontrolled price method; (b)     resale price method;  (c)     cost plus method; (d)     profit split method; (e)     transactional net margin method; (f)     such other method as may be prescribed by the  Board.

(2)     The most appropriate method referred to in sub- section (1) shall be applied, for determination of arm’s  length price, in the manner as may be prescribed:

       Provided that where more than one price is  determined by the most appropriate method, the arm’s  length price shall be taken to be the arithmetical mean  of such prices, or, at the option of the assessee, a price  which may vary from the arithmetical mean by an  amount not exceeding five per cent. of such  arithmetical mean.

(3)     Where during the course of any proceeding for  the assessment of income, the Assessing Officer is, one  the basis of material or information or document in his  possession, of the opinion that-  

(a)     the price charged or paid in an international  transaction has not been determined in  accordance with sub-sections (1) and (2); or  (b)     any information and document relating to an  international transaction have not been kept  and maintained by the assessee in accordance  with the provisions contained in sub-section (1)  of section 92D and the rules made in this behalf;  or (c)     the information or data used in computation of  the arm’s length price is not reliable or correct;  or (d)     the assessee has failed to furnish, within the  specified time, any information or document  which he was required to furnish by a notice  issued under sub-section (3) of section 92D,

the Assessing Officer may proceed to determine the  arm’s length price in relation to the said international  transaction in accordance with sub-sections (1) and  (2), on the basis of such material or information or  document available with him:

       Provided that an opportunity shall be given by  the Assessing Officer by serving a notice calling upon  the assessee to show cause, on a date and time to be  specified in the notice, why the arm’s length should  not be so determined on the basis of material or  information or document in the possession of the  Assessing officer.

(4)     Where an arm’s length price is determined by  the Assessing Officer under sub-section (3), the  Assessing Officer may compute the total income of the  assessee having regard to the arm’s length price so  determined:

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       Provided that no deduction under section 10A  or section 10B or under Chapter VI-A shall be allowed  in respect of the amount of income by which the total  income of the assessee is enhanced after computation  of income under this sub-section.

       Provided further that where the total income of  an associated enterprise is computed under this sub- section on determination of the arm’s length price paid  to another associated enterprise from which tax has  been deducted or was deductible under the provisions  of Chapter XVIIB, the income of the other associated  enterprise shall not be recomputed by reason of such  determination of arm’s length price in the case of the  first mentioned enterprise.    

Determination of arm’s length price under section 92C.

Rule 10B. (1) For the purposes of sub-section (2) of  section 92C, the arm’s length price in relation to  an international transaction shall be determined  by any of the following methods, being the most  appropriate method, in the following manner,  namely: -

(a)     comparable uncontrolled price method, by  which, -

(i)     the price charged or paid for  property transferred or services  provided in a comparable  uncontrolled transaction, or a  number of such transactions, is  identified; (ii)    such price is adjusted to account for  differences, if any, between the  international transaction and the  comparable uncontrolled  transactions or between the  enterprises entering into such  transactions, which could materially  affect the price in the open market; (iii)   the adjusted price arrived at under  sub-clause (ii) is taken to be an  arm’s length price in respect of the  property transferred or services  provided in the international  transaction;

(b)     resale price method, by which, -

(i)     the price at which property  purchased or services obtained by  the enterprise from an associated  enterprise is resold or are provided  to an unrelated enterprise, is  identified;  (ii)    such resale price is reduced by the  amount of a normal gross profit  margin accruing to the enterprise or

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to an unrelated enterprise from the  purchase and resale of the same or  similar property or from obtaining  and providing the same or similar  services, in a comparable  uncontrolled transaction, or a  number of such transactions; (iii)   the price so arrived at is further  reduced by the expenses incurred  by the enterprise in connection with  the purchase of property or  obtaining of services; (iv)    the price so arrived at is adjusted to  take into account the functional and  other differences, including  differences in accounting practices,  if any, between the international  transaction and the comparable  uncontrolled transactions, or  between the enterprises entering  into such transactions, which could  materially affect the amount of gross  profit margin in the open market; (v)     the adjusted price arrived at under  sub-clause (iv) is taken to be an  arm’s length price in respect of the  purchase of the property or  obtaining of the services by the  enterprise from the associated  enterprise;

