Lose-lose? BPO tax circular returns to haunt sector again

NEW DELHI: The vexed issue of taxing the global profits of foreign companies with captive business process outsourcing firms in India has erupted once again after lying dormant for a couple of years. It has made investors uneasy.

The dreaded tax circular of January, 2004, as the IT-enabled services industry realises now, had never been shelved or softened.

The issue is under the arclights again because the Supreme Court is expected to give its verdict anytime now on a special leave petition pertaining to top US investment bank Morgan Stanley’s captive unit, which employs around 1,600 people in Mumbai (See box).

The Central Board of Direct Taxes (CBDT) is serious about taxing BPOs and a spate of notices has recently been sent out to foreign companies. Its stand is that foreign firms’ global incomes attributable to the activities of their captive BPOs in India are taxable.

This has alarmed Kiran Karnik, president of Nasscom. He told DNA Money, a number of factors have played to the advantage of India, including cost and easy availability of qualified people. Foreign entities, he said, need clear-cut instructions on the issue because taxing their BPOs could imply that the tax books of parent companies abroad would need to be opened up to the tax authorities here.

But AK Sinha, joint secretary of CBDT, said there is no need to make any changes in the January 2004 circular.

Indian laws require that the BPO be remunerated at an arm’s length (that is, at market price) so that the government gets a share of taxes on such income. The other bone of contention is: can a captive BPO constitute a permanent establishment (PE) of the foreign parent in India, as per the regulations?

A PE is defined as a fixed place from which a foreign enterprise carries on its business in India. Once a PE is constituted, the foreign company becomes liable to tax in India.

Rajiv Anand, associate director, Pricewaterhouse Coopers, says if the captive BPO of a foreign firm does constitute its PE, the profits of the foreign enterprise, to the extent attributable to such PE, could then be taxed in India.  

“The concern is that the tax authorities often impute a PE status to foreign BPOs in disregard to internationally accepted principles of interpretation governing the constitution and taxation of a PE. Typically, in view of the double taxation avoidance treaties that India has entered into with various countries, the captive BPO may be treated as the PE of the foreign enterprise only if the BPO is involved in concluding contracts on behalf of the foreign company. Where, however, this is not so, it is unlikely that the captive BPO unit in India can expose the foreign company to PE taxation in India,” he said.

Tax authorities are of the view that since BPO activities comprise a substantial part of the overall business of the foreign enterprise that it is servicing, the BPO should be
treated as an extension of the foreign enterprise, thereby constituting a PE of the foreign enterprise in India. Anand says such an interpretation is not in accordance with the rules governing a PE.

“Usually, Indian BPOs operate as a separate distinct legal entity incorporated in India, having their own management and infrastructure. In view of this, it is very difficult to make an argument that such BPOs qualify as a mere extension of the foreign company and hence become taxable in India. These BPOs operate independently, and the mere fact that they may be wholly-owned by the foreign enterprise would not itself give rise to a presumption that they are a mere extension of the foreign company in India,” Anand said.

Supreme Court advocate Pavan Duggal, who specialises in outsourcing laws, says business would suffer.

Duggal said the government is wrong in its approach on foreign BPO taxation and is trying to extend jurisdiction to entities that are located outside the territorial boundaries of India. “Academically, it looks like an attractive concept but is utterly impractical and ineffective in the real world,” he adds.

Though the business would not go away, new investments may be seriously affected in the case of companies that are operating in multiple locations, says Karnik.
With more attractive destinations springing up all over the globe, the incentive for foreign entities to have back- office operations in India would be less and they could look for greener pastures, says PwC’s Anand. “If a foreign company is not setting up an entity in the home country, then definitely it will find Malaysia, China and Philippines more conducive to investment,” adds Karnik.

Duggal already claims to know of three such firms who recently changed their plans to set up BPOs in India and instead went to Bangladesh, Laos and Malaysia.

The Morgan Stanley case

Morgan Stanley & Co Inc had filed an application with the Authority for Advance Rulings (AAR) seeking a confirmation that its captive BPO in India, called Morgan Stanley Advantage Services(MSAS), did not constitute a permanent establishment (PE) and the arm’s length pricing paid to the unit discharged it from any taxation in India. On the PE issue, AAR held that though MSAS did not constitute either a fixed place of business of Morgan Stanley  Inc or an agency PE, the deputation of employees for more than a particular period did constitute a PE. On the arm’s length pricing to the captive unit, AAR said that it was sufficient for attribution of profits to PE.

The tax department filed a special leave petition (SLP) in the Supreme Court on July 31, challenging some of the conclusions of AAR. Several issues have been raised in the SLP which can have a far-reaching impact on captive BPO taxation.

The tax issue

When in January, 2004, the Central Board of Direct Taxes (CBDT) issued a circular stating that if an Indian service provider carried out a “core revenue generating business activity” for a foreign company, it would constitute an agency permanent establishment (PE) of the foreign firm, the industry was in up in arms.

After a string of representations, the CBDT withdrew the January circular and issued a new one on September 28, 2004, which provided that if the Indian service provider was dependent on the foreign firm and concluded contracts for the services offered, it would be considered to be a dependent agency PE of the foreign entitity. The circular also suggested that the only tax the Indian government would seek would be on the arm’s length pricing paid to the Indian entity.