Tax succour, pain for captive BPO firms

Tax succour, pain for captive BPO firms
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First Published: Tue, Jul 10 2007. 04 15 PM IST
Updated: Tue, Jul 10 2007. 04 15 PM IST
New Delhi: In a decision with far-reaching consequences for back-office work done in India by foreign-owned captive units of global companies, the Supreme Court has ruled that US investment bank Morgan Stanley would not have to pay tax in India on global income earned from transactions with its captive back-office unit in the country, Morgan Stanley Advantage Services, if these deals were done at market prices.
However, the court’s ruling in the income-tax department’s case against Morgan Stanley said the local back-office unit of the bank would have to pay tax on profits generated locally and further gave the tax department the right to determine the extent of this profit.
The ruling means that the profits of the Indian BPO unit of a foreign company will be taxed at the normal corporate tax rate of 33.66% or at the minimum alternate tax rate of 11.33% of profits, whichever is higher.
The Supreme Court partly upheld the ruling of the Authority for Advance Rulings, a quasi-judicial body whose rulings are binding on taxpayers and the government, pending judicial appeal, which had ruled against the income-tax department’s plea that Morgan Stanley Advantage Services should be considered a “permanent establishment” and also the global income of its parent earned from its transactions with its Indian subsidiary should be taxed.
The court judgement is likely to be seen as a precedent for guidance in imposing tax in all such cases in the future.
Income-tax rules define a permanent establishment as a foreign-owned entity carrying out any business for at least six months in India. Such an entity can be a joint venture or a 100% unit of a foreign company registered under Indian company law and will not include branch or liaison offices.
If the Morgan Stanley unit had been termed a permanent establishment by the apex court, it would have been taxed at a higher rate of 41.82%, as are other foreign companies operating in India. Domestic companies pay 33.66% tax. But almost all call centres and BPO firms operating in India are exempt from corporate taxes, except for a minimum alternate tax of 11.33% introduced from 1 April, as part of the government’s incentives to the booming sector.
These incentives are due to expire in March 2009.
Industry and tax experts had estimated a Rs1,200 crore tax liability on foreign-owned back office firms if the Supreme Court had ruled in favour of the income-tax department.
According to Everest Research Group, a Dallas, US-based tech industry tracker, about 30% of the over $30 billion or Rs1.2 trillion worth of work outsourced to India is rendered by foreign-owned “captive firms”. About 110 of such firms operate in India; 27 of these are units of global banking and financial services firms.
On Monday, the Supreme Court bench of Arijit Pasayat and S.H. Kapadia vested with the taxman powers to determine the extent of profits the local unit is making which is to be taxed.
Executives in the back office industry said they feared this would leave significant discretionary powers with the income-tax department. “This is worrisome since it leaves a lot to interpretation and can lead to a lot of trouble,” a senior official at a trade body said, asking not be identified since he had not read the court judgement.
Tax consulting firm Ernst & Young, which had been engaged by the tax department in the Morgan Stanley case, for instance, had computed the mark-up on costs or profit margins of Morgan Stanley’s back office to be about 29%.
But this number could vary from one BPO unit to another and despite the Supreme Court ruling, there could be more disputes on the subject in future, said tax experts.
“My view is that the Supreme Court ruling will mean the tax officer will have the right to determine arm’s length nature of transactions (which in turn will determine the extent of tax liability),” said Sudhir Kapadia, partner at tax consultancy KPMG International.
The apex court also said that if Morgan Stanley sends its employees on deputation to India for more than 90 days, then the Indian unit will be considered a “service PE” (permanent establishment) and the profits deemed to have been generated by these individuals for the parent will be taxed at the rate for permanent establishments.
Experts interpreted this as more paper work for the captive units. “A lot of companies who have deputed personnel working in their enterprise will be exposed to service PE and have to prove that their related party transactions are at arms’ length,” said Amitabh Singh, a partner at Ernst & Young.
In the case of Morgan Stanley, the Authority for Advance Rulings had last year ruled that the company was indeed a permanent establishment but then said it still couldn’t be taxed as such because its local employees were paid market wages.
Commenting on Monday’s ruling, a spokesperson for Morgan Stanley said, “The firm welcomes the decision which it believes brings significant certainty on the taxation of outsourcing units”.
(Reuters contributed to this story.)
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First Published: Tue, Jul 10 2007. 04 15 PM IST