(c)     cost plus method, by which, -

(i)     the direct and indirect costs of  production incurred by the  enterprise in respect of property  transferred or services provided to  an associated enterprise, are  determined; (ii)    the amount of a normal gross profit  mark-up to such costs (computed  according to the same accounting  norms) arising from the transfer or  provision of the same or similar  property or services by the  enterprise, or by an unrelated  enterprise, in a comparable  uncontrolled transaction, or a  number of such transactions, is  determined;  (iii)   the normal gross profit mark-up  referred to in sub-clause (ii) is  adjusted to take into account the  functional and other differences, if  any, between the international  transaction and the comparable  uncontrolled transactions, or  between the enterprises entering  into such transactions, which could  materially affect such profit mark- up in the open market; (iv)    the costs referred to in sub-clause (i)  are increased by the adjusted profit  mark-up arrived at under sub- clause (iii);

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(v)     the sum so arrived at is taken to be  an arm’s length price in relation to  the supply of the property or  provisions of services by the  enterprise;

(d)     profit split method, which may be  applicable mainly in international transactions  involving transfer of unique intangibles or in  multiple international transactions which are so  interrelated that they cannot be evaluated  separately for the purpose of determining the  arm’s length price of any one transaction, by  which -

(i)     the combined net profit of the  associated enterprises arising from  the international transaction in  which they are engaged, is  determined; (ii)    the relative contribution made by  each of the associated enterprises to  the earning of such combined net  profit, is then evaluated on the basis  of the functions performed, assets  employed or to be employed and  risks assumed by each enterprise  and on the basis of reliable external  market data which indicates how  such contribution would be  evaluated by unrelated enterprise  performing comparable functions in  similar circumstances; (iii)   the combined net profit is then split  amongst the enterprises in  proportion to their relative  contributions, as evaluated under  sub-clause (ii); (iv)    the profit thus apportioned to the  assessee is taken into account to  arrive at an arm’s length price in  relation to the international  transaction :

Provided that the combined net profit  referred to in sub-clause (i) may, I the first  instance, be partially allocated to each  enterprise so as to provide it with a basic  return appropriate for the type of  international transaction in which it is  engaged, with reference to market returns  achieved for similar types of transactions  by independent enterprises, and  thereafter, the residual net profit  remaining after such allocation may be  split amongst the enterprises I proportion  to their relative contribution in the  manner specified under sub-clauses (ii)  and (iii), and in such a case the aggregate  of the net profit allocated to the enterprise  in the first instance together with the  residual net profit apportioned to that  enterprise on the basis of its relative  contribution shall be taken to be the net  profit arising to that enterprise from the

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international transaction;

(e)     transactional net margin method, by  which, -

(i)     the net profit margin realized by the  enterprise from an international  transaction entered into with an  associated enterprise is computed  in relation to costs incurred or sales  effected or assets employed or to be  employed by the enterprise or  having regard to any other relevant  base; (ii)    the net profit margin realized by the  enterprise or by an unrelated  enterprise from a comparable  uncontrolled transaction or a  number of such transactions is  computed having regard to the  same base; (iii)   the net profit margin referred to in  sub-clause (ii) arising in  comparable uncontrolled  transactions is adjusted to take into  account the differences, if any,  between the international  transaction and the comparable  uncontrolled transactions, or  between the enterprises entering  into such transactions, which could  materially affect the amount of net  profit margin in the open market; (iv)    the net profit margin realized by the  enterprise and referred to in sub- clause (i) is established to be the  same as the net profit margin  referred to in sub-clause (iii); (v)     the net profit margin thus  established is then taken into  account to arrive at an arm’s length  price in relation to the international  transaction.

(2)     For the purposes of sub-rule (1), the  comparability of an international transaction  with an uncontrolled transaction shall be judged  with reference to the following, namely:-  

(a)     the specific characteristics of the property  transferred or services provided in either  transaction; (b)     the functions performed, taking into  account assets employed or to be  employed and the risks assumed, by the  respective parties to be transactions; (c)     the contractual terms (whether or not  such terms are formal or in writing) of the  transactions which lay down explicitly or  implicitly how the responsibilities, risks  and benefits are to be divided between the  respective parties to the transactions; (d)     conditions prevailing in the markets in  which the respective parties to the  transactions operate, including the

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geographical location and size of the  markets, the laws and Government orders  in force, costs of labour and capital in the  markets, overall economic development  and level of competition and whether the  markets are wholesale or retail.

(3)     An uncontrolled transaction shall be comparable  to an international transaction if -

(i)     none of the differences, if any, between the  transactions being compared, or between  the enterprises entering into such  transactions are likely to materially affect  the price or cost charged or paid in, or the  profit arising from such transactions in  the open market; or  (ii)    reasonably accurate adjustments can be  made to eliminate the material effects of  such differences.

(4)     The data to be used in analyzing the  comparability of an uncontrolled transaction with an  international transaction shall be the data relating to  the financial year in which the international  transaction has been entered into:

Provided that data relating to a period not being more  than two years prior to such financial year may also be  considered if such data reveals facts which could have  an influence on the determination of transfer prices in  relation to the transactions being compared.

Most appropriate method.

Rule 10C. (1) For the purposes of sub-section (1) of  section 92C, the most appropriate method shall be the  method which is best suited to be facts and  circumstances of each particular international  transaction, and which provides the most reliable  measure of an arm’s length price in relation to the  international transaction.

(2) In selecting the most appropriate method as  specified in sub-rule (1), the following factors shall be  taken into account, namely:-

(a)     the nature and class of the international  transaction; (b)     the class of classes of associated  enterprises entering into the transaction  and the functions performed by them  taking into account assets employed or to  be employed and risks assumed by such  enterprises: (c)     the availability, coverage and reliability of  data necessary for application of the  method; (d)     the degree of comparability existing  between the international transaction and  the uncontrolled transaction and between  the enterprises entering into such  transactions; (e)     the extent to which reliable and accurate  adjustments can be made to account for

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differences, if any, between the  international transaction and the  comparable uncontrolled transaction or  between the enterprises entering into such  transactions; (f)     the nature, extent and reliability of  assumptions required to be made in  application of a method."    (emphasis supplied)      27.     The methods, quoted above, namely, CUPM, RPM, CPM,  PSM, TNMM etc. are mentioned in Section 92C read with Rule  10B.  The most appropriate method has to be applied for  computation of the arm’s length price.  It will depend on the  facts and circumstances of each particular international  transaction (see: Rule 10C).  Section 92C inter alia provides  that if the Assessing Officer, during the course of any  proceedings for the assessment on income, is of the opinion on  the basis of material or information or document that the price  charged or paid in an international transaction has not been  determined on arm’s length basis or if he finds that the  assessee has not maintained proper documents relating to the  international transaction in accordance with the provisions of  the I.T. Act or if he finds that the data used in the  computation of arm’s length price is not reliable, the Assessing  Officer may proceed to determine the arm’s length price in  relation to the said transaction.  Rules 10B, 10C and 10D  explains the determination of ALP under each of the above  methods.   

28.     At this stage, it may be noted that on the question of  appropriateness of the said TNMM, the AAR did not give its  ruling as the transfer pricing as proceedings had commenced  before the tax officer before MSCo could seek the ruling.   However, after the impugned ruling, Transfer Pricing Officer  and the Assessing Officer have found the said method (TNMM)  to be appropriate.  In our view, apart from the orders passed  by the Assessing Officer and the Transfer Pricing Officer, the  said method (TNMM) is the appropriate method in the case of  Service PE as TNMM apportions the total operating profit  arising from the transaction on the basis of sales, costs,  assets, etc.

29.     As regards determination of profits attributable to a PE in  India (MSAS) is concerned on the basis of arm’s length  principle we have quoted Article 7(2) of the DTAA.  According  to the AAR where there is an international transaction under  which a non-resident compensates a PE at arm’s length price,  no further profits would be attributable in India.  In this  connection, the AAR has relied upon Circular No.23 of 1969  issued by CBDT as well as Circular No.5 of 2004 also issued  by CBDT.  This is the key question which arises for  determination in these civil appeals.

30.     To answer the above question we quote Article 7 of the  U.N. Model Convention which reads as under: "ARTICLE 7 :    ATTRIBUTION OF BUSINESS PROFITS

Article 7 of the UN Model Convention states as under: business profits 1.      The profits of an enterprise of a Contracting State shall be  taxable only in that State unless the enterprise carries on  business in the other Contracting State through a  permanent establishment situated therein.  If the  enterprise carries on business as aforesaid, the profits of

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the enterprise may be taxed in the other State but only so  much of them as is attributable to (a) that permanent  establishment; (b) sales in that other State of goods or  merchandise of the same or similar kind as those sold  through that permanent establishment; or (c) other  business activities carried on in that other State of the  same or similar kind as those effected through that  permanent establishment.   2.      Subject to the provisions of paragraph 3, where en  enterprise of a Contracting State carries on business in  the other Contracting State through a permanent  establishment situated therein, there shall in each  Contracting State be attributed to that permanent  establishment the profits which it might be expected to  make if it were a distinct and separate enterprise engaged  in the same or similar activities under he same or similar  conditions and dealing wholly or independently with the  enterprise of which it is a permanent establishment. 3.      In the determination of the profits of a permanent  establishment, there shall be allowed as deductions  expenses which are incurred for the purposes of the  business of the permanent establishment including  executive and general administrative expenses so  incurred, whether in the State in which the permanent  establishment is situated or elsewhere.  However, no such  deduction shall be allowed in respect of amounts, if any,  paid (otherwise than towards reimbursement of actual  expenses) by the permanent establishment to the head  office of the enterprise or any of its other offices, by way of  royalties, fees or other similar payments in return for the  use of patents or other rights, or by way of commission,  for specific services performed or for management, or,  except in the case of a banking enterprise, by way of  interest on moneys lent to the permanent establishment.   Likewise, no account shall be taken, in the determination  of the profits of a permanent establishment, for amounts  charged (otherwise than towards reimbursement of actual  expenses), by the permanent establishment to the head  office of the enterprise or any of its other offices, by way of  royalties, fees or other similar payments in return for he  use of patents or other rights, or by way of commission  for specific services performed or for management, or,  except in the case of a banking enterprise by way of  interest on moneys lent to the head office of the  enterprise or any of its other offices. 4.      Insofar as it has been customary in a Contracting State to  determine the profits to be attributed to a permanent  establishment on the basis of an apportionment of the  total profits of the enterprise to its various parts, nothing  in paragraph 2 shall preclude that Contracting State from  determining the profits to be taxed by such an  apportionment as may be customary; the method of  apportionment adopted shall, however, be such that the  result shall be in accordance with the principles  contained in this article. 5.      For the purposes of the preceding paragraphs, the profits  to be attributed to the permanent establishment shall be  determined by the same method year-by-year unless  there is good and sufficient reason to the contrary. 6.      Where profits include items of income which are dealt  with separately in other articles of this Convention, then  the provisions of those articles shall not be affected by the  provisions of this article.

Note: The question of whether profits should be attributed to

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a permanent establishment by reason of the mere purchase  by that permanent establishment of goods and merchandise  for the enterprise was not resolved.  It should therefore be  settled in bilateral negotiations."        31.     Article 7 of the U.N. Model Convention inter alia provides  that only that portion of business profits is taxable in the  source country which is attributable to the PE.  It specifies  how such business profits should be ascertained.  Under the  said Article, a PE is treated as if it is an independent  enterprise (profit centre) dehors the head office and which  deals with the head office at arm’s length.  Therefore, its  profits are determined on the basis as if it is an independent  enterprise.  The profits of the PE are determined on the basis  of what an independent enterprise under similar  circumstances might be expected to derive on its own.  Article  7(2) of the U.N. Model Convention advocates the arm’s length  approach for attribution of profits to a PE.

32.     The object behind enactment of transfer pricing  regulations is to prevent shifting of profits outside India.   Under Article 7(2) not all profits of MSCo would be taxable in  India but only those which have economic nexus with PE in  India.  A foreign enterprise is liable to be taxed in India on so  much of its business profit as is attributable to the PE in  India.  The quantum of taxable income is to be determined in  accordance with the provisions of I.T. Act.  All provisions of I.T.  Act are applicable, including provisions relating to  depreciation, investment losses, deductible expenses, carry- forward and set-off losses etc.  However, deviations are made  by DTAA in cases of royalty, interest etc.  Such deviations are  also made under the I.T. Act (for example: Sections 44BB,  44BBA etc.).  Under the impugned ruling delivered by the AAR,  remuneration to MSAS was justified by a transfer pricing  analysis and, therefore, no further income could be attributed  to the PE (MSAS).  In other words, the said ruling equates an  arm’s length analysis (ALA) with attribution of profits.  It holds  that once a transfer pricing analysis is undertaken; there is no  further need to attribute profits to a PE.  The impugned ruling  is correct in principle insofar as an associated enterprise, that  also constitutes a PE, has been remunerated on an arm’s  length basis taking into account all the risk-taking functions  of the enterprise.  In such cases nothing further would be left  to be attributed to the PE.  The situation would be different if  transfer pricing analysis does not adequately reflect the  functions performed and the risks assumed by the enterprise.   In such a situation, there would be a need to attribute profits  to the PE for those functions/risks that have not been  considered.  Therefore, in each case the data placed by the  taxpayer has to be examined as to whether the transfer pricing  analysis placed by the taxpayer is exhaustive of attribution of  profits and that would depend on the functional and factual  analysis to be undertaken in each case.  Lastly, it may be  added that taxing corporates on the basis of the concept of  Economic Nexus is an important feature of Attributable Profits  (profits attributable to the PE).     

Conclusion: 33.     To conclude, we hold that the AAR was right in ruling  that MSAS would be a Service PE in India under Article 5(2)(l),  though only on account of the services to be performed by the  deputationists deployed by MSCo and not on account of  stewardship activities.  As regards income attributable to the  PE (MSAS) we hold that the Transactional Net Margin Method  was the appropriate method for determination of the arm’s

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length price in respect of transaction between MSCo and  MSAS.  We accept as correct the computation of the  remuneration based on cost plus mark-up worked out at 29%  on the operating costs of MSAS.  This position is also accepted  by the Assessing Officer in his order dated 29.12.06 (after the  impugned ruling) and also by the transfer pricing officer vide  order dated 22.9.06.  As regards attribution of further profits  to the PE of MSCo where the transaction between the two are  held to be at arm’s length, we hold that the ruling is correct in  principle provided that an associated enterprise (that also  constitutes a PE) is remunerated on arm’s length basis taking  into account all the risk-taking functions of the multinational  enterprise.  In such a case nothing further would be left to  attribute to the PE.  The situation would be different if the  transfer pricing analysis does not adequately reflect the  functions performed and the risks assumed by the enterprise.   In such a case, there would be need to attribute profits to the  PE for those functions/risks that have not been considered.   The entire exercise ultimately is to ascertain whether the  service charges payable or paid to the service provider (MSAS  in this case) fully represents the value of the profit attributable  to his service.  In this connection, the Department has also to  examine whether the PE has obtained services from the  multinational enterprise at lower than the arm’s length cost?   Therefore, the Department has to determine income, expense  or cost allocations having regard to arm’s length prices to  decide the applicability of the transfer pricing regulations.     

34.     Economic nexus is an important aspect of the principle of  Attribution of Profits.

35.     In the light of what is stated above, the impugned ruling  by AAR stands modified to the extent indicated hereinabove.   Accordingly, both the civil appeals filed by the applicant  (MSCo) and by the Department are partly allowed with no  order as to costs.